Saturday, 29 December 2012

Poseidon Concepts - Value or Value Trap?

The average company trades for about 15 times earnings.  What if I told you about a company that was trading not for 10 times earnings, not for 7 times earnings, but for 4 times earnings?  Oh, and that's 4 times quarterly earnings - just over 1 times dividends.  Sound too good to be true?  It's kind of true - but, alas, it's also sort of too good to be true.  The dividend in question was recently suspended, and the quarterly earnings, unfortunately were not from the most recent quarter, or, perhaps, for any quarter in the foreseeable future.  Let me explain.
The company in question is Poseidon Concepts.  Spun out of Open Range Energy last year, Poseidon experienced astronomical growth by offering oil and gas companies a simple, but very efficient, alternative to storing water used for drilling.  Employing a device not unlike an above ground pool, Poseidon’s novel concept was not only cheaper, it was quicker and less environmentally risky than the standard methods then being used.  In an impossibly short period of time, Poseidon had a foothold in most major North American plays.
The high point came in this year's first and second quarters - the same quarters mentioned above - when earnings per share were $0.38 in each period, and funds from operations were $0.49 and $0.48, respectively.  Until only this past week, the company paid a dividend of $0.09 per month, or $1.08 per year, within reach of the current share price, which has fallen by a gut-wrenching 90%-plus from its high.  What a difference a quarter makes.  By the third quarter, Poseidon's net income had fallen to just $0.10, in part due to a $9 million charge for bad debts that the company is unlikely to collect on.
What happened?  It appears the company was hit on two fronts.  Not only has demand been weak industry-wide, increased competition pushed down margins, too.  Indeed, some firms in the industry have been forced to offer discounts of up to 75%, a sure sign of a commodity-type offering.  Though the company holds a patent on its main product - which is responsible for the bulk of its business - it doesn't appear that it will prevent competitors from offering similar items.  And there was never any doubt that the high margins and returns on capital that Poseidon has enjoyed would invite salivating rivals.  To be sure, the company is rightly trying to use their installed base of storage tanks as a foundation from which to sell added products and services, but it remains to be seen if they will be successful in a fast-changing market.
Clearly, there have also been some troubles specific to Poseidon, as well.  For one, it appears that the recent wild growth was faster than management could handle.  Indeed, at the end of the third quarter, receivables were $126 million, compared to revenue in the first nine months of the year of $148 million.  On such a large base of uncollected cash, further write-downs could be immense.  At the end of the third quarter, $36 million of Poseidon's receivables were past due, a worrisome figure, particularly after having written off $9 million altogether.  Though receivables in the oil and gas services industry are regarded as difficult to collect on, competitors have not suffered nearly to the extent that Poseidon has.  Painful as it must have been, however, the newly arranged board has made the right decision to suspend the dividend, which will give them much more liquidity, buying precious time to - hopefully - right the ship.  In addition, at the end of the third quarter, $44 million remained undrawn on the company's credit facility, which doesn't come due until June of 2014.
The changes at the top are unusual.  Scott Dawson, former CEO of Open Range Energy and current Chairman of Poseidon will step into the CEO role immediately.  Lyle Michaluk will move from the CEO role into the CFO role, which is unusual in such cases - after all, most ousted CEOs are not offered another senior executive position, nor would they ordinarily be interested in accepting one.  Similarly, Cliff Weibe will assume the role of Chief Technology Officer, having until recently served as the Chief Operating Officer.  Both men, as well as one other director, have resigned from the board.  On a positive note, if there was reason to suspect any major ethical breaches or wrongdoing, it's virtually impossible that any of the above officers would have been offered alternative positions.  Based on the facts available, it seems reasonable to conclude that the company simply grew too fast for the management team, and the company's processes and system of controls, to handle.  In the third quarter report, the company, to its credit, admitted to weaknesses in internal controls, specifically a lack of accounting expertise, and pledged to remedy to problem as soon as possible.
Is the stock a buy at today's dramatically reduced price?  It's impossible to know - which means, "No."  Wise investors only commit hard-earned capital if the odds of permanent impairment are low - for now, the picture is simply too fuzzy to rule out that possibility.  As Warren Buffett has often said, the first rule of investing is "Don't lose money," and the second rule is "Don't forget the first rule."  Many bottom-feeding investors may be tempted to scavenge on Poseidon's shares, knowing that if the story works out they could enjoy a radically high return.  But if they look down first they will likely find that they're not protected by a margin of safety, and ignoring the risk while dreaming about the upside is foolish.  If things turn for the better in the months to come, there will likely be an opportunity to buy shares at a higher, but still bargain price, with the confidence that any mortal danger the company may now be facing has passed.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Thursday, 27 December 2012

