In his most recent shareholder letter, posted one week ago, Warren Buffett shed more light on Berkshire Hathaway's (BRK.A, BRK.B) CEO succession plan. It sounds like they’re in pretty good shape for the CEO role, but that they’re going to have more difficulty finding a chief investment officer who can take over. Buffett has long said the board will split his current position into two (CEO, CIO) upon his death.
So who will it be? My guess is that it will be someone very much like Buffett himself: A self-effacing, modest person who avoids the limelight, doesn’t go on the speaking circuit, and doesn’t attend black-tie events. It’s likely to be someone happy to be paid well, but not extravagantly, for doing what he or she loves (it's fair to say the person could be the highest paid in Omaha, however).
It'll be a family-oriented person who would not enjoy the fast-paced lifestyle of an East Coast hedge fund manager. This person will be more likely to be out coaching his or her kids’ sports teams rather than hobnobbing with other executives. It is this independence that likely has helped and will continue to help this person make superb investment judgments, I’m betting. Because of the trust Buffett will be placing in this person, his or her views and opinions will be deeply respected and closely watched.
The investment officer selection process at Berkshire is going to be fun to watch over the next several years.
Full disclosure: I own shares for clients as well as personally.
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
What Rate of Return Is the Market Implying?
Market pundits on CNBC continue to talk about the market being overbought at these levels and mentioning the likelihood that there could be a better entry point at which to put new cash to work. I tend to agree, as I look at market volatility at a nearly 20-year low (similar to this time last year) that is due to “revert to the mean.” So the market may be overbought and participants in general complacent about market risk, but is the stock market overvalued?
It’s hard to answer that question, of course, and I don’t know for certain. Various market participants use different methods to come up with the rate at which to discount the stock market’s future growth. And all have different returns they are willing to accept for the risk they take in equities. That's not finance theory, but it's the way I see it. I, for one, am always in a better mood when the markets are down and thus the implied future rate of return up.
Based on current S&P 500 Index levels, I calculate the implied future return on the market to be a little under 8.0% based on a long-term trend growth rate of 6%. This tells me that indexing from this level is likely to yield below-average future returns. So is the market overvalued? Well, are you willing to accept the added risk inherent in stocks for about 3% more than a 10-year Treasury? That's really the long-term Treasury rate plus inflation. I see that as being fairly valued to slightly overvalued.
It’s hard to answer that question, of course, and I don’t know for certain. Various market participants use different methods to come up with the rate at which to discount the stock market’s future growth. And all have different returns they are willing to accept for the risk they take in equities. That's not finance theory, but it's the way I see it. I, for one, am always in a better mood when the markets are down and thus the implied future rate of return up.
Based on current S&P 500 Index levels, I calculate the implied future return on the market to be a little under 8.0% based on a long-term trend growth rate of 6%. This tells me that indexing from this level is likely to yield below-average future returns. So is the market overvalued? Well, are you willing to accept the added risk inherent in stocks for about 3% more than a 10-year Treasury? That's really the long-term Treasury rate plus inflation. I see that as being fairly valued to slightly overvalued.
Opportunities in Ethanol?
Over the past year, ethanol has become a buzzword that has attracted much media attention and debate. Environmentalists like it because it burns cleaner (I would counter that you get 20-30% less mileage from ethanol than ordinary gasoline). Politicians love it because it is “alternative energy,” a phrase that is sure to garner some good publicity and public support as they look for ways to curb our “addiction to oil.”
Producers love it, since domestic producers are generally protected from foreign producers (such as Brazil) by a $0.54 tariff on imported ethanol that has now been extended to January 2009. Largely because of a 51 cent-per-gallon tax break, ethanol has received about 50 cents more per gallon than gasoline at the wholesale level (right now it’s about $0.45 more).
Who also loves ethanol? Corn growers. That’s right, because corn prices were up over 80% last year and have stabilized at over $4 a bushel. This is a boon for farmers. Lots of them can do well at around $2/bushel…
Let’s do some quick math. A bushel of corn yields 2.8 gallons of ethanol. This amounts to $1.45 per gallon in the cost of corn alone! If this were the business’s only cost, it could still be pretty profitable, but ethanol production is very capital-intensive. They need get the corn to the plant, process the corn and separate byproducts, refine the corn into ethanol (using mostly natural gas), then ship it to the destination, which is done not by pipeline but by rail car. So the producers are captive to suppliers and at the mercy of shipping companies - trains - who are their only viable option.
