learning value

In the face of uncertainty, buy PM for stable income

2019-09-26T07:05:00.001-07:00

Philip Morris sells cigarettes. It is one of the largest tobacco companies in the world that provides stable high dividend income with the least risk.

Tobacco companies are dismissed by investors because of the growing trend of Socially Responsible Investing. We do not often hear pitches about a tobacco company from famous investors on TV or in conferences due to its reputation risk. And it is not surprising that institutions like large pension funds and endowment funds shy away from tobacco stocks. Also it is well known that cigarette volumes have been declining for many years now and will probably continue the trend down in developed countries like WHO predicts. Moreover, any investments in tobacco industry would face litigation risks and regulatory uncertainties, just like the recent headlines about vaping issues all around the world: US, China and India.

It is however a good idea at this time to consider buying PM stock for below important facets:

1. It is a very stable business. People buy cigarettes in good times and bad times, even in a recession. It is pretty hard to quit because the additive nicotine in the tobacco products. Majority of the smokers attempting to quit are not successful as in most of the markets the smoking rate is only declining slowly (in low single digits annually). Due to the addictive nature of the products and customer loyalty to its iconic brands like Marlboro, demand for PMI’s products are very stable through economic cycles. For more information about market share and volume trends, investors can refer to PMI's detailed report here.

In the last 10 years, net revenue of PMI has been average about 29B USD and fluctuated within a 10% range. The volume of PMI sales has been declining, but since it enjoys considerable amount of pricing power again due to addictive products and customer loyalty, PMI has been able to successfully raise prices and improve product mix to offset the volume impact on revenue. Most of the fluctuations in annual revenue are due to foreign exchange rates as US dollar appreciates or depreciates against other currencies.

2. It has a first mover lead in Reduced Risk Products (RRPs) via heated tobacco platform iQOS. PMI is a leader in a tobacco industry transformation to create a smoke-free future and they believe the RRPs, while not risk-free, are a much better choice than continuing to smoke. IQOS are sophisticated electronics that heat specially designed heated tobacco units. While the idea of heating tobacco (instead of burning it) has been around for more than two decades, it took years of research and development to create a product that is satisfying to adult consumers. IQOS heats the tobacco just enough to release a flavorful nicotine-containing tobacco vapor but without burning the tobacco. Here’s the key point: the tobacco in a cigarette burns at temperatures in excess of 600°C, generating smoke that contains high levels of harmful chemicals. But IQOS heats tobacco to much lower temperatures, up to 350°C, without combustion, fire, ash, or smoke. The lower temperature heating releases the true taste of heated tobacco. Because the tobacco is heated and not burned, the company claims the levels of harmful chemicals are significantly reduced compared to cigarette smoke. The regulators including FDA will need to confirm whether these products are indeed reduced risk or not. In the meantime, iQOS is getting some early success in the markets that it has been launched. In East Asia markets, iQOS had a promising start and brought in over 3B USD sales of RRPs for PM in 2017. After it slowed down materially in 2018 in those markets, PM management put in more investments including new products launches and has been able to stabilize market share in the last couple of quarters.

IQOS also had early success in some EU and Eastern Europe markets, and management is put more investments behind it with 2020 in mind to push for a sustained success in adoption.

It is highly likely that it will develop into a razor blade business model, where iQOS devices be sold at very low margin but the heatsticks (HEETs) at very high margin (likely close to cigarettes). Of cause a lot more innovation is probably required for heated tobacco to replicate the smoking experience and to offset the decline in combustible volumes, but PMI is on the right track. Also keep in mind that iQOS is just one of the platforms that PMI is working on for RRPs. The management has done a good job in taking a very carefully measured approach for new products from concept to launch mostly through investing internally. They did not just go out and buy the hottest products on the market.