Valuing the New Leucadia National

It's difficult to value companies like Leucadia National, which has elements of a conglomerate, a hedge fund and a private equity firm all at the same time.  Wholly owned operating businesses in a range of industries, common stock positions, royalty streams - Leucadia has used a wide net when fishing for value opportunities.  In the past, shareholders tended to use book value as a rough proxy for intrinsic value, with the stock price moving roughly in tandem with shareholder's equity over long periods of time.  However, there have also been long stretches when the share price has traded significantly above and below book value.
The recently announced merger with Jefferies, combined with the 2011 purchase of National Beef, means that the operating business component of Leucadia's value has expanded markedly, and the approach to valuing the company must be revisited.  The appropriate way to value the company is probably to attach a multiple to operating earnings and add it to book value.  Upon the announcement of the merger, Leucadia estimated its combined business will have a book value of $9.3 billion, or $24.69 per share (including the dilutive effect of shares issued in the merger transaction).  Net to Leucadia, its four largest operating businesses - Jefferies, National Beef, Berkadia and Garcadia - currently produce roughly $480 million in combined after-tax earnings.  A 12x multiple would make this earnings stream worth around $5.8 billion or about $15 per share.  Leucadia, then, may be worth around $40 per share, significantly higher than it currently trades for.
Whatever the method Leucadia's managers themselves use to value their business, they must agree that the business is undervalued - after all, they recently initiated a share repurchase program.  Wise investors will consider allocating some of their own wealth alongside one of the finest collections of investing talent in the world.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Leucadia National and Jefferies to Merge - An Analysis

Several weeks ago, an admirable case study in the history of value investing came to an end - at least the long and satisfying first part did.  Leucadia National, long stewarded by the two-man team of Ian Cumming and Joseph Steinberg, merged with Jefferies, a leading mid-sized investment bank.  Technically, Leucadia swallowed Jefferies - at least the 71% that it hadn't already digested - but in some ways it feels like the reverse.  After all, not only will Jefferies become the anchor company in Leucadia's collection of businesses, Jefferies' chief executive Richard Handler will become CEO of Leucadia, as well as remaining at the helm of his own firm.  Ian Cumming will retire from his day-to-day role, while remaining a director, though Steinberg and the rest of Leucadia's senior management will remain on board.
Why the change?  Clearly, succession played a large part in the move.  Leucadia's aging masters weren't going to be around forever, after all.  In fact, Cumming had already signaled his intention to retire by declining to extend his contract past 2015.  Steinberg, however, will remain with Leucadia, both as Chairman and as an active executive, and has (to this writer's knowledge) not made public when he plans to move on.  Evidently, the opportunity to hand over the CEO role to a young and able manager with many years ahead of him was one that Cumming and Steinberg couldn't pass up.  Leucadia shareholders can take comfort in the fact that they've worked with Handler and his team for many years.  Indeed, they've enjoyed a personal relationship for more than 20 years, and an active business relationship for more than a decade.  Handler, for his part, regards Cumming and Steinberg as valued mentors.  Given that Leucadia's wholly owned operating businesses are run at the company level, and most of the company's senior managers will remain, Handler should be able to manage his newly expanded role.
How will the two businesses fit together?  Many mergers are sold on the basis of "synergies" that often fail to materialize, but Handler actively downplayed this motivation.  However, there are several areas where this merger could make 1+1 equal more than 2.  First, the deal flow that Jefferies is involved in will unearth opportunities for Leucadia that would otherwise not be available.  In fact, this has already happened in the past - Leucadia's investment in Fortescue, for example - thanks to the longstanding relationship between the respective companies and management teams.  Second, Leucadia has a large net operating loss, an asset that it can't quickly capitalize on without more operating earnings.  The new company, however, is expected to fully utilize the NOL over the next several years, which will turn it from a theoretical balance sheet item into cold, hard cash.  Finally, being part of a large and strong company such as Leucadia may allow Jefferies to escape the vicissitudes of the market, such as the one it suffered from in 2011, where the company looked to be in mortal danger for a short period of time, despite being fundamentally sound.  For a smaller investment bank, the mere perception that it's suffering financial distress, however false, can quickly create that very reality.  This will be less likely to happen as a part of Leucadia, though not impossible. 
While Leucadia will look very different in the future than it has in the past, the company has always been evolving, never staying the same for very long.  (Surprisingly, Handler stated only that he hoped that Jefferies will remain a part of Leucadia for the long-term, whereas many shareholders might have assumed that the two companies would be permanently married; this is a notable difference from Berkshire Hathaway, to which Leucadia has often been compared, which makes a promise of forever when it acquires a business).  What has remained constant, though, is a superb management team with the knowledge and temperament to take advantage of opportunities to create value for shareholders, in whatever form they arise.  Only time will tell if Handler is up to the challenge, but the ongoing presence of most of Leucadia's top brass is likely to mean a continuity of values, philosophy and process, even if the Leucadia's next chapter has a few unexpected plot twists in the future.
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Glacier Media - 2012 Q3 Update