And they have no control over the selling price of the finished product. Of course, they can use futures contracts and OTC swap transactions to lock in prices and smooth revenues. But the producer itself has no influence on prices. They can’t simply make a “better” ethanol than someone else, no matter what marketing says. As of today, the March ethanol contract on the CBOT was going for $2.00 per gallon. The so-called “crush spread” is about $1.25 at the moment (crush spread = ethanol price times 2.80 minus the price of corn per bushel). So the gross margin on corn is approximately 31%. Not bad. But that’s just the cost of goods sold. Consider all the SG&A and interest expenses these plants have to cover, that $1.25 per bushel can get used up rather quickly.
Anyone downstream of corn production does not so much like ethanol, because it has increased costs substantially. Ethanol demand currently accounts for about 20% of corn production. New plants are coming online soon and will boost that demand significantly – and production is looking to double by 2008 if planned construction takes place. This does not bode well for producers, as corn prices are likely to stay high. On the supply side, farmers can grow on additional acres and convert from existing crops to corn. But the supply of land is limited. Maybe they shouldn’t have sold so much land to developers – corn is now where the money is!
Several of these new plants are likely to be ill-conceived - a response to favorable market conditions this past summer. I recently reviewed a prospectus and projected financials for a new biodiesel plant that it proposed to go up here in Iowa. They’re projecting $2.35 per gallon on the top line for biodiesel to make this work! These projections were prepared in August, when gasoline prices at the pump were over $3.00! I question the assumption that with diesel pump prices to consumers right around $2.50 that they'll get wholesale rates that high. And the soy oil they're using as an input costs over $2.20 per gallon right now. Biodiesel is a bit different than ethanol in that there is the same amount of energy in 0.88 gallons of biodiesel compared to a gallon of gasoline and gets a higher tax break. So it actually trades at a slight premium. But making it work with soy oil alone priced above the wholesale price of diesel is a pipe dream.
I typically don’t like purely commodity industries where there are no bargaining powers with suppliers, and who have no pricing power whatsoever. If this were a business not protected by tariffs and tax breaks, it would not exist. But those tax breaks and tariffs are more likely than not to continue, because of the support of politicians from both sides of the aisle.
Given all the press about alternative energy, you might think ethanol companies would be doing quite well. Yet publicly traded ethanol pure-plays such as VeriSun (VSE) seem to reflect declining sentiments about industry prospects. The most difficult questions to answer are also those that are fundamental to an investment decision in this industry - (1) what will gasoline prices do and (2) where will corn prices be? Frankly, I can't answer either with conviction. But given increasing demand for corn, a crop that has little ability to expand significantly in supply, and increasing capacity coming on line for ethanol production, more likely than not the returns to this industry will fall and the most efficient producers will win out.
Producers love it, since domestic producers are generally protected from foreign producers (such as Brazil) by a $0.54 tariff on imported ethanol that has now been extended to January 2009. Largely because of a 51 cent-per-gallon tax break, ethanol has received about 50 cents more per gallon than gasoline at the wholesale level (right now it’s about $0.45 more).
Who also loves ethanol? Corn growers. That’s right, because corn prices were up over 80% last year and have stabilized at over $4 a bushel. This is a boon for farmers. Lots of them can do well at around $2/bushel…
Let’s do some quick math. A bushel of corn yields 2.8 gallons of ethanol. This amounts to $1.45 per gallon in the cost of corn alone! If this were the business’s only cost, it could still be pretty profitable, but ethanol production is very capital-intensive. They need get the corn to the plant, process the corn and separate byproducts, refine the corn into ethanol (using mostly natural gas), then ship it to the destination, which is done not by pipeline but by rail car. So the producers are captive to suppliers and at the mercy of shipping companies - trains - who are their only viable option.
And they have no control over the selling price of the finished product. Of course, they can use futures contracts and OTC swap transactions to lock in prices and smooth revenues. But the producer itself has no influence on prices. They can’t simply make a “better” ethanol than someone else, no matter what marketing says. As of today, the March ethanol contract on the CBOT was going for $2.00 per gallon. The so-called “crush spread” is about $1.25 at the moment (crush spread = ethanol price times 2.80 minus the price of corn per bushel). So the gross margin on corn is approximately 31%. Not bad. But that’s just the cost of goods sold. Consider all the SG&A and interest expenses these plants have to cover, that $1.25 per bushel can get used up rather quickly.
Anyone downstream of corn production does not so much like ethanol, because it has increased costs substantially. Ethanol demand currently accounts for about 20% of corn production. New plants are coming online soon and will boost that demand significantly – and production is looking to double by 2008 if planned construction takes place. This does not bode well for producers, as corn prices are likely to stay high. On the supply side, farmers can grow on additional acres and convert from existing crops to corn. But the supply of land is limited. Maybe they shouldn’t have sold so much land to developers – corn is now where the money is!