3. It enjoys superior ROIC with very low capital requirements. In the last 10 years ROIC (defined as EBIT/(NWC + NPA)) has been averaging 180% with the high of 220% and the low of 120%. That is high no matter what company you compare it to. It becomes even higher if excess cash is removed from the calculation. Normally people would say it is a great business for a company with 50% ROIC. 180% is insanely high! To put into context, from 2009 to 2018, PM generated 120B in operating profit with no increase of Net Working Capital and only about 1B USD increase in NPA to invest in RRPs in 2017. The business does not require high capital investments so it spins out cash to serve debt, pay dividends and buy back stocks.

4. The management has allocated capital intelligently. It is rare to find a management good at both business operations and capital allocations. Very often we see companies buy back shares in the open regardless whether it is undervalued or overvalued, and sometimes they buy back at peak earnings and valuation without cash reserves for a down cycle. That does not create but destroy value for shareholders. PMI has done it differently. They bought back shares aggressively after the split with Altria in 2008 when valuation was low and created value for shareholders. In more recent years they did not buy back shares at high prices but have been increasing dividends instead. With recent low valuation of the stock in the market, it presents an opportunity to create value for shareholders again via share repurchases and hopefully we will hear from management in the near future.
5. Tight government regulations over the years across the countries have created high barrier to entry for the tobacco industry. That in turn created a low competition environment for the industry, which is observable from relatively stable market share among big industry participants. It is almost unheard of that the large tobacco companies engage in price competition. PMI is probably the most skewed to premium brands like Marlboro among large companies. Cigarette brand loyalty tends to be higher in premium brands, which benefits PMI greatly. Comparing that to the erosion of brand loyalty in other consumer stables brands we have seen, it is night and day! PMI management would never need to worry about Costco or Walmart starts a private brand cigarette.

6. The stock recently sold off after the news that PMI and Altria are in talks regarding a potential all stock merger of equals. Management confirmed the talks but gave no details about the deal. There are two possible outcomes. If there is no deal, either because vaping regulatory risks related to Juul or whatever other reasons, the stock should bounce back to previous levels. If there is indeed a deal, we will need to see the terms but strategically it should benefit PMI in the long term. One benefit is iQOS adoption in the US. The merger would be the best way to align interests of both companies on that front. The combined company would be able to launch iQOS in the US more effective. Secondly, there is potential for cost synergies considering they were operating under one roof before and essentially sell the same products in different regions. The increased scale would create even more cost advantage also. There is also a benefit of currency hedge if the merger happens. All PMI’s net revenue is derived in foreign currencies but majority of its debt (about 20B) is in USD and some of its cost is also in USD. With a US distribution and USD cashflow, PMI would have a natural FX hedge.

7. The historically low valuation presents an opportunity to buy PM stock for stable income. It trades around 110B market cap with 24B long term debt. EBIT TTM yield is above 8% and EBIT 10y average yield is close to 9%. The dividend yield is about 6.5% with growing dividend amount. Compare all those to the recent 10yr notes PMI offered at 3.375% interest rate, the premium in investing the stock seems to provide large enough rewards for the risk.

Of cause with any investment there are risks. First is the regulatory risk with regards to iQOS. FDA will likely announce its opinion on the safety of iQOS products in the near future, particularly whether it reduces risks as compare to smoking. Should FDA's opinion be negative, iQOS adoption in the US as well as in the global markets would be greatly impacted. There is also a risk for PMI to overpay for Altria in the potential merger. The talks between the companies started a while ago before issues related vaping intensified. Now Juul may face great regulatory uncertainties, which should have an impact on its valuation. If PMI does not discount that in the valuation for merger with Altria, it would destroy shareholders' value and market price of PMI stock would likely decline. Lastly if the merger indeed happens, integration of large companies would add operational risks in the short term, and the market usually puts a discount to the valuation of combined company as compare to sum of parts valuation at first.

