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.

Management

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.

Price

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.

Conclusion

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 - 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

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.

Conclusion

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.

Glacier Media - Investment Analysis

Glacier Media Inc. is an information communications company that provides primary and essential information and related services through print, electronic and online media. Specifically, Glacier operates in three core business segments: local newspapers, trade information, and the business and professional information sectors.

Local Newspapers

Glacier's newspapers provide content to small, underserved local markets, where there are few, if any, competitors.  While the Medicine Hat News may not be known for its editorial gravitas, and may not treat readers to Pulitzer Prize-winning reporting, it is a primary source of information in its market, and, like many similar papers, has been a source of community-focused news for decades.  People will always be interested in what's happening in their local community, and advertisers will always be interested in reaching them, so the demand for these papers will exist for the long-term. 

This will likely allow small and some medium-sized community newspapers to avoid the dark fate of large metropolitan newspapers, which cover a broad range of regional, national and global issues, and compete with innumerable sources, most of which make their contently freely available online.  Glacier's free-of-charge local newspapers generate sales from advertising, not subscriptions, and the company doesn't depend on declining paid classified advertising.  Since most of Glacier's properties are situated in energy-rich Western Canada, the company is likely to enjoy a strong macroeconomic tailwind in the future.  In addition, the geographical concentration offers opportunities to sell regional and national-scale advertising, as well as other revenue and cost synergies.

Trade Information, Business and Professional Information

Financial publications occupy a rare niche, many of which have been able to prosper even while charging for content, and this commercial exemption doesn’t just apply to the big-name indispensables, such as the Wall Street Journal, the Financial Times of London and the Economist.  Glacier, for example, offers paid trade and business publications - notably The Western Producer, a go-to source for agribusiness coverage in Western Canada - largely in the areas of agriculture, energy and mining.  In many cases, these publications provide information that's necessary to managers, businesspeople and investors if they're to make informed decisions.  As long as these high-quality sources make money for their readers, they'll be able to charge money for their product. 

Return on Equity

Glacier's adjusted return on tangible equity has averaged over 100% for many years in the past, far exceeding the 10-12% that most businesses earn.

Management

Investors in Glacier Media have little opportunity to get a first-hand feel for the senior managers: they don't hold forth on quarterly conference calls, they don't address analysts on the road-show circuit - indeed, they don't make any media appearances, at all.  The primary direct communication with shareholders comes in the President's Message section that leads off all quarterly and annual reports.  However, as with many who have an "actions-speak-louder-than-words" philosophy, Glacier's managers have forged a fabulous record in lieu of lofty verbal pronouncements. 

They have a superb record of capital allocation.  For the most part, the excess cash flow that Glacier has generated has been used to make acquisitions.  The acquisitions have been successful, as they have been made at attractive prices with a high return on capital.  When they have not made acquisitions, the company has paid down debt, repurchased stock (though, importantly, only when the stock has been undervalued) and it pays a healthy dividend.

They've also shown an admirable streak of independent thinking.  For example, despite the omni-presence of the internet, and the many obvious advantages it offers to news consumers, many continue to enjoy reading dead-tree newspapers, and advertisers continue to find the medium useful, too.  In addition, the physical presence of such publications serves as a marketing vehicle to maintain brand awareness and to drive online activity.

There's a noteworthy reason management consistently acts in the interests of shareholders: because they're owners too.  Indeed, Chairman Sam Grippo, CEO Jonathon Kennedy and one other Director together own 34% of Glacier's outstanding stock.

Price

Glacier's maintenance capital expenditures are in the neighborhood of $5 million, so in 2011 free cash flow amounted to $0.44 per share.  The company's large acquisition of several Postmedia properties closed late in the year, so very little profit from the new purchase made it into 2011's final tally.  It would not be outlandish, then, to assume FCF of around $0.55 in 2012.  Net debt as of the first quarter of 2012 was $1.40 per share, giving the company an enterprise value of $3.50-3.70 or so at the stock's recent market price.  Conservatively projecting that Glacier generates $0.55 of FCF in 2012, $0.60 in 2013 and $0.65 in 2014, and assuming that the company does nothing but pay down debt, where would that leave shareholders at the end of that timeframe? 