Several of these new plants are likely to be ill-conceived - a response to favorable market conditions this past summer. I recently reviewed a prospectus and projected financials for a new biodiesel plant that it proposed to go up here in Iowa. They’re projecting $2.35 per gallon on the top line for biodiesel to make this work! These projections were prepared in August, when gasoline prices at the pump were over $3.00! I question the assumption that with diesel pump prices to consumers right around $2.50 that they'll get wholesale rates that high. And the soy oil they're using as an input costs over $2.20 per gallon right now. Biodiesel is a bit different than ethanol in that there is the same amount of energy in 0.88 gallons of biodiesel compared to a gallon of gasoline and gets a higher tax break. So it actually trades at a slight premium. But making it work with soy oil alone priced above the wholesale price of diesel is a pipe dream.
I typically don’t like purely commodity industries where there are no bargaining powers with suppliers, and who have no pricing power whatsoever. If this were a business not protected by tariffs and tax breaks, it would not exist. But those tax breaks and tariffs are more likely than not to continue, because of the support of politicians from both sides of the aisle.
Given all the press about alternative energy, you might think ethanol companies would be doing quite well. Yet publicly traded ethanol pure-plays such as VeriSun (VSE) seem to reflect declining sentiments about industry prospects. The most difficult questions to answer are also those that are fundamental to an investment decision in this industry - (1) what will gasoline prices do and (2) where will corn prices be? Frankly, I can't answer either with conviction. But given increasing demand for corn, a crop that has little ability to expand significantly in supply, and increasing capacity coming on line for ethanol production, more likely than not the returns to this industry will fall and the most efficient producers will win out.
Watsco Continues to Expand
Watsco, Inc. (WSO) continued to roll on its growth path this past year, growing earning per share by 17% while expanding operating margins and gross profit margins year-over-year.
This is a boring business, but a profitable one. Watsco distributes air conditioning, heating, and refrigeration equipment and related parts and supplies. The company is still small and operates in an industry where demographic trends are favorable for continued growth as the industry consolidates. The market is highly fragmented, with over 1,300 companies in the space. The company’s goal is to build out a national network and broaden its product offerings. In this industry, larger players will benefit from economies of scale in purchasing from a concentrated group of manufacturers, and the ability to spread higher revenues over a large fixed cost base – in distribution and store location infrastructure. Watsco is the largest player in the industry, yet commanded only 7.4% of the $26 billion U.S. HVAC market at the end of 2006.
Watsco is controlled by its CEO, Al Nahmad, so while interests of existing shareholders are not aligned directly with shareholders, you can believe he’s looking out for the company’s interest given the amount of net worth he’s got tied up. From a management perspective, I like that they don’t need to worry about dissident shareholders trying to take this thing over. Private equity loves highly profitable companies operating in niche markets with very little debt. All things considered, I’d say the control issue is a good thing for outside shareholders at the moment, because this business is protected from takeovers that should allow it to continue on its growth path.
The risks here relate to the economic cycle. Its products are durables that will be effected by a downturn in economic activity. However, 75% of the company’s revenues are derived from the service and replacement market, which is less cyclical. People still want their homes cool when they don’t have a job.
At current prices, Watsco appears fairly priced, trading at about 17 times forward earnings with a 1.8% dividend yield. For a projected growth rate of around 20% for the next several years, this doesn’t seem overvalued, either. If the stock pulls back to the mid-40s, as it did this past summer and again in late December, I’d think seriously about adding to positions.
Full disclosure: Clients own shares in WSO.
This is a boring business, but a profitable one. Watsco distributes air conditioning, heating, and refrigeration equipment and related parts and supplies. The company is still small and operates in an industry where demographic trends are favorable for continued growth as the industry consolidates. The market is highly fragmented, with over 1,300 companies in the space. The company’s goal is to build out a national network and broaden its product offerings. In this industry, larger players will benefit from economies of scale in purchasing from a concentrated group of manufacturers, and the ability to spread higher revenues over a large fixed cost base – in distribution and store location infrastructure. Watsco is the largest player in the industry, yet commanded only 7.4% of the $26 billion U.S. HVAC market at the end of 2006.
Watsco is controlled by its CEO, Al Nahmad, so while interests of existing shareholders are not aligned directly with shareholders, you can believe he’s looking out for the company’s interest given the amount of net worth he’s got tied up. From a management perspective, I like that they don’t need to worry about dissident shareholders trying to take this thing over. Private equity loves highly profitable companies operating in niche markets with very little debt. All things considered, I’d say the control issue is a good thing for outside shareholders at the moment, because this business is protected from takeovers that should allow it to continue on its growth path.
