- Turley Muller
- My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.
Wednesday, December 12, 2007
Friday, December 7, 2007
Here are just some thoughts about a few abnormalities in the mortgage market that I have observed.
Jumbo-Conforming Mortgage Spreads:
Jumbo spreads on 30-year fixed rate mortgages remain elevated at approx 100bps versus historical spread of 12-25bps. According to Bankrate.com, the average rate for a conforming 30yr fixed is 5.62% and 6.60% for jumbo 30yr mortgages. Jumbo mortgages are loan amounts above $417,000 which exceed the requirements for Fannie / Freddie securitization. Since jumbo loans are ineligible for Agency MBS, they are less liquid. see article (august)
Since most prime jumbo mortgages are underwritten according to Fannie Mae guidelines, the credit risk between conforming and jumbo loans are the same. That’s why borrowers could usually get almost same rate on a $416k loan as they could a $418k loan. Any spread reflects the liquidity premium of the loan, not the default risk. Now, we have seen that liquidity premium spike affecting the most creditworthy borrowers.
Conforming mortgage rates currently are in-line with the yield on the 10yr Treasury, thus the mortgage crisis has left Agency MBS relatively unaffected since it’s such a highly liquid market. Jumbo AAA paper commands 100bps premium since investor appetite has diminished.
It appears that in part, investors are suspect of the credit quality of any jumbo loan not guaranteed by one of the Agencies even if the originator claims the loan conforms to Agency underwriting standards. Certainly there is a lack of trust with regards to the composition of the underlying mortgages for private label MBS and CMOs. A MBS may be backed by 1000’s of loans from several originators or even hundreds of independent brokers, thus it’s essentially not economical to thoroughly examine each mortgage backing the security. Investors are so far removed from the point of origination that they have to trust proper procedure was followed and rely on legal recourse if originators took a short-cut.
In addition, it appears elevated spread is due to reduced confidence in private insurers ability to guarantee the principal. Historically this has not been a concern since the backers of private label MBS were financially strong and thought to have the wherewithal to handle defaults on the underlying mortgages. Low mortgage defaults coupled with high recovery rates on collateral resulted in a low number of reimbursements required by private insurers. Now that the above situation is reversed, insurers’ ability to cover losses is now a question.
I am somewhat surprised that jumbo spreads have not shown any signs of tightening. According to the graphs from Bankrate.com, jumbo rates began to decrease mid-October, yet reversed course as spreads rose again in November. This is an indication that the non-conforming mortgage market has virtually not improved since the crisis began in July.
LIBOR – CMT Disparity:
Borrowers with LIBOR ARMs scheduled to reset soon are in for a surprise. ARMs reset to a rate which is determined by adding the pre-disclosed margin to the current rate of a specified index. At the time of origination, a borrower can choose which index he/she prefers. Most common indices are the 1-year CMT (Constant Maturity Treasury) and 1-year LIBOR.
Historically, LIBOR has been roughly 50bps (40 bps since 1990) higher than CMT, thus the margin has been 50bps higher for CMT ARMs, hence equating the combined rate (margin + index). Essentially, the choice between the two is a coin flip since both mortgages will reset to nearly the same rate.
Currently, there is a huge disparity between CMT and LIBOR rates. The CMT is approx 3.10 and LIBOR is 4.45, a difference of 135bps which is 85bps higher that the historical relationship. What does this mean? Well, for borrowers that took out a LIBOR 3/1 ARM, three years ago, their mortgage will reset to a rate 85bps higher than if they had chosen CMT. The new rate for CMT ARMs would be 5.85% (2.75 margin + 3.10) and LIBOR ARMs would be 6.70% (2.25 margin + 4.45). Wow!
The short answer for why the CMT-LIBOR spread has become disconnected is because the CMT is truly risk-free rate since it is based on 1-year Treasury yields. LIBOR is the prime rate European banks charge each other and involves credit risk because banks are not government institutions. The long history of a static spread implied credit risk was not perceived as a dominant factor in the determining components of the LIBOR rate. I say this because the LIBOR spread to Treasuries had been constant, suggesting that the mark-up was more customary as opposed to changes in risk perceptions. Recently this has not been the case whatsoever. The credit risk premium is a dominant factor in LIBOR rates as evidenced by the 1yr LIBOR rate remaining high while the risk-free rate has declined. This is a clear indication that the credit quality of banks has significantly deteriorated due to risky mortgage holdings.
FNMA - FHLMC MBS Price Spread:
Another thing that I have noticed recently is that Freddie Mac MBS are trading about 4 ticks or 1/8 pt worse than Fannie Mae MBS. This is strange because Freddie Mac Gold PC pays on the 15th of the month while Fannie Mae payments are 10 days later on the 25th. Since Freddie MBS CFs occur sooner than FNMA, investors should “pay up” for Freddie MBS because its PV of cash flows is larger than PV of FNMA MBS, all else equal.
Freddie Mac MBS always traded at a premium to Fannie throughout my experience on a mortgage trading desk, just as logic would suggest. Recently, Fannie MBS has garnered a slightly higher price despite the payment delay, which raises the question “Why?” Ostensibly the price inversion is due to concern over Freddie Mac’s ability to back its mortgage bonds. Obviously, fears are not paramount, else the spread would be much greater, but this does illustrate that investors are paying attention to something that historically was just a given.
Generally speaking, Freddie and Fannie MBS have had the perception of being free of credit risk due to the implicit guarantee by the Federal Government. Ginnie Mae MBS carries the full faith and credit of the US Government. Agency MBS are backed by high quality mortgages and 80 LTV (PMI required if LTV >80); Fannie and Freddie haven’t ever incurred significant losses from mortgage securitization. In fact, they make a handsome profit securitizing, because the revenues generated from guarantee fees (insurance premiums) far exceeds the losses covered on mortgage loans.
Now, there are questions about the actual risk inherent to both Freddie and Fannie. Both have engaged in risky side businesses that may have impaired their primary business of backing prime MBS. Another concern is the possibility of a higher than expected default rate on mortgage collateral of MBS they issue. Hence, guarantee fees charged for securitization are way to low with respect to actual losses.
Given the major problems announced at Freddie Mac recently, investors are apprehensive as evidenced by Freddie MBS trading back to Fannie MBS, the reverse of historical norms.
Wednesday, December 5, 2007
I wrote about Authentidate (nasd:ADAT-$0.92) several weeks ago claiming that it may be an attractive speculative play(article) given its potential upside coupled with a limited downside. My thesis was that ADAT’s new Inscrybe web platform might accelerate adoption of its products, which has immense market potential. I felt that the stock price should find support around current levels due to the cash on the balance sheet and the decrease of selling pressure. I wanted to discuss some recent developments in light of my previous opinion on Authentidate.
Authentidate recently announced a deal with The Bosch Group that comes on the heels of an October 12th announcement of an alliance with Lufthansa Revenue Services.
Authentidate announced November 28th that The Bosch Group domiciled in Germany is employing electronic signatures in its credit memo process with vendors effective immediately. Costly paper processes can be replaced with electronic forms compliant with the law.
Here is a simple overview of the process: Bosch sends out a credit memo to its vendors to purchase materials and then the vendors fill the order and return an invoice for the shipment. Both the credit memo and invoice can be signed electronically and archived with Authentidate’s eBilling Signature Server. Hence, not only will Bosch being using ADAT’s solution, all its suppliers will be as well. Authentidate’s solution satisfies the requirements stipulated by the German VAT Act and EU Invoicing Directive.
This is a significant development for several reasons.
1) Bosch Group is a large company employing 260,000 in 50 countries, and generated sales of 43.7 billion Euros in 2006. At its core, Bosch is a procurement and logistics firm supporting its R&D and manufacturing operations. Thus, Authentidate’s service should be an integral part of Bosch’s IT processes representing the potential for significant revenue.
2) Bosch’s decision to go with Authentidate demonstrates the trust and confidence it has in ADAT’s offering. Ostensibly, a firm such as Bosch, chooses partners carefully and with due diligence.
3) Adoption by a major industry player opens the door for further adoption by its peers and competitors. Bosch’s choice can lead to Authentidate becoming the de facto “industry standard” from achieving legitimacy in the eyes of IT directors industry-wide.
It’s hard to predict the revenue impact from the Bosch agreement, but it suspect it should be significant. If Bosch revenue is approx $65 billion, then 1/100 of 1% is 6.5 million, which may be the high-end with $650k at the low-end of the range. That’s purely a guess, but with the little information to go on, that’s my logic and would expect revenues closer to the low end of the range.
The spill over effects could be significant due to the publicity associated with a company of Bosch’s stature. I expect to see 3 or more new announcements in the next 3 months resulting from the Bosch decision. Granted, these are likely to come from much smaller players, yet I expect momentum to accelerate as ADAT’s solutions achieve critical mass (Bosch & Lufthansa).
