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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, August 29, 2007

Allowing Yuan to Float- Only Real Inflation Solution for China

The Wall Street Journal reported that the CPI in China jumped 5.6% for the month of July. Food prices are mostly to blame with meat products rising 45%. China’s Central Bank has been attempting to head-off inflationary pressures by raising short-term rates for the forth time this year. On August 22nd, the one-year rate banks pay on deposits increased 27bps to 3.60%. The one-year benchmark lending rate was lifted 18bps to 7.02%.

The People’s Bank of China wants to encourage its citizens to park more of their money in deposit savings accounts which has been a tough sell due to negative real deposit rates (stated interest - inflation). Inflation fears prompt citizens to increase present spending because postponement leads to a loss of purchase power.

Raising rates will not curb China’s inflation problem. China’s currency is way too undervalued and that is the primary force driving up consumer prices. A cheap Yuan makes Chinese goods cheap relative to the rest of the world. Cash has been pouring into China’s economy due to the huge demand for their inexpensive goods. That increases China’s money supply, thus fuels inflation. If the Chinese government would let their currency float, then natural economic forces would resolve the problem. Demand for Chinese goods means demand for their currency which would cause the Yuan to appreciate and subsequently slow the demand for their exports. Yet, the currency is fixed at an artificial exchange rate thus hoards of trade dollars continue to flow into China with no end in sight.

With respect to food inflation, the problem is that China has 1.3 billion people and that’s good number of mouths to feed. Throughout China’s existence, it has been a self-sufficient society isolated from the rest of the world. China produced most all the food it needed with in its borders. Ever since China opened up for trade, its GDP has been soaring. The primary driver is from the movement of production from inefficient goods to areas where they have a comparative advantage. Farming isn’t one of them. To feed the whole population requires farming land that is arid with very low yields. On the margin, it may take 20 acres and 10x the labor to produce the same amount of rice that 1 acre in Arkansas could. The solution is to move those resources and labor into competitive export industries, such as manufacturing. They money made from manufacturing exports can be used to import rice.

The wide-scale shift to urban centers and manufacturing by default expands China’s GDP. China’s economy was inefficient since capital and labor were deployed in areas that offered very low returns. Hence, the Chinese were engaged in activities they were very poor at, not focusing on what they did best. Allocating factors of production to their most efficient use automatically boosts domestic output. Export good that can be sold higher abroad than domestically, and import goods that are less expensive across the border.

A key issue to making this all work is a floating exchange rate. When China’s population left the fields for the factories, agricultural production capacity shrank. A larger proportion of China’s food supply has to be imported to offset reduced domestic production. China’s problem is the high cost of imports. The actual goods aren’t more expensive per se, it’s the high cost of foreign currency needed to purchase them. That’s the flip side to the coin. China’s undervalued currency allows the flooding of its exports to foreign markets, yet importing is costly.

The goal of the Chinese government is to build their economy by exporting; an undervalued currency accomplishes that goal as well as protecting domestic markets from imports. Demand for food is inelastic, meaning that price increases do not lead to lower quantities demanded. If the movie ticket prices go up, people will see fewer movies, but if the price of food increases, consumers are forced to absorb the higher cost.

Attacking inflation by tightening the money supply won’t address the whole problem. The only real, long-term solution to Chinese price stability is to allow the currency to float.

Saturday, August 25, 2007

Kohl’s (KSS): Most Attractive Relative to Retailers: Costco (COST), Target (TGT) & Wal-Mart (WMT)

In looking at a few names: Kohl’s (NYSE:KSS), Wal-Mart (NYSE:WMT), Costco (Nasdaq:COST) and Target (NYSE:TGT), I find Kohl’s to be the most compelling. Costco appears to be rich, and Target and Wal-Mart look fairly valued. Kohl’s offers best growth potential at lower multiples, as well as the highest margins and return on assets.

Concerns over consumer stamina have raised caution among investors regarding names in the retail space. Most retailers have sharp declines in their stock price in the last couple of months. The primary factor responsible for the retail weakness stems from expectations of a pullback in consumer spending. Slower economic growth, higher energy/food prices, and tighter credit all point to less robust consumer spending.

I think that we are overdue for below-trend consumer spending, thus in the near-term investors’ concerns are probably justified. Yet, equity values are based on very long time horizons. A few years are only a minute fraction of total value. Stock prices falling due to a weak near-term outlook can provide opportunities if their long-term prospects remain attractive. I like to use industry sell-offs to boost long-run returns by acquiring solid companies trading at relatively cheap prices.

If you have noticed, most of my recent commentary has been on retail companies. On a relative basis, the long-term outlook is easier to predict for established names thus making them attractive when trading at low multiples.