The risks here relate to the economic cycle. Its products are durables that will be effected by a downturn in economic activity. However, 75% of the company’s revenues are derived from the service and replacement market, which is less cyclical. People still want their homes cool when they don’t have a job.
At current prices, Watsco appears fairly priced, trading at about 17 times forward earnings with a 1.8% dividend yield. For a projected growth rate of around 20% for the next several years, this doesn’t seem overvalued, either. If the stock pulls back to the mid-40s, as it did this past summer and again in late December, I’d think seriously about adding to positions.
Full disclosure: Clients own shares in WSO.
Money Market Redemptions Hit 2 1/2 Year High
Let's take a look at recent fund flow data once again. According to AMG Data Services, for the week ended January 31st, "Money Market funds reported net cash outflows totaling -$35.720 billion, the largest outflow from the sector since 6/30/04 and fewer funds reported inflows (678) than any week since 6/29/05 as more funds reported net redemptions than any week since 4/27/05.”
To put these outflows into perspective, the last time the outflows were that large (6/30/04) the S&P 500 Index was down about 3% over the next 30 days.
To put these outflows into perspective, the last time the outflows were that large (6/30/04) the S&P 500 Index was down about 3% over the next 30 days.
2007: A Look Forward
Here we are going into another new year. Seems amazing that another year has passed us by. At each yearly crest I realized how quickly time really does go.
I will quit waxing philosophical to deal with what I look for in the stock market in the year ahead. What will the market do and what companies or sectors might do well in 2007?
I must qualify my forthcoming statements by saying that I don’t think broad market predictions are worthwhile. If I get any of this right, it will have been from dumb luck and not clairvoyance. Putting one’s thoughts down on paper (or blogs), though, allows a person to reflect on past statements and determine what was right or wrong about an analysis. It’s useful to document one’s investment thesis or underlying assumptions when making investment decisions or developing projections. To do so allows one to more readily learn from past mistakes and to develop better analytical processes to hopefully avoid similar mistakes going forward.
The contrarian in me likes to look at companies that have been beaten down in the current year to find future winners. As I look at the Dow 30, I see five companies that haven’t really moved much this year. 3M (MMM) and Alcoa (AA) were basically flat; Wal-Mart (WMT) is down 2.9%; Home Depot (HD) is down 4%; and Intel (INTC) has been the biggest loser, down 19%. The worst performing sectors in the S&P 500 Index were information technology, health care, and consumer staples, though they are all higher.
Let’s start with next year’s winners. In this year’s discard pile, there are two I like – Wal-Mart and Home Depot. Each company is a past stock market darling whose stock has fallen on hard times. Both trade at a valuation that discounts overly pessimistic views yet these two companies are still growing well, enjoying high returns on capital, growing dividends, and share buybacks. I expect these two companies to benefit the long-term investor if purchased at these levels, though I will not give a timetable on when they will rally.
In the coming year, I suspect that the domestic stock market will do the better than most developed international markets. Emerging markets may continue to do well, as there remains an abundance of capital in search of investments. This depends on lot on how the prices of basic commodities hold up, as they are the dominant source of emerging market exports. U.S. investors in international markets in 2007 may face a headwind in the form of a rising dollar, which lies in contrast to this year. As of today, the MSCI EAFE Index is up 22.3% year-to-date in dollar terms, but in local currency it’s up only 12.7%. So nearly 10% of its 2006 return has been due to the declining dollar.
The dollar has been trampled this year and it seems all of the talk I hear about it is bearish. So I’ll take the opposite view and say the dollar will be up in 2007. A wild card is whether the Chinese will allow their currency (yuan) to float. If so, this would help reduce our trade deficit, which is bullish for the dollar. In addition to the dollar tailwind (for U.S. companies), financially strong large and medium sized companies stand to benefit the most if credit markets tighten significantly and world economic growth slows.
I think we could have another up year in the market, probably in the range of 8-12%. But I don’t think we can get this upside with the low volatility we’ve had since August. I think we’re going to be able to buy the market at lower levels, which obviously increases the upside for an investor buying on dips. That said, I don’t advocate trying to time the market. I for one am no good at it. I DO advocate paying close attention to the prices paid when investing in individual companies. If the market is not offering you a margin of safety, money markets pay you nearly 5% to sit on the sidelines.
I don’t see a lot of talk about P/E multiple expansion for next year. In fact, I hear many pundits on CNBC saying “we don’t see much multiple expansion in 2007.” This leads me to believe we will have some, but I think this will help to cushion returns, because earnings growth will not be as robust as expected. Multiples may expand as earnings grow moderately. A 15.5 forward P/E only has to move to 16.28 to add another 5% to the market's total return.
