Bassett Stock Price Movements - Mattresses or Fundamentals?

Bassett Furniture has seen significant movement in the stock price of late.  Moreover, as I have mentioned in previous posts, here and here the trend of the stock price has been pretty much one way - up almost every day (though not yesterday).  There are three good reasons for the stock price to rise, though none explain the consistency of the increase. 

One possibility that only recently crossed my radar screen is the stock performance of mattress manufacturers such as Sealy, (which sells mattresses under the Bassett name and through Bassett furniture outlets), Terpurpedic and several others.  All of them have seen strong gains in the last several weeks, in part because of speculation that strapped homeowners and recently rehired employees are choosing to make small purchases to improve their lives and that one of htese is a better mattress.  For myself, I can say that I believe a mattress is an investment in better sleep, which in turn leads to more energy and less stress - in short, a better life.  In this way, a mattress is a special piece of furniture, unlike most of the other functional stuff in the home.  A mattress helps to protect your health, and it is not worth sleeping on a bad one.

So perhaps Bassett is participating in general market moves in the mattress sector (though it hardly seems possible that Bassett's performance would be strongly influenced by only the mattress segment, I doubt it is big enough to influence overall earnings that significantly).

The real reason I believe Bassett stock has been rising is that the fundamentals of the business are coming to look much better, and this is converting the furniture business portion of the stock valuation to a positive figure and allowing the balance sheet items to receive full valuation (2 years ago it appeared that management might burn all of the investments that were not directly deployed in the business in a possibly futile attempt to keep the business afloat, rather than shut it down).

Keeping it short - I believe the true reasons for the improvement are the following:

• Strong balance sheet has been strengthened by the sale of IHFC
• Converted an accounting liability into an asset (cash)
• Provides added liquidity to restructure and invest and be opportunistic in a weak market
• Provides means to ride out an extended period of housing weakness
• Shareholder friendly management 
• Paid several special dividends
• Restored quarterly dividends
• Repurchasing shares at low valuation enhances intrinsic value per share
• Restructuring of the business seems to have positioned the business for profit at reduced volume
• Finally able to close or take over underperforming licensee stores and improve ops (company stores open more than 1yr are earning a profit as a group)
• Able to invest in capturing additional share in local markets
• Growth into new markets
• Adding locations for the first time in some time
• Positioning business for growth / upswing (assumes no recession)
• Able to invest in operations at a time when real estate and labor are relatively inexpensive, good opportunities to sign leases at low rates and lock in low rents
• Recovery in housing 
• There are some signs that housing is making a turn, or at least, that the pace of decline is slowing
• Many households have been aggressively reducing debt, positioning them to make larger purchases in the next few years and to trade up from IKEA.

So, I maintain that Bassett is well positioned to ride out the next few years and to invest in key markets that will be the drivers of growth in the years ahead, and to do so while locking in lower fixed costs, providing terrific operating leverage whenever a pickup in consumer durable spending materializes.

That was fast - Unusual activity in BSET

An reported story - on Friday, Bassett Furniture, BSET, (Disclosure, I am long BSET), saw a massive rise of 5.5% on volume of 200,000 shares, 10x the normal amount.  There was no news nor any press release from BSET.

As I posted earlier this week, the chart of Bassett stock indicates that someone is on an acquisition spree for a stock that is undervalued compared to the sum of its parts.

As I have said, the company is really two halves - one is an investment company with a strong balance sheet (though relatively few investments at the moment).  The balance sheet already reflecats over $20mn of impairments, much of which could be reversed, particularly if business improves.

The other half is an operating company that manufactures, designs, distributes and retails furniture.  The open question has been, can the business make a go of it, in the face of sharp declines in consumer spending.  This past quarter, we received the first indication that, so long as business does not deteriorate further (on the top line), yes, Bassett can be a modestly profitable venture.  The natural operating leverage in the business (which has increased with the acquisition of several retail outlets from former licensees) means that with a modest uptick in volume, profitability should recover nicely (leading to reversals of the valuation adjustments on upto $19mn in deferred tax assets).

Looking at massive liquidity, and the opportunity to use BSET to shelter income tax for some profitable venture (if not from the Bassett furniture business itself) the company looks like a good acquisition target for a private equity firm.

Up to now, whoever has been acquiring shares has been doing so quietly, trying not to increase the price dramatically.  However, with the very large volume on Friday, I expect an announcement over the weekend or latest sometime next week that someone will have to announce something.

What do you all think?

BSET Posts Encouraging Results

Bassett Furniture, BSET, is an interesting play on a recovery in consumer spending and housing.

Last week, the company released its 1st Quarter Earnings statement and there was much to like, but with some caveats that suggest the questions around the business have not been fully answered.

The company is primarily engaged in designing, manufacturing, distributing and retailing custom furniture with a more "grown-up" and traditional style than say, IKEA, which engages in the same set of activities.

The stock, is actually a hybrid of two components: one is an incredible balance sheet that historically has included investments in other firms, real estate and hedge funds.  Indeed, much of the company's profits in recent years have been the profits of these investments.  The other part is the operating business, which has struggled.

At the moment, the company is valued at $100mn or so.  This essentially values the company at its working capital.  The net working capital as of 28 Feburary was $90mn, but in a subsequent event, the US government announced that BSET was entitled to $9mn in anti-dumping offsets.  This sum is the result of actions taken years ago by the Federal Government, but the monies have been only dispersed slowly. If we add this as a receivable, we have about $99mn in working capital, almost exactly the price of the stock.

(The US for a time had an anti-dumping law that saw the US government impose penalty tariffs on firms that were "dumping" products on the market and then use the monies collected not to fund the government, but to provide subsidies to the "harmed" firms.  This strikes me as a double down on protection, since the tariffs should already raise competitors prices, to then pay an additonal subsidy seems silly, perhaps this is why the law was amended).

Much of the working capital, it should be added, is in cash, raised by liquidating several of the company's investments, including hedge funds and it's large share in the IHFC in North Carolina (this asset was actually carried as a liability on the books, because dividends received exceeded the entity's income, so it had a shareholder deficit), It was able to sell this "liability" for $80mn.  Accounting is so much fun, sometimes.

This effectively values teh company's long term assets, most of which are property, plant and equipment, as well as some rental real estate and a large deferred tax asset, at zero.  This seems silly, since it is likely that even in a weak real estate market, much of the real estate the company owns could be sold at a price higher than its carrying value.  After all, land that the company owns in Bassett, VA has been on the books for decades, still shown at the lower of cost or market.  Most of the company's retail store fronts owned are rented (admittedly to itself or to licensees), but rented commercial property usually gets good prices and cap rates are still low.

Better yet, the company has taken massive valuation allowances against many of its assets, including a $19mn valuation allowance against its deferred tax assets.  At present, the company cannot predict that it willl earn enough to reverse this allowance, but if earnings improve, it could be sitting on a $19mn gain (or at least a portion thereof) because it can use these assets to reduce taxes in the future.  The company has noted that the $9mn in antidumping subsidies would allow the company to reverse over $3mn in DTA.

It also has valuation allowances against its remaining interest in one hedge fund, which will likely have at least a partial reversal, and $4mn in allowances against notes receivable (mostly from struggling licensees).  If business were to improve, and licensees were better able to meet their obligations, these allowances could also be reversed.

All in all, if we were purely evaluating the balance sheet, we could value the company at $13-$15 per share.  But what of the struggling furniture business?  For a great balance sheet supporting a crappy business is worth less than it seems.