In this scenario, debt would be paid down entirely, with a total of $0.40 to spare.  Assuming a 12x multiple on $0.65, the shares would trade for nearly $8.00.  Importantly, with no debt on the balance sheet, all FCF would be available to return to shareholders.  FCF of $0.65 on today's share price would be the equivalent of having a bond with a coupon of over 30%.  Not bad for a steady, low-risk investment.  (In practice, of course, the future will unfold at least somewhat differently: the company will almost certainly close more acquisitions over the next few years, for instance).

Conclusion

Warren Buffett, who once considered newspapers among the finest possible investments, later lamented that competition from cable and satellite channels, and especially from the internet, had made the long-term economics of the industry "terrible."  Recently, however, he's reentered certain corners of the newspaper market, though only on a small scale.  In areas where there's a strong and enduring sense of community - for example, in his own hometown of Omaha, where he recently bought the World-Herald - newspapers have a good chance to remain profitable for the long-term.  Few people can make the same boast as Glacier's management: they beat the Oracle of Omaha to this insight.

It may become more difficult for Glacier to grow by (cheap) acquisition in the future, now that there's a broader understanding that not all newspapers face a bleak financial future.  However, Glacier's existing assets, management team and stock price offer a low-risk, high-reward opportunity for investors.

Sources: 2011 Annual Report, 2012 Q1 Report

There's ongoing commentary on Glacier Media: A 2012 Q2 update; a 2012 Q3 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.

Potash Corporation of Saskatchewan - Investment Analysis

Potash Corp is one of the world's leading producers of fertilizer.  Sales of potash account for 64% of gross margins, with the remainder split between phosphate and nitrogen-based fertilizers (since the company's future rests largely on its potash operations, this analysis will focus there).  Five of the company's six potash mines are located in Saskatchewan, the sixth in New Brunswick.  Potash Corp directly supplies the North American market, and sells into the offshore market via Canpotex, a marketing arm operated jointly with Mosaic and Agrium.

Demand

Every year, the world's population grows by around 75 million people, relentlessly increasing food demand.  Indeed, now over 7 billion, global population is expected to reach 9 billion by 2050.  Equally important, as poor people in the developing world grow richer – from, say, $1000 US/year in annual income to $2000 – a large proportion of incremental income is used to purchase more nutritious food, namely protein-filled meat.  However, between two and seven pounds of feed (depending on the animal) are required to produce one pound of meat, putting major pressure on the world's crops.

However, little arable land remains available for development.  To produce more yields per acre, therefore, increased fertilizer use is inescapable.  In fact, despite genetic modifications to crops, more efficient irrigation, and other productivity enhancing measures, fertilizer is responsible for about half the world's crop yield.  For most of the past decade, humanity has consumed more food than has been produced, with the difference being drawn from stockpiles.  This will ensure high prices for most crops for years to come, giving farmers an incentive to invest more in fertilizer.  Since the 1960s, potash demand has grown on average by 3% per year, an upward trend likely to continue indefinitely.

Supply

However voracious the demand for a product, if new supply is very easy to produce, prices - and profits - will remain low.  Happily, Potash Corp occupies a supply-side "sweet spot": it owns many years worth of reserves, allowing for not just steady but growing production; however, there isn't an over-abundance of supply in the industry overall, which would hold down prices.

Company Reserves

One major challenge that most mining companies face is the "hole-in-the-ground" conundrum: each ounce, pound or tonne sold puts them one unit closer to being out of business.  Potash Corp, however, has 100 years of reserves just at existing shafts, and several centuries' worth of additional supply available, so even investors named Methuselah needn't worry about exhausting reserves.

