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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.

Thursday, February 21, 2008

Chesapeake Energy Consistently Beats EPS Estimates

Chesapeake Energy (nyse:CHK) $44.16- Chesapeake Energy announced 4th quarter and full year earnings Thursday after the close. For Q4, EPS came in at $.93 / diluted share and $3.21 / diluted share for full year 2007. Analysts expected $.81 and $3.06, respectively. Profit was down year over year due to lower natural gas prices, realized selling price was $8.43 versus $9.11 a year earlier. I recommended CHK back in July when I wrote this analysis: CHK- Follow the Smart Money.

It’s confounding that the 25-30 analysts that follow CHK consistently underestimate quarterly EPS results. CHK has beaten estimates for 21 straight quarters; the average surprise is 14.5%. The question is why are the analysts consistently off the mark? 21 periods in a row?

I know that forecasting earnings is a tough task as no one can accurately predict the future. But, for the past several quarters I have calculated my own estimates and my accuracy has range from hitting the number to being of a few cents. For 4Q07, released Thursday after the bell, the consensus was $.81, my estimate was $.91. and the actual came in at $.93. The analysts were off 12 cents.

Is it that I am a prolific forecaster? No, it’s because the numbers are out there. CHK doesn’t provide revenue and earnings guidance, but they do provide production and expense forecasts. CHK Outlook Applying some simple math, one can calculate an EPS figure.

I have included a screen shot of my model-my estimates are in green, the actual in bright yellow.

In addition, a week before announcing earnings, CHK releases its production results Production Announcement. Therefore, the EPS forecast model could be refined by entering the actual production figures. Selling price and costs are still unknown, but the figures from CHK’s outlook have always been practically spot-on.

With the all the needed information available, how do the analysts continue miss by so much? I have no clue. We know that they are highly intelligent people with considerable resources. I surmise that since they cover so many companies, sometimes it’s not feasible to keep up-to-date on every single stock in their coverage universe. Possibly, analysts don’t want to post a number that the company won’t beat, risking straining ties to the target firm. I guess it just goes to show the quality of equity research.

It’s no secret that the analysts low-ball the consensus estimate, for The Street prices-in an earnings beat each quarter. Of course, I can’t be sure that the Market does, but since shares react sluggishly, sometimes fall, after toping estimates, suggests that market is expecting higher actuals.

A common pattern for CHK is moderately rising share prices in the days leading up to the announcement and continuing for a day or two after the release, and then a pullback nearly erasing all recent gains.

In my opinion, Chesapeake is attractive. The CEO, Aubrey McClendon has been on a buying spree; he bought 20 million worth of CHK in January. Ostensibly, A CEO wouldn’t snap up shares on margin if he/she didn’t think the stock was going higher. Nobody can predict future stock prices, but CEOs are in the best position. Thus, Aubrey McClendon’s purchasing record is a bullish indicator. I discussed insider buying in CHK- Follow the Smart Money.

CHK has massive amounts of acreage that it acquired at attractive prices. It has been ramping up drilling, and production will continue to increase drastically. Rising gas prices coupled with increasing production will provide a significant boost to revenues.

I believe gas prices should continue to increase in the years ahead. Since NG is a clean fuel, there will be pressure to use more, in place of dirtier energy sources, such as oil and coal. John Bougearel wrote a terrific analysis on NG that’s worth a read. NG Prices Remain Elevated.

I believe in the long run, CHK will provide handsome returns. The stock has had a big run-up recently, and might be ripe for a pullback, thus I would probably be buying on dips.

disclosure: I am long chk

Festival of Stocks #76 @ StockMasters

This week’s 76th edition of the Festival of Stocks is at The StockMasters. Be sure to check out this weeks articles!

My article Starbuck's Valuation: A Few Thoughts was included in this week’s edition.

You can catch up on past editions by visiting the Festival of Stocks homepage. There you can also find out how to submit an article for next week’s Festival or learn about how you can volunteer to host an edition of the Festival of Stocks on your own blog.