Well, much of the new-found liquidity raised by selling long-term investments, has been used to restructure its operations, especially retail, and the efforts are finally producing some results.

The company's wholesale operations, which design, source, manufacture and distribute furnishings to both Bassett's branded retail network (much of it company owned) and to 3rd party retailers has traditionally made a profit.  In 2011, huge write downs caused wholesale to lose money, but evidence is that the wholesale segment finally has its cost structure aligned with volumes, as the company still made a good operating profit with lower volume.  Given operating leverage in the business, and improved gross margins, any lift should see nice profit growth at the wholesale level.

The retail level has struggled and has traditionally lost money.  This is still true, however there are many encouraging signs that the company has finally turned a corner.  Stores open and manageed by the company for a longer period, actually earned a small operating profit as gross margins improved and SGA were held to reasonable levels.  Other stores still spend.

If the furniture busienss can earn $0.30 per share per quarter (approx $3.3mn) which can definately be achieved by the wholesale segment, requiring simply a break even at retail, the business can be valued at $6 a share ON TOP of the balance sheet, from which many cash distributions can be made (more on this below).  If retail can also make a contribution, so much the better. 

Growth would help at both levels.

Here the results are more mixed, as actual sales in the quarter declined.  But this was tempered by a 10% increase in orders taken.  It is not clear yet whether this was just order shifting (from Q1 to Q2), perhaps because of slower delivery times, or whether this indicates a greater willingness of Americans to purchase bigger ticket items.  Only time will tell, so I remain a patient holder of the stock.

The final bit to notice is that the company has been using its cash to pay dividends and to repurchase stock.  The company repurchased nearly 1% of shares oustanding in the first quarter, and there is continued evidence of slow but steady accumulation.  Take a look at this chart, the 1 month price movement, courtesy of Yahoo! Finance.

I have never seen a stock with such a steady set of rises.  The stock increases almost every day, but only in small increments, as though someone is trying to prevent large buying from raising the price too much. 

I am certain that there is active accumulation of the stock.  Slow but steady accumulation which is driving the price higher, but enabling the shares to be purchased at the lowest possible price.  It could be the company's purchases, or it could be an investor or a fund, but I believe there is enough to drive the stock higher from here.

Buffett's Biographer Accuses him of Hypocracy

Alice Schroeder, who wrote the "authorised" biography of Buffett, The Snowball, is now arguing that Buffett has been making major mistakes in the past few years, including an increasing focus on partisan politics and policy, engaging in investment practices he condemns in others and - gasp - mediocre investment returns.

Just before we explore her argument - a word about Schroeder, as I have read her biography of Buffett.
Schroeder's biography is a must read for any Buffett follower.  If you have not read it, buy it NOW.  You will quickly realize why what only Buffett does what he does.  Quite simply - if you are an Outside Passive Minority Investor (OPMI) you are not following Buffett's investment style.  This doesn't mean you shouldn't use Graham/Dodd principles or look for great growth companies like Philip Fisher.  It just means, don't be fooled by mutual funds and newsletters selling their "Buffett-like" investing advice.

The most amazing story in the book to me was hearing about how Buffett would pour over the Value Line Investment Survey and the Moody's stock profiles.  In the days long before the internet, these were essential tools for doing stock screens.  You had to request the SEC filings of companies, unless you owned their stock, so there was more than a bit of effort required.  Buffett, not wanting to miss any good opportunities, noted that he reviewed and valued EVERY SINGLE company in the books.  He notes that there were many on which he didn't spend much time, but here was a guy putting a value on each of 2000 companies about every 3 months.  So dedicated was he to this practice that he piled the books into the back of his car when he went on his honeymoon.  Most of us just look at a few companies we know of or have heard of.  Some more of us look at various screens and the like, Buffett set out to value every listed US company.

Back to Schroeder's argument - I rather agree with some of her points.  Buffett has become a celebrity businessman, and most celebrities like having the floor.  Since politics is simply the biggest stage their is, it may be that he is drawn to it like a moth to a flame. Schroeder is right, he is entitled to his opinions and to enter the public space to share them.  But she is also right to argue that Buffett's true legacy is Berkshire and that the company operates in lots of heavily regulated industries, including insurance, banking, transport and energy and that it all seems rather well, not right, that Buffett should be so tightly wound up with the people who should be setting policy for his firms.  It is worse when Buffett argues that policies from which he has benefitted should be denied others.  This is a ladder pull by someone high up the economic slope.  Should future investors really be denied the same opportunities to build wealth that he has enjoyed?

Likewise, she notes that the same person who decried derivatives as "financial weapons of mass destruction" himself runs a book of derivatives with billions in nominal value.  True, Buffett sold the options, so he hopes (and expects) the options to expire worthless - enabling Berkshire to keep the money - but in acknowledging that like nuclear energy or chemical engineering, or kitchen knives, derivatives have potential to be employed usefully and productively as well as destructively - Buffett has done an about face on the topic.  Yes, his current position is more correct - the danger lies mostly with the user, since the thing itself is morally neutral - but it is his earlier position that is used to argue for overhauls of the global financial industry.  And if he thinks that the main problem is the banks can't handle derivatives (and prop trading) then why is he buying them and saying how smart they are?

Her biggest criticism is that Buffett is earning poor returns.  Since 2000 this has largely been true - even measured by Buffett's yardstick, growth in Book Value per share vs. the S&P.  There are a few reasons for this - one is that the sums of capital Buffett needs to deploy are now so large that paradoxically, his investment universe is shrinking.  He needs investments that enable him to deploy billions in capital on a single deal, and there are only a few hundred firms where this is possible.  Most of these firms do not have significant amounts of undervaluation, since they are solid businesses and so it is more difficult to make outsized returns on these investments, (though I believe that large and mega cap stocks have actually represented the best values in the market over the past 5 years).  In general, I believe his purchases of large cap stocks have been sound, they are all strong companies trading a reasonable prices (although their growth may be suspect).

Buffett's other problem is legacy.  He has acquired a stable of good businesses, but since "trees do not grow to the sky" many of these businesses are reaching maturity, and in some cases may even be in decline (the Washington Post comes to mind.  For the first time, the company did not make the list of significant equity investments).  Buffett is not at liberty to sell them, however, because he made a deal with the owners of those businesses that Buffett would be a permanent home for them.  This means the full range of strategic options for businesses in such a situation, which normally would include mergers, are not available to his companies.  Berkshire's investors got the gains up front, now they have to pay the piper.  This is not to say they got a bad deal, only that slower growth is in Berkshire's future.  If decline is managed well, as it was with the original textile businesses, it can even produce value for shareholders.  But is the board prepared to manage these firms into what may be terminal decline in some cases?  Hard to say.

It seems reasonable that the share price is undervalued.  Berkshire has incredible earning power, but future returns on equity are likely to be satisfactory, not extraordinary, and so the company will trade nearer to book value than in the past.  Whether that is Buffett's fault, in the sense of making poor current decisions, brought on, as she believes by declining acumen, or whether it is really just the burden of historical investments now earning normal returns, remains to be seen.

I think the jury is still out on this, even if Schroeder is right to question Buffett's judgment.

Buybacks vs. Dividends - McKinsey weighs in

This week the McKinsey Global Institute published a study indicating that most stock buyback programs are value destroyers, in that they tend to buy high and not low.  Their specific example is a technology company that repurchased increasing amounts of shares during the stock market boom into 2008, but then stopped buying shares, even as they plunged during 2008 and 2009.

