Friday, July 27, 2007

Wall Street's Overlooking Bed Bath & Beyond's Long-Term Value

Bed, Bath, & Beyond Corporation (BBBY) has encountered a rough road recently. Currently trading at $35.46, BBBY shares are off nearly 18% from the high of $43.32 reached back in February.

I believe that three factors are responsible:
  1. The general weakness in the retail space from slowing consumer spending
  2. Housing market recession which affects demand for goods specific to BBBY
  3. Decelerating sales growth as new store openings are nearing saturation.
These are very significant concerns but I feel the first two are temporary and the last issue will be addressed with international expansion and new store additions outside BBBY's core concept.
In short, the market is discounting current weakness over a too long period of a time and underestimating long-term growth potential. For the a long-term hold strategy, BBBY shares are attractive at the current price level. BBBY is trading around 16x current year's estimated EPS and 14x next year's estimates. Analysts are forecasting 5yr annual growth of 14-15%, which translates into a PEG ratio close to one.

Remember these EPS estimates represent the depressed, current operating environment and not normal trend growth. From the long-term perspective, we don't select stocks based on this or next year's earnings, rather the long-term earning potential of the company. That being said, normalized near-term EPS would be much higher, thus the forward-looking multiples would be much lower making the stock even more attractive. Value presents itself under conditions of pessimism and near-term challenges, which should be taken advantage of because in the long run returns will be much greater when acquiring shares currently under pressure. Expectations have been lowered, weak hands have been forced out, and now the upside reward outweighs the downside risk.

Sales and EPS growth momentum is strong, averaging 18% and 24% annually the last five years, respectively; I believe 14-15% going forward is attainable. Same-store sales growth will probably average 3-4% and new stores will add 7-8% annual growth for the next five years. With a sizable cash position and weak stock price, I expect significant buy-backs that could provide an additional 4-5% boost to EPS growth. If growth ends up being more tepid that expected, shares will be subject to pressure, but also will provide share buy-back opportunities that could serve as a "hedge" by supporting EPS growth and share price.

The company has close to 900 stores and believes it can achieve more than 1,300 stores domestically. In addition, BBBY operates 30+ Christmas Tree Shops and about 40 Harmon Stores that also provide growth potential.

Bed, Bath, & Beyond has just begun to expand internationally by opening its first store in Canada. International growth could be very significant for BBBY. The firm demonstrated its power to expand rapidly into new markets with ease and should be able to duplicate that success in similar markets outside the U.S. A major advantage is BBBY’s management structure/policy. Store managers, only promoted from within, are responsible for 75% of product selection. This allows the firm to cater to local tastes and preferences as well as the ability to react quickly to any preference changes.

Most products are ordered directly from suppliers thus bypassing the need for company distribution centers. This results in a lower cost structure. By not forcing its concept when entering new markets, BBBY can attract customers by adapting to the local culture. This is a significant benefit when expanding abroad since cultural differences can be accommodated using this management structure.

Remember when the "No-Limit Texas Hold" poker fad erupted? BBBY shook me down when I visited a store to buy kitchen essentials and left with poker chip sets and a card shuffler. I had no intention or real need to buy such products but they got me because of management's ability to respond to consumer interest.

Seemingly, every time I make a trip to Bed, Bath, and Beyond for truly innocent purposes, I depart with those products found on center-aisle displays. If you have been to a BBBY, you know to what I am referring. Nifty products, often unrelated to BBBY's overall product concept, that are tough not to consider buying. It's that anecdotal evidence that illustrates the firm's prowess for making the shopping experience for mundane products exciting and unique. Most importantly, they offer sheik and appealing products at hard-to-beat prices. It's that type of consumer experience specific to Bed, Bath, & Beyond that will keep consumer interest and dissuade them from shopping elsewhere.

Aside from just prospective growth, BBBY deserves a higher multiple considering its high returns on equity and capital. ROE has averaged approx. 24% the past 5 years and profit margins are among the highest in its industry. The established position and consumer acceptance built over the years give BBBY a competitive advantage against existing and potential new competitors.

Bed, Bath, & Beyond’s high margins represent the massive potential cash flow that can be returned to shareholders. In the past five years, net margin has averaged 9.2% with a standard deviation of 0.7%, which is very impressive for a retailer. Over time, capital investment will decrease resulting in higher free cash flow available to owners. Economies of scale and operating efficiencies will continue to bolster return on invested capital and allow the firm to maximize free cash flow per $1 of invested assets.