Wednesday, February 20, 2008

Do Low Multiples Mean the Market is Undervalued?

S&P 500 is trading at low price multiple to expected earnings, 13.7 according to WSJ. The historical forward P/E has been in the range of 14-16, depending on how far you look back. With interest rates incredibly low, 3.88% on the 10-year, should make the fair-value multiple even higher.

According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2. Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.

So is the market cheap? The low price multiples suggest that it is.

The Consensus estimates point to a strong recovery. According to Thompson, Analysts predict earnings to jump 15.3 percent this year.

In my opinion, that magnitude of growth is wildly optimistic. The Market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts thus making multiples higher.

The most probable outcome will be downward revisions to the earnings estimates. It’s possible that some of the consensus numbers are stale, meaning analysts have been slow to update them. This seems plausible given the current environment of uncertainty, and the inherent lack of visibility, may delay updates to estimates. In some cases, analysts may be waiting for a clearer picture going forward, or updated guidance from firms before making revisions to this and next years’ full year estimates.

Another possibly is that the required rate of return investors demand from equities rose, the “Equity Risk Premium.” This implies that the Market perceives increased risk inherent in the equity markets. This seems plausible since volatility has increased relative to years past. Higher perceived risk leads to higher demanded returns which compresses price-earnings multiples.

In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the Market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.

Monday, February 11, 2008

Starbuck's Valuation: A Few Thoughts

Starbuck’s Coffee (nasd: SBUX)- Discounted Cash Flow Valuation: $23

Starbuck’s stock has been getting a beat-down for more than a year already, down more than 50% from the $ 40 high reached Nov ’06. In the past few months, SBUX fell from the $ 26-28 range where it was treading water all summer into the fall. Now, trading around $18, SBUX is still not cheap. Applying a discounted cash flow model gives a fair value estimate of $23. 

Even though fair value exceeds current price by a decent amount, the margin of safety is too small given Starbuck’s negative momentum and expected near-term weakness. However, for a long-term investment horizon (10yr+), I believe SBUX can be bought here. However, Starbuck’s may have rough time in the near-term.

Last August, I placed a value on SBUX of $35 /share. SBUX announced it is scaling back store additions for the coming year, thus I slashed my sales growth forecast resulting in the steep drop in valuation. Projected 5 year growth rate assumption decreased from 18% (aug) to 14%. The other input assumptions really didn’t change, just the revenue growth projection. Read SBUX: Long-term Hold

The last 5 years, SBUX sales growth averaged 23.5% fueled primarily by new store additions. Starbucks cut its previous forecast for 2008 new stores from 1,600 to 1,175 (US), plus mentioned closing 100 or so underperforming locations. The company is forecasting ’09 US store additions of less than 1000. Slower/less growth in Starbuck’s store count translates into less revenue in future periods.

Fear of slowing growth is the main culprit to Starbuck’s stock price slide. Concerns that a slowing economy will materially affect SBUX might be discounted in the share price, but SBUX is well insulated and recessions are short-lived events. Stocks are valued over a long-time horizon, at least 50 years. Worries about McDonalds giving SBUX a run for its money are laughable. Yes, MCD may negatively impact Starbuck’s growth, but only slightly, if at all. I believe that new store expansion has been too aggressive, causing cannibalization of store traffic. Aware and addressing this issue, Starbuck’s is scaling back store openings. Read SBUX Face-off

Foot traffic at comparable stores declined (or was flat) for the past several quarters, leading me to suspect sales cannibalization. Some geographies likely became over-saturated, thus a new store takes traffic from an existing, causing weak SSS comparisons. Surely, some customers who constituted the sales at new locations had visited a SBUX in the previous year. Take a person who had 20 store visits last year. This year that customer returned 10 times to that location, but also went to newly opened store on other ten occasions. That’s where the foot traffic is going, to the 1,800 stores opened this year. Read SBUX Cannibalization

Last fall, management maintained saturation played no part in declining foot traffic as concerns rose. The Reduction to planned store openings is an admission that cannibalization is becoming an issue. On the last call, the CEO said they were slowing down store additions to avert sales cannibalization of existing locations. So, it is problem, the primary problem, not the MCD noise or economy fears.