 

This seems a fitting academic underline of my point about why dividends are better than buybacks: management rarely buys shares at a significant discount to intrinsic value, whereas investors who receive dividends and reinvest them benefit from dollar cost averaging and can also choose to make opportunistic purchases (without an automatic reinvestment plan).

Management faces thre, e hurdles that almost guarantee that it will make poorly timed purchases of its own stock:

·         Management rarely has lots of spare cash when the stock is cheap.  Buybacks require significant free cash flows.  When a company is generating significant free cash flow, however, the market often places a premium on the price of the stock.  The corollary to this is that when markets are weak (and buybacks represent the best value) management usually has better priorities for its funds, including: preserving cash to ensure adequate liquidity in the face of difficult credit conditions, opportunistic acquisitions – everyone else’s stock is cheap, too, after all, and reinvesting in operations when goods, materials and labor are readily available.

·         Timing of buybacks often coincides with option exercises, which are more likely to occur when the price is high.  If the company makes corresponding open market purchases to offset dilution, the company is allowing sellers to pick the timing of the transaction, which is rarely going to work in the buyer’s favor.  Stock buybacks at nearly all firms are partially aimed at eliminating the dilutive effects on EPS that stem from new (or treasury) shares being issued as part of employee compensation.  Naturally, those employees want to exercise their options at a high price, and since multi-year fixed value options offer the holder significant discretion in when to exercise, options are more likely to be converted at cycle highs.

This is one of the most important misalignments of shareholders and management – the classic agency problem options were supposed to fix. When the same management that is selling high for its own account on the one hand is also directing the company’s cash to buy at the same time must be committing the company (and the other shareholders) to buying high.

·         Large scale buying by one investor tends to drive prices higher.  The kind of buyback activity that drives EPS and sometimes share prices higher requires significant acquisition of shares – at least a few percentage points of shares outstanding.  Such significant buying is best done by those who do not have to report their purchases, and who do not move markets.  Companies that pile up their repurchases (say in the run up to the end of the quarter) can become major market participants buying large quantities of shares in bulk and bidding up prices.  Even if management tries to buy opportunistically when share prices are weak, their own buying may eliminate the weakness.  This is good for shareholders in general – ideally share prices would always trade near intrinsic value so that all shareholders would get paid full value when they sold – but it inhibits management’s ability to create value for loyal shareholders.

Given these limitations, I generally agree with McKinsey that managements that want to repurchase stock should do so using a method calculated to minimize the disruption of the markets.   Moreover being sellers themselves they have a fiduciary responsibility not try to steer the purchases of those to whom they are selling – this is sitting on both sides of the table.

Instead, management that wants to repurchase say 25 million shares in the course of a year should simply buy 100000 shares per day on each of the 250 days or so the market is open and trading normally.  If these can be purchased in blocks near market price, fine, if they have to be purchased in lots, also fine.  If this means that the shareholders are not big enough buyers on days when management is exercising lots of options (which expire on the same day) so much the better.  This may lower the spread on the option – so what?

Finally, this raises a question about whether options should be used for compensation at all.  This is another topic, for another post.  Suffice it to say, I am not a fan of incentive programs that turns management into sellers of shares.

Bank shares rally on JPM

This week, we find out about how banks have fared on the stress tests to which they are being subjected by the US treasury.  In an interview a few days ago, Brian Moynihan, CEO of Bank of America indicated that the banks would be shown to be fine, even under extreme conditions (including unemployment of 20% with the related cases of default).



Today JP Morgan demonstrated that they are in the strongest position of all of the US banks by announcing a dividend hike and a massive buyback, equivalent to almost 10% of their market capitalization.  With a payout ratio of 25%, JPM appears to have lots of room to increase the amount of its dividends go forward.

I believe that BAC is in a similar position, even though operational changes have allowed Chase to take over leadership in branches, I firmly believe that BAC is a stronger franchise.  (I cannot believe that I am saying this given that J. Pierpont Morgan is a personal hero).

By 2013 BAC will also be paying a dividend and buying back some of the nearly 11bn shares outstanding.  The stock, which had a nice rally today, will trade at $16-20.  Even with the rally since December, the stock is well positioned to post nice gains over the next 12-24 months.  This is why I am very long the stock, it is by far my largest position.

Some investing wisdom

I haven't had much time to write lately, so I figured I would share some investing wisdom I have come across recently.


Matt Schifrin over at Forbes has written a great synopsis of the investing habits of some extraordianrily successful individual investors.

Jason Trennart raises and interesting argument that successful investing may require less of the technical tools taught in busineses schools and more of the social sciences contextual approach to problems, with the ability to synthesize data of various (and often qualitative) sorts.  Personally,  I believe this is true.  As an historian (undergrad) with an MBA, I can say that while financial skills are important (value is a financial concept), evaluating the risks around the estimate of value often require imprecise contextual thinking.  This is most true in evaluating the managers who hold investors assets in their hands.

Aelph suggests that buy and hold investing is neither dead nor a bad idea.  Admittedly, returns on equity do fall for most businesses over time as it gets harder to redeploy cash generated by the business in initiatives with the ROI of previous investments, but this is an argument for dividends, not an argument against buy and hold.

And a two-for-one: Aelph also has eight rules of investing.  I generally agree with them, though I think he puts too much emphasis on relative valuation, which is a strategy for long-only mutual funds and investment "professionals" who cannot afford to appear to be too passive (especially if the market is rising).  Personally, I believe a real advantage of the individual investor is the luxury of looking at absolute valuation, and mitigating risk by NOT INVESTING when there aren't attractive risk/return opportunities (e.g. US equities in 1999 and 2000).

Finally, I have to give Aelph huge credit for the diligence with which he posts.  I aspire to have that much to contribute.

More evidence of risks investing in China

On the back of lowered Chinese Communist Party targets for economic expansion, the Economist is noticing a series of trends cropping up in China - higher wages, more difficulty adding workforce and above all the need to innovate in order to continue expansion - trends the Strategic Investor suggested as far back as 2007, would begin to manifest themselves in 2012.

How could we be so accurate - simple, we just looked at the simple math of economic expansion (which, despite claims of "miraculous" activity everywhere from West Germany to Korea, is actually quite straightforward).

GDP is simply the product of hours worked and outper per hour.  China faces challenges in both places.  For the past 30 years, China has been able to lift both by increasing workforce participation (by limiting births and time off, keeping women in work) and by employing that labor at higher output factory jobs (albeit labor-intensive ones).  But after decades of low birth rates, the Chinese workforce has finally peaked, which means that unless the Chinese can find a way to keep more older workers in the workforce (tough when many jobs are physically demanding), hours worked is likely to fall.  Of course, if the remaining workers were to work more hours, hours worked could be maintained, but hours worked is not terribly elastic, and if history is any guide, rising incomes will lead to FEWER hours worked, not more, as workers use higher incomes to consume more leisure.

What of higher productivity?  Increasing output per hour is a certainty in China, as the capital stock increases, there will be gains in worker productivity.  These gains will likely be slower, however, because China will have to have better managers to organise the labor around knowledge work, and because success in more cutting edge technologies involves innovation, not duplication.  Here, Communist regimes have a dismal record, which is more or leses echoed by the Economist.  China has few, if any, global brands that are truly home grown.  Lenovo, after all, became famous by purchasing the PC assets of IBM.