Additionally, Authentidate is hosting Signature Day in February, which is a conference that explains and promotes the use of its technology. The Lufthansa and Bosch developments should provide momentum and create interest leading up to the conference. This should attract more participants and ultimately more customers.
As I said in my previous article, the next couple quarters will be a key indication whether ADAT’s offerings are gaining traction. The stock price has stabilized, yet for it to move higher adoption must come to fruition. If that does not occur, ultimately Authentidate will run out of cash in three years.
Disclosure: I am long ADAT
Monday, November 19, 2007
I just read Charles Mizrahi’s new book, Getting Started in Value Investing just released this month from Wiley Publishers, (amazon book link) and I found it to be phenomenal. I wanted to discuss my views on Value Investing and why I liked the book so much.
Getting Started in Value Investing is a terrific guide for anyone studying the discipline of Value Investing. The text is also an excellent companion for experienced investors as well. The author does a excellent job explaining the Value Investing process. He presents the material in a manner that really helps the reader get in the Value Investing mindset. Regardless of investing experience and knowledge, all investors seeking better results will benefit from reading Charles Mizrahi’s book.
Value Investing is one of the most written about subjects in the finance/investing space. There are dozens of books just covering methods of Warren Buffet specifically, plus dozens of other texts on the value approach. It’s never difficult to find this kind of reading material, yet it can be difficult to discern the truly meaningful content from the vast pool of titles. That being said, there are good number of Value Investing books that pretty much contain the same information thereby conveying same message. At least, that is what I have encountered from reading scores of writings on this subject.
Essentially, after reading many Value Investing guides, I began to have the notion that if I’ve read several, I must have read them all. Yet, When I discovered Getting Started in Value Investing, I quickly recognized that it was no ordinary investing guide. The value methodology and principals remain the same, but the presentation of the material and the manner the author delivers the message is highly effective. Mr. Mizrahi has unique and wonderful writing style that is entertaining and captive, allowing the material to really “sink-in”.
Getting Started in Value Investing is not just another investing book, and it’s not just a beginner’s manual either. It engages the reader, and the flow of information is so well organized that it reads effortlessly. Mizrahi’s examples and illustrative stories train the reader’s mind to think and operate in the Value Investing mental framework. Knowing the principals and methods to Value Investing is rather worthless unless they are properly practiced- when it counts- differentiating the noise from the news, when money is at stake.
I have come across little investment literature that provides level of beneficial information received from reading Mr. Mizrahi’s work. It’s helped shape my thinking- by adopting a stronger focus on value, which I have gained through the text’s memorable examples and pep-talks.
Mr. Mizrahi opens with a quote from Warren Buffet commenting that in 35 years of investing, he has not witnessed a trend towards the value approach. “There seems to be a perverse human characteristic that likes making easy things difficult.” Successful investing is not difficult if one applies the Value principles correctly, along with reducing preventable mistakes as possible. Success is about making more good investment decisions than bad ones. Reading this book explains how Value Investing increases the probability of good decisions and limits the risk of making poor investment decisions.
Getting Started in Value Investing begins with the author stating the book will teach all the methods one needs in order to invest successfully. Yet, he adds a caveat: successful investing will depend on the ability to keep emotions in check as well as avoiding the latest fad on Wall Street. The book demonstrates how to remove emotion and act on the facts.
Getting Started in Value Investing contains all the tools that the reader needs to be an successful Value Investor. Each method is clearly explained, and also demonstrated with effective examples. Mizrahi explains how to analyze firm management, financial statements, competitive position, and how to calculate a stock’s intrinsic value along with applying a margin of safety. These are the tools needed to identify attractive investment opportunities.
My biggest investing weakness is making a trade on emotion without doing the necessary research. When I analyze my poor investment decisions, often the reason is “Just wasn’t thinking.” It just happens, I get caught up in the market noise and act without much thought, or even the realization of what I am doing. Investors must resist being transfixed on the whims and emotions of the market. The Value Investing approach hinges on taking advantage of the Market’s mood swings by purchasing stocks at a considerable discount to true value. A stock price less than its true worth provides a margin of safety. This reduces risk because an investor has more leeway with the accuracy of his/her intrinsic value opinion. For example, if one believes a stock to be worth $50, but in reality, the true value is $40, the investor will still make out all right buying at $30, when unreasonable investor sentiment causes a stock to be undervalued.
It’s very easy to lose sight of the pillars and principals of Value Investing when the market is being testy. Remaining steadfast to the value tenets and not wavering during volatile times can be challenging. This requires the confidence to believe that he/she has the correct view, versus the collective view of investors. Mr. Mizrahi provides motivating insight on how to deal with Mr. Market’s psychosis, and illustrates the mental framework needed to resist succumbing to market distractions.
The hardest part can be pulling the trigger on an undervalued investment even though one has performed extensive and thorough research. Market noise can lead to excessive pessimism of investors causing them to overlook the long-term value of a company. The market can ignore a firm’s strong and honest management, the longevity of the competitive moat, and its solid profitability and return on capital. The Value Investor must determine if those factors are likely to remain intact going forward, which thereby answers whether or not, the excessive pessimism is warranted. Reading this book will teach how to distinguish value plays from value traps.
Who’s right? The Market or the Value Investor? To paraphrase a quote from Ben Graham that Mr. Mizrahi shares in his book: if you base your investment decision on exhaustive research and factual data, then take action regardless if others disagree. The opinion of others doesn’t determine whether you are right or wrong. Your opinion is right because it’s founded on extensive research and judicious reasoning. Reading this book stimulated my thinking and decision process, helping me to be cautious when I haven’t performed necessary research, and aggressive when I have.
It’s much easier for humans to cope with making a bad decision as long as everyone else did as well. A Tough pill to swallow is a poor decision made against the grain. Getting it wrong when everyone else gets it right, evokes considerable emotional distress, as opposed to everyone getting it wrong with nobody getting it right. Those disproportionate emotional/mental pay-offs spawn the herd mentality because it shields us from “Looking Dumb” which is a title for the section addressing that issue in the book.
The author provides anecdotal illustrations of how to think and act in order to invest successfully. I love an example he gives about buying “straw hats in the winter” may appear to be stupid, but combine the low winter price and the Summer demand, and six months later, that stupidity turns into high profitability.
I truly found this book to be an instrumental addition to my library. The writing and explanation are excellent, and the examples and anecdotes are highly illustrative. The book provides the necessary tools and explanation for evaluating investments. In addition, and probably most important, the book succeeds with illustrating the proper mindset and thinking needed to take action. I recommend buying a copy.
Labels: Book Review
Thursday, November 15, 2007
Authentidate (nasd:ADAT) is an attractive,speculative play offering massive upside potential with little downside risk. ADAT trades @ near cash with a price / book multiple of 0.8x and has zero debt on its balance sheet. Optimistic expectations stemming from the USPS choosing Authentidate as the sole provider of the electronic postmark (EPM), drove ADAT’s shares to nearly $20 in 2004. As customer adoption has been much slower than expected, revenue traction has been soft causing shares to sink to all-time low price of $0.85. The concept of Authentidate’s product/service offerings has always been solid value proposition, yet support for customer implementation has been rather weak.
Authentidate restructured the company and adopted a new strategy resulting in the August release of its Inscrybe™ web-based platform. Inscrybe simplifies the implementation process, which will lead to increasing customer adoption and a dramatic acceleration in revenue growth. The prospects of accelerating revenue growth coupled with high gross margins make ADAT worth considering as a speculative holding given limited risk for further price deterioration.
Company Description: (from ADAT 10-k)
Authentidate Holding Corp. is a worldwide provider of software and web-based services that enable enterprises and individuals to exchange information securely and conduct trusted business transactions. Our offerings are targeted at enterprises and office professionals, and incorporate security technologies such as electronic signing, identity management, and content authentication to electronically facilitate secure and trusted transactions. In the United States, we also offer our proprietary and patent pending content authentication technology as a web-based service in the form of the United States Postal Service® Electronic Postmark. See USPS EPM.
New Product: Inscrybe Office
Taken from company press release 8/15/2007-
Inscrybe Office is based on Authentidate's proven Inscrybe suite of capabilities serving the document exchange needs of large enterprises today. The new web-based service combines powerful features, such as electronic signatures, content authentication and trusted time stamps using the United States Postal Service® (USPS) Electronic Postmark (EPM) seal, along with a host of other features that simplify the online exchange of critical and time-sensitive documents. Inscrybe Office is available to anyone with web access, via MyInscrybe.com, a new self-serve portal designed to provide individual users personalized access to Authentidate offerings.