Einstein Noah still has upside for a possible merger

2012-07-24T19:46:00.000-07:00

Bagel maker Einstein Noah Restaurant Group (BAGL) announced that it is looking at a possible merger or sale of itself at the beginning of May, which sent its shares up more than 20 percent from $14 to $17.

Is there still upside should a bid come?

I think so because things can be much improved if it falls into the right hands. In particular Tim Hoons would be a good buyer for BAGL, and a merger would benefit both companies.

Company	BAGL	MCD	THI	SBUX	PNRA
EV/Sales	0.82	3.68	2.94	2.91	2.08
EV/EBITDA	7.23	10.21	12.46	16.81	12.45
EBIT Margin	6.71%	30.76%	19.54%	12.84%	12.36%

1. Transformation from company-owned model to franchise model

Einstein Noah ownes and franchises restaurants primarily under “Einstein Bros.”, “Noah’s”

and “Manhattan Bagel” brands. It gets about 90% of its revenue from company-owned restaurants. It is fair to say it is running a company-owned restaurant business. The management has been working to expand through a significant expansion of franchise and license restaurants, and looking to sell existing company-owned restaurants to prospective franchisees, even before the announcement. I think it is the right strategy for the company as franchise model adds additional revenue without much capital commitments and additional expenses, more capital efficient for expansion as compare to company-owned model.

BAGL's business is similar as McDonald's, Tim Hortons, etc. If a big player like Tim Hortons with expertise in operating franchise restaurants acquire BAGL, it could speed up the transformation and improve return on capital quickly.

2. Scale and efficiency

Economics of scale is very important in restaurant industry. If you look at operating margins of big vs. small

players, it is obivous that big players enjoy better efficiency. Think about product supply for example. Say you have 100 stores in the west and 100 stores in the east so you decide to have two manufacturing facilities to supply bagels, one for each region. Maybe when you expand to 500 or 1000 stores in each region, you still have those two manufacturing facilities with some expansion probably. That is operation efficiency.

Same thing goes with suppliers. Which one you think you can get better price if you buy 100m bagels per year vs. 100k bagels per year? How about marketing? If you have 1000 franchise stores and take 5% of sales from each store, you have more marketing budget than your competitor who only have 100 stores. A successful national marketing campaign can drive sales growth and improve brand awareness, which in turn leads to more stores and more marketing budget. In many ways a merger with successful integration can improve operation efficiency and margins and create value for shareholders.

3. Menu opportunity

If you look at the menu of Einstein Bros, and compare it to McDonald's and Tim Hortons, you probably immediately know what I am talking about. If Tim Hortons can sell all their stuff in BAGL stores, it is reasonable to believe sales will grow higher. It also comes down to economics of scale again. Big players like McDonald's and Tim Hortons can spend tons of money on research and development, and constantly supply improved offerings to the customers. McDonald's smoothies and iced drinks were very successful in the past few years after Financial Crisis. Starbucks also got a boost when they put more stuff into their stores for sale. It is always good to sell more since fixed costs like lease or property depreciation are not going to increase along with incremental sales, and sales growth from new items can potentially contribute more to profits.

4. Location

Now that is the reason I think BAGL is particularly a good buy for THI. THI dominates in Canada and

has been trying to get into the US market for a few years with limited success. Stores are concentrated in New York, Michigan and Ohio, mainly northeast and close to Canada. With 800 additional stores from BAGL, THI can immediately double its stores in the US and reach markets where it has not yet established presence, for example, Califolia and Florida. THI can even keep using the same brands -- “Einstein Bros.”, “Noah’s” and “Manhattan Bagel” as they are American and might be good for marketing and brand recognition in the US.

5. Greenlight Capital

Greenlight Capital (David Einhorn's hedge fund) is the majority holders of BAGL. Does it make sense for them to sell?

Or are they just bumping up the share price? I doubt that $30m market value increase would put a dent into the PnL of a 7+ billion hedge fund. Greenlight probably really wants to do a deal and it makes sense for them to look for a strategic buyer and do a private transaction. Think about what would happen if they say they are going to sell in the open market or distribute it fund partners. In a private transaction, Greenlight avoids market impact of liquidition, and it can potentailly get better price from a strategic buyer also.