Valuation- P/E & Expected Growth:

KSS ($58.92): According to Yahoo Finance, KSS trades at 15.3x this year’s estimated EPS and 13.0x next year’s. That represents annual growth of 16.3% and 17.7%. Analysts project 17.4% annual growth for the next 5 years, slightly less than the 18.5% average growth for the last 5 years. Using next year’s P/E, Kohl’s possesses a very attractive PEG ratio is 0.75. My personal calculation for Kohl’s projected 5-year growth rate is only slightly lower at 17.3% (based on next two EPS estimates and Value Line’s 3-5 year EPS estimate).

WMT ($43.74): In comparison, WMT trades at 14.3x and 12.8x current/next years’ EPS estimates. That translates into annual growth of 5.5% and 11.5% growth for the current year and next year, respectively. Expected 5-year growth is 12.2% giving WMT a 1.05 PEG. My calculated 5-year growth estimate is a bit lower at 10.4%.

COST ($61.68): Costco shares are expensive trading at 24.3x and 21.2x current/next years’ EPS estimates. EPS will increase 10.4% this year, 14.6% next year, and average 12.7% annually for the next 5 years. Costco’s PEG is a lofty 1.67. My estimated growth rate is 11.7%, which makes COST even more expensive. Costco’s ROE is rather week, averaging less that 12% the past 5 years.

TGT ($63.09): Target’s P/E multiples are 17.5x and 15.4x for current & next years EPS estimates, respectively. That equates to 13% average growth for next two fiscal years reported, and analysts are estimating annual growth of 14.8% for the next 5 years. Target’s PEG ratio calculates to about 1.04. I am projecting annual growth of 13.5% for the next 5 years.

Discounted Cash Flow Valuation:
I employ a 3 DCF stage model- 1) 5yr revenue constant growth phase 2) 10yr transition phase-input assumptions converge to long-run average 3) Normal growth- sales grow @ inflation and capex = depreciation

The assumptions that drive the valuation process are sales growth, margins, net investment, and working capital requirements.
I expect Kohl’s revenues to grow at 11% annually for the next 5 years versus 9% for Target and Costco, and 7% for Wal-Mart.

Based on my model, intrinsic value for Kohl’s falls in the mid 70’s, roughly 25% higher than the current $60 share price. Wal-Mart’s DCF intrinsic value is above $50 suggesting shares are a good buy at current price of $43.74. DCF valuations for COST and TGT suggests fair value roughly in-line with current market. Costco’s capital spending and working capital requirements are very low which may possibly explain why it trades at a much higher multiple relative to other retailers.

This final measure that I examine is ROA (Income/Sales x Sales/Assets), or otherwise stated: Net Margin x Asset Utilization. For a low margin firm to be attractive, asset utilization must be high- relatively assets are needed to generate sales, thus the return on sales (profit margin) can “turnover” more frequently with regards to assets invested. ROA is a great tool in comparing similar businesses.

On a ROA basis, Kohl’s 12.3% (lfy) is the most attractive of the four. ROA for the other 3 firms: WMT-7.8%, TGT- 7.7%, and COST- 6.5%.
Competition among WMT, COST, and TGT is driven mainly on price. The manner by which these competitors can offer unique and attractive product assortments gives slight pricing power ability.

Kohl’s offers a very unique apparel selection as well as its “off-mall” store location strategy results in lower operating costs. Kohl’s high profit margins could serve as a deterrent for price wars since it could lower prices more than competitors could and still be profitable. Closer competitors such as Macy’s and JC Penny have margins of about 5%

In summary, KSS looks to be the most undervalued relative to other retailers. KSS is trading at lower multiples and has the highest expected growth rate. Even if Kohl’s actual growth is lower, shares would still be a decent value. Costco appears to be the least attractive investment given its high PEG and low margins and ROA.

Disclosure: I do not have a position in any of the stocks mentioned.

Saturday, August 11, 2007

Mortgage Payment Reduction Fuels Consumer Spending

In this commentary, I show the impact of lower mortgage rates on economic activity with some illustrative math. Consumer spending was boosted with the aid of mortgage payment reductions. Now that is over, purchase power needed to fuel the continued economic expansion appears to be at risk.

Mortgage Math & Economic Effects:
Falling interest rates allow homeowners to refinance their mortgages into lower monthly payments thus boosting consumer spending significantly. Since mortgage payments are non-discretionary, they essentially resemble taxes as they reduce gross income into actual, disposable income. Thus, reductions in mortgage payments (or taxes) are highly stimulative for the economy.

The example below helps to illustrate that point as we compare 8.5% and 5.25% rate loans with 150K loan amount. For the sake of simplicity, we will ignore tax-effects. There is only a $325 difference in payment, but a $117K difference in total interest paid over the life of the loan.