Inscrybe Office, is a user-friendly service designed for business or personal use, to securely and conveniently sign, seal and confirm receipt of important documents over the web. In addition to supporting multiple electronic signatures on the same document, the new service offers senders and recipients the benefits of secure and verifiable online document exchange, with optional features such as acknowledgment of receipt, verification of recipient identity, and audit trails. A user may employ any combination of these optional features to legitimize a document transaction.
Inscrybe Office is ideal for legally binding or compliance-dependent transactions such as business or personal contracts, agreements, closing documents, transcripts, offer letters, prescriptions, authorizations and much more. Inscrybe Office has appeal for professionals and enterprises across a diverse range of industries such as education, financial services, healthcare, legal and real estate.
Authentidate provides security solutions for electronic documents so that legally binding contracts can be signed electronically. Authentidate’s technology verifies each party’s identity, timestamps the documents, and archives them at a 3rd-party retention facility. A “paperless” world falls short due to the requirements for signed, original documents, yet Congress passed the E-sign act in 2000 making electronic signatures legally binding given the specific security requirements are fulfilled.
Here is an example of the advantages to Authentidate’s offerings. To execute a contract, a physical signature must be obtained for an original document. This involves the need to print out a paper copy, sign it, and fed-ex the documents ($30 overnight) to the counterparty. The counterparty then receives the documents, goes to have their signature notarized, and then fed-exs the documents back to the originator In total, the transaction probably takes 2-3 days, several labor hours, and around $60 of shipping overhead.
With Inscrybe™, documents are sent and electronically signed online, thus taking only minutes to complete the whole process. Depending on volume discounts, an EPM only costs .10 to .80, providing huge cost savings from traditional signature methods. Evolution towards a truly “paperless” world is encumbered by the need for physically signed documents, yet Authentidate’s solution eliminates the need for paper copies allowing documents to reach a fully “paperless” state.
Operating Performance History:
Authentidate sold its DocStar and DJS marketing group to focus solely on security solutions. Looking at historical financial statements doesn’t represent an accurate picture of Authentidate’s current operations. For example, income statement found on Yahoo Finance shows sales of $17.5m-2005, $16.5m-2006, and $5m-2007. This figures include revenue from discontinued business segments. Revenues from continuing operations only are illustrated below.
Sales growth for the past 5 years has averaged 56% per annum. Management declined to give specific guidance, but insinuated that Inscrybe (August release) will accelerate customer adoption and usage rates causing a significant increase in sales growth. Gross margins have historically ranged 60-70%. SG&A expenses have been the primary problem, totaling $16.8m fro FY07. Ostensibly, sales would probably have to reach an annual run-rate of $25m for ADAT to attain profitability.
In my opinion, shares of ADAT shouldn’t fall much further due to multiple factors that should provide a price floor. Just looking at the balance sheet, shares almost trade at the value of cash items on the books. ADAT is debt free; liabilities only consist of accounts payable and deferred revenue. ADAT’s market value is roughly equal to net-tangible assets and lower than $1.13 BVPS. I feel these factors should place a limit to further price declines. Taking account of intangible assets, such as product technology, patents, and the USPS contract, a case can be made that ADAT should trade at a higher multiple to book value.
I think the important aspect to recognize is that ADAT, if needed, could sell itself to a larger company at a price, at least equal, but likely higher, than present value. Given the high gross margins for revenue streams, ADAT’s business model could be very attractive to a firm with a more efficient overhead cost structure. A market value of $29.3m and cash of $28m suggests the business model (incl. EPM) can be purchased for a little more than $1 million. If ADAT is unable to achieve a desired revenue run-rate accompanied with needed overhead cost-reductions, I am confident that another firm, with greater resources, could deliver successful results.
Thus, I feel that, just from value derived from the assets, ADAT shares should encounter a support level around its current price. If investors fail to see Authentidate’s value, it’s likely a firm in the related space will. It would be much more costly for a firm to “start from scratch” in duplicating Authentidate’s offerings than to just buy Authentidate itself.
1) $0.81 cash per share
2) $0.84 tangible book value per share
3) $1.13 book value per share
4) EPM contract with USPS
5) Authentication patents
6) Inscrybe web-based platform (incl. customer book)
In the past, there was considerable interest for Authentidate’s product offering, yet the delivery and implantation aspect was more difficult for the customer which impeding adoption. Healthcare related firms have been the primary adopters thus far due to the benefits of processing medical claim documents electronically. To receive reimbursements, patient care services must submit certificates of medical necessity signed by a physician to Medicare or insurance provider.
Doug Guy, SVP at American Home Patient commented about incorporating Authentidate’s solution (ADAT PR 4/23/2007) "We are realizing significant operational efficiencies as a result of deploying the Inscrybe eCMN capabilities in our billing centers and branch locations. Over the past 12 months, we have seen a 65% reduction in turnaround time of documents processed by physician offices through Inscrybe, a significant reduction in unbilled dollars, and a marked improvement in internal document processing throughput. Besides a direct impact on our bottom line, it has improved the service experience for our physician and patient communities."
The market potential is massive. Enormous. The state of Indiana has been using Authentidate’s technology for DMV and court-related documents. In Germany, firms are authenticating electronic invoices for VAT tax compliance standards. The legal, financial, real estate, medical, and likely almost every other industry could benefit from using ADAT’s document security solutions.
The core issue is developing a critical mass of users, since adoption spreads virally. Hence, a user wanting to send documents requires the counterparty to use the technology as well. Think of a fax machine. The first fax machine was useless since it requires another fax machine to receive. Yet, as fax usage increased, more and more people purchased fax machines so they could correspond with those already using fax machines. Thus, adoption rates begin at a slow pace but accelerate quickly resulting in exponential growth.
The attractiveness of speculating on ADAT is that revenue traction could explode in a short time period. ADAT doesn’t face any direct competition; it’s real challenge is developing product awareness so that a critical mass can be attained. The degree of the operating leverage inherent in ADAT’s model (high gross margins) translates into more dollars falling to the bottom line as revenues increase.
In my mind the question will not be “IF” but rather “WHEN” regarding revenue traction. Since Authentidate is unprofitable, it needs to see significant revenue growth sooner than later. It should be evident over the coming 2-3 quarters whether ADAT’s revised strategy and Inscrybe platform is highly successful. I estimate the company has enough cash to fund operations for the next 2.5-3 years. It’s very uncertain if Authentidate will be successful in accomplishing this objective, yet at the current share price, it’s worth taking a gamble.
Tuesday, November 6, 2007
Check out the great articles included in 61st Festival of Stocks, November 5th 2007
Hosted by Blain Reinkensmeyer at Stock Trading To Go.
I thank Blain for hosting the Festival this week and selecting my article: Apple’s versus Amazon’s valuation.
Dividend Guy takes us through his valuation of Dividend Stock Wednesday: SNC-Lavalin (CA:SNC)
George at Fat Pitch Financials asks Vitaliy Katsenelson, CFA of Contrarian Edge about his new book and investing in an “Interview with Vitaliy Katsenelson, author of Active Value Investing.”
Past editions are archived @ Festival of Stocks homepage.
Submit your blog article to the next edition of festival of stocks using our carnival submission form.
Labels: festival of stocks
Tuesday, October 30, 2007
In performing a valuation study on Amazon.com and Apple Inc. it is evident that both stocks are priced with high expectations for growth and profitability. Both trade at high P/E multiples; that doesn’t automatically signify that the two are overvalued as long as solid justifications for the high multiple can be ascertained. Decomposing the value assumptions (expectations) which are implied by the current share price, an understanding of future performance required to support the share price can be obtained.
I evaluated Amazon and Apple and made some comparisons with respect to P/E multiples and DCF model valuation. I concluded that Apple’s current valuation is reasonable based on input assumptions I believe are sensible given historical performance and growth momentum. Amazon, on the other hand, I determined it’s overvalued primarily due to my operating margin assumptions.
The key underlying factor implied in Apple’s market valuation is the continuation of rapid growth and stout margins for many future years. This attainable, in my mind, given Apple has already demonstrated the capability to create new products and attract customers. Amazon’s market value hinges in the expectation that margins will expand. Amazon has yet to prove that it can boost margins consistently for years now. Until Amazon exhibits consistent improvement in its margins, I will use historical op margins of 4% in my valuation assumptions. Without rising profit margins of at least 6%, AMZN is overvalued.
Relative Valuation- Price/Earnings Multiple
Apple ($185) currently trades around 37x 2008 consensus EPS estimate of $4.97. On the surface, it’s a pretty rich multiple, yet in reality, Apple’s multiple is lower when taking account of a couple issues.