After accounting for one-time items, and the seasonality of the assets acquired last year from Postmedia, Glacier Media posted solid results in the third quarter.  The company's focus on local newspapers, as well as business and trade publications that consumers are willing to pay for, means that it's largely able to escape the pressures suffered by larger papers that compete infinite alternatives, many of them free of charge.  Still, the soft national advertising market in Canada has some effect on Glacier Media, as it has all year.
Glacier has a glowing opportunity to create value for shareholders over the next few years, even in the absence of any new acquisitions.  With $131 million, or $1.47 per share in net debt ($27 million of it's non-recourse), management can add significant value simply by paying it down.  In addition, the company intends to repurchase shares, and increase the dividend over time.  In fact, management offered a fairly strong hint that a dividend increase is forthcoming, noting that the topic will be addressed in early 2013. 
At today's payout level of $0.06 per year, Glacier Media's stock offers investors a dividend yield of about 3.5%, significantly higher than the market's average yield, which has long stood at about 2%.  If the dividend were increased even to $0.08 per annum, the yield would jump to 4.5% at the current share price.  Given the general wariness about newspapers and similar content, it's possible that Glacier Media will behave more like a trust than a stock, with significant income, but less than dramatic share price performance.  No matter: for a company that throws off $0.40 or so in free cash flow, there's ample room to increase the dividend; shareholders that reinvest the dividend will do well over time.  And eventually stellar performance will surely mean some upward movement in the stock price, too.
My original analysis of Glacier Media is here.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Sunday, 16 December 2012

Berkshire Hathaway's Amended Stock Buyback

Suddenly, Berkshire Hathaway recently announced an increase in the ceiling price for its share repurchase program, from a maximum of 110% of book value to 120%.  Though sudden, the move is not a shock: Warren Buffett has said in the past that he could live with a somewhat higher figure than the original 110%.  The announcement included the disclosure that the company had repurchased about $1.2 billion worth of stock from the estate of a long-time shareholder, as well.
There's reason to suspect that Buffett values Berkshire by attaching a multiple to normalized earnings, and adding that figure to book value.  In his 2010 Letter to Shareholders, Buffett estimated that "normal" earnings power was about $12 billion after-tax, assuming no extraordinary insurance losses or other outlying charges; that number is probably closer to $14 billion now. Assuming a 12x multiple, Berkshire's earnings are worth $168 billion, or about $102 000 per share, and its book value currently stands at around $115 000/share, giving the company an "intrinsic value" of around $217 000 per share.  Thus, at the present stock price, the company is selling for about 61 cents on the dollar.
Given Berkshire's sheer size, its universe of potential investments is a rather small one, and at minimum this move opens another avenue in Buffett's hunt for places invest - specifically, by doubling down on Berkshire's current collection of assets.  In the past, Buffett seemed to regard share repurchases as a mild form of admitting defeat, but given the present gulf between price and value, he's clearly more enthusiastic. The first buyback announcement had the effect of putting a floor under Berkshire's stock price, a floor that was mostly above the 110% threshold, meaning the company was able to repurchase only very few shares. The latest announcement appears to have had a similar effect, and it remains to be seen if the company will be able to act in a major way or not.  If it can, Buffett has created a low-risk, easy way to create meaningful value for shareholders.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Saturday, 24 November 2012

Dell - Value or Value Trap?

Dell is cheap - very cheap.  The computer giant's market cap is around $17 billion.  However, with cash and investments of $14.2 billion, minus $9 billion in debt, Dell's net cash position is about $5.2 billion, giving the company an enterprise value of under $12 billion.  In 2011, free cash flows (net income + depreciation and amortization - capital expenditures) were $3.75 billion, up from $3.2 billion the year before.  Results, to be sure, have softened significantly in 2012.  For the first 9 months of the year, free cash flows have amounted to $2.3 billion, down from $2.9 billion in the comparable year-ago period.  Still, if Dell were able to generate $2.7 billion in FCF for the full year, the company's enterprise value/FCF ratio would stand at a paltry 4.5x multiple.
How can a cash-rich, highly profitable industry leader sell at such a dirt-cheap price?  Dell's stock has swooned largely due to fears that the personal computer is about to go the way of the floppy disk.  Are these fears warranted?  Probably not.  Certainly, the rise of smart phones and tablets have bit a chunk out of Dell's business, and the days of the PC being a fast-growth market are likely over.  However, most consumers - at least in the developed world - still have a PC, in addition to a smartphone and/or tablet.  Moreover, businesses remain more comfortable equipping staff members with personal computers, at least for now. 