8.50% 30yr Fixed Rate Mtge
Loan Amount: $150,000
Monthly Payment: $1,153
Total Interest Paid: $265,213

5.25% 30yr Fixed Rate Mtge
Loan Amount: $150,000
Monthly Payment: $828
Total Interest Paid: $148,190

Monthly Payment Diff: $325
Annual Payment Diff: $3900
Total Interest Paid Diff: $117,023

After 5 years, more than 95% of the loan balance remains @ 8.5%. This prompts many borrowers to make extra payments to reduce outstanding principal quicker, which results in lower total interest paid.

At 8.5% total interest paid is 1.75x the amount borrowed (265k/150k). Assuming that a borrower doesn’t want to pay more total interest than amount borrowed, we assume in the first 60 months the borrower pays an additional $350 per month. Total interest paid now is slightly less than the loan amount.

Assume: 8.5% Borrower-
First 60 months- pays extra 30% of Payment:

Orig Monthly Payment: $1,153
Add’l Principal Payment: $350/mo
Total Monthly Payment: $1503
Total Interest Paid: $148,010

For the 5.25% loan, we assume no extra payments since total interest is less that loan amount. thus less urgency to reduce principal balance. The difference between the 8.5% and 5.25% is much greater, $675 monthly or 8100 per year. That’s a huge boost. Yet, it doesn’t end there.

Let’s assume a borrower took a 8.5% mortgage in ‘98 when rates were high. The borrower paid an extra $350 plus the $1,153 regular payment for 5 years. In 2003, rates were at historical lows and the borrower qualified for a 5.25% mortgage. At this time, only $117k of principal balance remained so the homeowner took a 5.25% for $117k to pay off the 8.5% original. The new monthly payment is now $647 versus $1503 leaving $856 in extra income per month, or $10,272 annually.

Another alternative is borrowing against the value of the home. Assume home values have risen 10% annually; the property appraises at $250k. With $117k still owed, home equity is 1 - (117/250) or 53%. Withdrawing equity so that it falls to the customary 20% results in a $82,820 cash payout. The monthly payment will be $1104 / month, with monthly/annual savings of $399/$4788

Alternative 1: Refinance Balance @ 5.25%
Balance @ 60m w/ extra pmt: $117,180
New Monthly Payment: $647
Old – New Payment: $856
Annual Savings $10,272

Alternative 2: Cashout Refinance
New Property Appraisal: $250,000
Loan Amount @ 80% $200,000
minus payoff old loan - $117,180
Cash Received: $82,820
New Monthly Payment $1,104
Old – New Payment: $399
Annual Savings $4,788

Current Cycle History:
Estimated home ownership is close to 70% of the 110+ million households in the US. If the average household has $10k more a year to spend, then that’s a huge boost for the economy.

And that’s what we observed beginning to happen in 2002 as mortgage boom started to take shape and GDP started to quickly accelerate. Lower house payments freed up massive amounts of discretionary spending spurring economic growth.

After the 2000 bubble, businesses had over-invested and still had excess capacity needing to be filled. Exports were weak due to the strong dollar, government spending was accommodative (yet focused on defense and national security), and a lack of capital investment meant consumers had to carry the economy on their backs. With super aggressive monetary policy, the Fed coaxed interest rates down to levels not seen in decades. This sparked a massive refinance boom and infused huge sums of money into the economy. Corporate profits grew and eventually job growth became robust pushing unemployment down into the mid 4% range.

Well Runs Dry:
In order for growth to continue, consumers must find sources of expendable income. Hence, rates must continue to decline so that borrowers can keep lowering their monthly payments to increase spending power. When rates bottom and level off, eventually most all outstanding mortgages will catch up meaning that they carry the lowest rate possible and no additional savings can be attained through refinancing.

Appreciating home values may temper this effect to some degree. Essentially, higher property values translate into credit limit increase similar to that of credit cards. Home equity grows faster from rising home values than actual paid-in equity. Thus, homeowners have a more valuable asset to borrow against resulting in greater purchasing potential.

Consumers can then run up all other types of high interest debt, such as credit cards, then tap home equity to consolidate high interest debt into essentially a low-interest long-term obligation. When home values stop appreciating, then the consumer can only withdraw equity that has actually be paid-in.

REFI Addiction:
As the consumer lowers his monthly payment by refinancing from 8.5% to a 7%, he notices the increase in discretionary funds. A year later when rates have fallen he refinances from the 7% to 5.5%. More additional income is available. He hopes rates fall even further so that another refinance opportunity presents itself. So, do mortgage lenders. They make a bundle on all the fees they charge for refinancing. When there are no more mortgages with a rate high enough worth refinancing, mortgage lending suffers.