Barriers to Entry

Building a new potash mine – or expanding an existing one – is a very difficult technical challenge, and even if all hurdles can be cleared, the economics are imposing: a two million tonne/year greenfield (new) potash mine in Saskatchewan costs between $4.0-5.5 billion (including infrastructure), and takes at least seven years to produce at full capacity.  Few investors are interested in an investment of such size when the payback period is so far in the future.  After all, a lot can happen over a seven year period (or longer), including rising costs, falling fertilizer prices, royalty changes, credit crunches, and many other unwelcome developments. 

According to Potash Corp, a netback of at least $600 is required to justify such an endeavor, even assuming a very affordable expansion and settling for a very average 10% internal rate of return.  More expensive investments, and a more ambitious 15% return would demand a netback at or above $1000 per tonne.  Currently, netbacks are under $500 per tonne.  These formidable barriers to entry serve to insulate existing producers from new competition, however. 

Eventually, high prices will ensure new greenfield supply, which will push down prices, and make the industry less attractive.  However, new supply can't sneak up and surprise the industry, and it's virtually assured that potash sales will provide investors with attractive returns for many years.  In fact, past projections of future supply have turned out to be much higher than what was actually achieved.

Two added factors make Potash Corp's supply situation yet more attractive:

OPEC-like Economics

Potash Corp is one of three North American producers that sell into the offshore market via Canpotex, which operates a shared infrastructure, reducing costs.  But the marketing body's most important function is to restrict supply when demand is soft, thus propping up prices, similar to how OPEC operates in the global oil markets.  A similar arrangement between several large Russian and Belarusian producers operates in Europe, and the two marketers combined supply over 60% of the world's potash.

Low Cost Producer

Potash Corp is among the world's lowest cost producers.  In a commodity industry, the surest, and often only, way to gain a competitive advantage is to be the low-cost provider.  Just as drivers don't care whether they fill their tanks with Shell's gas or Exxon's, farmers aren't loyal to one supplier's potash over another's; the only thing that will attract a farmer's hard-earned dollars is a more affordable price.  Though Potash Corp is willing to accept reduced volumes in return for higher prices, if it was unable to do so, it could remain profitable even at lower prices.  In fact, it has done exactly that: due to the recession, the company operated at a mere 30% of capacity in 2009, but nonetheless logged the third best results in its history to that point, in part due to its low-cost economics.

Management

Potash Corp has a first-rate management team.  CEO Bill Doyle is competent, honest, an independent thinker, and a patient, long-term planner.  There’s a solid bench of talent behind him, which isn't always the case among senior management in the mining industry.  The company manages its operations reliably and safely, and maintains good relations with its largely unionized workforce.  In addition, it has an unusually transparent board, and superb relations with investors.  One could argue, however, that the board has lavished the CEO with compensation beyond what's necessary to motivate and retain him, though the stock has performed exceptionally well during his reign.

Shareholders will only enjoy excellent returns if earnings are reinvested wisely.  Over the past decade, Potash Corp's management has done an excellent job allocating capital.  The company has reinvested much of its income internally – it'll amount to nearly $8 billion by the time expansions are complete – at high returns on capital: from 2004-11, ROE ranged from 13%-76%, and averaged 29%.  $6.3 billion has been spent repurchasing shares during that period, shrinking the share base by more than 20%.  Most importantly, buybacks have been pursued only when shares were cheap or reasonably priced.  $2 billion was spent over the same time frame on equity investments, which have ranged in price from between $8-10 billion in recent years.  Finally, the company pays a modest, but quickly growing, dividend.  Shareholders can rest assured that management will use earnings to add value in the future.

