Saturday, February 25, 2012

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).


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.

Thursday, February 16, 2012

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.

Tuesday, February 14, 2012

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.

Monday, February 13, 2012

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.

Thursday, February 09, 2012

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.

Tuesday, February 07, 2012

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.