The consumer is likely to remain strong in 2007. There is no reason to believe otherwise or to bet against them. Yes, the savings rate is flat-to-negative and home equity extraction has slowed significantly. But workers in general have not shared commensurately in the prosperity corporations have enjoyed recently and labor markets are tightening, leading me to conclude that wage levels will continue to ratchet higher and provide additional discretionary income.
Of course, discretionary income depends a lot on what energy prices do. Higher oil, natural gas, and gasoline prices leave less discretionary spending for the consumer. So where will prices go in 2007? Well, the low supply/growing demand argument continues to have merit. I’m not sure where the “normal” prices for oil and gas are, but under normal circumstances prices should approximate the marginal cost of production. The marginal cost of production is probably in the $20-40 dollar range (yes, it’s a wide range because its difficult to know for certain). The marginal cost is probably on the higher end due to higher drilling costs and a tight labor supply that have left the industry with higher incremental production costs. The prospect of serious supply disruptions keeps a premium on oil prices that I don’t think with abate soon.
It will be interesting to see how it plays out. Happy New Year.
I will quit waxing philosophical to deal with what I look for in the stock market in the year ahead. What will the market do and what companies or sectors might do well in 2007?
I must qualify my forthcoming statements by saying that I don’t think broad market predictions are worthwhile. If I get any of this right, it will have been from dumb luck and not clairvoyance. Putting one’s thoughts down on paper (or blogs), though, allows a person to reflect on past statements and determine what was right or wrong about an analysis. It’s useful to document one’s investment thesis or underlying assumptions when making investment decisions or developing projections. To do so allows one to more readily learn from past mistakes and to develop better analytical processes to hopefully avoid similar mistakes going forward.
The contrarian in me likes to look at companies that have been beaten down in the current year to find future winners. As I look at the Dow 30, I see five companies that haven’t really moved much this year. 3M (MMM) and Alcoa (AA) were basically flat; Wal-Mart (WMT) is down 2.9%; Home Depot (HD) is down 4%; and Intel (INTC) has been the biggest loser, down 19%. The worst performing sectors in the S&P 500 Index were information technology, health care, and consumer staples, though they are all higher.
Let’s start with next year’s winners. In this year’s discard pile, there are two I like – Wal-Mart and Home Depot. Each company is a past stock market darling whose stock has fallen on hard times. Both trade at a valuation that discounts overly pessimistic views yet these two companies are still growing well, enjoying high returns on capital, growing dividends, and share buybacks. I expect these two companies to benefit the long-term investor if purchased at these levels, though I will not give a timetable on when they will rally.
In the coming year, I suspect that the domestic stock market will do the better than most developed international markets. Emerging markets may continue to do well, as there remains an abundance of capital in search of investments. This depends on lot on how the prices of basic commodities hold up, as they are the dominant source of emerging market exports. U.S. investors in international markets in 2007 may face a headwind in the form of a rising dollar, which lies in contrast to this year. As of today, the MSCI EAFE Index is up 22.3% year-to-date in dollar terms, but in local currency it’s up only 12.7%. So nearly 10% of its 2006 return has been due to the declining dollar.
The dollar has been trampled this year and it seems all of the talk I hear about it is bearish. So I’ll take the opposite view and say the dollar will be up in 2007. A wild card is whether the Chinese will allow their currency (yuan) to float. If so, this would help reduce our trade deficit, which is bullish for the dollar. In addition to the dollar tailwind (for U.S. companies), financially strong large and medium sized companies stand to benefit the most if credit markets tighten significantly and world economic growth slows.
I think we could have another up year in the market, probably in the range of 8-12%. But I don’t think we can get this upside with the low volatility we’ve had since August. I think we’re going to be able to buy the market at lower levels, which obviously increases the upside for an investor buying on dips. That said, I don’t advocate trying to time the market. I for one am no good at it. I DO advocate paying close attention to the prices paid when investing in individual companies. If the market is not offering you a margin of safety, money markets pay you nearly 5% to sit on the sidelines.
I don’t see a lot of talk about P/E multiple expansion for next year. In fact, I hear many pundits on CNBC saying “we don’t see much multiple expansion in 2007.” This leads me to believe we will have some, but I think this will help to cushion returns, because earnings growth will not be as robust as expected. Multiples may expand as earnings grow moderately. A 15.5 forward P/E only has to move to 16.28 to add another 5% to the market's total return.