Valuation

Given the company's cost structure and the complex formula that determines its mining taxes, it's difficult to project Potash Corp's future earnings.  Helpfully, the company has published broad guidelines for its earnings potential over the next few years.  The most aggressive scenario they contemplate is actually quite realistic, and would see the company earning around $6.0 billion by 2015 or 2016.  However, free cash flow would be approaching $6.4 billion, as the company's ongoing capex will have fallen significantly below its depreciation and amortization expense.  Assuming a multiple of 15 times FCF, Potash Corp's market cap would be $96 billion.  Assuming earnings of $23.7 between 2012 and 2016, D & A of $4.2, and capex of $5.5 billion, cumulative FCF through 2016 would amount to $22.4 billion.  Assuming the company's common stock investments appreciate by 50%, to around $12 billion, and subtracting current net debt of around $4.3 billion, the total return for shareholders could plausibly amount to about $126 billion, or $148 per share.  Even if shareholders assumed a more cautious total return of $125, from the current $40 or so price, the return would be well over 25% per year through 2016.

Risks

Any mining project carries with it significant technical risks.  However, Potash Corp operates six mines, and a problem at any specific mine - water inflow, challenges with expansions etc. - won't affect production elsewhere.  The company has decades of experience, and formidable resources, so any problems that arise are likely to be dealt with effectively.

The company's most serious risk is the threat of substantial new supply pushing down prices.  Though the barriers to entry into the potash market are high, they're not infinite, and at some point high potash prices will prompt new supply.  There have been long stretches in the past when profitability in the industry has been ruined by excess supply, and it could happen again in the future. 

While there are over 50 potential potash projects worldwide, only a handful of those stand much chance of being developed.   The most talked-about potential new entrant into the potash industry is BHP Billiton, which may develop its large Jansen project.  However, the company has yet to decide when – or even whether – to go ahead with its project, and recent reports suggest the company may postpone a decision for up to two years.  Overall, it seems unlikely that there will be any new greenfield supply in the industry for a decade or so.

Conclusion 

Potash Corp is a superb company.  It has a valuable economic and strategic resource.  For all the uncertainty that investors face - economic, political, technological - peoples' appetites won't disappear any time soon.  Increasing demand for food, combined with an enviable supply-side equation for the company, means Potash Corp stands to reap huge and growing profits, and high returns on capital, for at least a decade to come.  An experienced, high-quality management team will navigate the company through any challenges, and will continue to create shareholder value.

Sources:

2011 AR, 2012 Q1, a Globe and Mail article on BHP Billiton, and several recent company presentations and transcripts:

http://www.potashcorp.com/media/POT_2012_BMO_Conference.pdf

http://www.potashcorp.com/media/POT_2012_BMO_Transcript.pdf

http://www.potashcorp.com/media/Doyle_Presentation.pdf

http://www.potashcorp.com/media/Brownlee_Presentation.pdf

http://www.potashcorp.com/media/Delaney_Presentation.pdf

http://www.potashcorp.com/media/Moore_Presentation.pdf

http://www.potashcorp.com/media/POT_2012_Analyst_Meeting_Transcript.pdf

There's ongoing commentary on Potash Corp: an update on the first greenfield mine in the potash industry for over four decades; a 2012 second quarter update; 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.

IBM - Investment Analysis

Warren Buffett sat out the Dot Com Bubble of the late 1990s, just as he had refused to partake in a similar mania in the 1960s, because fast-changing technology companies are inherently difficult to predict, prices were sky-high and, besides, he's a self-described "luddite."  The value of a business lies mostly in the earnings that it will generate over time, and a wildly unpredictable future makes it too difficult to reliably value a business.  Long time Buffett followers were surprised, then, when the technophobic investor announced a $10.9 billion stake in IBM.  For as long as anybody can remember, paradoxically, the company has been leading the world into the mysterious future.  What was the Oracle of Omaha thinking?

Though the company is indeed one of the world's most innovative, its business model, Buffett explained, is slow-moving and "sticky."  That is, the company's "switching costs" are high.  When the IT manager of an institution contracts IBM, the business's hardware, software, systems and staff become intimately entwined with Big Blue.  The costs of untangling - in time, money and risk - are high.  It's neither quick nor easy to move to a competitor's system: staff may need retraining, hardware may need to be replaced, and data could be corrupted, lost or stolen.  It's a hassle.  Besides, competitors have the same will and ability to hold on tightly to clients.  For IBM, however, it creates a solid, predictable revenue stream, and an installed base to add new products and services onto.

