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.