So what’s the solution? We know consumers would love to lower their monthly payment and lenders love charging money to make that happen. But, the market dictates the rates which neither the borrower nor the lender control. One solution is to alter the product offering in such a way that it offers lower payments than what the rate market requires, and capture the below market portion on the back end.

1 month, 6 month or 1 year ARMs that offer a teaser rate. Initial interest is set way below market, then later resets to current market plus a margin. Interest-only products allow the borrower just to pay interest for usually half of the loan term, then Interest and principal must be paid during the second half which means they payment increases significantly. Another product that offers lower monthly payments is option ARMs. Borrowers don’t even have pay to the full interest due, instead they can make a predetermined minimum payment. Unpaid interest is tacked onto the loan balance leading to interest building on interest. The borrower can end up owing more than the original loan amount.

As home appreciation began to stagnate (thus rising home equities) lenders reduced the required amount of residual equity. Some products allow borrowing against the full value of the property.

Additionally, Lenders can influence housing prices with products that increase borrower’s willingness to pay more for a home. A key determinant of affordability is the standard 20% down payment.
A borrower may be able to handle the extra $500 in payment for a $300k versus $200k home, but not the extra $20k in down payment. Lenders offer zero-down mortgages where there is no upfront cash requirement.

Since humans are more focused on the immediate future, many are preoccupied with what they have to cough up now, less so on future interest and principal payments.. So, when home shopping, this product can foster the “Buy now, Pay later” attitude resulting in buyers to be less price-conscious.

Credit Crunch:
As rates reset on exotic and risky mortgage products, monthly payments increase resulting in higher default rates. Lenders respond by tightening credit requirements and cutting back offerings on risky products. As a result, the amount which can be borrowed decreases putting more expensive homes out of reach. Homeowners unable to afford the increased payments now have significantly fewer people able to buy their home before foreclosure. Foreclosures prompt further increased lending standards. Home values plummet as owners try to unload compounded by fewer available buyers able to get financing.

Spillover Effects:
The ending of refinancing eliminates the consumers’ ability to increase disposable income. The reduction in home values prevents the cash out of equity for spending purposes. Consumer’s that have become over-extended, reign in spending and focus on debt reduction. Credit card lending becomes tighter and more expensive. All of this, pressures consumer spending and overall economic activity. Industries related to housing experience a falloff in revenues, which means less employment hence less marginal consumer spending.

We have begun to see some weakness in the consumer as retail numbers have been soft. Retail stocks have seen some heavy selling. It will be interesting how this all plays out, but it definitely has the potential to be very bad for the economy. The fed needs to recognize the severity of this situation and act soon by lowering rates. There is an impact lag in monetary policy, thus by the time problems actually appear it will be too late.

Using Excel to Import Financial Data from the Web

There truly is no better program when it comes to crunching financial data than MS Excel. It is very simple to build valuation and analysis models by creating spreadsheet formulas to perform calculations on a firm’s financial data. Getting the data into Excel can be a problem especially if it has to be manually keyed-in. That can become very time consuming and transcribing figures manually is very error prone. With the use of VBA macros, Excel can import specified data automatically from the web. This is an extremely powerful tool for researching investments. Randy Harmelink developed an Excel Add-in that imports a whole myriad of stock data. The best part is that anyone can download and use.

Professionals on Wall Street have had this type of automated analysis for years through such services as Bloomberg. Yet, for the individual investor not willing to shell out $2k a month, he/she resorted to a legal pad and financial calculator. Every investor needs to do their own math so that they get a grasp to the larger story that the numbers tell.

Mr. Harmelink’s Excel Stock Market Function Add-in is located in the files section on this website:

It’s a yahoo group where members discuss ideas and share spreadsheets.
Additionally, Models I have created that use this add-in are posted in the files section at this yahoo group:

I recommend visiting these sites and downloading/installing the add-in and then look at the spreadsheets already created by group members.

When I conduct my analysis of a given stock, I usually apply three valuation methodologies

1) 5yr Forecasted EPS / Exit Multiple
2) 3-Stage Discounted Cash Flow Valuation
3) Relative Price-Multiple Valuation

For this post, I will discuss the first model and will discuss the others in subsequent posts.