On a comparative basis, consider the following illustration. For the last fiscal year reported, Bed, Bath, & Beyond's net income was 594 million, and if we did a rough discounted cash flow valuation, assuming zero real growth and zero net investment (capex-depreciation), we would get an intrinsic value around $46 when discounting at the long-term treasury rate (((Income/Treasury Rate)+(Cash-Debt))/Diluted Shares))). That value is about 30% higher than the current stock price. Applying the same calculation to similar firms such as Target (
TGT) and Macy's (M), yields intrinsic values 14% and 13% below current share prices, respectively.

Future growth is expected to make up the difference for those two firms, yet for BBBY growth is expected to destroy value? That's what the back of the envelope math implies, or that growth will be negative and cash flows will decline. Negative growth is highly unlikely just as it’s unlikely positive growth will destroy value when return on invested capital exceeds BBBY’s cost of capital. Relative to those similar firms along with dismissing alternative explanations, it appears that the stock is undervalued. Yet, that math is very crude and only somewhat meaningful in a relative context.

A more involved, 3-stage growth DCF valuation model suggests BBBY’s fair value is $50/share assuming: 9% sales growth and 13.5% EBIT margin for the next 5 years, for the subsequent 10 years assuming: sales growth gradually declines to 3%, EBIT margin falls to 11.3%, and capex & deprecation converge to equilibrium. For a reality check, applying the same valuation method to Target and Macy’s returns intrinsic values roughly inline with their current market prices. In sum, analysis suggests that the stock price is suffering from the recent, disappointing news surrounding Bed, Bath, & Beyond, and in addition, the market is overlooking the significant cash-flow generating potential of the firm over the long run.

Highly profitable, entrenched firms make great investments, but too often that’s no secret on Wall Street, thus the price tag accordingly accounts for such qualities. Yet, when the near-term future looks bleak and long-term picture is believed to be unaffected, an investment opportunity presents itself. Knowing that down the road a firm, such as BBBY, will still be an attractive business is a gift when the market is fixated on the immediate future and takes share prices down accordingly

Monday, July 9, 2007

Chesapeake Energy: Follow the Smart Money

Chesapeake Energy (NYSE: CHK) appears to be attractively valued @ $35/share, and apparently, I am not the only one thinking that. The CEO, Aubrey McClendon has been pouring his own money into the stock for some time now. Other insiders have been doing the same, according to shares bought / shares sold ratio has been 9.6x last 3 months and 5.5x in the last year.
Additionally, Southeastern Asset Management, with a solid long-term record with their Long Leaf Funds, has been a huge acquirer of CHK stock in the past year. The group’s manager, Mason Hawkins, follows a value investing approach- seeking great companies currently out of favor in the market, thus providing a good purchase price.

Currently, CHK trades 11.5x current years EPS estimates and the average analyst 5yr projected growth rate is 18% resulting in an attractive price to growth ratio (PEG) of .6. It also should be noted that those figures are probably even conservative given the fact CHK has beaten consensus estimates the past 18 quarters by an average of 15%.
Chesapeake went on an acquisition binge the last few years and now it appears they are focusing on developing the newly acquired leaseholds and ramping up total firm production. Declining gas prices allowed CHK to purchase leaseholds at attractive prices raising the level of potential profit.

So here is the story: CHK has tons of land yet to be developed but known to hold tons of natural gas. These fields are all inland; CHK doesn’t face the risk of hurricanes, yet would benefit from price increases due to any hurricane related capacity reductions. Chesapeake owns its drilling fleet and coupled with industry leading technology, its operating costs are relatively low. Historically, Chesapeake’s success rate has been very high and proved reserves continue to expand. According to management, Net Asset Value (share) is $50 @ $7.50 gas price and $56 @ $8.00 gas price.

Additionally management does a terrific job with transparency and keeping shareholders informed. CHK has limited gas price exposure significantly via successful hedging endeavors. This allows CHK to focus on the development and conversion of its competitive advantages, and not be subjected to the whims of the commodity market which are beyond its control.

Trading at a discount to its industry peers CHK is very attractive, especially given its limited risk profile and substantial growth prospects. Those who know best, “the smart money” are believers in Chesapeake shares. Insider purchases can be a powerful indicator, and nobody better knows the true intrinsic value of CHK than the CEO, Aubrey McClendon, thus it’s probably a smart move to follow his lead.