China still has many advantages, as do the US, Canada, the UK and Germany.  But as China "catches up" with them and attempts to invade space they now occupy, it will struggle with the limitations of its economic model.  I expect a hard landing in China before the decade is out - possibly as early as 2015.

CL boosts dividend

You heard it here first: CL.  After reviewing CL's 10-K, I predicted that the dividend would rise to $0.62 per quarter from $0.58.  My logic was that this number gets closest to a 50% payout ratio (based on 2011 EPS), without going over.  This is usually the level CL tries to maintain, providing an effective payout ratio in the mid- to upper-40% range (as forward earnings are usually higher than trailing earnings, restructurings notwithstanding).

As I expect earnings around $5.30-$5.40 in 2012, I will predict now that dividends in 2013 will be raised to $0.67 per quarter, for a full year payout of $2.68, with a possibility to skew a bit higher in the event that mangement is able to expand margins (and EPS) faster than I expect.  If management is able to keep repurchasing 20mn shares (gross), then EPS will likely be higher than my anticipated range, since outstanding shares will fall by 3%.

Overall, this represents a dividend growth rate of 7-9% per year plus the 2.5% yield you are collecting.  A very nice and safe 9.5% return in a low return evironment.

Does Crime Pay? Forbes thinks so

One of the best financial magazines ever, Forbes, has always approached the topic of investing and managing money with a low-tax slant and a healthy dose of humor (wealth and happiness are correlated, despite claims of many starving artists to the contrary.  It's just that the correlation is logarithmic). 

Anyway, they are starting a nice series on how crime might indeed pay - the secret is to be a financial "advisor" of any type.  They favor a Ben Graham appraoch - make sure you have fat pitches and high probabilities on the upside and relativel low risk (a margin of safety) on the downside.

I am looking forward to part 2.

CL 10-K Released

One of my favorite days of the year is the date of the release of the Colgate-Palmolive (CL) form 10-K, otherwise known as the Annual Report.  In it, we get to drill into the numbers, and look at the gruesome details of the company's performance.  While much of this information is provided by CL in the earnings announcement in January, the full report is always my basis for evaluating the company, as it is only in the annual report that we can fully understand the changes to the capital account (i.e. how many shares the company handed out in compensation).

Valuation

Let's do the important part first - I think the intrinsic value of CL lies between $95 and $105, with a best guess of around $101.

It is always important to compare the actual results to those of your projections for the company in a DCF.  With some self-congratulation, I was surprisingly accurate, having nailed Net Income (before minority interest) within $4m on a line item of $2554m, about 2/10th of 1% error.  This was achieved with some underestimation of total revenue offset by overestimation of the gross margin the company would achieve.  Several of the operating estimates were quite close, even though they were significantly different from FY2010 results.

As I slightly underestimated depreciation and overestimated capex, actual owner earnings were higher than I anticpated (before minority interest).  Using a discount rate of 8%, which seems fair for such a solid and apparently predictable earnings stream and a terminal growth rate of 2%, We arrive at a PV of $48bn, very close to the current market value of $45bn.  Using a truly fully diluted measure of shares outstanding (which assumes all unvested restricted stock awards and options will be exercised), we have a value of about $95 per share.  One would be tempted at this point to argue that the shares are fully valued, indeed, that they could potentially be somewhat overvalued.

The key variable in my mind is gross margin.  Management has communicated a 65% gross margin target, although, due to price actions in 2011 and commodity costs, margins actually fell in 2011.  The above valuation assumes that margins return to their previous norm of 59%, and growth ticks on at about 6% per year, excluding currency fluctuations.

Were management able to restore margins to 59% and to further expand them, at 0.5% per year over the next decade, falling slightly short of their target, present value would be about $55.5bn, or $110 per share on a truly fully diluted basis (505mn shares outstanding).  These are, to my way of thinking, the main anchor points.  That is, intrinsic value of CL lies between $95 and $105.  So a 3 to 13% gain seems possible, with a nice 2.7% div yield.  One should expect a dividend hike to around 62c per quarter and a price around $101.

Thoughts on management effectiveness

If the Ian Cook era at CL has a theme, it is leverage.  While previous managements have been systematic repurchasers of stock, this management has become downright aggressive.  At first, I thought this was a reaction to a tax code change that required the company to convert the convertible preference stock used to fund the Employee Stock Ownership Plan.  This conversion created 21mn common shares overnight (they had always been there, but were only slowly converted over the previous two decades).  I thus assumed that the step up in repurchases was aimed at keeping the number of shares outstanding relatively stable.  In fact, Cook has continued to repurchase shares at a rate of about 20mn per year (up from 14mn or so under Reuben Mark) and has initiated a significant repurchase program of 50mn shares, which he has indicated he wishes to complete within 2-3 years.

This is no bad thing, provided that he is able to repurchase shares at a discount to intrinsic value.  It appears that CL is doing so, but that discount might be rather small.  What is more likely, however, is that the company has a very high ROE (return on shareholders equity) target.  The single best way to manage the amount of equity is not, sadly, to manage the business, but rather to manage the capital account.  Dividends are a key aspect of CL's investment value for investors, but these are also hard to cut (especially since the company prides itself on paying uninterrupted dividends since 1895 and on raising dividends every year for a half century).  Buybacks offer far more flexibility.

Consider this table (it is my favorite and another reason I always read the annual report).  In it, we see the 10 year development of many key statistics for the company.

The first observation is that Sales On Assets has been pretty stable over time. This means that to grow the business 6% per year, we have to expect assets to grow at about the same rate, thus we can expect that CapEx will continue to exceed depreciation, or there will be some big acquisitions, or the company will stop growing.  Cook has stated that his "funding the growth" initiative is designed to free up the capital to grow from operatoinal efficiencies.

What we also notice is after a very weak point in 2004 (when the company announced a major four year restructuring) there was a steady lift in shareholders equity, book value per share and most important improvement in ROA and ROE.

Since 2008, (the start of Cook's tenure) however, asset effectiveness has been on a bit of a downward trend, and while the company continues to deploy assets quite effectively (earning 19% on assets), there is still concern that the company may be finding it difficult to deploy cash as productively as before.  Part of the issue, when we dig into it, is that the company has made some significant investments in European operations, acquiring GABA and Sanex, major continental brands.  This strengthens the company's market share in Europe, certainly, but as Europe is the geographic market with by far the worst ROA growing there will hurt ROA, unless significant operational synergies or asset dispositions can be found.  (Europe was the laggard even before the acquisition massively boosted identifiable assets of the Europe operation), 

It would be more enjoyable to see further growth and investment in pet nutrition, since this segment earns massive operating profits on assets (about 50%).

The other feature we notice is that assets are being financed with debt, not with equity.  This has the benefit of lower interest rates and boosting ROE (which, as I said, is a key metric in exec compensation) bit it also leaves the company vulnerable to seizures in the credit markets.  Given the remarkably low rates available, however, it is understandable that management wants to aggressively remake the balance sheet.

All in all, CL is a company whose stock I enjoy holding, and whose dividends I enjoy receiving.  I will likely purchase more when I liquidate some winning positions, always taking a part of the gains and converting them into a permanent, rising annuity.

Please note, I can supply a copy of the DCF model I use to anyone who writes.