The EPS / PE model doesn’t require much data to calculate.
-Historical EPS
-Historical DPS
-EPS estimates (current yr and next yr)
-Projected 5yr EPS growth rate
-Stock’s Beta

First, I analyze historical EPS growth to see if it’s accelerating, decelerating, or constant. I compare this to the analyst’s forecasts and make any adjustments to arrive at what I think is a reasonable growth rate.
Then I take last year’s EPS and project it out 5 years- (EPS * (1+g)). If Consensus estimates are available for this year and next year I will use those figures for year 1 & 2 EPS, and the apply my forecasted growth rate for years 3-5. At the end of year 5, I multiple EPS by a P/E ratio that is reasonable- Industry average etc. That will give the projected stock price in year 5. To calculate today’s value we must discount Year 5’s price back to the present using the required rate of return on equity. If the stock pay’s dividends, those too must be discounted back to the present and added to the PV of the stock price.

Using the Excel Stock Market Add-in all the required inputs can be downloaded automatically in excel. I have created a spreadsheet called Cash Flow Model that includes the above calculation that can be found at the locations mentioned above.

The primary drivers are the projected growth rate and exit multiple so it is crucial that these assumptions represent the most accurate predictions as possible. A useful strategy is to “invert” the model, meaning finding the input assumptions that equate model value to market value. For example, using the consensus growth rate and then finding the exit multiple value that returns the current price. Alternatively, the user could input a desired multiple then find the growth rate implied by the Market price.

The usefulness of valuation techniques is not to arrive at a single valuation as calculated by the model, yet to formulate a range of values for various assumptions. For instance, the assumptions that are implied by the price and valuations for pessimistic / optimistic scenarios. This provides the practitioner with an understanding of what must occur to support a given valuation.

I will discuss methods for estimating growth rates and exit multiple in upcoming posts.

Friday, August 10, 2007

Office Depot Looks Cheap Relative to Peers

Office Depot Corporation (NYSE: ODP) has dropped to around $23 from a 2007 high of nearly $40. Analysts have been cutting back their earnings estimates amid worries of a softening economy as well as management announcing a reduction in planned new store openings. Pessimism surrounding ODP and the outlook for the retail sector presents a buying opportunity for Office Depot shares with significant upside potential.

According to Zacks, Office Depot is trading at about 11x ’07 EPS estimates of $2.07, and less than 10x ’08 EPS estimates of $2.37. Annual EPS growth for the next five years is expected to be 13.9% resulting in an attractive PEG ratio of .7. Average EPS growth for the past 5 years has been 19%.

On a relative basis, Staples (SPLS) and OfficeMax (OMX) both trade at approx 13x ’08 EPS and have PEG ratios of about 1.0. The S&P 500’s forward P/E multiple is currently 15.

Boosting Profit margins is management’s primary focus and they have been showing signs of success. Operating margins doubled from 2.4% (2005) to 4.8% (2006). ODP trimmed their projections for new stores from 150 to 125 in 2007 and 200 down to 150 in 2008 citing less operating visibility going forward. I believe this was a major factor behind downward revisions to EPS estimates.

There are a couple factors that should help support Office Depot’s earnings. I think that the strong focus on cost-cutting measures will continue to lift margins and boost earnings. Additionally, with the stock trading at such low multiples, management will be more inclined to boost share buy-backs. Since budgeted capital expenditures have decreased due to fewer store additions, management will have more cash to repurchase shares aggressively.

The domestic office products market is an estimated $320 billion of which ODP, SPLS, and OMX make up 10%. Thus, there is still abundant room for growth and industry consolidation. The industry is highly competitive but Office Depot is well entrenched and has a strong brand. ODP has plenty of room to expand internationally.

Office Depot is trading at too low of a multiple. If ODP were to trade at a multiple similar to it’s peers of 13x the stock should fetch more that $30 or 30% higher than current value. Taking next this years expected EPS and discounting by 9.5% minus a 3% normal growth rate would produce a value of $31.50. That is essentially the same as applying a 15 multiple equivalent to the overall market. My discounted cash flow models also confirm a fair value north of $30. There is significant evidence that ODP is worth more than what the current market perceives.

Sub-Prime Fears Affect Prime Borrowers

Sub-prime woes are showing signs of pinching the most credit-worthy borrowers as jumbo-conforming spreads on prime mortgages have sky rocketed. Mortgages are considered “Jumbo” for amounts over $417,000. Fannie Mae and Freddie Mac will only securitize mortgages with conforming loan balances into an Agency MBS which trade in a highly liquid market. The spread has generally been about 1/8 – 1/4 pt higher in rate for those High balance loans. As of this week, the spread has risen to roughly 80 bps (0.8%) according to That’s a national average, for some lenders it’s much worse. The WSJ reported last week that a broker informed them that Wells Fargo had raised their jumbo 30yr rate from 6.875% to 8% effectively suspending production for that loan program. Why? Ostensibly from an absence of demand on Wall Street.