What is the upside potential then? Trailing twelve month EBITDA of BAGL is around $48m, Cash and debt were 9.6m and 72.32m as of last quarter. So we should expect 10%-15% upside at least if it get acquired at 8 times EV/EBITDA multiple, and of cause that also depends on your purchasing price. I think a reasonable deal price should be north of 20.

EV/EBITDA Multiple	8	9	10	11
EV	$322.64m	$370.81m	$418.98m	$467.15m
Price per share	$19.10	$21.90	$24.80	$27.60

Let's take a look at another case -- Ancestry. Last month Bloomberg reported that Ancestry is weighing a sale and working with Frank Quattrone’s Qatalyst Partners LLC to find buyers, 'according to a person with knowledge of the situation'. Shares of ACOM have since surged from $22 to $26 in a couple of days. Looking at stock chart, it is basically where it was a month ago before crushed due to the cancellation of fourth season of NBC TV show 'Who Do You Think You Are'. The show follows one of the celebrities in each episode as they embark on personal journeys of self-discovery to trace their family trees. It is a very good marketing strategy and contributed significantly to revenue growth of Ancestry in the past few years.

Company overview

ACOM's main business is operating Ancestry.com, a website that provides subscribers web-based services and content collection to research their family histories, build their family trees, collaborate with other subscribers, upload their own records and publish and share their stories. Ancestry's main revenue source is from monthly fee that it charges subscribers.

The foundation of the business is an extensive collection of historical records (over 10 billion now) including

historical census data, military records, immigration records, family histories, etc. The company spent years and millions in acquiring all the records worldwide and have them digitalized, indexed and put online. They face no competition in online family history service business since no other competitors have such offering, and I do not know if anyone would ever want to build the same thing again from scratch. The website and user interface is pretty good to me when I tried their service last year. You can try their 14 days trial. For someone that is very interested in researching family history and tracing family tree, the service may actually be cost efficient. With a niche market and a smart marketing strategy ('Who do you think you are'), the company was able to grow revenue rapidly since 2009.

A few things worth nothing:

1) Spectrum Equity V, L.P has been unloading shares since IPO. It has decreased share holdings from 55% to 28% in 3 years.

2) Growth is slowing in the US. In the first quarter of 2012, the impact of fewer viewers of NBC’s show caused the growth rate for revenues to decrease compared to 1Q 2011. And now without the show, can the company still grow subscriber base?

3) Revenue is concentrated in the US and UK, where baby boomers are facing tighter personal spending budget. Can the company make significant progress in other markets to drive growth?

4) The company is active on acquisition front, and recently acquired We're Related, LLC and Archives.com.

5) Shares have been heavily shorted despite the company has 100 million share repurchasing program. As of June 15, 7.8 million shares were shorted, about 30% of total float. One can smell the war between the company and short sellers from far away.

Who would be the buyer?

Would Google or Facebook be interested as some analysts suggested? Not very likely. Both giants are more interested in far reaching businesses that target the broad market. And they are more into free ad-based model than the fee based model that ACOM operates.

Would private equity be interested? Maybe.

They would certainly be more interested when it was 20% cheaper. The company does not have issue of capital or operation. Not much improvement one can expect to bring outsize return. And also if another private equity firm buy it from Spectrum Equity, they would need to be confident that they have considerably better understanding of the business and industry than the seller.

At the time of finalizing this post, ACOM popped up 15% to $31 in after market due to rumors of buyout talks with PE firms. It was definitely worth looking after the May drop and probably still worth analyzing as an on-going business even now. But I would not participate now at these levels as one should not expect much upside any more.