Dividends vs. Buybacks

One final thought from the Jeremy Siegel article I referenced in my previous post - Siegel equates dividends and stock buybacks.  This is important, because in his quasi-mea culpa, The Future for Investors in which he clarified his view from Stocks for the Long Run, he observed that - geez, much of the return of stocks is actually based on dividends.

Dividends, once upon a time used to offer stock investors higher present yields than bonds, because investors saw dividends as far riskier, since unlike bond covenants, there was no obligation of the company to declare one, whereas bonds had fixed payments according to the covenants in the issues.  The low multiples required to offer 4-7% yields  - normal sums for much of the period Siegel studies, is a big reason why returns have been so strong since 1926, the starting point for the S&P and the oft-cited Ibbotson stock return analysis began.

Dividends today generally still offer lower yields than bonds (though with ultra-low bond yields, dividends are now becoming attractive for income investors).  Nevertheless, few firms yield above 4%, leaving the investor wondering if in fact historical returns are even possible in this market.  The lower yield should cause Siegel to argue for lower earnings expectation go forward.  Instead, Siegel argues that while dividends are lower, companies are instead repurchasing stock, which is also a cash distribution to shareholders and one which drives higher the (tax deferrable) gains in stock prices.  Or does it?

I would argue that the apparent equivalence of dividends and buybacks is a case of sensible accounting misleading investors.  The apparent equivalence is in the accounting treatment of a buyback and a dividend in terms of the effect on the equity account of a company.  On the surface, both moves are a form of cash distribution from the enterprise. This overlooks the fact that a dividend does not direct the use of the shareholder's money, whereas a buyback most certainly does.  Instead of seeing these as alternative strategies for reducing the capital account, dividends should be seen as such, but buybacks should better be seen as investments, because buybacks only make sense if the asset being purchased (the company's own stock) is cheap.

Quick accounting review - when a company declares a dividend, there are the usual credits and debits - the retained earnings, a liability (credit) account, is debited and the dividends payable account - also a liability and credit account is credited.  Debiting a credit account reduces the account, and crediting a credit account increases it, so the net liabilities of the company remain the same, only retained earnings declines and dividends payable increases.  When the dividend is paid, the div payable account is debited and cash, an asset account - a debit account - is credited, reducing both the payable and the cash.

When a buyback is conducted, the capital account - that is, shareholders equity - will aslo be reduced, but in quite a different way.  Retained earnings is not affected (unless there is a subsequent retirement of the shares).  Cash, a debit account is credited, and the offsetting debit comes in the form of a debit to the treasury shares account, a liability and credit account.  The debit makes the treasury shares a negative value on the balance sheet (which you regularly see if you look at a company with large amounts of treasury shares, they are always carried "at cost" as a negative value which reduces equity).

It is no accident that like other investments under the cost method, the value on the books is held at cost.  This is because in actual practice, the company is making an investment in its own income stream.  Buying out other equity partners only makes sense if the value you would pay is less than the future cash flows of the shares that have been repurchased, properly discounted.

Companies should buy their own shares, if and only if, other investment opportunities (in physical plant, acquisitions, etc) are unattractive and the shares are trading at a big discount to intrinsic value.  Buffett, believing the intrinsic value of BH to be much higher than book value, has announced an open buyback of shares when they fall close to book value.  In this way, he is honoring this principle.  If, however, shares are near intrinsic value, a firm should not repurchase, as this will only lead to more selling from investors who believe the cash from the future flows, properly discounted, will not be worth more than the money that had to be laid out to acquire the shares.  If the shares are genuinely overvalued, such as tech stocks in the 1990s, or bank stocks circa 2006, repurchasing does not return cash to shareholders - it destroys value by overpaying for a business (which just happens to be the one the shareholders own).

Ask yourself, if you held a stake in a partnership and one of the other partners offered you a chance to buy part of his stake but you thought the price was outragous, would you feel better if instead of paying from your bank account, you instead used the business' profits to buy him out?   Wouldn't you rather have your share of the profits distributed to you to invest in something else with a more attractive price tag? 

Yet overpaying is effectively what you are doing when you let management overpay for buybacks.  (That they are often the partners whose stake is being acquired should give you pause to question whether your interests as an OPMI and theirs are the same).

This is why one of the first things I look at is the equity accounts - how much stock are people repurchasing and how much are they awarding to themselves.  It is the single best indicator of management's attitude toward shareholders.  One reason I decided to buy Intel stock (and Microsoft for that matter) is that they were significant net repurchasers of stock which I believe was trading at a significant discount to intrinsic value.  Both stocks have increased in price and so I would expect repurchases to be tempered and instead for dividends to be increased at a faster rate.

You could argue that CL, which continues aggressive repurchases with the stock at all time highs, may be making a big mistake.  I concede that this is a possibility, although my own valuation of the stock puts it in low triple digits on the strength of overseas growth, where CL is gaining an increasing share of a market that is growing rapidly along with incomes.

Why the efforts to claim they are equivalent?  At one time, companies argued that it allowed investors to take advantage of tax benefits associated with the deferral of capital gains (and what were lower tax rates on any gains).  Thus it was an attempt to offer shareholders tax efficiency.  Unfortunately, for most small investors, the sums are held in accounts with special tax treatment, such as IRAs or 401(k)s, so the tax advantages are mostly lost on such investors.  In any case this was mostly a cover for a less shareholder friendly strategy.  Repurchasing stock reduces both the equity account (which, all else equal increases ROE), and also has the effect of reducing shares outstanding boosting EPS, changes in which are heavily reported.  it allows management to massage KPIs (and often to produce significant compensation awards for themselves).

For Siegel, a man who supposedly studies valuation, not to focus on this sort of difference is pathetic.  He should be out educating investors about the significant difference between these two concepts, rather than assuming that one form of capital reduction is as good as another.

I highly recommend that if you are really focused on intrinsic value, the biggest single criterion for the evaluation of management is capital allocation, and one of the best metrics available to you is their use of the capital account, particularly as it relates to distributions from the firm.  If they buy back stock in periods of high prices and low, you have to wonder what the real motivation is.

Jeremy Siegel is at it again

It has been said that the only purpose of economic forecasters is to give weathermen a good name.  Nevertheless, making a case for a specific future is a business that seems to pay quite well, and there are apparently enough shameless forecasters (or deluded egotists looking to be annointed with Oracular powers) to keep at it relentlessly.

The famous author of "Stocks for the Long Term" and other books about the benefits of owning equities, and sometime Wharton School professor Jeremy Siegel is out again making market forecasts.  Unsurprisingly, his argument is that the best thing you can do is own stocks.

I don't have a big issue with thesis, but I do take issue with the argument that NOW the market is poised for strong returns.  Siegel seems to believe that the bumpy flatline of 2011 will be replaced with much stronger price performance in 2012.  The argument goes that in studying similar 5 year periods in which stock performance was a bad as that through 2011, the next 18-24 months showed strong gains in stock prices.

This is to substitute reason and logic with statistical correlation, a favorite attitude of several quants, and business school professors in general.  I think it is because their colleages all want to read about their correlation and regression analysis that they think that showing some correlations makes them a brilliant forecaster.

It may be true that the five years through 2011 had low stock market gains.  This is probably also true through 2010, and through 2009, even though 2010 did  not result in strong market performance in 2011.  The fact is, the markets bad performance is mostly attributable to 2007-2009, since March of 2009, the market has done brilliantly, so it is hard to see the whole market as beaten down and vulnerable.