IBM not only retains existing customers, the firm pursues new business very aggressively.  Deep Blue checkmated grandmaster Gary Kasparov, Watson outwitted even Jeopardy's foremost contestants - and each dramatic "machine-over-man" encounter gave IBM the opportunity to demonstrate both its technical prowess and its canny salesmanship.  When there's new business to be awarded, IBM will get its share.

The historical financials show not a capricious, shape-shifting hi-tech business, but a steadily growing earnings machine.

Year	2011	2010	2009	2008	2007	2006	2005	2004	2003
Earnings	16.3	14.8	13.4	12.3	10.4	9.5	8.0	7.5	6.6
EPS	13.06	11.52	10.01	8.89	7.15	6.05	4.91	4.39	3.76
ROE	79%	67%	80%	49%	43%	29%	25%	24%	25%

From 2003-2011 earnings grew at a compound annual rate of 12% per year, EPS was even higher, at nearly 17%, due to share repurchases, and return on equity improved from high to radically high (the average North American business returns 10%-12% on equity).

There's reason to expect the foreseeable future to be nearly as attractive as the recent past.  Buffett approvingly cited the company's ambitious 5-year "road maps," which it consistently delivers on.  Between 2010 and 2015, IBM has pledged to return $70 billion to shareholders via dividends and buybacks make $20 billion of acquisitions and reach at least $20 per share in earnings.  Given that less than a quarter of revenues currently come from the fast-growth BRIC markets, and the company's move away from low-margin hardware sales to high-margin software and services offerings, it's all but guaranteed that the company keeps its promises. 

Assuming a 17.5x multiple times 2015 earnings of $20 per share, plus another $15-17 in remaining dividend payments, an investor that buys the stock at its current sub-$200 price stands to gain around 20% per year over in IBM over the next three and a half years.  Not only is there virtually no business risk, there is very little financial risk given the company's steady results, its low-capital business model, and its sound financial position.  Since the company is a large-scale, long-term buyer of its own shares, there’s at least a soft floor under its share price, though the lower it goes, the happier patient investors will be, since their per share economic interest in the company will increase.  On the whole, the company has significant upside and very little downside.

Sources: 2011, 2010, 2005 annual reports, available at the company's website.
Disclosure: The author had no position in IBM at the time this article was published.

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 - Investment Analysis

Business Description

ARC Document Services' (ARC) primary business is providing document management services, document distribution and logistics, and print services to the architectural, engineering and construction industries. The company provides "blueprints," the drawings that are the universal "language" used in all aspects of the construction process, used by developers, architects, contractors, sub-contractors, suppliers etc. (up to 200 different types of trades are involved from start to finish on a large construction project, and many use these drawings).

Documents change constantly as a project progresses, and the changes must be tracked accurately, quickly and confidentially. The documents are generally larger than 11" by 17" and require specialized printing and finishing, and a deep understanding of construction work flows. Indeed, thousands of documents may be printed over the course of a single large project, a major feat of logistics and organization. ARC also houses company-owned equipment in customers' offices as part of their Facilities Management services, and in some cases customers outsource their entire printing and document management operation to ARC. In addition, ARC offers document management and printing services outside the construction industry, including to the retail, aerospace, entertainment, and health-care industries, mostly in the areas of advertising and promotion.

Competitive Position

ARC spent the last decade consolidating the industry and has established a dominant market position in a fragmented industry. Indeed, ARC has over 200 locations, eight times as many as their nearest rival. Most of ARC's stores are in the U.S., where they operate over 200 cities in 43 states. In addition, they have a presence in Canada, U.K., India and China.

Most competitors are privately owned, "mom-and-pop" shops that operate one or two locations, and generate less than $7 million in revenue per store. The prolonged economic slump, which has hit the commercial construction market particularly hard, has decimated many weaker players. Whereas in the past ARC trumped the competition by buying it, in recent years it has gained share as rivals have folded. The company may pay several thousand dollars to buy a customer list from a defunct competitor, rather than committing hundreds of thousands, or millions, of dollars to buy the entire business. Besides small, strategic "tuck-in" purchases, the company doesn't expect to make significant acquisitions in the future.