First, Apple always provides very conservative guidance. This is no secret; Wall Street adjusts its earnings estimates in response to management’s low-balling, yet Apple still manages to mightily exceed the consensus earnings number. Hence, history suggests that one should assume that future estimates are too low. AAPL has averaged 32% earnings surprise for the last four quarters, and for the last 2 years, earnings came in approximately 25% higher than estimates on average. Those figures don’t account for the revisions during the months leading up to an earnings announcement. In the past 2 months, Apple’s 2008 full year estimated earnings were revised upward about 13%, and we still have almost a whole year until 2008 earnings are released. Actual 2008 earnings might possibly be 10-30% higher than the current consensus estimate.
Second, EPS is an accounting measure based on accruals not actual cash received by the firm. Apple’s special accounting treatment for its iPhone spreads revenues over a 24 month period even Apple receives cash for the device sale up-front. Thus, the cash pouring into Apple pockets is recorded as deferred revenue on the balance sheet. When taking into account “cash earnings” opposed to accounting earnings, EPS would be somewhat higher depending on the level of iPhone sales / deferred revenue accruals.
In sum, investors pay a multiple based on their earnings expectations, not necessarily on the publicized consensus estimate- a whisper pro-forma estimate that adjusts for accounting issues and conservative guidance, Hence, for relative purposes, there’s a strong case for saying AAPL trades at lower P/E, possibly in the low 30’s.
Apple’s growth has been extraordinary the past couple years. Assuming that this will continue, a 30ish price multiple is likely justified. On average, analyst project 23% earnings growth annually for the next 5 years which produces a PEG ratio less than 1.5 (using a 33 multiple). Apple’s earnings have grown 150% the past 5 years according to Yahoo.
Amazon ($90) trades 56x its $1.61 FY08 estimate. Historically, AMZN reported EPS has been in a close range of the Street’s estimates, except for a couple of blow-out quarters. Thus, no clear, consistent earnings pattern exists to assume that estimates are too high/low. Amazon’s sales figures have been fairly consistent, but its profit margins are volatile. Amazon’s multiple 56x multiple is likely realistic.
The 5 year projected growth rate for AMZN is about 23% making the PEG greater than 2. That’s expensive but if you believe that margins will expand significantly then growth will be much greater and consequently AMZN shares less overvalued.
Discounted Cash Flow Valuation: FCFF
According to my DCF model the fair value of AAPL shares is $175 versus recent market price of $185. The input assumptions are fairly aggressive: expectations for sales growth and operating margins to maintain their strong momentum for many years going forward. The model uses 22% annual revenue growth for next 5 years, and for years 6-12 annual growth transitions from 15% to 5%.
Sustaining high annual growth rates becomes increasingly difficult due to the law of large numbers. Revenues only have to increase by about $5 billion to equate to 22% growth rate next year, yet in year five, a $11 billion annual sales increase is required to attain 22% growth. Apple will need to attract new customers in larger and larger increments to generate the level of expected sales implied by the share price.
Key Point: To justify Apple’s current share price, margins and sales growth must remain strong for a considerable period of time. Apple has significant momentum in its favor: massive brand power, innovative product design, and a strong portfolio that leverages individual products to boost demand of other products (“Halo Effect”). Apple products receive very high customer satisfaction, almost seeming every new user of Apple products end up loving them. However, there is a possibility that much of the low hanging fruit has been picked, and attracting new customers will be more difficult if they are not pre-disposed to adopting Apple’s products.
Conclusion: I am more confident than not, Apple will/can match these expectations. Yet, I am not completely confident Apple will meet or exceed the price-implied growth/profitability expectations. In my opinion, expectations are neither too high/low to assert comfortably that shares are over/under-valued. In essence, AAPL is fully-valued and to assume otherwise would entail prophetic guessing, in my opinion.
Amazon’s intrinsic share value is $60 based on the DCF model compared to $90 market price. 5-year expected annual sales growth is 24%, then transitions (7yr) from 21% to 5.5% starting in year 6. Input assumptions for operating margins hold steady @ 4% during the 12-year horizon. I believe achieving high sales growth levels will not be a problem for AMZN. Amazon Margins are the primary factor behind the discrepancy between market and model values.
Key Point: Amazon shares are priced on expectations for margin expansion in future years. Amazon’s operating margins have shown significant volatility in past periods, and the firm has yet to demonstrate it can attain above 4% consistently.
Amazon must offer discounted prices to generate revenue. Since many retailers sell the same products, competition is based on price. Competitors with the lowest cost structures can offer the lowest prices, thus business strategy revolves around attaining economies scale and cost efficiencies. Amazon sales have increased 100-fold in ten years but the operating leverage and cost advantages have not been so robust, as one would naturally expect.
In order to avoid price competition, Amazon must differentiate its offering. Amazon has been working to accomplish this, yet the increases in R&D spending shaves margins. The hope is that the high R&D expenditures will materialize in fatter profit margins as AMZN diversifies its revenue streams.
Conclusion: We have yet to observe solid evidence than Amazon will be able to boost margins above levels for the average retailer. Investors have been expecting that to happen, and management says that it will, but until then I am skeptical.
Both firms have lofty expectations to live up to, but Apple has the hot hand as of now. That’s not a secret, hence the reason AAPL is trading at a high multiple. Amazon is very rich at its current share price, but historically investors have been patient, and I don’t foresee a major drop in the share price in the near-term. If higher profitability doesn’t eventually come to fruition at Amazon shares will definitely come under pressure.
I don’t expect stock returns to be above normal for both Amazon and Apple in the coming quarters due to all the good news and the high expectations currently reflected in their share prices. But, both are terrific companies and If I owned them I wouldn’t want to sell them. In the long-run both should do well.
I do not have a position in any of the stocks mentioned.
Monday, October 29, 2007
Welcome to the October 29, 2007 edition of festival of stocks.
I am honored to host my first edition of Festival of Stocks. Special thanks to George at Fat Pitch Financials for giving me this opportunity. Here are this weeks submissions that I selected for this edition. Take a look and enjoy!
Allen Taylor presents Investing - Determining Your Goals posted at Investing World Today, saying, "Much like an exercise program, you will want to determine your goals before you begin to invest. Your goal might be retiring in 20-30 years, kids college funding or, if you got started a bit late, retirement in the next 5 to 10 years."
Eric Stanley presents How The Recent ?Credit Crunch? Could Affect You posted at Personal Finance Blog Articles, saying, "With banks and financial intuitions unsure on the risks involved with lending to one another, a ripple effect is being sent out into the rest of the lending world."
Thomas Humes presents Guidelines for Building Wealth posted at Wealth Building World, saying, "Review my guidelines for building wealth."
The Investor's Journal presents The Fundamentals of Successful Investing posted at The Investor's Journal, saying, "There are some basic fundamentals that I’ve learned the hard way through my mistakes in the stock market. This article will teach you the fundamentals of successful investing so that you don’t make the same mistakes that I did!"
FIRE Getters presents TIPS for Inflation and Deflation! posted at FIRE Finance. This article provides a great explanation of TIPS and the benefits of owning them.
Steve Faber presents What is The Pinchot Plan and Is it a Good Investment? posted at DebtBlog. Steve discusses several REITs affected by the Pinchot Plan.
Jorge H. presents Stock Replacement Strategy - Introduction posted at My Adventures into The Street, saying, "An introduction into a complex strategy involving stock replacement through options."
Ray Chong presents Protecting Profits - The Art Of The Trailing Stop posted at Trading Tips, Strategies and Insights. Ray explains a very useful method to protected profits using stop-loss orders. In my opinion, the sell discipline is one of the most under-rated aspects of investing. Ray’s commentary is a must read.
Pinyo Bhulipongsanon presents Mutual Fund Double Whammy posted at Moolanomy, saying, "This post explain the concept of mutual fund double whammy and walk through a real life example of how I dealt with it."
Sam presents Stock Investing With Warren Buffett. Investment Advice From a Billionaire. posted at Surfer Sam and Friends, saying, "Warren Buffett, billionaire investor, businessperson and philanthropist, is often called the "Sage of Omaha" or the "Oracle of Omaha." He is well known as the second or third richest man in the world, behind Bill Gates of Microsoft. His timeless philosophy of value investing has proven relevant and profitable in all types of markets and financial environments."
The Dividend Guy presents Dividend Stock Wednesday: Johnson & Johnson (JNJ) posted at Dividend Guy Terrific analysis of JNJ; I highly recommend reading.
Dereck Coatney presents Is Headwaters (HW) An Unnecessary Risk? posted at The Best Stock Trading in the World. Dereck talks about investing in HW.
Matthew Paulson presents When It Comes to Investing, There’s No Free Lunch posted at Getting Green.
Valulicious presents Company Sitting on a Pile of Cash posted at Valulicious, saying, "have fun with the carnival!"
Dirk Masuch Oesterreich presents Fundamental Outlook for Industrial and Precious Metals posted at Nevada Gold Investor.