Macy's, an improving story

2012-06-02T21:25:00.003-07:00

The business

Macy's is a retail organization operating department stores and online stores under two brands (Macy's and Bloomingdale's) that sell a wide range of merchandise, including apparel and accessories (men's, women's and children's), cosmetics, home furnishings and other consumer goods. Women's apparel and accessories account for more than 60% of sales. The business overall is simple, just to buy goods from suppliers and sell to customers. Complicate things are the 'how's, for example, how to initiate and execute strategies to grow sales and expand margins, how to compete with peers, how to build long term relationships with customers and so on. Those are also the things that differentiate the company and give the company competitive advantages.

The company enjoys a medium moat in my opinion:

1. High barrier to entry
High upfront capital requirement of opening new department stores and building operations
should put a high barrier to enter into the industry. It is different than apparel retail stores for example. One can start a couple of small retail stores with a new nice concept with little capital and expand from there. Few people would build a department store chain from scratch now. Acquiring an existing company in the industry would be a far better choice.

2. National scale
Macy's is the largest department store chain in the US and has about 850 stores as end of 2011. It
has completed integration as result of May and Federated merger in 2004, and as part of the My Macy's localization initiative, it has consolidated regional divisions and administrative functions. Now it can truly leverage the national scale of operating infrastructure to drive sales growth and margin expansion. Competitors can not easily get to the same level of scale without spending large amount of capital on merger, acquisition or store expansion.

Moreover, the size did not slow down the company. It acts quickly in terms of identifying new opportunities, adopting to market changes and implementing strategies. Based on execution
performance of past few years, I think the company can effectively leverage the national scale in its favor.

3. Store brands
Both Macy's and Bloomingdale's brands are world famous brands with good customer recognition. It is a gift from history and certainly a nice thing to have.

4. Unique offerings
Department stores have a very wide range of products available for customers and have the flexibility to choose brands and products to offer. That is an advantage against stand alone apparel retailers, which can not switch to other brands or products when products are out of fashion or are not selling well for some reason. And shopping in a department store is sometimes to some people an entertainment, which is quite different than going to a discount retailer or grocery store. I have seen a lot of customers easily spend half day there checking every section. Macy's and other department stores have a niche market segment that specialty retailers or discount stores can not directly compete.

Macy's also has a dedicated team working on private labels. The offering of private label brands and exclusive brands adds many unique products that customers can not find elsewhere and adds one more competitive strength. The sales of private label brands has been strong in Macy's and represented approximately 20% of net sales in the Macy's-branded stores in 2011.

The management

The management is focusing on three key strategies for continued growth in sales, earnings and cash flow in the years ahead:
(i) maximizing the My Macy's localization initiative;
Localization program is a very good strategy and has been executed very well. Stores customized to local tastes are better positioned to drive sales and to satisfy customers. As part of this strategy, the company consolidated marketing and merchandise purchasing, cut seven divisional offices, reduced central office and administrative expense, and expanded margin. Those helped the company to make decisions faster and partner more effectively with its suppliers and business partners.

(ii) driving the omni-channel business;
The industry has realized that most of future sales growth is going to come from new channels like online store and mobile store. Macy's was one of the fast runners that got out of the great recession with a very good online store. Online sales is growing rapidly and the management expects online and mobile sales to drive meaningful sales and earnings growth not far in the future.

The management is also experimenting new ideas and will scale quickly if anything can effectively drive sales and earnings growth. In fact, localization program was tested successfully in a couple of regions before implemented nationally. One current example is Bloomingdale's Outlet stores. 2011 test results were encouraging and in 2012 the management is planning to open 5 more Bloomingdale's Outlet stores to expand the idea further.

(iii) embracing customer centricity, including engaging customers on the selling floor through the
MAGIC selling program.
Management and analysts think this initiative contributed significantly to revenue growth. I do not disagree but I do not know how to quantify the contribution. I think it is good enough that it is getting employees engaged and energized.