Saturday, July 7, 2007

Industry Analysis: Porter's Five Forces Driving Competition

Porter's 5 Forces Model:

I. Threat of Potential Entrants-
Barriers to Entry
1. Economies of Scale
• Refer to declines in unit costs of a product as the absolute volume per period increases.
• Scale economies may be present in many functional areas: manufacturing, purchasing, R&D, marketing, service network, and distribution.
• Its possible to share economies across businesses within a firm if there are shared costs and/or shared benefits such as intangible assets such as brand strength and know-how
• Barriers can occur with economies to vertical integration
• New entrants are faced with huge cost disadvantages if they can not enter in minimum efficient scale
2. Product Differentiation
• Established firms have brand identification and loyalties, which stem from past advertising, customer service, product differentiation, or being the pioneer.
• Entrants are forced to spend heavily to overcome existing customer loyalties
3. Capital Requirements
• If large sums are capital are needed a barrier may exist especially if its risky or unrecoverable, upfront investment such as advertising and R&D.
• Most firms have access to capital, but if risky cost of capital will be high thus giving the advantage to the incumbent firms.
4. Switching Costs
• If switching costs are high, new entrants must provide a substantial inducement for customers to switch from an incumbent.
5. Access to Distribution Channels
• If incumbent firms have channels tied up, new entrant must provide incentives to channel members to accept its product through price breaks and advertising allowances
• New entrants may have to create new channels if the established ones are characterized by strong, symbiotic relationships among the members
6. Cost Disadvantages Independent of Scale
• Established firms may have cost advantages not replicable by potential entrants no matter what their size and attained economies of scale.
1. Proprietary product technology or patents
2. Favorable access to raw materials- established firms may have locked up most favorable sources
3. Favorable locations
4. Government subsidies
5. Learning or experience curve- unit costs decrease as firm gains more cumulative experience in producing a product. Costs decline because workers improve their methods and become more efficient (learning curve), layout improvements, and technology improvements.
7. Government Policy
• Government could limit entry by licensing requirements and limits on access to raw materials.
• Pollution control and product safety requirements
Expected Retaliation-
• Expectations of existing competitors will influence threat of entry
• History of vigorous retaliation
• Established firms with resources to fight back, including excess cash and borrowing capacity, exceed productive capacity, or great leverage with distribution channels or customers
• Established firms with great commitment to the industry and highly illiquid assets
• Slow industry growth: limits industry’s ability to absorb a new firm
Entry Deterring Price-
• Entry deterring price is the prevailing structure of prices which balances the potential rewards from entry with expected costs of overcoming structural entry barriers and risking retaliation
Properties of Entry Barriers
• Entry barriers can and do change as conditions change
• Firms’ strategic decisions affect entry barriers such as increasing advertising or establishing a distribution network or vertical integration; all can increase economies of scale thus barriers to entry

II. Intensity in Rivalry of Existing Competitors
1. Numerous or Equally Balanced Competitors
• With numerous competitors- increased risk of maverick firms who might think they won’t be noticed
• If few, equal competitors - may be prone to fight each other and if have similar resources, they probably have similar strategies thus same target market
2. Slow Industry Growth
• Slow growth turns competition into a market share game for firms seeking growth..
3. High Fixed or Storage Costs
• High fixed costs create strong pressures for firms to fill capacity which leads to price cutting when excess capacity is present
4. Lack of Differentiation or Switching Costs
• If offerings are perceived as commodity or near commodity, then competition is based on price and service, resulting in intense price competition
5. Capacity Added in Large Increments
• Risks of overcapacity thus periods of price-cutting to fill capacity
6. Diverse Competitors
• Competitors may have a hard time reading each other’s intentions accurately and agreeing on the rules of the game
7. High Strategic States
• Firm may have increased pressure to succeed in a particular industry in order to further its overall corporate strategy.
8. High Exit Barriers
• Exit barriers are economic, strategic, and emotional factors that keep firms from leaving poor industries
i. Specialized assets with low liquidation values
ii. Fixed costs of exit: labor agreements, resettlement costs
iii. Strategic Interrelationships: Image, shared costs
iv. Emotional barriers: loyalty to stakeholders, pride, fear
v. Government and social restrictions: govt. denial or discouragement for exit

III. Pressure from Substitute Products
• Substitutes perform the same function as the products in the industry, satisfy same needs and wants
• Substitutes that merit attention are ones improving their price performance trade-off and highly profitable products
• Substitutes limit returns by placing ceiling on prices

IV. Bargaining Power of Buyers
1. Purchases Large Volumes Relative to Seller Sales
• Raises importance of buyer’s business in firms performance
2. Products Represent Significant Fraction of Buyers Costs or Purchases
• Buyers are price sensitive and will search for best deals
3. The Products are Undifferentiated or Standard
• If buyers can find alternatives may play one supplier against another
4. Buyers Face Few Switching Costs
5. Buyer can Influence Purchase Decision of Consumers
• Retail has power over manufacturers when they can influence purchasing decisions- such as products that require sales assistance like appliances
6. Buyers Earn Low Profits
• Creates great incentives for buyers lower purchasing costs and find or bargain for best deal
7. Buyers Pose Threat of Backward Integration
• If pose threat, buyers are in a position to demand concessions
8. Quality Unimportant to Quality of Buyer’s Product or Services
• If quality is important then buyers are less price sensitive
9. Buyers Have Full Information
• If buyers have full info about demand, actual market prices, and even supplier costs, this provides greater bargaining leverage then when information is poor