Turley Muller presents Walgreen Company (WAG): Reasonably Valued? posted at Financial Alchemist. Here is my recent analysis of WAG and what to make of the recent sell-off.
Larry Russell presents Diversify To Avoid Investment Fraud posted at THE SKILLED INVESTOR Blog, saying, "Stories about investment fraud often seem to include the phrase "his or her life savings." There should never be a moment during your lifetime when your life savings are not heavily diversified across many investment vehicles and firms."
Leon Gettler presents Faulty forecasts posted at Sox First, saying, "Listed companies seem to have a knack of alienating investors and harming their share price by providing forecasts that are way off target, according to a global study. More than 70 per cent of companies admit to forecasting errors, and the average company forecast is off by as much as 13 per cent. To investors, the message is clear: be wary of company forecasts and do your own research."
Stirling Newberry presents Don't shoot your friends posted at The Agonist, saying, "What's really the problem with modern portfolio management?--the failure to understand that economics is the study of the games people play."
vld2czech presents Stockweb - Eastern Europe emerging stock markets posted at StockWeb.
Caw presents Designing the perfect(ly diversified) ETF posted at Money $ Liberty.
Blain Reinkensmeyer presents 13 Great Ways to Invest in Oil Without Buying Barrels posted at Stock Trading To Go.
Super Saver presents 10/22/07 Stock Purchase Update - Declined With Market Weakness posted at My Wealth Builder.
That concludes this edition. Submit your blog article to the next edition of festival of stocks using our carnival submission form. Past posts and future hosts can be found on our Festival of Stocks Index Page.
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Labels: festival of stocks
Friday, October 26, 2007
I am presenting this analysis in response to discussion on Fat Pitch Financials regarding the recent article "52-week-low-list-packed-with-quality-names" posted by George. Walgreen Company was a topic in the reader comments thread, and curiosity arose as to whether WAG is an attractive buy at current price levels. I promised to take an in-depth look and present my findings.
WAG Shares Drop Below $40:
Walgreen Company (nyse:WAG) traded around $48 on September 28, 2007 before it missed Q4 earnings estimates reporting 40c versus consensus of 47c. WAG shares fell nearly 17% to $40/share in response to the rare disappointment, and subsequently declined below $38 over the following trading sessions. With Walgreen trading at lower multiples (19x ttm), the natural question becomes “Is WAG undervalued?” It is the opinion of this analyst that Walgreen shares are reasonably valued @ $39ish, yet given potential risks, WAG would need to trade around $33-34 to provide a reasonable margin of safety.
Price Decline Stems From Risk Reassessment:
Walgreen shares plummeted due to a host of reasons, slowing growth prospects, competition worries, etc. I believe the primary factor behind the significant sell-off was the re-pricing of risk inherent in Walgreen. WAG shares have historically traded at a premium with trailing P/E ratios around 30x. Before the earnings miss, WAG traded around 24x trailing EPS.
Historically, Walgreen’s financial performance was very stable and predictable, thus investors required a lower return on equity relative to other stocks. Essentially, the high level of certainty pertaining to Walgreen’s prospective margins, ROE, EPS etc. resulted in investors paying higher multiples. This would suggest that beta values for WAG should be relatively low which coincides with the betas reported by various sources:
In the past 5 years, ROE has been in a tight range: 17.5% - 18.4%, and operating margins 5.7%. Prior to last quarter, Walgreen had only missed estimates 7 times in 21 quarters: 6 misses by a penny / 1 miss by two cents. Risk is defined by uncertainty, and with less uncertainty involving Walgreen translates into lower K(e) (required return on equity) and higher P/E multiples.
The 7 cents earnings disappointment raises questions about Walgreen’s consistency and predictability causing investors to reassess the entailed risk. Investors no longer are willing to pay inflated multiples for WAG since performance has become less predictable than previously thought. Walgreen’s share price falls to reflect increased risk as its trailing P/E multiple contracts from 24x to 19x. Ostensibly, reduced growth rate expectations play a partial role as well.
Q4 Earnings Disappointment:
Walgreens posted 40 cents a share versus estimate of 47 cents, with growth flat year over year. Sales grew 10.3% with front-end sales of comparable stores growing 6.1%. The major reasons for the profit miss were higher than expected SG&A expenses and lower reimbursement rates for the generic form of Zocor. Many analysts attributed the earnings miss due to internal budgeting mistakes such as increasing discretionary spending items such as salaries and advertising. Apparently, Walgreen failed to keep expenditures in line with level of reimbursements it was receiving, likely due to an overestimation of reimbursements resulting in overspending given actual receipts. These issues are expected to persist for the next 1-2 quarters, but analysts believe Walgreen can will easily remedy these problems and the long-term picture remains intact.
1) Increasing number of ”health maintenance” drugs
2) Aging baby boomer population
3) Prime store locations
4) High market share translating into scale benefits
Major Risk Factors:
1) Peaking generic drug cycle
2) Slowing growth- store saturation
3) CVS/Caremark competition
4) Non-drugstore competition- Wal-Mart, Target, other grocery retailers
Peaking Generic Drug Cycle:
The amount of branded drugs converting to generic is expected to drop in 2008 to 13b versus 21b for 2007. It’s likely the generic outlook has already been priced in evidenced by the 10% multiple compression (since May 2007) of the major drugstore stocks despite exceeding earnings estimates.
Walgreen reaps its highest margins from blockbuster drugs becoming available in generic form. Insurers pay hefty reimbursements for generic drugs that just went off patent to encourage switching from the higher-priced branded drugs. Typically, after six months or longer, those inflated payments begin to shrink. Thus, WAG relies on the continued release of new generic drugs to maintain its high margins. For example, Walgreen sold three times as much generic Zocor last quarter than a year ago, yet its profit from those sales remained about the same for both periods.
Walgreen’s principal growth engine has been store expansion. Currently WAG operates almost 6000 stores and plans to attain the 7000 store mark by 2010. Certainly, Walgreens still has room for expansion, but as more stores are added logically implies fewer prospective locations remain. In my opinion, the low hanging fruit has been picked, and new locations will be accompanied by competition from the likes of CVS, Rite Aid, and big box retailers such as Wal-Mart and grocery stores.
Walgreen’s competitive strength has been store location. Management careful scouts potential locations and often builds new stores from the ground-up. Walgreen stores are usually positioned on high traffic corners which also anchor large residential neighborhoods. Premium locations allow WAG stores to be highly productive, averaging 275 prescriptions daily versus 200 for its peers. The convenience of Walgreen locations insulates the drug retailer from competition due to consumers’ preference for accessibility versus price. Walgreen’s scale and high volume translates into pricing advantages over other pharmacies. The major threats of price competition belong to Wal-Mart and similar big-box retail/grocers. Walgreen has not been impacted significantly because of superior convenience of its locations
Since Walgreen depends heavily on store location, I believe store expansion will be challenging since WAG is very selective. Thus, how many prospective locations exist that would be a good fit for Walgreen? The law of large numbers is working against Walgreen, thus growth will moderate in the years to come from store count approaching the saturation point.
CVS / Caremark Competition:
The Caremark (pharmacy benefit manager) acquisition affords CVS a couple advantages. It provides scales, negotiating power, and reduced reimbursement rate pressures than normal drugstores. If this merger proves to be successful, then Walgreen will feel pressure to follow suit by acquiring a PBM. In addition, CVS is opening in-store clinics to treat patients for minor illnesses. Walgreen is introducing the same concept in its stores. The competitive theme between the two appears to be “as one company does, so will the other.”
CVS operates slightly more stores than WAG in an overlapping footprint, yet not necessarily in all the same markets. As CVS and WAG continue to increase store locations, it’s inevitable that the two will find each other on opposing street corners in the years ahead. CVS being a formidable competitor will impose a limit to Walgreen’s growth via store expansion.
Wal-Mart & Other Big-Box Retailers:
WMT announced last year that it would be offering select drugs for $4. Target followed with its own similar program. Large retailers and grocery chains are using prescription drugs to boost foot traffic in its stores. In some cases, drugs are “loss leaders” which entails pricing high demand items at a loss with the expectation that customers will also purchase high margin products during the visit. On the surface, this appears to be a huge concern for Walgreen. In fact, the impact on WAG has been slight to none for the past year. The reason is simple. Ninety-five percent of Walgreen’s customers have insurance meaning that they only pay $5 for a prescription, just $1 more than WMT and TGT. The slight pricing differential has not been enough to lure customers to Wal-Mart, possibly because of the hassle and lack of convenience associated with WMT and other similar retailers. Customer demographics are different; hence they are not competing for the same customer.