I think SBUX still has significant growth potential, albeit at a slower pace. SBUX still has some room to grow domestically and plenty of room internationally. Management needs to be more deliberate about expansion, instead of shooting from the hip putting stores any & every where.

Starbuck’s generates high returns on capital and equity. Usually competition and market forces drive returns down to a more normal rate, yet Starbuck’s possesses a very strong competitive position that will keep returns above normal for a considerable time. These factors underlie premium multiple that investor’s have placed on SBUX.

Examining Starbuck’s market valuation from price/earnings vantage point also suggests that shares are fairly-valued. Maybe slightly undervalued, maybe. Certainly not undervalued or cheap by any means.

SBUX is trading at 19x Sep FY earnings and 16x next year’s estimate. Using ValueLine and for estimates years farther out, I calculated my 5-year growth rate projection of 15%, not 19% analyst consensus estimate. 13-15% growth may not warrant a 19 multiple, but given ROI and the persistence of growth and competitive advantages, SBUX trades at a reasonable multiple. Interest are very low too, making a case for higher P/Es.

One area of concern is the downward trend in revisions to EPS estimates, which may portend even more downward revisions.

Earnings Estimates and Revisions:

Starbuck's Historical Data:

SBUX Valuation: Discounted Cash Flow Model

Sunday, February 10, 2008

Authentidate Expects Cash Flow Break-even in 12m

Authentidate (nasd: ADAT) reported its 2nd quarter financial results last Thursday (Feb 7th) - Revenues increased 66%- to $1.66 million versus $1 million for the year-ago quarter. Sequentially, Sales for the 2nd quarter grew 58%. . ADAT continues to lose money, posting a loss of 29 cents a share. Yet, gross margin was 68% for the period. ADAT ended the quarter with a 23.3 cash position.

The most significant development was management announcing plans to achieve cash flow break-even in 12 months.

ADAT is aggressively cutting costs and reducing headcount by 20%. Management believes increasing revenues and reduced SG&A costs will result in positive cash flow hopefully in 12+ months. In addition, the company believes they will have abundant cash (stilll) when they reach that milestone.

ADAT feels revenue growth should continue to accelerate from the addition of new customers. Many existing customers are in the beginning stages of implementation, and revenue will rise as they ramp up usage.

Last November 15th, I wrote about the attractiveness of ADAT: ADAT- Attractive Speculative Play. My thesis was ADAT is attractive because it trades for less than cash on hand, and it’s growing the top-line as well. It doesn’t make sense for a company to sell for less than cash unless it’s heading straight for bankruptcy and/or has significant outstanding litigation. That was a real possibility for ADAT, but now it's looking like ADAT has cleaned up its legal issues and has embarked on a plan to reverse its cash bleed.

Fixed costs and one-time expenses are the primary factors impeding profitability. Gross margins are about 70%, which should improve with volume. ADAT’s core risk was not prospective growth materializing; moreover, it was whether ADAT cold remain afloat long enough for the adoption to take hold.

Heavy year-end tax selling coupled with general lack of interest have knocked down ADAT shares lately, leading to undervaluation. Authentidate’s had a strong balance sheet due to piles of cash and no debt. Income statement should shape up as the company continues to grow and cut costs. The catalyst for significant price appreciation hinges on achieving CF break-even. In the meantime, I believe ADAT shares are worth are least $1.