In fiscal 2012, it must be admitted, PC makers have seen their sales fall substantially.  However, two short-term factors have converged to cause most of that decrease.  First, retailers have been drawing down inventories, so not all computer purchases by consumers have resulted in a sale for PC manufacturer.  Second, the long-awaited arrival of the latest version of Windows has led to a predictable delay among would-be buyers.  The next couple years, then, should see a return to modest growth, or at least a flat lining business. 
As a low-cost producer in a commodity-type business - except in the case of Apple's products, consumers regard one computer as about the same as all the others, so price matters - Dell has a long-held competitive advantage, and one that's likely to endure.  Moreover, Dell has expanded its software and services businesses to counteract slowing growth in its main operation.  Indeed, this fiscal year alone, the company has spent nearly $5 billion on acquisitions.  Corporate shopping sprees rarely work out well, though.  At minimum, it makes Dell's stream of future earnings more difficult to predict, since it may not have the same competitive advantage outside its core PC business. 
However, let's imagine that Dell's earnings hold steady over the next 5 years at $3 billion in FCF per year.  Let's assume further that the company commands a 12x multiple at the end of five years.  In that scenario, the company would be worth $15 billion in future earnings over five years + $36 billion in market value + $5.2 billion in present cash = $56.2 billion.  Divided by the current share count of around 1.74 billion, an investment in Dell would be worth roughly $32, more than a triple its current price.  Moreover, given ample room to repurchase shares at today's cheap prices, management has an opportunity to create even more shareholder value.  To illustrate, imagine that they used all $5.2 billion in net cash to buy back shares at current prices.  In this hypothetical scenario - and, alas, management has slowed repurchases recently, even as the share price has plummeted - the value of an investment in Dell would jump from $32 to around $42 ($15 billion + 36 billion = $51 billion/1.22 billion shares = $42).

These are significant ifs, of course.  The PC may indeed die off at a faster rate than this writer predicts, which could make Dell not a value, but a value trap.  For example, Kodak traded at 5x earnings all the way down to zero.  But if investors' fear of rapid change turns out to be overblown, Dell may present an opportunity, albeit more of the yield than of the growth variety.

Here is a later article on the debate between Mason Hawkins of Southeastern Asset Management, and Michael Dell's group over the value of Dell.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Saturday, 17 November 2012

Home Capital Group - 2012 Third Quarter Update

As ever, Home Capital Group posted stellar results in the third quarter.  Earnings were up 18.3% (EPS increased slightly faster, at 18.7%), and return on equity was 25.6%.  Sharply increased earnings allowed the company to add to their dividend, which now stands at $0.26 per quarter, for a 2% yield.  Dividends, the CEO pledged, will amount to about 15% of earnings over time, meaning that they'll increase at roughly the same rate as earnings.
At Home Capital Group, strong earnings never come at the cost of higher risk or a weaker balance sheet.  Credit quality remains rock-solid: net non-performing loans were just 0.28% of overall loans, and provisions for credit losses stood at 0.10%.  On the balance sheet, the tier 1 capital ratio was nearly 17%, while total capital ratio was nearly 21%.

The company addressed the much discussed topic of Toronto's condo market.  HCG's exposure to the condo market in general is about 7% of their residential mortgage portfolio.  However, half of those are insured (no credit exposure), and about 60% of the other half are townhouses, which are very popular.  Townhouses have a position in the market that is much closer to single family dwellings, rather than high rise condos, which represent 1-1.5% of their residential mortgage portfolio.  In short, whatever the problems that may come from Toronto's overheated condo market, HCG is unlikely to be affected much.  In general, management reiterated its long-held position that the Canadian real estate market is not likely to implode, though they conceded that prices could correct by 5-10%.

The company sees opportunities for significant growth far into the future, in part because the big banks are pulling back in certain areas, which will increase the pool of potential lenders that HCG caters to.  At current prices, the stock trades at perhaps 8 times 2012 earnings, with those earnings primed to growth rapidly in the years to come, offering long-term investors a tremendous opportunity. 

My original analysis of Home Capital Group is here.
Disclosure: At the time this article was posted, the author had a long position in HCG.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Monday, 12 November 2012

Home Capital Group - Investment Analysis

There is currently a low-risk, high-growth company, with a glorious track record and bright long-term future.  Here's the punch line: it's a sub-prime mortgage lender.  But this is not a joke.  The improbable-sounding company is Home Capital Group, a Canadian mortgage lender that focuses on niches ignored by Canada's dominant handful of big banks.  Most of Home Capital Group's customers are small business owners, immigrants, and the self-employed.
Qualifying business owners typically have significant assets and cash flow, but they may not have the required tax forms to prove their income.  That’s reason enough for the high-volume banks to decline their mortgage application.  HCG, however, is willing to take a careful, detailed look at the businesses in question, and the individuals operating them, and often find low risk opportunities to lend.