Banks seek to match the duration or “Life” of assets and liabilities. It’s very risky to borrow short-term, i.e. deposits, CDs, etc. and lend long-term for 15-30 years. Generally, financial institutions have a mortgage company/division responsible for originating mortgages and then selling to the secondary market. The mortgage division sells short maturity adjustable-rate mortgages to the bank to satisfy their loan investment portfolio objectives. Longer maturity conforming FRM are assembled into pools that FNMA, FHLC, or GNMA securitizes into MBS which mortgage bankers then sell to Wall Street. Non-conforming mortgages: jumbo, Alt-A, zero-down etc. are bulked up and then sold to Wall Street firms who use that paper to securitize “private-label MBS” or create CMO/CDO structures they offer to investors such as hedge funds.

Agency MBS is an extremely liquid market. Non-conforming mortgages are much less liquid since they are not securitized by a quasi-government agency so finding buyers can be difficult. I worked on a mortgage-trading desk for one of the top 15 largest banks for three years beginning back in 2004. Finding buyers for non-conforming paper was not hard then. Actually, Wall Street firms, especially those in the currently in the headlines, would be beating down our door for as many mortgages they could get their hands on. Lately it appears phones on trading desks at mortgage companies are silent. Certainly the case for Wells Fargo since it’s essentially curtailing jumbo mortgage production. Lenders do not want to originate mortgages they will not be able to sell.

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.

The credit risk of conforming MBS and jumbo MBS is significantly different. Agency MBS essentially has no credit risk since they are assumed to be backed by the Federal Government. Jumbo MBS or “Private Label” are backed by whichever Wall Street firm (and mortgage insurers) securitizes them. Thus, the credit risk associated stems from the issuer of the jumbo paper not the underlying loans per se. The credit risk on the mortgages are equal, yet the MBS credit risk is quite different.

In the past, investors assumed that jumbo MBS had minimal credit risk because the financial institutions backing them had enough capital to cover any defaults and that they were “too big to fail.”
Now, given the sub-prime fears, investors worry that non-prime defaults will hamper the backing institution’s ability to cover defaults on prime mortgages. Investors are calling into question the “too big to fail” cliché. Wall Street firms will find it difficult to sell additional mortgage-backed products to investors who are already worried about the fate of the current mortgage fund holdings.

With respect to jumbo spreads, it can be said that the sub-prime mess is spilling into the prime mortgage market. Homeowners trying to sell above $417k face significant challenges opposed to selling at a lower price. Sellers who have been asking slightly higher than the conforming limit may be forced to lower their price causing further downward pressure on home values. Think about how many homes were purchased above $417 during the explosion in home prices. Think about how many of those inflated home values were beyond the actual reach of buyers, but were purchased with a non-traditional mortgage. Interest-only, option payment, and adjustable-rate mortgages with low teasers allowed borrowers to afford expensive homes due to the low payments required during the loan’s early stages. As rates reset higher and monthly payments increase, borrowers will be more likely to default. To avoid foreclosure borrowers will try to sell at the amount owed on their mortgage, but with falling home values and ubiquitous home supply, it will be challenging for sellers to get what they owe.

Tuesday, August 7, 2007

Considerations for Starbucks as a Long-Term Hold

Starbuck’s shares have been under immense pressure the past few months as the stock has fallen to $26 from the $37 level seen back in January making the stock more attractive on a long-term hold basis. I would be compelled if SBUX share price fell to the low 20’s, but at around $26 shares still offer some value. My Discounted cash flow valuation Models suggest a $35 fair value assuming: 18% sales growth for the next five years and 13% average growth for the next ten years as revenue growth decelerates to a normal long-term rate of 3%. Margins should remain stable with a slght decline in later years. We can make forecasts with some relative degree of confidence given Starbucks’ consistent growth record, strong competitive position, and market potential.

I do not expect any significant catalysts to move the stock in the near-term, but operating with the assumption that markets are efficient in the long-run, SBUX should eventually rise to its intrinsic value. The recent disappointing news really only impacts the short-term picture. Starbucks’ dominance and brand strength should limit competitive pressures as it grows revenue through increased market penetration. Starbucks should be able to generate strong levels of cash flow for a long time period, and cash flows will increase from growth and the eventual decline in required capital investment. I believe Buffett would say that Starbucks has a wide competitive “moat.” As shares represent a reasonable value at $26, any further decline will boost the margin of safety and make SBUX worth considering even more.