The consumer is likely to remain strong in 2007. There is no reason to believe otherwise or to bet against them. Yes, the savings rate is flat-to-negative and home equity extraction has slowed significantly. But workers in general have not shared commensurately in the prosperity corporations have enjoyed recently and labor markets are tightening, leading me to conclude that wage levels will continue to ratchet higher and provide additional discretionary income.
Of course, discretionary income depends a lot on what energy prices do. Higher oil, natural gas, and gasoline prices leave less discretionary spending for the consumer. So where will prices go in 2007? Well, the low supply/growing demand argument continues to have merit. I’m not sure where the “normal” prices for oil and gas are, but under normal circumstances prices should approximate the marginal cost of production. The marginal cost of production is probably in the $20-40 dollar range (yes, it’s a wide range because its difficult to know for certain). The marginal cost is probably on the higher end due to higher drilling costs and a tight labor supply that have left the industry with higher incremental production costs. The prospect of serious supply disruptions keeps a premium on oil prices that I don’t think with abate soon.
It will be interesting to see how it plays out. Happy New Year.
Christmas Weekend Wisdom
"It is not necessary to do extraordinary things to get extraordinary results. "
- Warren Buffett
- Warren Buffett
Generic Approved For Key Biovail Drug
As mentioned in recent posts, Biovail (BVF) is in the process of restructuring itself on the eve of the introduction of generic competition to its key product. The company’s worst fears were realized when Thursday afternoon a decision was made to allow generic Wellbutrin XL, which is 41% of Biovail’s sales, on the market. The company was expecting this generic competition to come to market January 1st, so now its just going to come a little earlier than expected. This eliminates for investors the possibility of earnings surprises in the event the generic was not approved by that date.
Make no mistake; this is a big setback for the company, but one that the market was clearly expecting, judging by today’s mere 2.3% share price retreat in reaction to the news. The company is dealing with this – reducing their fixed cost based by eliminating their U.S. workforce and buying in all of their debt. While the share price has come up quite a bit to reflect renewed confidence in the company’s future, at current levels there doesn’t seem to be a margin of safety in the shares. This makes me wary of new investments at this point. But with expected dividends totaling $2.00 in 2007, the total return assuming no share price movement is a little under 10%, a satisfactory return until new products again boost Biovail’s revenues and reinvigorate growth.
Make no mistake; this is a big setback for the company, but one that the market was clearly expecting, judging by today’s mere 2.3% share price retreat in reaction to the news. The company is dealing with this – reducing their fixed cost based by eliminating their U.S. workforce and buying in all of their debt. While the share price has come up quite a bit to reflect renewed confidence in the company’s future, at current levels there doesn’t seem to be a margin of safety in the shares. This makes me wary of new investments at this point. But with expected dividends totaling $2.00 in 2007, the total return assuming no share price movement is a little under 10%, a satisfactory return until new products again boost Biovail’s revenues and reinvigorate growth.
Biovail Slims Down
Biovail’s (BVF) share price has risen substantially over the past couple weeks as good things are happening to the company. Yesterday, the company announced that it is shifting its strategy – cutting its U.S. sales staff (opting instead to contract with existing distributors), boosting R&D spending, buying in all of its long-term debt, tripling its current annual dividend, and paying a special dividend. The company also issued guidance for 2007 that was above expectations. The company’s own projections now assume that generic competition for Wellbutrin XL (41% of sales) will come online January 1st. Management is finally facing reality by factoring this early date into its projections.
These actions raise some questions. One problem that stuck out to me is that they’re forecasting roughly $2.00 in operating cash flow for 2007, which happens to be the exact amount they’re going to be paying out in dividends over the next 12 months - or rather, "contemplating" paying that amount, according to the press release.
They’ve got more than enough cash ($630M) to buy in their existing long-term debt ($400M). Doing this will reduce interest expense (and add to cash flow) about $.30 per share. But they’ll also need more cash for ramped-up R&D spending and severance related to the layoffs of its U.S. salesforce (12% of the total workforce). They’re going to be spending about $125M (roughly $0.75/share) each year over the next four years for R&D. And they’ll book restructuring charges related to the layoffs in the fourth quarter, but the cash outflows related to this will not be confined to one period.
All things considered, unless they get a significant new product on the market, I think they’re going to need more cash than they’re currently generating to maintain their announced goals for a length of time. The $1.50 annual dividend plus $0.50 special dividend totals $2.00 per share. With projected operating cash flows of $2.00-$2.12 per share and an additional $0.30 in interest savings, I get to only around $2.40 in annual operating cash flow on the high end (my hunch is that guidance already factors in the interest savings). They’ll save on compensation costs in future periods, but near-term severance costs will use cash. Paying out more than the cash flow they generate should work this year with no problem, because they’ll have quite a bit of cash left over after buying in debt. But if capital expenditures are higher than expected, current products do not perform as projected or those in the pipeline don’t take off, they may have to increase short-term borrowing or cut back their dividend plans in another year or so.