The second major group of customers is immigrants, who typically do not qualify for standard mortgages until they have lived in Canada for several years.  Immigrants are very low-risk customers: they simply don't leave family, friends and home to fail.  Invariably, they're willing to work sixty-hour weeks (or more) if necessary to make their mortgage payments.  Moreover, many of them were prime mortgage customers in their home country, and have an established track record for reliability.
50% of Home Capital Group's portfolio is composed of self-employed workers, who account for 16% of Canada's workforce.  Not only is this group growing quickly, it's well off.  On average, the self-employed are worth 2.7x more than their clock-punching counterparts.  Because of the "on again, off again" nature of such work, though, not all institutions are comfortable lending to this group, despite its appealing elements.  Once again, HCG is willing to spend the time trying to separate the reliable from the unpredictable, with enviable results.

Because the aspiring homeowners that the company caters to have few other options, Home Capital Group commands a sub-prime interest rate, but the quality of the mortgage holders is anything but sub-prime.  Just the opposite, in fact.  Measures of risk remain low - often lower even that the big banks - including the percentage of impaired loans, write-offs, and loans in arrears.  Though Home's customers may get a chance to own a home that they otherwise wouldn't, it's worth noting that the company is not engaged in charity work: it turns down most applicants.
If the returns are so great, though, won't the big banks move in?  It's unlikely.  The large institutions take a cookie-cutter approach to lending, and there's little sign that they are interested in, or able to, moving into Home Capital Group's niches.  In the unlikely event that the big banks were able to effectively compete and enjoy returns on capital as high as Home's, it would scarcely be noticed given their sheer size.  While Canada's sub-prime mortgage market is large enough to offer Home many more years of above-average growth, it's not large enough to be attractive the elephant-sized financial companies that already dominate the prime mortgage market.

Even if they wanted to, it's unlikely that they would do well.  Each has hundreds of branches, a physical footprint and army of staff that requires a high-volume business.  Whereas Home Capital Group spends a great deal of time and resources training staff, the banks tend to have a more automated system of approving or rejecting applications, which allows them to pay mortgage officers more modest salaries.  In addition, having been doing business in its niche for nearly thirty years, Home Capital Group has gained highly detailed knowledge about sub-prime lending, and proprietary systems, too.  It's not at all clear that the big would-be competitors could compete effectively.
In fact, while some have always predicted that the big banks would eventually move onto Home Capital Group's turf, the opposite has occurred recently.  The financial turbulence of the past few years has further strengthened the company’s competitive advantage, as many competitors have left the market.  They are now among about a dozen decent companies in their niche, half as many as in the recent past.  The company’s end market is large, offering an opportunity to grow rapidly for many years to come.  Often, excellent companies have more than one competitive advantage, and Home Capital Group can add its low cost structure and deposit taking licence to its niche dominance.


Though a superb business, Home Capital Group can't run on cruise control.  Like any financial company, it offers ample opportunity for failure by ignoring risk.  In addition, the complexity and flexibility of the financial accounting offers the chance for snake-oil salesmen to push their dark product.  Happily, Home Capital Group is under the wise and honest stewardship of Gerald Soloway.  Don't be fooled by his low-key, down-to-earth style: he's one of Canada's finest entrepreneurs and most accomplished chief executives.  In the late 1980s, he took control of a tiny company, and turned it into an exceptionally consistent and profitable business.
Whether small or large, every decision he makes is careful, conservative and sensible.  For example, when the Canadian government shortened the amortization period to 30 years, it left a window of several months before the changes came into force.  Many other institutions used the occasion to push a lot of long-dated product; HCG, on the other hand, stopped doing so immediately.

The management team is rational, conservative and candid.  In a business where a cautious approach to risk is imperative, the CEO rightly considers himself the chief risk officer, rather than delegating the responsibility to somebody else.  The results show: HCG has higher capital ratios than any of the large banks, and the proportion of delinquent accounts is as low or lower.
Management has been superb at allocating capital.  Most of the company's earnings have been retained, and have generated very high returns on capital.  In fact, return on equity has averaged around 28% for more than a decade.  Home Capital Group pays an average but steadily growing dividend, which is targeted at about 15% of earnings per share.  Currently yielding 2%, the payout will grow in line with earnings over time.  Finally, the company repurchases stock in small amounts, largely to offset stock options.  Unfortunately, a large-scale share repurchase is not in the cards, as Canada's regulators would frown on the company drawing precious capital for that purpose.


No business, no matter how dominant, is worth paying an infinite price for.  However, because of wariness about the financial sector in general, and specific concerns that Canada's real estate market is overvalued, HCG is selling at a cut-rate price.  Indeed, it currently trades hands at just 8x 2012 EPS, despite high returns on capital and a high growth rate.  The company has often traded at 15-20x earnings in the past, a level it will likely return to at some point.  Assuming a 15% growth rate for the next 5 years - far lower than it has been over the past 5 years - and a return to a multiple of 15x earnings, the stock would trade at $180-190 in 2017, not to mention dividends that will probably add up to $6-8.

