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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.

Tuesday, October 30, 2007

Valuation Analysis: Apple vs Amazon

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:
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:
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
APPLE:
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:
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.

Summary:
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

Festival of Stocks- October 29th Edition

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.

Technorati tags: festival of stocks, blog carnival.

Friday, October 26, 2007

Walgreen Company (WAG): Reasonably Valued?

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:

Zacks: .40
Google: .23
MSN: .16
ValueLine: .75

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.

Major Advantages:
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.

Store Saturation:
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.

Outlook:
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.

Summary:
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 Coffee (SBUX): SmartMoney Face-Off Review

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

  1. 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.
  2. 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.
  3. 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

  1. Discretionary spending is slowing, and “I can’t think of anything more discretionary than a morning cup of coffee.”
  2. 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.”
  3. 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.
  4. 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.

Consumer Spending:
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.

Competition:
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.

Sales Growth:
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.

Valuation:
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.

Conclusion:
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

Mortgage Fears Past Us?

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.





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