The future may be different. In the years ahead, Wal-Mart may succeed with its invasion of cities. If WMT opens smaller city-sized stores in close proximity to Walgreen locations, WAG would definitely feel the pain. If these low-price retailers can leverage their operating scale in the form of smaller, convenient store location they would have a competitive edge over existing incumbents. I expect we are many years away from this coming to fruition, yet it is a potential risk to consider.
In conjunction to Walgreen’s slowing growth and dwindling store expansion opportunities, substantial competitive risks are brewing on the horizon. This combination creates a tough sell for assigning WAG a relatively high multiple.
Walgreen was overvalued from some time, which explains the stock’s poor returns. The last time WAG traded below $40 was back in December 2004 (shares are up only 4% since then). For nearly three years, shares were primarily contained to $44-46 price range, breaking above $50 briefly. See Chart. The past five years, WAG shares are up 11.2% vs. 68% on the S&P 500. Earnings growth has averaged 15% for the last 5 years and sales growth has average 14%, yet share appreciation has been stagnant. Even as earnings increased, the P/E multiple steadily declined resulting in little change to WAG share price.
WAG projected EPS 5-year growth rate is 13.8% and shares currently trade @ 18x and 16x this year’s and next year’s estimates, respectively. PEG ratio is 1.3 based on this year’s expected P/E.
Considering the risks and prospective growth of Walgreen, I believe shares should trade @ 15x this year’s EPS estimate, translating into a fair value share price of $33.30.
I would feel that WAG was attractive at current levels if it weren’t for the negative sentiment overhanging the stock. The risks I outlined above are more what I think investors’ concerns to be, than that of my own. Since it’s the collective opinion of investors that move share prices, understanding the collective concerns is most important.
With poor stock returns and questions regarding Walgreen’s future, I don’t foresee a catalyst that would boost optimist and spark share demand. In short, I don’t expect any news of a magnitude capable of really boosting share prices.
I believe that the recent swoon in Walgreen’s share price was mostly due to investors reconsidering the involved risk in WAG shares, for the underlying story remains unchanged. WAG valuations had been rich for sometime, and the earnings disappointment spurred the market to seek justifications for such a high multiple. Slowing growth and a less predictable future for Walgreen results in a contraction of its formerly lofty P/E to more reasonable levels. With Walgreen’s poor stock performance, investor’s are likely to find shares unappealing for sometime. Walgreen is a quality name, with great potential and competitive advantages, but superior returns will only arise from a lower share price.
Wednesday, October 17, 2007
Starbucks (SBUX) is the subject of debate for the Face-Off column in this month’s (Nov ’07) issue of SmartMoney Magazine “Can Starbucks Serve Up Venti Profits?” If you are not familiar with this column, SmartMoney asks two experts to take opposing views on a company, and give five reasons on whether to buy/sell the respective stock.
Sharon Zackfia, analyst at William Blair gives the bull case and Mark Coffeit, portfolio manager of the Empiric Core Equity Fund responds with the bear case for Starbucks Coffee.
I have summarized the main points for both arguments below. I didn’t include all arguments from the article, just the most relevant.
BULL CASE: Sharon Zackfia
- Sales growth will continue to be solid due to new breakfast & lunch offerings and international expansion (profitability in China is better than U.S.). Store count is expected to double in 5 years.
- SBUX faces increased competition from MCD but they are not fighting for the same consumer. Until 2003, coffee consumption had been declining, but 2006 was the highest level since the mid-80’s. In growing markets, all competitors can win.
- P/E of 26x 2008 estimates is lower than the mid-30’s multiple SBUX has historically commanded. SBUX has maintained guidance for this year’s earnings since giving it August 2006. Growth is still impressive; It’s only large-cap retailer growing sales at more than 20% annually.
BEAR CASE: Mark Coffeit
- Discretionary spending is slowing, and “I can’t think of anything more discretionary than a morning cup of coffee.”
- Sales up 4% this year. “That’s not good for a retail company.” 26 P/E vs. 16 P/E for the Market. “Starbucks is priced for perfection” and the odds of it delivering perfection are the same for “tossing heads 10 times in a row.” “Could be dead money for five years.”
- Breakfast will attract more customers, but the flip side is that new additions make the business more complicated thus prone for making mistakes and turning customers off.
- McDonald’s has upgraded its coffee and will be offering lattes/cappuccinos that will cut into SBUX sales.
I the paragraphs below, I evaluate both stances and provide my opinion on the strengths/weaknesses of the contributors’ points.
The first bear case argument: can’t think of anything more discretionary than morning coffee? That’s a totally absurd statement. I can think of many things a pinched consumer would cut back on before coffee: entertainment, travel, fashion apparel, leisure spending, and electronics to name a few. I think most all consumers would cut out an upscale dinner or new X-Box before giving up their morning coffee.
Ms. Zackfia believes that SBUX may not be immune to consumer spending downturns, but it is well insulated. I agree.
a) Caffeine is a highly addictive substance.
b) Drinking coffee is a morning ritual for many.
c) The unit price of coffee is low, thus not a blatant target for budget cuts.
I hear people all the time talk about “their morning coffee” and how they have to have it. It’s a daily pattern for some, which implies that the purchase decision process has become automatic. Coffee is closer to a staple than a discretionary good.
Both agree that Starbucks and McDonalds product offerings are different, but Coffeit states that MCD provides a decent alternative. In my mind, there's much more to Starbucks than just its coffee. If that weren’t true, then SBUX couldn’t charge a premium. Additionally, if it were easy to duplicate SBUX model and offerings, many would have followed Starbucks years ago. SBUX has held of competitors since its incipience, so what makes them so vulnerable today? McDonalds and Dunkin Donuts have forever served coffee, likewise most every other restaurant.
Zackfia’s provides a stronger argument as to why MCD will not be a significant factor to SBUX sales growth since she cites evidence of growing coffee consumption.
I believe that MCD will only mildly impact growth in the sense of potential future new customers, not stealing current SBUX customers. I believe MCD is selling a good amount of coffee to customers who previously didn’t buy coffee from them nor SBUX. MCD is just taking advantage of their high foot traffic already in place.
Coffeit’s statement about 4% sales growth is misleading, growth was 20% year/year and 4.6% qtr/qtr. Sequential growth of 4.6% is not bad since multiplying by four quarters is close to 20%, putting it loosely.
The bull argument cites new stores and international markets paving the way for sustained growth. The bear does not address growth prospects of SBUX store expansion plans.
Both participants say new food additions at Starbucks will increase traffic, yet Coffeit claims that is a reason for not buying the stock. He implies more harm can be done, than good, since SBUX store processes will become more complicated.
In my mind, Coffeit contradicts himself since he says MCD new offerings present a threat. If McDonald’s is rolling out new coffee beverages, such as lattes, then their business becomes more complicated too. They face the similar risk of driving away customers from poor customer service. I believe SBUX is capable of better managing a new product addition due their better management and employees than MCD. It maybe a valid point, but all companies face that challenge when they introduce a new product line. It’s a part of business, and the odds are low that it will detrimentally affect either firm, but even less likely in the case of SBUX.
A multiple of 26x can be cheap or expensive depending on how one looks at it. The bear case is that SBUX is expensive because growth is slowing, and the bull case is that future growth can still be as high expected when SBUX traded at 35ish multiple. The bear states that SBUX is overvalued relative to a 16 market multiple.
SBUX should trade at a premium to the market because it has higher sales growth and higher returns on invested capital. SBUX has a valuable brand leading to a strong competitive position. Morningstar agrees, their economic moat rating for Starbucks is “wide.” A 26x multiple may be justified, but I would feel much more comfortable if it were in the low 20’s. It’s certainly not grossly overvalued at these levels as the bear implied.
I was not impressed with Coffeit’s arguments because of his dearth of evidence, and the little he did provide was misleading (stating 4% growth incorrectly). Second, He appeared to inject too much unsubstantiated opinion such as his comments about “coffee is discretionary spending” and the odds of SBUX performing up to priced-in expectations are “tossing heads ten times in a row.” If one chooses to use hyperbolic exaggerations, then he needs to provide sufficient evidence to support his inferences. Otherwise, I get an impression that his commentary contains a unwarranted bias. Third, Coffeit’s logic regarding the possibility of complications from offering sandwiches is a stretch.
The bull, Ms. Zackfia, lays out a reasonable argument. None of her main points make SBUX a compelling buy, but she does give reasons against taking a bearish stance. On balance, SBUX faces more opportunities than threats. The major risk I see is that competition may limit SBUX ability to raise prices if costs (such as dairy) climb significantly higher, and disproportionately affect Starbucks more than its competitors. I believe that scenario coming to fruition is less likely.
I opined on Starbucks back in August with this article: Long-Term Hold (SBUX near same price then- $26), and my thesis was SBUX was attractive given a long-term investment horizon, but I wouldn’t be inclined to buy unless the SBUX dropped close to $20. I based this on the fact that SBUX price multiples had fallen to a more palatable level, and that the company’s future growth prospects and return on capital appear to be intact. I concluded that Starbucks shares were not bargain, but reasonable enough for consideration.