With a solid and enduring "moat," a high return on capital, a truly superb management team, yet selling at a bargain price, Home Capital Group is a fantastic opportunity for investors.  The company, to be sure, is not without a few challenges.  The All-Star CEO is now in his 70s, and seems likely to step down sometime in the next few years.  While Soloway will ensure that whoever succeeds him is excellent, he's leaving impossibly big shoes to fill.  Next, it's likely that Canada's real estate market is overpriced, at least in certain markets.  While a correction of 10-15% is unlikely to affect Home Capital Group much, it could weigh on results somewhat.  Still, all things considered, investors who buy HCG today are likely to earn very good returns over a period of several years. 

There's ongoing commentary on Home Capital Group: A 2012 Third Quarter Update

Disclosure: At the time this article was published, the author had a long position in HCG.
Sources: A wide range of company filings available on Home Capital Group's website.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Tim Hortons - 2012 Third Quarter Update

Tim Hortons recently reported a rather soft third quarter, at least by its usual standards.  Sales were up 10.3% year-over-year, and adjusted operating income increased a modest 6.2%.  On a per share basis, the results were better, up by 11.8% (excluding a one-time charge) thanks to a lower share count as a result of the company's ongoing buyback program.  Same store sales growth eked out a 1.9% gain in Canada, and 2.3% in the US, over the prior year, far less than the usual 5% or more increments that shareholders have grown to expect.  Of note, the number of transactions actually fell, but were more than offset by increased prices and cheques.  Affirming the company's business model, however, corporate revenues grew significantly faster than system wide sales, which grew by only 5.9%.  Such a discrepancy cannot continue indefinitely, of course, but it highlights the fact the store operators absorb pressure more than - or at least before - shareholders do.  For example, when commodity prices increase, it tends to squeeze owners, while remaining about neutral for corporate.

Management explained the so-so performance by pointing to a sluggish Canadian economy, capacity constraints at Tim Hortons stores, and aggressive promotions by competitors.  The first problem will, hopefully, solve itself.  Too much demand is a high-class problem, and expanding capacity is a relatively straightforward and low-risk opportunity for the company: higher throughput drive-thrus, rearranged counters in stores, and adding stores near locations that are currently overflowing with business.  The last and most serious problem is increasingly intense competition, notably from McDonalds and Subway, particularly in coffee.  When one of your chief competitors is offering coffee free of charge, it can be difficult to match them; instead, Tim Hortons will respond by fighting on other turf, especially in food, especially the lunch menu.    

There is little reason for shareholders to panic.  Tim Hortons still outperformed most of its competition; its results were mediocre only compared to its own stellar past performance.  The company stood by its annual EPS guidance of $2.65-2.75 (excluding charges), and set out a clear and attainable path to increased sales and earnings.  Shares were hit after results were released, and if prices continue to fall, it could offer investors the chance to buy a stake in a very fine company for a reasonable price.
My original analysis of Tim Hortons is here.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

ARC Document Services - 2012 Third Quarter Update

ARC Document Services reported a predictably soft third quarter, given difficult end markets, and the secular shift away from traditional reprographics services.  Simply put, customers are printing less, and moving instead to cheaper and more efficient digital distribution.  In fact, in September, for the first time, large format black and white printing accounted for (just) less than half of ARC’s revenues.  In response to this shift, the company cut 10% of its staff, and more than 10% of its locations in October, in order to squeeze unnecessary costs out of a declining business.  The focus is now on devoting resources to the growing areas of managed print services, high-quality color printing and digital services.  ARC has landed several large contracts with multi-billion dollar firms, giving some visibility in future years.  In managed print services in particular, ARC has a solid competitive advantage, because it can support on-site printing with company branches located nearby - for example, to handle printing overflows.
Given the declining sales, margins have remained quite firm, and are almost certain to widen in the future, as end markets come back to life, and costs come down.  Operating cash flows, too, were a solid $14 million in the quarter, and at $31 million for the first 9 months, were up slightly year-over-year.  Capital expenditures, though they remain fairly low, have risen in recent quarters, as the company now purchases some equipment that it chose to lease in the past.  The company reiterated previous operating cash flow guidance, which is still expected to be $35-45 million.

My original analysis of ARC Document Services is here.

Disclosure: At the time this article was written, the author was long ARC stock.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Saturday, 10 November 2012

Tim Hortons - Investment Analysis

Tim Horton's is one of Canada's most admired companies, and is frequented by fiercely loyal customers.  Indeed, 40% of the restaurant icon's customers visit the company at least 4 times per week.  All of these rushed early morning, lazy afternoon, and last-minute evening visits add up: the company has a 41% market share in the Canadian quick service restaurant industry, a striking figure, given the hyper-competitive competitive landscape.  In the coffee space, the proportion is radically high: Tim Hortons accounts for nearly 80% of the coffee sold in similar stores. 
As enthusiastic as that group of fanatics is, however, there's one cohort that Tim Hortons has made even happier: its shareholders.  With operating margins approaching 20%, return on invested capital even higher, and same stores sales over the past decade increasing at over 5% per annum, the company's financial metrics are as mouthwatering as its famous coffee.  There can hardly be a better example for Peter Lynch's "buy-what-you-know" investing mantra.