Siegel also seems to disregard economic growth in his analysis, assuming, apparently, that growth is largely constant over time.  What happens if an aging society leads to low growth, a la Europe - or Japan?  Will the surprisingly strong results that were available to investors from 1871, when modern corporations were only just being created, still obtain?  Is it not possible that the growth that underpinned the 8.7% Siegel takes as a given, is in fact a one-time fluke related to the uspurge of productivity a corporation?

For that matter, what would Siegel's numbers look only at US equities, and disregard problemmatic foreign markets.

Finally, Siegel fails to mention the significant and long-term (20 year) periods in which bonds have outperformed stocks.

I do not mean to suggest that the markets might no go up.  I cannot really say how markets will perform.  Moreover, several stocks are still reasonably priced.  But to assume that because some correlations you have done suggset it, is pure crap.

Siegel may be right, the market may have a terrific year, certainly it is off to a strong start.

Aging, Workers and Deflation

This article is really fascinating, even if it is about Canada.

In actual practice, it is about a global phenomenon - lower population - which is going to transform how the world works, plays and above all, retires, over the next several decades.  The short synopsis is that declining family size is shrinking the pool of workers.  This is going to either a) drive up wages b) drive down consumption, c) encourage labor substitution with increasing automation, or d) a combination of all three.

Output looks set to slow its rate of increase, if not to stagnate altogether.  Output is a product of output per hour worked x number of hours worked.  This second factor is itself a product of hours per worker and number of workers.  Thus, output can be thought of as

Output per hour X hours per worker X workers.  If the number of workers declines, then either hours per worker must increase (Stakhanovite sweatshops, anyone?) or output per hour must increase, or output stagnates (one or both of the first two terms must increase just to prevent a decline!)  Since output per hour (productivity) has been increasing smartly over the past several decades, one might think humanity "in the clear".  In fact, rates of productivity growth have generally been declining (prior to the recession anyway) as more and more work moves to services, which are harder to automate and generally less productive anyway.

The effect of this may be to generate a rather extended and continuous DEFLATION.  If demand declines (older folks don't buy as much) increases in purchasing power will come in the form of productivity enhancements driving down prices, a cycle which encourages deferring consumption in favor of lower prices tomorrow.

Wages, of course, may rise to reflect the need for additional workers, but higher wage demands may only accelerate the use of labor saving capital, as prices of finished goods can still decline, compressing margins (and profits).

With more retirees, social insurance programs will also put pressure on worker's wages, as governments look to raise revenue to meet promises to the most reliable voters.

When looking very long term, indeed, even medium term now, that the question of the "new normal" in terms of growth is the biggest question facing investors.  It is by no means certain that the world will return to anything like the rates of growth it has experienced since the Industrial Revolution.  At the end of industrialization may be only modest growth with limited productivity enhancements that can only be generated through massive education investments - and then only pay off decades down the line.

MSFT hits 52 week high

Microsoft has finally begun to get some credit for the number of successful business lines it has.

Not only does it have the annuity-like Windows and Office products, it has claimed #1 in gaming, and has reached a near perfect margin on online search.  This last bit is one of the areas the company has invested in massively, only to continuously lose money.  However, with increasing share of a growing business, MSFT may finally be able to break even on an operating basis sometime in 2013 - there is light at the end of the tunnel.

The biggest value factors, however, are the options on Windows 8 and the new Windows Phone platforms.


My own view is that the stock is worth about $34 per share, excluding the value of the Windows Phone option, and if everything works well, the stock could fetch $40.  There is ample room to raise the dividend and buybacks are good for investors at anything up to $30, because of the low valuation.

The big concern one has to have is the massive resistance in the chart from here.  Since 2000, the best strategy in MSFT was to sell whenever the stock hit $30.  It did make a brief run to $35 in 2008, and might make it there again, but further priec appreciate will be difficult to capture.

Buffett article in Fortune

Warren Buffett, picking up on themes he has discussed many times before has a remarkably clear argument for the long term power of investing in real assets.

While I think his argument is persuasive, I have written a short reply questioning one of his core assumptions: that popular governments will always pursue inflationary policies.  I am not so sanguine.  Popular governments have often found deflation fighting more difficult than one would assume, and it is not clear whether an aging population, such as in Japan, is not a significant and contributory factor to deflationary policies.

You can read the article here.



My response:

As always, Buffett has a clarity which is refreshing and insightful.

The core assumption that Buffett makes that he does not explicitly clarify (though he hints at it) is he believe that ultimately, governments will always prefer inflation, and therefore over any extended period, he rules out the possiblity of deflation, which is the one scenario in which nominal assets could outperform real assets, even under conditions of low rates.
That he does not consider this possibility is a real weakness in his argument, as several societies have indeed experienced prolonged bouts of inflation, including the US between about 1870 and 1892 and again between 1928 and 1940.  These were admittedly periods of extreme economic turmoil, as overleveraged households and firms folded, and bank failures encouraged credit and monetary contraction.

More recently, Japan is undergoing the same experience, even as the rest of the world has boomed.  What would be interesting, from my perspective, is Buffett's view on the affect of aging on asset prices and a tendency toward deflationary policies.  After all, old folks tend to have assets (and usually want nominal assets with steady, predictable cash flows, not lumpy albeit fast growing ones) - so their stronger voting power can encourage politicians to support policies favorable to creditors.  Moreover, consumption declines with age, which may lead to an environment of falling prices and lower economic activity generally.

Since most people in the world now live in countries that are either at or below the replacement rate, most countries are expericing significant aging.  Is it not possible as we look out over the 21st century that growth itself may grind to a near halt?  In which case, might nominal assets outperform after all?

Earnings: Cisco, Diamond Foods, Groupon

Well, CSCO had a positive surprise today, in which we saw higher sales of networking equipment leading to faster revenue growth for the quarter.  Happily for CSCO common stockholders, or at least Ralph Nader, the company has also decided to increase its quaterly dividend by 33% from 6 cents to 8 cents.  Because of strong bottom line growth, this actually represents a decline in the payout ratio from 22% to 20%, indicating plenty of room for further dividend increases, as Ralph Nader has encouraged.  Nader, self-reported holder of 18,000 CSCO shares, will take home an extra $360 a quarter.

In the short-term at least, the rally in the price and the improvement in the company's performance suggest that investors think CEO John Chambers is doing the right things.  If these results continue, they will be right.  I still have deep reservations about his leadership, and so even though the stock is cheap (although much less to than in the August selloff) I continue to stay away.  My own tech sector bets - MSFT and INTC - have performed admirably and both still have upside.


Diamond Foods, maker of those yummy Diamond nuts, and also owner of Kettle Chips and Pop Secret popcorn had terrible news.  The common is down over 40% in after hours trading, due to the announcement that the CEO and CFO have been placed on administrative leave, and that earnings will have to be restated after an ongoing internal investigation indicated that several payments to suppliers had been missated. This looked like a bit of an overreaction to me, since core products are customer favorites and the company is making money, but it turns out there is a good reason for the decline.

The company is involved in a "purchase" agreement with P&G to acquire the Pringles potato chip business.  This sounds incredible - since it is hard to see why P&G would part with such an asset.  Incredible that is, until you realize that in buying this busienss, they are issuing P&G (together with any other Pringles shareholders) some 26mn shares, which provides P&G a majority stake in return for Pringles.  This is not exactly what I would call a sale, since, ultimately, P&G will retain a majority stake in its signature snack brand and acquire a majority stake in several other brands.  As the majority owner, P&G will be in a position to set dividend policy and also be in a good position to tender for the remaining shares of Diamond Foods sometime in the future. This is really a sale of Diamond Foods to P&G, albeit an installment sale, in return for minority pariticipation in the earnings streams of Pringles for some period.