V. Bargaining Power of Suppliers
1. Dominated by Few Sellers and More Concentrated than Industry it Sells to -
• Suppliers selling to more fragmented buyers will have more influence in prices, quality, terms
2. Suppliers Do Not Face Threat of Substitutes
• Power of large, powerful suppliers can be checked if they compete with substitutes.
3. The Industry is not Important Customer of Supplier Group
• If suppliers sell to many industries, and a particular industry does not represent a significant fraction of sales, suppliers can exert power
• If industry is important customer, suppliers fortunes will be tied to the industry, therefore they will want to protect it with reasonable pricing and assistance in activities like R&D and Lobbying
4. Suppliers Group Products are Differentiated/ Switching Costs involved
• Buyers facing switching costs or differentiation does not allow them to play suppliers against one another
• High switching costs can place firms at the mercy of their suppliers
5. Suppliers Product is Important Input to Buyer’s Business
• If input is important to manufacturing process or product quality then supplier power is increased.
6. Threat of Forward Integration
• This provides a check for firms to improve their purchasing terms
• Labor must be considered as a supplier. Unions and scarce, highly skilled labor can bargain away potential profits (Nasdaq:AMZN)- Not Worth the Price

Trading near $70 per share at the end of the first week in July, Amazon appears overvalued. The price is very steep considering its volatile past and its razor thin profit margins. One thing AMZN has delivered is top line growth. Sales have been increasing at a very robust rate, yet very little falls to the bottom line. This means little cash is left to distribute to shareholders.

Even though Amazon retains all income to plow back into growth, stocks are valued on the premise of CF that could be distributed if the company so chose. Revenue has grown an average 28% annually the past 5 years, yet operating margins have average just a little more than 4% and net margins less than 2%.

Currently AMZN trades at 68x this years estimated earnings and 52x next year. Google trades 32x next year’s eps and Ebay trades at 24x. Both have Similar growth prospects as Amazon, but their margins are extremely higher and they also don’t have to invest in physical inventory such as AMZN.

No matter how fast Amazon expands, the fact is profitability will remain weak due to intense competition endemic to the retail industry. Amazon has to offer low prices to bring consumers to cyberspace as opposed to the bricks and mortar outlets. Prices also have to be low enough to offset the cost of shipping. Many large bricks and mortar companies are becoming more savvy with creating and managing their online stores. As they continue to improve, Consumers can shop online and possibly have the option to pick the items up from a physical store if one exists nearby.

Amazon is working on providing more web-based services and downloadable media products but competition looms there as well. In that aspect, Amazon is up against the likes of Google, Ebay, and Yahoo, all of whom have been in the game much longer. Additionally, AMZN has had to spend heavily on research and development in those endeavors essentially offsetting much of the benefits it provides. Amazon's share price has nearly doubled since April on the heels of improved earnings and outlook.

Some of theEPS improvement can be attributed to an artificially low tax-rate due to loss-carryovers, favorable forex translation, and cutbacks in R&D. So, the question is: are those conditions sustainable in the long-run?

3 years ago AMZN earned $1.39 / share with the aid of a negative tax rate and a lower R&D spending the next two years EPS declined to $.78 then to $.45. This year’s EPS is expected to be up @ $1.02 but with rates rising and a tired consumer, sustaining EPS growth will still be difficult even if AMZN has additional help with low tax rates and forex gains.

Revenues have to continue their rapid pace for a substantial length of time and margins have to expand in order to justify the current price. At AMZN’s current level, the required rate of return is too low given the involved risks. Amazon has to meet very high expectations just to keep to stock where it is now, eliminating upside potential and creating huge downside risks.

Many of Amazon’s peers trade at lower multiples and they are better performers. That’s contrary to fundamental logic of paying up for higher returns. It doesn’t make sense to pay more and get less.

A more realistic valuation in my opinion is $45/Share. I definitely believe the stock has gotten ahead of itself, and short covering has definitely helped push the stock higher as 8 million shares of short interest got squeezed out last month.

I wouldn’t bet against this price momentum either; I wouldn’t short it unless the technicals completely collapsed. I wouldn’t buy it either unless it dropped into the low 40’s.