This recent action makes me think that management is preparing for something on the horizon – like a private equity deal or acquisition. Why else would you elect to become debt free and start paying nearly all operating cash flow as a dividend? Does the founder/chairman/largest individual shareholder want to exploit the low price and take the company private for himself? If he wanted that, he’d be more likely to use the extra cash allocated for dividends to reduce the outstanding share count. It seems to me the founder wants to get the cash off the balance sheet in the event a buyer emerges to buy the whole company at a price he considers undervalued.
These actions raise some questions. One problem that stuck out to me is that they’re forecasting roughly $2.00 in operating cash flow for 2007, which happens to be the exact amount they’re going to be paying out in dividends over the next 12 months - or rather, "contemplating" paying that amount, according to the press release.
They’ve got more than enough cash ($630M) to buy in their existing long-term debt ($400M). Doing this will reduce interest expense (and add to cash flow) about $.30 per share. But they’ll also need more cash for ramped-up R&D spending and severance related to the layoffs of its U.S. salesforce (12% of the total workforce). They’re going to be spending about $125M (roughly $0.75/share) each year over the next four years for R&D. And they’ll book restructuring charges related to the layoffs in the fourth quarter, but the cash outflows related to this will not be confined to one period.
All things considered, unless they get a significant new product on the market, I think they’re going to need more cash than they’re currently generating to maintain their announced goals for a length of time. The $1.50 annual dividend plus $0.50 special dividend totals $2.00 per share. With projected operating cash flows of $2.00-$2.12 per share and an additional $0.30 in interest savings, I get to only around $2.40 in annual operating cash flow on the high end (my hunch is that guidance already factors in the interest savings). They’ll save on compensation costs in future periods, but near-term severance costs will use cash. Paying out more than the cash flow they generate should work this year with no problem, because they’ll have quite a bit of cash left over after buying in debt. But if capital expenditures are higher than expected, current products do not perform as projected or those in the pipeline don’t take off, they may have to increase short-term borrowing or cut back their dividend plans in another year or so.
This recent action makes me think that management is preparing for something on the horizon – like a private equity deal or acquisition. Why else would you elect to become debt free and start paying nearly all operating cash flow as a dividend? Does the founder/chairman/largest individual shareholder want to exploit the low price and take the company private for himself? If he wanted that, he’d be more likely to use the extra cash allocated for dividends to reduce the outstanding share count. It seems to me the founder wants to get the cash off the balance sheet in the event a buyer emerges to buy the whole company at a price he considers undervalued.
An Opportunity to Buy Pfizer on the Cheap?
Shares of drug maker Pfizer might drop precipitately at market open Monday, on the heels of an announcement that further development for a new blockbuster drug hopeful (torcetrapib) will be halted. Pfizer has pumped millions of dollars into the development of a drug they thought was going to be huge only to have their (and investor’s) hopes dashed. But that’s the drug business, and Pfizer still has more time to replenish its pipeline looking forward to 2011, when Lipitor, its top seller, loses patent protection. Maybe this replenishment won’t all come from one drug, as was hoped with torcetrapib/atorvastatin. But not being so dependent on one drug may turn out to be to Pfizer’s advantage, owing to the increased diversification benefits.
The concern now is with pipeline replenishment and thus revenue replacement. The company has frequently added to its product lineup with acquisitions, and this recent development may pressure them to be more aggressive in this space over the next few years. Meanwhile, with the prospect of declining revenues, the company is focused on cost reduction, having announced a week ago that it’s cutting its global workforce by 20%.
The bottom line is that even without torcetrapib in the pipeline, Pfizer still has a decent drug pipeline and cash to buy more drug assets. It’s a very financially strong company with a hefty dividend and tons of free cash flow. If shares drop 10-20%, as many analysts are expecting, it'll be a good opportunity to buy the stock. If the shares are down that much we’re talking about a stock with a 9-10% free cash flow yield, trading at 11-12 times forward earnings with a 4% dividend. At that price, a long-term buy and hold investor is likely to achieve above-average results.
The concern now is with pipeline replenishment and thus revenue replacement. The company has frequently added to its product lineup with acquisitions, and this recent development may pressure them to be more aggressive in this space over the next few years. Meanwhile, with the prospect of declining revenues, the company is focused on cost reduction, having announced a week ago that it’s cutting its global workforce by 20%.