Businesses are often reluctant to implement new IT when current processes aren’t broken. The attempt to capture cost savings entails a risk of creating costly, unforeseen problems. Often, the hurdle is reaching critical mass- tested and proven among multiple firms. No firm is eager to be the guinea pig; but once several are on board, others are quick to sign up. In US, ADAT is in the stage of building a foundational user base; the initial customers are the most difficult to attract, Signing up customers will become easier with every new customer addition because a large user base legitimizes the product/service. Existing customers, in a way are vouching for the ADAT's e-doc solution.

Authentidate’s traction has been much slower than expected, but recent signs are pointing to a ramp-up in customer adoption. In a recent article:ADAT- Gaining Traction, I highlighted Authentidate’s recent contract developments.

BULLet Points:

1) Cash Holdings > Market Value
2) Book Value per Share- $ .97
3) Revenue Growth- TTM: 45% MRQ: 66%
4) SGA expense expected to decline significantly + high GM =>Operating Leverage

ADAT shares rose 30%, to 61 cents in Friday (2/8) trading, pushing its market cap up to 21m. The stock spent the morning session trading below the open, before gaining momentum to end the day up 14 cents & accompanied with strong volume.

Disclosure: Long ADAT

Friday, February 1, 2008

Starbuck's Traffic Decline Due to Cannibalization

Starbuck’s Coffee (nasd: SBUX) is experiencing a slowdown in same-store sales – specifically declines in transaction volume or “foot traffic.” This has been cause for alarm as some theorize that the business model is in jeopardy. Yet, I believe that SBUX is intact, and it’s the aggressive store expansion that has caused cannibalization. However, not positive, cannibalization can be addressed and solved, but it will entail slower growth than what has been expected.

Starbuck’s Historical Performance:
Starbucks turned out 17% sales growth for the Q1 2008, yet same-store sales increased only 1%: 2% rise in value per ticket coupled with 1% decline in transaction volume. In the US: SSS dropped 1%: 2% increase in average ticket value and 3% decline in number of transactions.

Cleary, foot traffic is declining for stores older than one year, and some are speculating that customers are defecting to McDonalds. Simply, this is not the case. Foot traffic declines are primarily a result of cannibalization from new store openings. Sales growth continues to be robust due to new store additions, yet some of that traffic is stolen from stores open longer than 13 months.

Looking back several months, Starbucks management stated on the 07Q4 conference call (11/15/07) that the 1% decline in US store traffic (# transactions) in Q4 was not due to saturation. For FY07, store traffic was basically flat. I don’t know how they could be denying the fact that their aggressive store expansions haven’t cannibalized sales from existing stores. That implies that virtually all sales generated from the 1,788 new stores opened FY07 are from customers, who hadn’t been to Starbucks in the past 13 months (FY06).

I’m really surprised that there hasn’t been a greater decline in transactions just from the simple fact that a new store addition may be more conveniently located for a regular customer than an existing store. It’s safe to assume that a portion of the new store traffic includes customers, who had been going and would still be going, to an existing location.

SBUX management is accepting the fact that cannibalization is occurring as evidenced by the announcement to dial down the number of planned new store openings.

Same Store Sales Metric Explained:
The highly popular same store sales (SSS) metric can be quite nebulous at times. Its purpose is to capture organic sales growth from existing (comparable stores) and exclude growth attributed to additions of new stores. Overall revenue growth due to new store openings can conceal falling sales at existing stores unless sales from the both segments are isolated. SSS compares sales of stores open at least a year (13m) thus excluding growth associated from an increased store count in the current period. Comps can indicate if competition is affecting sales, or if customers are spending less due to economic hardships. SSS can also uncover if the firm’s product offerings have become less relevant to consumers.

SSS can be clouded since often SSS growth is driven by new store growth, which counters the purpose and value of the SSS comparison. New store additions can affect SSS growth when the new stores require time to reach maturity (or peak revenues), which may be several months to several years. Considering a new market lacks an existing customer base, a new store will have to build a customer base by increasing awareness with promotion, advertising, and word-of-mouth. In addition, the new store will need to become familiar with local tastes and preferences in order to optimize its inventory by stocking a product assortment that best matches the surrounding community. These are just a couple factors that describe the revenue growth curve for a new store.