Competitive Position:
Coffee, it’s a bean that comes from the ground. Pretty simple. Most every restaurant sells it. Yet, Starbucks is able to sell coffee to more customers at even a higher price. The price premium that the brand commands is direct evidence of the firm’s competitive advantage. Consumers perceive real value in Starbucks’ offerings which is very difficult for competitors to duplicate. People are never going to quit drinking coffee; it’s a daily routine for most people. Additionally, caffeine is addictive according to health experts. When you take a product that a significant portion of the population consume on a frequent basis that they may even be addicted to, you have a very sustainable business. Starbucks’ has superior customer service and product consistency which gives customers confidence that their expectations will be met. In other words, consumers know what they are getting as opposed to other outlets with less product familiarity and consistency. Starbucks has already captured many premium locations as well as surrounding locations that provide convenience leaving little potential for entry by competitors. Current competitors pose a mild threat to eroding Starbucks’ strong consumer base due to already engrained habits. McDonald’s offers premium coffee which has received higher ratings in surveys, yet that doesn’t change the fact that it’s still McDonald’s. MCD has a reputation for mediocre service and product inconsistency and lacks the product breadth of Starbucks. The Starbucks’ brand appears to be much more than just coffee, and this brand strength will assuage risks as the firm continues to grow.

Growth Potential:
Revenue and earnings have grown at roughly 25% annually for the past five years, and should continue at an above-average rate given Starbucks’ competitive position and already proven record. Management is expecting 18% top-line annual growth and 20-22% in the bottom-line for the next several years. Domestic same-store sales have been stabilizing at around 4%, with transactions accounting for 1%. Internationally, same-store sales increased 7% for Q3 driven by 5% transaction growth. International comparable sales growth has been north of 5% every quarter.

Starbucks had 14,396 stores at the end of Q3 and management believes they can ultimately hit 40,000 total stores. International expansion is the key factor in the firm’s long-term growth ability. At the end of Q3, SBUX had 4,000 stores outside the U.S., and the company believes it can achieve 20,000 locations abroad meaning that projected expansion is only 20%. Domestically, SBUX feels it can double in size of its current business.

At $26, SBUX trades at 30x current year estimated EPS of $.87 (Dec 2007) and 25x next year’s $1.06 estimate. That is not exactly cheap, yet analysts are forecasting 5 year annual growth of 22% justifying the high P/E multiple. Aside from just prospective growth, SBUX deserves a higher multiple due to its high return on invested capital. Two primary drivers of ROIC are profit margin and asset utilization: Remaining profit from a $ of sales and the amount of assets needed to generate that $ of sales. Starbucks’ margins have been healthy and trending upward the past 10 years. Brand strength should continue to support pricing power and cost efficiencies will continue to increase from scale benefits spreading fixed costs over a larger revenue base. Requirements for capital asset investment should decline from decelerating growth and because capital investments are made “up front.” Starbucks’ asset utilization (sales/total assets) has trended upward the past ten years along with ROA doubling from 7% to 14% and ROE increasing from 11% to 26%. Each dollar of fixed assets generate $3.50 in sales- very impressive given McDonald’s FA turnover is 1.0x and Panera Bread’s is 2.4x.

Starbucks possesses one of the most valuable brands in existence and operates in a space where consumers are habitual users less subject to swings in macro-economic conditions. Starbucks generates healthy operating cash flow but free cash flow is paltry due to the capital expenditures required to support robust growth. When growth normalizes 12-15 years down the road, OCF will be substantial and without capital expenditure needs OCF will roughly equal FCF. SBUX’s price decline is warranted in part, yet it’s likely that the decline has been too drastic. Considering the overall long-term picture, SBUX is not a bad choice at current levels, but any continued pessimism pushing SBUX would make for a great buying opportunity. Trading Based on Technical Factors-Not Fundamentals

Amazon shares continue to defy gravity even with increasing amount of discussion stating shares are overvalued. Barron’s (article) has been the latest to opine stating “The Bottom Line: At 56x 2008 EPS estimates, AMZN are too expensive.
Best to take substantial profits and wait for a better deal later on.” I gave a similar opinion in a piece earlier this month (my article) based on my belief that multiples are just too extreme given paltry margins and lofty growth expectations.
While fundamental analysis strongly suggests AMZN is overvalued to peers, I advised against shorting and further added that shares could go higher in the short-term due to price momentum. Amazon has been trading up mostly due to the technical factors underlying trading activity:

1) Buying stemming from short covering
2) Price strength and momentum dissuades profit taking by longs
3) Investor apprehension to go short fueled by sharp gap-ups

Daily volume has averaged about 11 million shares for the 144 day trading period since the start of 2007. Volume exceeded 15 million only 18 days, exceeded 20 million on 14 days, and only 7 times did daily volume exceed 30 million. There were 5 sessions where shares increased more than 5% and only 1 session where AMZN was down more than 5%. Nearly all of AMZN’s move up occurred on 3 days: 2 days following Q1 earnings release & day after Q2 announcement.