Scale gives them several competitive advantages: 1) A large geographical footprint that enables ARC to take on regional, national and global contracts that smaller competitors cannot; 2) As the industry moves to offer more digital services, ARC can spread research and development spending across many locations, but most competitors cannot (ARC has spent over $100 million in the past decade on technology innovation); 3) Economies of scale make ARC one of the lowest cost producers in the industry; 4) A large installed base of the company's equipment in customer offices ensures repeat business - "stickiness" - and studies show that such customers tend to use more services than they otherwise would.

Financials

The company enjoys high margins and a variable cost business model (55% of costs are variable), allowing it to produce significant free cash flows, even in a weak economy. In addition, maintenance capital expenditure requirements are modest, averaging about 1.6% of sales, or $7-10 million per year. Though ARC will invest a small amount of added capital to grow, overall capital expenditures should not exceed $15 million annually. The company believes it can double sales from the existing footprint - by adding a second and third shift - and doesn't expect to pursue a significant acquisition program in the future. This means that happy shareholders are likely to benefit from dividends and share buybacks in the future, though not until the company has further paid down debt.

                      2011 2010 2009 2008 2007 2006 2005 2004

Sales             423   442    502  701    688    592   494   444

EBITDA*       67     75      107   173    177    148   110   91

EBITDA Margin* 15.8% 16.9% 21.2% 24.7% 25.7% 25.0% 22.2% 20.5%

FCF** 34 45 90 118 93 91 60 55

*adjusted for unusual items

**defined here as operating cash flows, less capex

Management

CEO "Suri" Suriyakumar has been with the company since 1989. He was President and COO from 1991 until 2001, when he became the CEO. The leadership team is experienced, having navigated through several business cycles and a range of economic, financial and political challenges. In addition, management owns 19% of the company, and are paid only modestly on an annual basis, aligning their incentives with shareholders'. The CEO is honest, energetic and capable. He has assessed the current tough market soberly, resized the business accordingly and has never pretended that a robust recovery was upon us. It must be admitted, though, that the company amassed too much leverage in the pursuit of acquisitions in the past.

Valuation

The company can realistically hope to generate as much free cash flow at the top of the next cycle as it did at the top of the last one. After all, the US economy will likely have expanded by 15-20% overall, the company has taken significant market share from competitors, and it has expanded into adjacent, high-margin markets. Furthermore, at the top of the last cycle, the company had a very substantial debt load, with large related interest payments (around $25 million per year). However, within the next few years the company will likely pay down most or all of its debt, so interest payments will be negligible in a few years.

Assuming FCF peaks at around $120 million, and a multiple of 12x, the company's market value would stand at $1320/45 million shares = $32. Moreover, once debt is paid down, the company's FCF will be available for tuck-in acquisitions, dividends and buybacks, adding further value for shareholders. From today's $5-6 share price, the investment is a screaming, table-pounding buy.

Conclusion

ARC's markets typically lag behind the general economy by 12-18 months. Since this recovery is slower than most, it is possible that the company won't see a return to significant growth until 2013 or 2014. In the meantime, however, ARC is gaining market share, as smaller competitors close or are acquired, paying down debt, and investing in improvements to technologies. Having rationalized their store base in the past few years, the company has a much leaner cost structure, and will realize significant FCF as it returns to growth.

Risks

ARC has a significant amount of debt and high interest payments.

The company has grown mostly by acquisition in the past (140 locations since 1997). If further tuck-in opportunities do not arise, they may have trouble growing beyond past results.

Over 30% of sales are in a single state (California).

About 70% of sales are to commercial construction customers, which has been a weak market and may not pick up for some time.

Sources:

Financial filings and presentations that can be found on the company's website: http://www.e-arc.com/

There's ongoing commentary on ARC: Here is an update on the first quarter of 2012

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