Friday, July 6, 2007

Barron’s Erroneous Take on Apple’s iPhone: Setting the Record Straight.

In Barron’s July 2, 2007 weekly print edition, Mark Veverka gave his analytical opinion regarding Apple’s prospect in the article titled “Fight Apple’s Temptations – Briefly.” Veverka seeks to make the point that the iPhone is not largely important to Apple’s overall business. As the subtitle points out- “It’s the software, Stupid” The author is referring to Mac OS and its software “Boot Camp” that allows users to run Windows and Mac OS simultaneously on a Macintosh machine. He believes that it’s the “Halo effect” of the iPhone that will drive Mac sales, which in his opinion, will have to be robust to support Apple’s current stock price.

While he makes some interesting and solid points, his analytical ability is called into question when he makes some indisputable, gross errors. It also makes one wonder if there are editors or fact checkers that review the work before it is published so that Barron’s reputation won’t become tarnished.
What I am referring to is the Veverka’s statement appearing in the second section of the article:

“As important as iPhone’s launch is, computer sales will be key to the stock’s maintaining it’s upward trajectory will into 2008.”

I do not necessarily disagree with that statement. Further Veverka adds:

“To put things into context, if Apple sells 10 million iPhones in 2008, that would add only 500 million in revenue.”

Hold up, let review our math from 1st grade, Ok if 10 million times 5 is 50 million, and 10 million times 50 is 500 million, then 10 million times the $500 selling price of the iPhone has to be 5 billion, not 500 million as the author stated. Ok, maybe it’s a typo. However, when he further says:

“Or 2% of its 21.6 billion estimated total (2008 Revenue). Thus, a big part of the story is the Mac.”

The aforementioned string of incorrect statements leads me to believe that it’s not just a typo, but very sloppy work. Anybody slightly familiar with Apple knows that iPhone is expected to add 5 billion in revenues and 2.5 billion in profit next year, and It would stand to reason any editor proofing the article would notice those misstatements. I mean after all, why has Apple’s stock been rising the past six months on the tear that it has? Is all the frenzy around the Mac? Uh no. It’s the iPhone, Stupid. Additionally, “21.6 billion of its estimated total”??? Estimated 2008 revenues? Which Veverka incorrectly states 500 million is 2% of? Actually, the consensus sales estimate for 2008 is 29.2 billion from both ThompsonFN and Reuters. For FY 2007, which ends this September, is expected to come in at 23.7 billion. Trailing revenues in the last 4qtrs has been 21.6 billion which is not an “estimated figure.” That’s an actual or historical figure. After seeing the erroneous statements the article, the author, and Barron’s (only to very slight degree) lost credibility in my mind. It’s tough to listen to the Veverka’s points when one has the impression that he has no idea what he is talking about.
I must point out that Barron’s corrected the 500 million to 5 billion and 2% to 23% in the article posted online. Yet, the article’s major point is how less significant the iPhone is to Apple’s success than what the majority of people perceive it to be. That’s true if the iPhone is only 2% of sales, but totally ignorant when it’s expected to be a quarter of sales. Thus, the purpose of the article is really lost.
Veverka points out that Mac sales will be the key to maintaining the stock’s upward trajectory. I previously mentioned I can agree with that statement, but in a different aspect. Veverka seems to think (since iPhone sales will only be 2% of revenue) Mac shipments will have to bear the heavy lifting. My thoughts are that Mac sales will only be crucial on the margin. To explain, iPhone sales will be a major portion of revenue and also demonstrate the major growth, yet it that forecast is already priced into the stock. For the stock to head higher, Apple must exceed expectations. Since the iPhone expectations are already lofty, the source for upward surprise will have to be from the Mac side which is forecasted to only grow 15% (1.5 billion) next year. To set the record straight, 5 billion (most think more like 6-7 billion) of sales growth next year will be driven by the iPhone; only 1.5 billion of sales’ increase will be attributable to Mac sales. Apple’s stated goal is the 5 billion figure, and they are notorious for low-balling thus Wall Street has revision that number upwards in making their estimates. That leaves less room for an upward surprise in expectations. Yet, the 15% growth rate is conservative, and Apple will easily exceed and mostly likely grow Mac revenue 25% or 2+ billion next year. That will be the source of surprise needed to keep moving the stock and not the majority of the absolute sales dollar growth. In essence, contrary to Veverka’s opinion, the iPhone is largely important since its expected to make up the major portion of sales growth and a significant portion of overall revenues. Even though Mac sales will be a small portion of growth, increasing success is tantamount in keeping and increasing investor’s interest and expectations.
Memphis, TN, United States