4/25/2007: $56.81 + $12.06 (26.9%) 104m
4/26/2007: $62.78 + $5.97 (10.5%) 62m
5/21/2007: $68.30 + $5.00 (7.9%) 36m
7/25/2007: $86.18 + $16.93 ( 24.4%) 60m

AMZN Short Interest (shares): According to
4/13/2007: 48.5m
5/15/2007: 53.9m
6/15/2007: 46.2m
7/13/2007: 40.6m

With YTD daily volume averaging aprox 11m, -6m over the period leading up to the first major break-out, normal volume is quite thin considering there are close to 50m shares short that eventually will have to be purchased. After the first spike on 4/25 short interest increased from April’s 48.5m to 53.9m in May but subsequently declined the following two months. It appears from the short interest rising 11% in May that shorts become more aggressive , thinking if it’s a short at $40 - even more the case at $60. As the data reports, shorts lost resolve and covered 13.3m shares in the time period leading up to the July figure. It will be interesting to see next month’s figure after the huge pop in 7/25. My guess is that short interest will have declined significantly since much of the price jump was probably due to buying associated with decreasing short interest.

Amazon’s Q1 surprise and increased EPS estimates sparked robust share demand as the market acted to price-in the revised expectations. Shares rose almost 38% in two sessions on exploding volume.
Impressive Q2 earnings results accompanied with a brighter than expected outlook again caught the Market by surprise. In the subsequent session, shares rocketed 24% on heavy volume.

Taking advantage of the bombshell dropped on short-sellers, new buyers take a position betting that shares will go even higher stemming from heavy short covering. Some current longs are less hesitant to sell and take profits knowing that the pent-up share demand will push prices up even further. As the price rises, losses snowball for those whom are short. Nasty short-squeezes prompt covering at any price to escape additional punishment. Shorts aren’t concerned about buying at overvalued prices if it results in minimizing potential losses. This creates price-equilibrium distortions since share demand is predicated on supply factors and not expected future cash flows. Thus, we have investors basing buy/sell decisions on supply & demand factors and not necessarily valuation and fundamentals. This implies that the market is inefficient since higher prices foretell even higher prices and in an efficient market past prices do not predict future prices.

In the case of AMZN, we know that higher prices will predict even higher prices since is very probable that demand will swell from: longs buying to lean on the shorts and from shorts buying to get out from underneath the longs. These instances provide some vindication for technicians who claim price / volume data can predict future price moves. In my opinion, the widespread recognition of this pattern creates a self-fulfilling prophecy due to many investors sharing the exact same expectations and acting collectively resulting in the expected price movement becoming the actual price movement.

Even though, future price moves may have been predictable, it would have been rather difficult to exploit fully in the case of Amazon since share prices reacted so quickly to news. As I mentioned earlier, AMZN shares were relatively quiet except for just the handful of sessions surrounding major news events.
The general assumption is that the Market is efficient, if shares overreact to the upside and become overvalued, longs take profits and shorts rush in to make profits. The onslaught of selling pushes shares down to its rational, fair value. The process is reversed for situations when stocks are oversold.

AMZN shares were driven mostly by buying related to technical factors and not fundamental factors. Sure, earnings expectations rose warranting a rise in value, but not to the extent that occurred. AMZN needed the positive news just to support its current price, not causing shares to double and stretching valuations further. Generally, when share prices overact longs sell and short-selling increases thus guiding prices back down to a value reflecting the collective expectation of future cash flows. Longs may be less eager to sell an overvalued stock if they feel technical factors are present to support lofty price levels. Hence, significant short interest representing future demand.

Another tenet of an efficient market is overbought imbalances are corrected by short-selling and profit-taking increasing supply.
Additionally, no matter how outrageous valuations become, after short-sellers are burned once they become apprehensive about making the same mistake again. Thus, there isn’t the proper lever present to adjust overbought shares sporting stretched valuations. AMZN had a sizable short position when the stock was in the 40’s, which increased 11% after the stock shot up to the 60’s yet shares continued to rise and short interest steadily declined. It appears selling pressure has had only a slight impact on AMZN shares.

AMZN Short interest has declined in the last two months reported. That suggests that some of the buying boosting AMZN was from short covering and that shorts have been less sanguine about shorting AMZN. It may be that shorting AMZN is analogous to putting a nail in one’s own coffin: Rising short interest attracts demand from investors attempting to “squeeze” short players anytime there is positive news released.

It just seems most probable that the factors I mentioned above are partly at work regarding Amazon’s doubling in price. With so many voices expressing concern about Amazon’s unjustified valuation, I would expect to see that sentiment come in to fruition by AMZN shares returning to reality. That has yet to really happen; just some observations to think about. It will be interesting to see the upcoming months’ short interest numbers and Amazon’s share price behavior.

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