And that makes this misstatement incredibly significant - because it may be the case that the misstatement was intended to improve margins at DMND while the value of the company was being determined for the sale.  The number of shares received by P&G is dependent on the share price, the higher it is, the lower P&G's post-transaction stake.  Now, even if the transaction goes through, Procter is likely to get an even larger stake, possibly more than 60%, and current shareholders stake in both the existing business, and any future flows from Pringles will be commenurately lower.  If the deal were to fall through, DMND would probably be worth $26-30 purely based on the existing business, provided there aren't additional misstatements that have to be taken.

Finally, Groupon seems to be conducting a firesale of its own stuff.  The company's business model is based heavily on spending lavishly on marketing and sales, so much so that SG&A exceeds gross margins.  This can go on for awhile, and in fairness to Groupon, revenue was up something like 194% over the prior year quarter, so the money spent is having an impact.  But management is going to have to show that that it can continue to grow while maintaing cost controls.

The interesting question is what happens with LinkedIn, which reports on Friday, as both are indicators of the potential growth of social media: which all points to the prospects of Facebook achieving what, in my mind, is a ludicrous $100bn valuation, even if Steven Altucher disagrees.

Good Commentary on Bill Gross' FT Article

Foriegn Policy has a discussion about Bill Gross's article in the FT that discusses what is happening with the ZIRP and how it can trap people in cash.

The comments are more insightful than the blog post, actually, and I think this goes a long way to understanding the Japanese malaise, which I have always believed was caused by low interest rates.  In theory, lower interest rates should favorably improve the risk/reward ratio of risk assets and always encourage additional borrowing.  However, at some point, low, low interest rates can actually CREATE risk, because the price of credit becomes so unattractive that the risk/reward ratio actually skews in favor of holding cash, even though it earns nothing.

This is the flaw in the "Greenspan put".  It works, so long as there is room to reduce interest rates and steepen the yield curve sufficiently to enable financial intermediaries (banks) to borrow short and lend long.  But when short term rates hit the lower bound of zero, further reduction in long term rates (as in Japan) flattens the yield curve, reducing the value of the carry trade (and discouraging further purchase of long bonds).  Moreover, with interest rates very low, the probability of both price, inflation and interest rate risk increases significantly.  Few people want to lend large sums of money over an extended period to a deeply indebted government, running massive deficits for as far as the eye can see.  The probability of inflation producing negative real returns is too great.  Speculators and traders might be willing to buy bonds if they believe that there is room for significant price appreciation (yet lower rates), but again, the risk/reward profile of low rates is that there is limited upside (as the curve flattens, fewer buyers will materialize for the reasons mentioned above) while the the downside risk (higher rates due to inflation or default concerns) is massive.

In short, investors are truly concerned about ensuring that they can get their capital back - and bonds do not look like a relatively safe place to preserve one's capital, let alone a place to earn a modest return in the form of coupons.

Having made bonds unattractive, however, has not made equities or risk assets attractive, really, as they are also subject to significant risks.  Instead, people park their money in demand accounts earning nothing, and low rates actually reduce incomes, resulting in lower spending, resulting in lower final demand, resulting in less economic activity, which increases investors risk aversion and the availability of attractive risk assets.

If you couple that with massive missmatches between generations in terms of assets - with older generations, benefitting from massive expropriation in the form of transfers to themselves from younger, more risk-seeking savers - you receive a double whammy in which retirees and near retirees hold all the financial assets and are petrified of capital loss.

Pretty soon, you wind up with decades of slow growth.

All of which suggests deflation in our future, in which case, the smart money is on nominal assets.  In other words, buy Treasuries.  I am not sold, as I believe most governments are out to increase inflation and if they really want to, they can succeed, but I would be cautious about companies that rely too much on debt financing.

CSCO: Ralph Nader and I agree

Hard for me as it is to believe, Ralph Nader, "Consumer Advocate" sometime presidential candidate and general left-loony gadfly and I agree about Cisco Systems (CSCO): John Chambers is bad for shareholders.

In an editorial for Reuters, Nader - apparently a CSCO shareholder with 18,000 shares - complains of the poor use of company cash, which has primarily gone to counteract dilution from the excessive equity compensation the CSCO management team, led by Chambers, has handed itself over the years.

Nader is arguing that with massive cash balances and $3bn a quarter in operating cashflow, the dividend at 6 cents is really insulting and represents hostility towards shareholders.

I myself have written an article detailing my own view that CSCO as a business is cheap, worth probably $30 a share, or even a bit more, but that the business carries a risk that merits the discount - "John Chambers risk" which is the risk that all of the shareholders money will be used for management compensation

While I agree with Nader that management could and should take some near term steps to enhance shareholder value, the fact is, as long as Chambers is there, the stock will price the risk of his management into the stock price

2012 Theme: Inflation vs. Deflation

In the embedded video, "Bond King" Bill Gross discusses the outlook for inflation and deflation and shows why getting the right answer to this question is a major factor for investors: asset classes perform quite differently under "reflation" (increasing inflation), disinflation (lowering inflation) and deflation.



Mind you, most financial assets, both nominal and real, perform best under periods of falling inflation, the "30 fat years" described by Gross.  Under reflation, both nominal and real assets perform badly, but real assets perform much less badly, as they can "keep up" with rising prices, albeit slowly.  Finally, nominal assets do well in deflation and real assets do very poorly in deflation.  The problem for nominal assets (e.g. bonds) is default, which rises sharply and can lead to a permanent impairment of capital.

The real question is: which are we likely to have.  While Gross doesn't say - he makes it clear that the jury is still out - he does help to deconstruct the problem and lay out some of hte markers.

Thinking about M&A Strategy

The McKinsey Global Institute has just published a study that looks at different M&A patterns or strategies that large (non-bank) firms employ to grow the business.  The blow matrix shows how McKinsey thinks about what firms are actually doing.  Not all strategies are created equal, and McKinsey is quick to note that different industry segments have tended to different strategies. 

It is perhaps not a big surprise that the largest companies are the most likely to use acquisitions to grow, as organic growth in mature markets (which large firms dominate) have difficulty growing at faster than the rate of inflation.

Smaller companies are relatively more likely to focus on organic growth or on "selective" deal making, where usually few deals are done, which deals may be transformative (target represents a significant share of acquirerr market cap).  McKinsey has found that companies that employ a programmatic approach to acquisitions do best.  This may be due to the expertise gained in evaluating and integrating such deals, or it may reflect good discipline in purchaing without overpaaying.

HELE is a bit too small to qualify here, but it too could be said to be selective or perhaps "programmatic".  It has looked diligently for additional reveneu and has only really been able to generate organic growth with the OXO brand (thought OXO itself was one of a series acquisitions.

Helen of Troy (HELE) successfully integrating Kaz

In TSI’s most recent post about HELE, we noted that the big question mark for the company was the effectiveness of the Kaz, Inc. integration.  This was a big transformative deal, on par with the OXO acquisition, as Kaz would account for about 40% of the revenue of the combined company.  Based on the most recent earnings release, HELE has done a magnificent job of turning that business into a success, and if the stated goals of increasing gross margins to reflect those of the historic HELE are achieved, the acquisition will be a dirt cheap out-of-the-park home run.