Individual store revenue curves widely vary due to numerous factors. The type of industry that the firm operates makes a difference. The most significant determinant is the existing customer base, specifically brand awareness and familiarity. New markets where brand penetration is absent will not have much, if any customer base. Highly visible brands in distant markets can create awareness in un-penetrated markets resulting in a more rapid build in the customer base once a new store arrives. Store additions in markets that are in close proximity to existing stores will have an existing customer base to draw from. This scenario will likely result in the quickest maturity since a portion of the customer base will be cannibalized from the other existing stores.

Retailers that are aggressively adding stores in new markets tend to have overestimated SSS figures. This is how it works: A retailer with 1000 stores opens 300 new stores, which won’t reach maturity for at least two years. The following year, the retailer now has 1300 existing stores with 300 generating 60% of maturity sales. For the year, the company adds 400 new stores bringing the total to 1700, but the SSS comparison only involves the 1300 existing at the start of the year. At year end, those 300 stores operating at 60% the year before, are now at 90% of peak store revenues. The increase in sales per store associated with those stores open longer than a year but less than time to maturity are included in SSS calculation. Thus, adding new stores will boost SSS sales if there is a considerable period between the open date and the date the customer base matures.

In general, there is a direct relationship between SSS and store count increases, especially when new stores are added in markets characterized by a small customer base that gradually increases. If possible, calculating sales per store at existing stores versus new stores can aid in uncovering situations where SSS is blurred from aggressive store expansion. If there is a wide discrepancy between the two, it’s likely that SSS is overstated. For instance, if existing stores have historically averaged 500k per store, and new stores (less 1 yr) average 250k, then SSS will grow as new stores approach peak sales of 500k. The 250k per store generated by new additions are responsible for growth associated with new stores only. Yet, for the subsequent year, the SSS metric will use 250k in comparison.

Starbuck’s Same Store Sales:
In the case of Starbuck’s, I believe that the slowdown in SSS is due to new stores having a larger initial customer base (higher sales/store) thus the comparisons are tougher. Stores coming online generating sales/store closer to peak sales and maturing more quickly will result in higher new store sales growth and lower SSS growth in the subsequent period.

A logical assumption is that during SBUX expansion into new geographic markets, new stores gradually grew traffic as brand exposure increased with time. In contrast, stores opened in already well penetrated markets require less effort drawing traffic since many consumers have already experienced Starbucks’s offerings. SBUX current store footprint virtually blankets the US, therefore a significant portion of store additions will be in locations in the vicinity of existing SBUX stores. SBUX is highly visible, well-established brand that reduces the local effort needed to inform and attract a customer base because of the large percentage of local consumers is already familiar.

Many new Starbuck’ stores provide a more convenient location for some of its current customers who are regular visitors at more distantly located stores. Thus, SBUX customers switch to the new location. It’s also likely that some customers opt for a new location to avoid the high traffic stores. Yet, it’s hard to argue that sales generated at new locations do not come at the expense of existing stores. How much? It’s hard to say without conducting extensive market research and customer surveys.

I have little doubt that cannibalization is responsible for the decline in SSS transaction growth. Traffic migrating from an existing store to a new store, causes SSS revenue to fall, but total revenue is unaffected because of the offsetting increase in new store sales growth. The overall effect is negative because the same level of revenue is spilt between two stores instead of one, thus lowering margins and return on invested capital. Yet, if new stores increase an existing customers’ visits/yr and allow existing stores to capture new customers as well, then growth could outweigh cannibalization.

According to my calculations, for the past couple years, it appears that revenues at new stores are closer to revenue/store at existing locations than in previous years. This suggests more recent store openings have a larger initial customer base.

Turning Cannibalization into Positive Growth:
It’s possible that this type of cannibalization can actually end up being positive for SBUX if several factors occur.