I reiterate my earlier (August 2007) position; Starbucks has moved from being very overvalued to reasonably valued, and SBUX would be very attractive/undervalued at a low-20’s share price.
Disclosure: I do not have a position in SBUX.
Saturday, October 6, 2007
Discussion and debate about the mortgage upheaval has been relatively limited the past few weeks even though the risks have not gone anywhere. Maybe since that mortgage mess is becoming more like “old news” is the reason for the slip in attention, but more likely it’s the Fed’s 50 bps rate cut that has ushered in a tide of silence. Instead, increased focus has been given to a returning of the Bull Market coupled with the opportunities in the Tech space. The resulting implication is that the market is confident that the Fed will act to resolve lingering mortgage and housing threats, as the air swirling around Wall Street suggests that the problems are past us, or at least, have been identified.
With so much origination of Alt-A and sub-prime mortgages the past two years, problems have not had enough time to fully appear. In addition, home values are now falling thus more loans will go bad due to borrowers’ inability to liquidate at a price high enough to satisfy the outstanding loan balance.
Don’t get me wrong, nobody is dismissing the crisis, but with the averages roaring back and hitting all-time highs, it does raise a question. “What was the purpose for the exacerbated volatility and nasty market declines we observed in August?” Or, “Was it because the market was afraid the Fed wouldn’t cut? And now that it did problem solved?”
I don’t, and I bet many other’s don’t either, think the mortgage and housing woes can be directly cured by monetary policy. I believe that there are still a few banks and mortgage finance players walking the planks of the gallows. Additionally, the effects of ARM resets and foreclosure possibilities hasn’t fully encumbered the consumer, a situation that will broadly affect the economy.
Credit Suisse published a terrific Mortgage Research Report which illuminates the difference in the residential market five years ago versus last year, including the evolving trend to where we are today. A glaring statistic is the mix of purchase money mortgage originations: In 2002, subprime 6% and Alt-A 5% compared to 2006, sub-prime 20% and Alt-A 20%. Remember, Alt-A is not “Almost prime” as it is sometimes referred; It’s essentially sub-prime dressed up, in my opinion. So, we have 40% of purchase originations with questionable credit quality versus 11% just 4 years earlier.
Alt-A purchase originations hovered around 5% during 2001-2003, then tripled to 15% in 2004, and rising again to 18% in 2005 up to 20% in 2006. My educated theory for the spike (educated since I am a former mortgage professional), was due to the slowdown in mortgage originations after the re-finance boom after rates bottomed in 2003. After the most credit-worthy borrowers had taken out mortgages, the primary source of new originations would have to come from more risky borrowers.
Lenders needed the origination income and investors needed the yield. Both were willing to accept the higher risk. Partially, because home values were rising at an astonishing clip, this assuaged foreclosures since periled borrowers could unload their property to satisfy mortgage obligations if needed. In essence, at the onset, foreclosures were below trend due to the strong housing market, and lenders and investors extrapolated this trend forward in support of their heighten risk-taking endeavors. Many borrowers were given mortgages that were way out of their league. Lenders grasped assurance from the underlying collateral, since home appreciation had been so robust. In reality, rising home prices were supported by the increased number of buyers able to receive financing. Lending to risky borrowers causes home values to rise, and rising home values makes the loans appear less risky, so even more lending results, followed by additional home demand and subsequent appreciation.
The problem with Alt-A mortgages is that many lack documentation of income and assets. Many will only require a credit score if there is typical 20% down payment. The problem with a credit score is that it’s calculated from a credit history, and history is no certain indication of the future. Additionally, an individual may have good credit because he/she has never a challenging debt load. The best indication of loan performance is the borrower’s income; the stability and the amount it exceeds loan payments. In order to ascertain the cash amount a borrower is capable of paying out, one must know how much cash the borrower has coming in. Without verified income, it’s very difficult to gauge the credit quality of a mortgage.
Teaser rate, Interest Only, and Payment Option ARMS provide initial affordability with low monthly payments. These low payments eventually reset to much higher amounts, many times beyond the borrower’s reach. Several years ago, borrowers who faced this dilemma could refinance into a new mortgage thus keeping their payments low. Yet, today, lenders have tightened the credit clamp eliminating this potential alternative to default.
The key issue is that many more loans populate the “probable default universe” than what we are currently seeing. We have just begun to see mortgages go bad, yet there are potentially many more loans that haven’t had enough time to appear as troubled. Falling home values will unveil the trouble that has been obscured by the creative mortgage products.
Homeowners unable to service their mortgage are confronted by a housing market with less demand due to tightened credit standards. Rising negative equity enhances the incentive to default, as opposed to exploring every possible alternative to avoid foreclosure. Lenders reaction to increased defaults only guarantees that there will be many more to come, especially since lax underwriting guidelines tempered defaults for the past few years (either via refinance or property sale).
Many banks own these risky loans in their investment portfolios. It’s tough to profit under flat and inverted yield curve conditions, and Alt-A and IO mortgages allow extra yield to mitigate high cost of funds. Banks prefer short maturity assets due to the short duration of their liabilities, thus ARMs best suit their investment objectives. 3 and 5 year ARMs are popular holdings which mean many still have yet to reset. Borrowers facing dramatic payment increases due to ARM resets have been able to refinance into another mortgage to avoid the rate increase. Now that credit has tightened, it is likely that many borrowers will be unable to escape payment resets by refinancing into another mortgage. Additionally, lenders have curtailed offerings of the “initial low-payment” mortgage products allowing borrowers to refinance out of loans scheduled to reset.
With tightened credit standards and the elimination of these creative loan products, future mortgage originations should fall drastically. Housing market will experience increased weakness due to less qualified borrowers providing the demand needed to offset the enormous home supply. Builders and other related industries are feeling the pain. Mortgage lenders have either closed their doors or made significant reductions. These woes could affect demand in other non-related industries. Homeowners witnessing the decline in their home value could decrease consumption due to a contraction in the wealth effect. Yet, according to the stock market, it appears we have nothing to worry about.
Thursday, September 20, 2007
Price to book ratios are a popular method for gauging a stocks relative value. Just like price to earnings ratios, P/B multiples that are relatively high usually signify that the stock is overvalued. Investing in low P/B companies has forever been a staple strategy among value investors. Yet, stocks trading at higher P/B ratios can still be good investments and actually be undervalued.
Understanding the drivers of the P/B ratio helps determine whether the stock deserves a high multiple. Often, the P/B multiples published are not forward looking. The share price is forward looking, yet the book value (denominator) is a historical figure taken from the balance sheet.
This shortcoming results in P/B multiples failing to capture the full picture. Trailing P/E (historical) ratios exhibit exactly the same symptom therefore forward P/Es are more meaningful and popular. Thus, determining a forward P/B multiple is essential for assessing a stock’s fair value.
Lloyd Sakazaki recently wrote about P/B multiples recently in this article. Lloyd has a very informative blog which I recommend checking out. Lloyd’s primary point is that high P/B multiples may stem from high expected earnings growth.
Essentially, the future is expected to be better than the past, thus investors have bid prices higher given that expectation. Additionally, relatively high P/B multiples may be justified if the firm produces high returns on equity (ROE). Expanding on Lloyd’s commentary, we can illuminate the underlying factors affecting P/B ratios .
1) Return on Equity: ROE= EPS/BVPS
Stocks with higher ROE should trade at higher P/B multiples. Now, that’s expected future ROE, not historical. Often, a link may exist between a firm’s historical ROE and future ROE. Companies with stable performance (predictable), the past may be an indicator of the future, and what has happened usually continues to happen. Sometimes. Analyzing historical ROE trends can help in making sense of a P/B ratio. Yet, stock prices reflect future expectations; undoubtedly, it is only future returns on equity that affect share value.
ROE projections are vital to the evaluation process of P/B multiples. Future ROE estimations can be accomplished by estimating future EPS and future BVPS: Expected ROE= EPS (expected) / BVPS (expected).
To figure out next year’s BVPS, dividends and share buy-backs need to be subtracted from EPS and then added to beginning BVPS.
Expected BV/Share= BV/share (last fiscal year) + (EPS (current yr estimate) – DPS (expected dividend) - Share Repurchases/share)
Comparing expected ROE to last year’s ROE aids in analyzing the P/B multiple. If future ROE is expected to be much higher than historical returns, a relatively high P/B may be reasonable especially given the forward P/B will be much lower due to the ROE increasing.
Higher ROE translates into higher P/B multiples assigned by the market. P/B ratios have to be evaluated in the context of ROE, and since stock prices are forward looking, forward P/B multiples must be compared to expected ROE. To ascertain the appropriate P/B ratio warranted for any given ROE rate, peer comparisons are needed.