Until this latest earnings release, it was hard to get a flavor for the success of management in reducing costs and improving operating performance in the Kaz business.  Clearly, the company was having some success.  The pro-forma for Kaz, (which was privately held) had a full year operating profit of about $4m, or a measly 1% of sales.  Some of this may have been a function of Kaz’s prior status as a private company, in which several benefits for senior manager/owners may have been borne by the company, it is hard to tell from the financials.

HELE demonstrated already in the first quarter that they intended to improve operating performance.  The Kaz business (which is conveniently listed as separate own segment) had no reported operating income – HOWEVER – that was after a $1.5m allocation of operating expense from traditional HELE segments.  On a stand-alone basis, Kaz had earned $1.5m in the first quarter.  Ignoring seasonal effects, this implied a $6m operating profit, or a 50% improvement.  This level of enhanced earnings would be just enough to pay the interest on the additional financing, but not to also count for the equity, but was encouraging enough that the market bid up the stock to all-time highs (at which point, management decided to unload its options, and the stock tanked).

The second quarter earnings report brought additional good news on the Kaz front.  Thru the second quarter, Kaz managed to earn $7m operating, again, after a $3m allocation of overhead from traditional HELE.  Thus, after two quarters, HELE management had succeeded in increasing operating earnings by 2.5 times – with two quarters to go.  Better yet, management indicated that operating profit at Kaz was highly seasonal, that the first two quarters were not representative and that the third and fourth quarters would produce far more operating income than the first two quarters.  They delivered.

Kaz earned $13.5m operating in Q3, again, before $1.5m in reallocated expense – or $15m as a stand-alone entity.  The 9 months figures are $20m and $26m, 5 and 6.5 times full year operating as a private company.  While I expect the fourth quarter to be somewhat weaker than the third, an additional $7-$10m operating is not out of the question, for full year operating of $27-$30m ($33-$36m before allocation of $6m in corporate overhead).   This is a stunning improvement.  In 14 months of ownership, management will have increased operating income of the Kaz business by a factor of somewhere between 8 and 10!  With $194m price tag, the company will be earning (pre-allocation) something on the scale of 18% on investment, against a WACC of 12-15%.  Note that much of the purchase was financed with debt issuance of $100m, at 3.9%, and expansion of the company’s credit line.  Cash on hand was also used, and as the credit line has been paid down, a greater portion of the financing is now coming from equity, but this is certainly a terrific start.  Were management able to increase margins even five or six percentage points, they could add another $20m in gross, which should, all else equal, flow directly to operating profit.  (Management has stated repeatedly its intent to lift Kaz margins from the mid thirties to the traditional HELE margins of the mid forties, but this seems unlikely, and in any event a long term goal at best.   Were they successful, there would be yet another $20m in operating, even before any volume growth from market growth or new product introduction).

Either of these events would increase operating earnings per share by 60 cents.  Kaz, as a US entity, has a higher tax rate than traditional HELE, which is a Bermuda company, but based on my expectation of Operating profit for FY2012, NOPAT should be a healthy $20-$22m or about 60 cents above FY2011.

Figures for the fourth quarter in the Kaz segment will be distorted by the acquisition of PUR Water.  This will raise gross margins, as the business had high gross, but operating is less clear at this stage.  Advertising revenues around PUR will increase SG&A.  However, management has identified several opportunities to grow the business, and given the incredible cost control HELE has been able to exercise, this looks like another good opportunity to reinvest the company’s growing cash flows in high return activities.  Indeed, operating earnings are now rising so rapidly that the company can now purchase a $100m business every year simply from internally generated funds.

PRICE TARGETS

Analysts have begun to argue that the stock could be worth as much as $50 per share, as EPS will likely top $4 in FY2013.  This is based on continued strong performance from Kaz, continued high single digit growth in the OXO brand and modest growth in sales of the personal care segment.  I think a price of $45 is quite reasonable, as I believe HELE is entitled to a 11x multiple.  This is low for a consumer staples company, in part because there are several risks. 

RISKS

The first risk is that management is becoming overly focused on growth through acquisition and takes its eye off the traditional HELE business segments.  This would be a problem because the traditional business is both strong and profitable, and at 60% of revenue, and an even greater share of operating profit, these segments are crucial to the performance of the company.  Thus far in FY2012 they have disappointed some, as revenue has grown but only as a result of heavy promotional activity.  This could mean that management has been somewhat distracted and is not executing as sharply, and is thus relying more heavily on promotion to move product.

The second major risk is that management makes a poor acquisition, either by purchasing a product or business unit whose competitive position is too weak, or by simply overpaying.  Fortunately, HELE tends to acquire mature products, within establish markets and along with a license for or outright ownership of brand names.  Often these have been built by major firms (e.g. P&G) but are either too mature or too small to get the attention they need.   HELE then focuses relentlessly on cost and on using the HELE sales force to increment sales.  Still, the company’s record is not without some black eyes.  Some years back they purchased an infomercial business (with a goal of promoting HELE product, I think) and were forced to close down the business within two fiscal years.  More recently, the company massively overpaid for its acquisition of Belson, and had to take a huge impairment on Goodwill and intangible assets.  TSI hopes that the increased earnings and cash flow of the business enable the company to look at a greater range of deals and to be able to be even more successful buying “gems”.  (Of course, as a company grows, scale can also reduce the range of opportunities one can look at, by making many deals “too small” to have material impact on earnings, but HELE is probably a few years away from this point).

Third, one has to be concerned about input costs.  As a products maker, HELE is subject to significant commodity cost exposure.  Moreover, many of HELE products are made in China, where labor costs are experiencing significant inflation.  This matters, because with a managed-fixed exchange rate, labor costs in USD, GBP and EUR are rising, which could constrain margins.  Furthermore, over time, the yuan is rising against other currencies, compounding the effect.  There are ways of combating this, including increasing scale as the business grows, and moving production to yet lower cost markets, or even sourcing in the local market.  Again, as the business grows, it has more options.

The fourth major risk is heavy dilution.  In FY2012, HELE revised the compensation for executives, and expanded the number of options available by 3 million, to about 10% of shares outstanding.  Not all available options need be distributed, of course, but TSI assumes that substantially all will be.  The question is, over what time period – if this is done over 10 years, such that management only receives about 1% of outstanding equity each year, things will be fine.  If it is more aggressive, current shareholders should assume dilution and slower growth in EPS.

OUTLOOK

Even with these risks, TSI expects that HELE will continue to grow revenue and profit at strong rates.  Organic growth will never be super fast, as the company competes in mature product categories, but the company executes well and, if it remains selective, it should be able to grow the bottom line even faster than the top line.

While the company has never paid one before, I look forward within the next five years to seeing the company begin to pay a small dividend to attract the value-growth retail investors it needs to expand its multiple.  Most of these will be retail investors looking for a means to have a decent yield with growth potential.

Finally, if the company can continue to grow revenue and market cap as it has, it is not unreasonable to believe that it can join the midcap S&P400 within the next five years, which would certainly give it a boost, as would an inclusion in the Russell 1000.  But one step at a time.

At this point, I am looking forward to seeing the full year results for the quarter ending the end of Feburary, at which time I fully expect the company to exceed $100m in net income for the first time, to see how Kaz and the PUR acquisitions are faring and to hear about management’s next plans.