Scale provides the company with one of its most important competitive advantages: advertising.  The strength of the company's annual advertising blitz, however, applies much more to the Canadian market than it does south of the border.  After all, a national television spot in Canada is ultimately spread across over 3000 locations, with very little waste, since almost all Canadians live close to a Tim Hortons location.  This does not apply in the US.  Not only are there only 700 locations, they are heavily concentrated in just a few states.  That means the company will have to rely mostly on local and regional marketing, where it’s more difficult to take advantage of its hefty resources.
A persistent - and valid - concern among investors is the company's capacity to grow outside the Canadian market.  Management believes that it can expand to 4000 locations north of the 49th, but that will only allow for a few more years of significant unit growth.  To maintain double digit sales increases, Tim Hortons will have to successfully expand in the US and elsewhere.  This is far from assured.  McDonalds thrives around the globe; Gap Inc. flourishes largely only in North America.  There's no reliable formula to predict which concepts will "translate" in another market and which will fail.  Historically, many American brands have succeeded in Canada, but the reverse has rarely been true. 

Offering investors hope are two facts: the company has a larger footprint in the US - around 700 stores - than it did in Canada after the first 20 years of operating in each respective market.  What's more, US same stores sales growth has been an impressive 5.8% per year over the past decade, marginally ahead of its Canadian performance.  Success, though, has only come in certain markets - in the Northeast and Midwest, mostly in New York, Ohio and Michigan - and it’s not clear how deeply the US can be penetrated.  Moreover, sales per US store runs at about half the rate of a Canadian location.  However, by focusing on creating a "critical mass" in successful American markets, the company strives to capitalize on economies of scale in areas such as advertising. 

The company's business model at least mitigates some of the uncertainty of expansion outside of Canada, generating low-risk, high returns to shareholders.  The bulk of its revenues are generated from distribution (sales to store owners), and rent and royalties charged to franchisees, who operate 99% of the company's locations.  Though over the long-term the corporate office can only thrive if operators flourish, a notable amount of risk is borne by the store owners.

Given the company's high market share, long history of above average same store sale growth, there may be a risk that "comps" will be less appetizing in the future.  However, a company posting "average" same store sales growth is one that growing exactly in line with nominal GDP (real GDP plus inflation).  By that measure, Tim Hortons' growth has only been modestly above average over the past decade.  And, given that the average cheque is just $3.00-3.75, there remains ample room to pull on that "lever" to increase sales.  In addition, the company is in the process of increasing the capacity of its drive-thrus at many locations; for many on-the-go consumers, a few extra seconds can make the difference between grabbing something on the way to work or not.

Management is especially important in hyper-competitive industries such as retailing and food service, and there are legitimate questions about the future CEO.  Currently, Paul House is serving as the interim Chief Executive, and until a permanent replacement is tapped, shareholders will be left wondering what comes next.  Despite what appears to be a deep bench of talent, the Board has decided to hire from the outside.  It is generally agreed that the food service industry is not overflowing with top-tier talent, though the quality and power of the Tim Hortons franchise may mean that the company is able to recruit one of the best.
In the all-important area of capital allocation, management has done a decent job.  From 2009 to Q2 2012, the company generated around $1.6 billion in operating cash flows.  Nearly $600 million was reinvested in the business, which, considering Tim Hortons' high return on invested capital, was money well spent.  Close to $350 million was returned to shareholders via dividend.  The dividend has increased at a clip of around 25% per year for the past 5 years, and currently yields just shy of 2%.  (The company has a long-term goal of distributing 30-35% of prior year normalized net income as a dividend).  Over $1 billion was spent repurchasing shares.  In general, it's debatable whether the company has created value with its buyback program in recent years.  The price paid, after all, has tended to be around 20 times earnings (at the time of purchase), which is not exactly bargain-bin shopping.

At today's price, the stock probably offers little margin of safety.  At around 17.5x 2012 earnings (EPS is expected to be around $2.70), shares are discounting fairly high growth for a number of years into the future.  If the company's growth were to slow significantly - which could happen, given that the US expansion has been spotty, having modest success in a few states, and none at all in others - there is a risk of a "one-two" punch: a combination of P/E multiple compression, plus only modest EPS growth.  While Tim Hortons remains a superb franchise, investors may be wise to hold out for a more attractive share price.   