2) Expanded ROE (Dupont Formula) = Profit Margin x Asset Utilization x Leverage
Margins, asset efficiency, and capital structure determine ROE. Analyzing these underlying factors give insight in estimating future ROEs.
Net Margin (Income/Sales) x Asset Utilization (Sales/Total Assets) equals return on assets, or ROA. Multiplying ROA by the ratio of Assets/Equity (leverage) gives ROE.
a) How attractive income stream? (profit margin)
b) Amount of capital investment (Assets) required to capture income stream?
c) Shareholders’ investment required to finance total assets?
Investors’ willingly pay premiums for firms possessing highly profitable business models. The distinguishing variable is asset turnover. High profitability may require large sums of assets, hence greater investment offsets the benefit of greater return on sales. Contrarily, low margin businesses can boost returns if asset requirements are small.
Thus, firms having high margins and low asset investment needs are the most attractive and command higher P/B multiples. Finally, using debt will boost ROE since additional capital can be employed without diluting the ownership base. The use of excessive leverage compresses P/B ratios because of the increased financial risk weighs down share prices.
Companies can generate high ROE from intangible assets not recorded on the balance sheet. This will cause greater asset turnover since recorded assets are lower.
Intangible assets such as brands, technology, human capital, knowledge etc. have value since they drive earnings. Investors will pay accordingly for ownership of these intangible assets. Paying a premium results in a higher share price, and coupled with a lower BVPS due to non-recorded assts, P/B ratio is higher.
I discussed this aspect in more detail in a previous article.
3) Expected Earnings Growth:
EPS growth rate will affect future ROE since EPS is the numerator in the ROE formula.
P/B ratios are most often calculated by dividing the share price by the book value per share. The BV/share is the amount of shareholder’s equity found on the balance sheet (assets-liabilities=equity) divided by the number of common shares outstanding.
Since stock prices reflect future expectations, a P/B multiple calculated from a historical book value leads to distorted ratios. We can calculated a forward looking P/B multiple that will make comparisons more meaningful.
Forward P/B Ratio= Current Price / Expected Book Value Per Share
If expected earnings causes a significant increase in future book value per share, then there will a considerable difference between trailing P/B and forward P/B ratios. This is especially true is EPS has been negative causing BVPS to decline. Hence, P/B ratios may be distorted if BVPS is depressed, yet estimating a forward P/B ratio will reveal if the P/B is still relatively high.
To better gauge if a P/B ratio is warranted, earnings and ROE expectations need to be examined. P/B ratios may be high on a trailing basis, but considerably lower on a forward basis. After uncovering the firm’s prospects, peers should be referenced for comparison. If P/B is relatively high and ROE is much higher than comps, then the higher multiple may be warranted. A common mistake is thinking a stock is undervalued because of a low P/B. If ROE and EPS growth are below average, then that’s the reason why the multiple is below average. It’s not undervalued; it deserves a low multiple because it’s expected to deliver low returns. Share prices indicate the future expectations of ROE as indicated by the P/B multiple. High multiples are justified when the ROE expectations implied are reasonable, and even higher multiple is warranted if you believe the implied ROE is too low.
Tuesday, September 18, 2007
Much, if not all attention regarding Apple has been focused on the iPhone. Apple’s recent $200 price reduction on the iPhone resulted in analysts, journalists, and investors debating the true demand for new device. Additionally, the effects of the price cut on Apple’s earnings has been a hot topic of discussion. Certainly the iPhone is relevant to Apple’s performance, but ostensibly it’s the Macintosh computers that will have the most impact. Specifically, Mac’s ability to run Windows natively has the potential to be a colossal catalyst for boosting Mac market share.
Apple released “Bootcamp”, which allows Mac users to install and run Windows just like one would on a PC. Apple’s new OS, OS X 10.5 “Leopard”, slated for release this November will include Bootcamp software. Additionally, third party software called “Parallels” allows users to run Windows and Mac OS simultaneously.
The Windows capability has not yet been aggressively publicized by Apple, and analysts and investors have been relatively quiet on this issue. Yet, for more than two decades, the lack of Windows compatibility has been the primary reason behind consumers’ decision to NOT purchase a Mac computer. Now that Windows can be installed on Macs, sales could really explode. I believe that this aspect of Apple should garner more attention, and I will explain why.
Macs are a perennial top award winner in consumer surveys and industry publications. Marketing research has suggested that for many PC buyers Macs were their first choice, yet they declined to purchase due to the need to run Windows software. Computer buyers employ what marketers refer to as a “non-compensatory” purchase decision model. For every product attribute evaluated and compared, supremacy in most categories cannot offset a deficiency for a particular attribute. Explicably, Macs may score higher in a consumer’s mind for every attribute, but the fact that it’s a non-Windows machine eliminates the purchase possibility from the buyer’s selection set of product alternatives.
Simply, consumers want a machine that runs the same operating system that 95%-99% of all other computers run. In most cases, consumers require a machine than runs windows due to work or school related factors. Alternatively, there is a significant risk in buying a computer that may become extinct or no longer supported by software developers. That was a real concern years ago, when Apple was against the ropes as market share had been estimated to fall as low 1%.
A popular statement: “I really want and prefer to buy a Mac, but I need a Windows machine since that is what we use at work.” The lack of Windows compatibility has been an insurmountable hurdle for Apple for decades even though significant demand for its machines exist.
Apple has certainly recovered since the days of old with market share currently estimated well above 5%. While still miniscule, Apple has delivered substantial progress. The bright side of the matter is the enormous room for potential growth from seizing share from the Windows PC makers- Dell et al.
In one aspect, Mac’s ability to install and run Windows OS makes them no different than Dell, HP, Gateway, etc., which there is little difference among those traditional PC devices. In essence, installing Windows on a Mac means that there are no longer grounds for consumers to eliminate Macs as a products choice on that reason. Thus, a consumer could just as well buy a Dell or Gateway or Mac. Think about it. The primary factor keeping buyers from purchasing a Mac for decades has been overcome. Plus, if that barrier hadn’t existed we know that Mac sales would have been significantly higher. The bottom line: pent-up Mac demand can come to fruition now.
Given that Macs now compete with Dells and HPs as product choice in buying a PC, Macs retain an edge. Macs provide all of the functionality as other PCs, yet the Mac OS serves as a bonus, if you will. Why would someone choose a Dell or Gateway when that can buy a Mac, and not lose Windows functionality, yet gain all the benefits of Mac OS? I think that is a very central question. Especially since Mac prices have become more competitive.
Despite the lack of publicity I think this is huge. We know that there are a significant number of consumers who would prefer to buy a Mac but can’t get past the Windows issue. Now that this is no longer an issue, how many Macs can Apple sell? I can envision some individuals buying a Mac to solely run Windows just because they prefer the aesthetics of Mac’s design.
We have seen a dramatic increase in Mac sales and market share, yet I perceive the general consumer is unaware of the Windows capability. I am confident that when a more aggressive publicity campaign occurs, Mac sales will react robustly. I think that it’s the PC savvy segment, aware of Bootcamp that has been snatching up Macs recently, not entirely the normal, less aware consumer. Just from anecdotal evidence, people I have surveyed exhibit little awareness. Eventually that will change with time, and the impact on Apple’s revenues will be much greater than the iPhone or iPod.
Running dual OS on a single machine allows the Windows to Mac OS migration process much easier. Previously, it has been either one or the other. Moving to Mac OS means turning off the light on Windows. That’s a very difficult process and extremely risky. Any migration works best under a dual, parallel operating environment since it doesn’t require choosing one over the other. Particular tasks can still be handled in the Windows environment if the Mac OS proves to be unsatisfactory. Apple experienced much difficulty in persuading users to abandon Windows for a Mac, now that is no longer an issue.
It’s seems that the only benefit in using Windows is the fact that nearly everyone else uses it too. It’s unstable, crashes frequently and susceptible to a host of viruses. That’s the antithesis of the Mac. Granted there is much more software available to Windows, that will surely change as Mac OS gains acceptance. As more and more software is developed for Mac OS, adoption will follow suit. And as Mac share has been increasing, we have witnessed already increased interest from software developers.
It’s not unreasonable to predict that Apple can progress to 10% share soon. Especially given the “Halo Effect.” Sales of iPhones and iPods will drive consumer interest in Mac computers, and when consumers become more aware of the Windows capability I believe market share can easily reach 30%. It’s not unrealistic to think that Macs could capture even more share. Why not? Apple’s iPod has 70-80% share, and why would a consumer purchase a Dell over a Mac? Price is the only reason that I can think, but for a higher price, the consumer receives more. I know I will never buy a traditional PC again.