1) Transactions/Customer are higher at new locations than what was lost from existing stores.
2) Costs for new store openings are lower.
3) Relieve capacity pressures at high volume locations

It’s positive if a customer who averaged one visit/month at an SBUX is now averaging five visits/month at the new location. SSS will fall because store visits have fallen from 12/yr to zero. But, new store sales will increase by an amount larger (60/yr) than that lost in SSS (12/yr).

If SBUX can migrate regular, high frequency visitors from a high volume store to a new store, then that will free up capacity to attract new and low frequency customers at the high visibility locations. Premium locations serve as a marketing tool as well. The SBUX brand is exposed to the large sums of people passing by daily. Since Starbucks historically has not aggressive engaged in advertising, the stores serve as its primary marketing effort.

High traffic at a SBUX can be both beneficial and disadvantageous for attracting consumers with minimal brand experience. High volume indicates that the offerings are very liked and demanded, and provides a vote of confidence for those unsure due to lack of brand experience. Yet, some consumers may reluctant because they are unwilling to deal with long lines.

Consumers willing to engage crowded locations are more likely to be regular visitors who perceive SBUX product value to exceed the cost of waiting. The cost of a premium location is worthwhile when the additional expense for visibility attracts new customers or increases visits of low frequency customers. The additional expense provides less benefit if the highly visible locations are packed with regular customer who “crowd out” curious, potential customers.

The ideal scenario: high frequency visitors go to convenient, but less visible (lower store cost) locations thereby freeing up service capacity at the premium locations. This will allow the highly visible, premium locations to attract more new / seldom customers.

Anecdotal Evidence:
To give an example, I will describe my recent Starbuck’s visiting pattern. Of course, this is just my experience and may not accurately represent the norm. Yet, I can envision that a portion of SBUX customers share a similar pattern. I think it’s at least worth mentioning and contemplating.

The SBUX store closest to my house was a premium location in mid-town. During morning rush hour, the drive-thru line spills all the way out into the street. Occasionally, I couldn’t get in line because I would be blocking traffic at the intersection so I would have to keep moving. At this time, I probably visit SBUX once every two months (6 visits/yr). This distance from my house and the large crowds at SBUX dampened my visit frequency. Several months ago, a small SBUX opened close to my house downtown. With much smaller lines and the convenient location, I now go to Starbucks at least twice a month (24 visits/yr) and usually spend more too.

Now- my visits have increased, my average ticket has increased, and the new location is likely less expensive to open and operate. In addition, since I no longer visit the high traffic SBUX, there will be smaller lines to capture customers who may pass-up due to the high volume.

I have asked several acquaintances what would influence them to visit SBUX more frequently, and the top responses I received were convenient location and shorter lines. A few essentially mentioned they don’t think about SBUX until they see a store, but usually the road traffic and store parking lot appear to be a hassle.

My experience is just an anecdotal scenario that has little value unless we could ascertain the exact percentage of consumers who share my experience. Yet, I am certain that some do, and at minimum, it’s a worthy scenario to a least consider.

Starbucks needs to manage its store expansion strategy more effectively to reduce the negative effects of cannibalization. Situations where cannibalization is unavoidable, SBUX needs to find methods to limit the negative impact to achieve scenarios I mentioned above. Essentially, this involves selecting locations that can be supported by an existing customer base coupled with potential to attract new customers. It appears that SBUX is beginning to understand the issue from the recent announcement to slow store expansion as well as closing underperforming locations. Management plans to be meticulous with respect to store additions. A scaled back expansion plan will translate into slower sales and earnings growth, hence price multiple. It appears that this information is reflected in the stock price as the multiple has already been compressing for some time.

I believe that sales and earnings growth, albeit a slower rate, will still be above average and persist for a considerable length of time. Shares are fairly valued currently, yet as a long-term hold, SBUX is relatively attractive.

Disclosure: No position in SBUX

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