There's ongoing commentary on Tim Hortons: a 2012 Third Quarter Update

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Wednesday, 31 October 2012

Potash Corp - An Acquisition of Israel Chemicals?

A number of outlets are reporting that Potash Corp is in discussions with the Israeli government about acquiring or merging with Israel Chemicals Corporation.  Potash Corp already owns 14% of the company, has long intended to gain control of ICL, and management has recently been hinting at M & A opportunities that they're exploring.  Still, the news took some by surprise.  After all, fertilizer is a strategically important asset, and after BHP Billiton's offer for Potash Corp in 2010 was rejected, many expected it to be a long time before any similar attempts were made.  That CEO Bill Doyle has met in person with Prime Minister Benjamin Netanyahu suggests that the matter is being seriously considered by the Israeli government, though.
Despite Potash Corp's sterling record of capital allocation in general, and common stock investing in particular, shareholders should be wary.  Reports suggest that Potash Corp is considering issuing stock to fund the acquisition.  Using stock as a form of currency can only be justified if that currency is fully valued, or overvalued.  Potash Corp stock, however, is currently very cheap.  It's possible of course that ICL's stock is trading at an even more discounted price, but that's unlikely to remain the case when a takeover premium is added.

Reports suggest that it will cost Potash Corp around $13 billion to gain control of the remaining stock, making ICL too big to acquire with cash.  If a company is too big to acquire, though, a deal should not be pursued.  At $40 per share, Potash Corp would have to issue an additional 325 million shares, diluting current shareholders by 38%.  Management has indicated that if they see no hope of eventually gaining control of the companies they hold minority interests in, they would exit their position(s). 
If Potash Corp were to sell their position in Israel Chemicals Corp at current prices, and used the proceeds to repurchase its own stock, it might reduce shares outstanding by around 4%, after accounting for taxes.  There is scant evidence that the market has ever rewarded Potash Corp for its stock investments, so it’s difficult to argue that POT's stock would suffer.  EPS, though, would increase by a noticeable, but not dramatic, amount.  And by reinvesting in their own assets, which they are intimately familiar with, Potash Corp would also be making a less risky move. 
It's difficult to draw any firm conclusions until the terms of a deal are made official, but there's reason to fear that Potash Corp is about to make an expensive mistake.  Government intervention saved Potash Corp shareholders from a low bid a couple years back; many investors will now be hoping that government intervention prevents their firm from paying too much.

My original write-up on Potash Corp is here.
Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Sunday, 28 October 2012

Potash Corp - 2012 Third Quarter Update

Among the reasons that many investors prefer potash to other minerals and commodities is that it tends to be less volatile - in terms of both prices and volumes.  In many cases, that's true.  The potash industry, however, remains a lumpy business.  The soft results of the third quarter - EPS was $0.74, down from $0.94 in the year-ago quarter - are a result of demand lumpiness from both China and India.  Prices have remained quite firm, though, at $429 per tonne, in line with the second quarter, though down about 5% from a year ago.
In China, demand for seaborne potash has been weak in recent months, as the country meets in near-term needs by drawing down domestic inventories, as well as increasing purchases of more locally sourced production.  The Chinese are very shrewd negotiators, and some of their recent behavior is motivated by the desire to purchase fertilizer at lower prices.  Ultimately, however, Chinese demand for potash increases every year, and short-term tactics to gain negotiating leverage do not change the long-term supply-and-demand equation, which favors suppliers.  Potash Corp management - along with the other members of Canpotex - has elected to counter reduced demand with reduced supply, and pledged to continue doing so into next year, despite the ever-growing gulf between the company’s capacity and its actual production.

India poses a different and trickier problem.  Indian fertilizer buyers depend on heavy government subsidies.  The subsidy regime, though, has been reorganized in the past year, and now favors outlays on nitrogen-based products, at the cost of potash.  But Indian crops face a widening fertilizer imbalance, where the proportion of potash as a percentage of overall fertilizer inputs is far below the scientifically recommended number.  In consequence, India's yields are far below those enjoyed elsewhere in the world.  Over time, this problem will be corrected, but given the political element to it, how and when any remedial action plays out is unclear.
Happily for shareholders, potash demand is robust in virtually all areas outside of China and India, particularly in North America and Brazil.  Given that the two countries have a combined 2.5 billion mouths to feed, and relatively high food inflation, it’s only a matter of time before agreements are signed and potash shipments resume.

As Potash Corp moves closer to completing its large, long-running capex program, the company will begin to generate substantial amounts of free cash flow, especially compared to today's stock price.  Management recently approved a significant increase of the dividend, to $0.21 per quarter, a 2.1% dividend yield at the current share price.  Though significant, a dividend payout at that level leaves ample room for further dividend increases, share repurchases and acquisitions (management reaffirmed their long-term intention to take control of one or more of the companies that Potash Corp owns common stock positions in).
My original write-up on Potash Corp is here.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.