Macy's has a decent talent pool and most of the management team are veterans with the company and grew up from middle or low level positions. They understand the business and the company bottom up and are certainly ideal to run the business. With stock and option compensation programs, the management's interest is partially aligned with shareholders'.

Moreover, the management's capital allocation decisions are creating value for shareholders.

1) Capital expenditure

2012 capital budget is modest at about 850m, which includes renovation of New York City flagship store. New store opening plan is conservative: the company had opened two new Macy's stores and intends to open five Bloomingdale's Outlet stores during the remainder of fiscal 2012. The company has announced that in 2013 and early 2014 it intends to open three new Macy's stores, one Macy's replacement store, one new Bloomingdale's store, one Bloomingdale's replacement store, and may open additional Bloomingdale's Outlet stores. Management does not have aggressive plan of expansion, and will not destroy shareholders' value by investing capital ineffectively.

2) Dividend payout
With strong cash flow, management is returning capital to shareholders. The company recently doubled dividend payout, and dividend yield is a little over 2% now. It is reasonable to believe that the dividend payout will continue to increase over time.

3). Paying down debt

The company still have a large amount of debt on its balance sheet, and management is using cash flow to pay down debt. It is arguable how much debt is ideal for the business, but it is good for shareholders since reducing unnecessary interest expense will boost earnings and cash flow.

4). Repurchasing shares

The board authorized the company to repurchase $1.3 billion shares at the end of fiscal 2011.

That might reduce share count by 30-35m from 416m shares currently outstanding. That is going to increase per share earnings and cash flow for remaining shareholders.

Finance

Total debt stands at 7758m on the balance sheet as of 2011. It is less a concern as interest coverage ratio as of 2011 is greater than 5 and the company is using cash flow to pay down debt.

At the same time the company is using the low rate environment to replace high cost debt to get interest expenses down. In Janurary 2012 S&P upgraded Macy's credit rating to investment grade, which helps the company to lower interests also.

Valuation

EV/EBITDA of Macy's is about 6 at the time of writing. It would not be a terrible idea to start buying at EV/EBITDA 5.5 or below.

There will be volatility in the market and there will be volatility in the stock. Wise investors should use the volatility in their favor. When Mr.Market sells at below intrinsic value, do not miss your chance.

Peer group comparison

Company	2011 OM	2011 Sales	EV/EBITDA	FCF Yield
JWN	11.50%	10,877	7.4	5%
JCP	3.90%	17,260	12	2%
KSS	11.50%	18,804	5.4	7%
M	9.00%	26,405	6	7%
SKS	5.40%	2,970	6.47	5%

Disclosure: Long M

Is Warren Buffett buying into the global restaurant chain?

2012-05-24T18:55:00.000-07:00

There is a news report recently that Warren Buffett might be accumulating a stock that he does not want to disclose yet. Last time he did that he bought a big chunk of IBM. What is he buying now?

The check list:
1. Simple business with wide moat that lasts decades.
2. Good management that is both able and honest.
3. Consistent and good owners' earnings return without high leverage.
4. Attractive price.

There are probably many companies that could qualify. However, if he is deploying around $10 billion into one stock like what he did in IBM, only a handful of large/mega cap names look possible.

I can think of a few names: DIS, MSFT, PEP, MCD and UTX.

He sold his shares of DIS long ago and it is probably unlikely that he is changing his view about the company and management.

He said publicly he is never going to buy MSFT.

He holds 9% of KO, so it is unlikely that he will also take a big position in PEP.

Then here comes my guess: McDonald's (MCD).

It is a low-tech predictable business with long-term history of excellent returns and global expansion. The management team did a excellent job during the downturn. P/E and EV/EBITDA are both a little bit higher than IBM but still reasonable.

I also think UTX would be a good choice, but the only thing is the market cap is a bit lower than ideal.

What do you think?

Disclosure: The author does not have position in any name mentioned and does not intend to trade any name mentioned in the next 48 hours.