The bottom line is that even without torcetrapib in the pipeline, Pfizer still has a decent drug pipeline and cash to buy more drug assets. It’s a very financially strong company with a hefty dividend and tons of free cash flow. If shares drop 10-20%, as many analysts are expecting, it'll be a good opportunity to buy the stock. If the shares are down that much we’re talking about a stock with a 9-10% free cash flow yield, trading at 11-12 times forward earnings with a 4% dividend. At that price, a long-term buy and hold investor is likely to achieve above-average results.
WB Wisdom
"Lethargy, bordering on sloth should remain the cornerstone of an investment style. "
- Warren Buffett
- Warren Buffett
Value Investors Catch a Break
Today, the S&P 500 experienced its largest loss in 5 months, down almost 1.4%. This is the fifth largest decline this year and one of only 13 days this year that were down more than 1.00% (we’ve had 15 that were up more than 1%). While I would not say that stock market valuations are getting out of hand, after its recent run-up it’s nice to see a day where the stock market is down. It reminds us that volatility is something to be expected when investing in stocks.
What has troubled me over the last couple months is the low volatility of the recent rally. We have not had a day down more than 1% since July 13th. July 12th was also down more than 1%. Today, the decline was broad-based, with some 90% of the S&P trading lower and 27 of the 30 Dow stocks declining. Is this the start of a “correction”? Maybe or maybe not.
In the seven trading days beginning with July 12th, the market was down about 1.8%. In the seven trading days starting with June 6th, the S&P 500 was down 5%. For 2006, after the first -1% drop in a while, two-thirds of subsequent seven-day trading periods were followed by market declines. The average performance this year for the seven days starting with a –1% day? Down 2.3%.
I’ve got to say it’s a relief to see that the market can actually go down. Though undervalued stocks can be found in every type of market – think Apollo (APOL) – a couple more days like this and we might find a few more stocks in the bargain bin.
Ability to Pass Up Investments is Key
As Warren Buffett has said, the ability to say “No” is one of the most important powers an investor has. Knowing when to turn down an investment can be more important as when to say yes. Another way I’ve heard Buffett look at it is to imagine as an investor that you’ve got a 20-slot punch card that represents your lifetime of investment decisions to be made. Looking at it from this perspective, it’s likely each investment decision will be made more carefully.
Another crucial part of making good investment decisions is being aware of your own biases. These biases are well-documented in behavioral finance: overconfidence, hindsight bias, overreaction, belief perseverance, and regret avoidance, for example. Knowing where you decisions are coming from helps to determine whether your choices are truly objective and rational, not overly influenced by your own biases.
Another crucial part of making good investment decisions is being aware of your own biases. These biases are well-documented in behavioral finance: overconfidence, hindsight bias, overreaction, belief perseverance, and regret avoidance, for example. Knowing where you decisions are coming from helps to determine whether your choices are truly objective and rational, not overly influenced by your own biases.
Dell Up, Let's Upgrade It!
Yesterday, Dell (DELL) released its preliminary results from the third quarter. Revenues and earnings came in above expectations. They’re making progress on the customer service issues they’ve had. And their international businesses performed well, growing much faster that the overall industry in those countries while gaining market share.
Today, Bear Stearns and Needham upgraded Dell. With these actions, they’re telling their clients that, since the stock is up and the future seems clearer, now is the time to buy. In other words, "Wait to buy it until it goes up." This is the exact opposite of when an analyst should be recommending a "Buy." I'm glad I don't have an account with them.
These analysts wanted to see evidence that a turnaround is in place before issuing the upgrades. This C.Y.A. mentally may have cost their clients a great opportunity, as Dell is a company whose stock over the past few months has presented a tremendous value. And today it’s up around 10%. Where were the “buy” ratings before? Unfortunately for the firms’ clients, waiting until the point when everything is clear can reduce the eventual profits they earn. Uncertainty creates opportunity.
Dell will continue to invest in customer service, new product introductions, and international expansion. In the press release, management says future operating and financial improvements will be “nonlinear.” This simply means that capital expenditures will sap some near-term earnings and cash flows. As a long-term investor, I feel great when a business invests in its future growth, especially when incremental investment returns are as high as Dell’s. Managing with too much focus on the short-term can impair a company's competitive advantages and be detrimental to shareholders.
Dell is generating massive amounts of free cash flow, enjoys 40%+ returns on equity, has almost no debt, and carries significant insider ownership. The company finished the quarter with almost $12 billion in cash – this amounts to 20% of Dell’s market value as of yesterday’s close. There is still quite a bit of upside from here.
Disclosure: I own shares of Dell.
Today, Bear Stearns and Needham upgraded Dell. With these actions, they’re telling their clients that, since the stock is up and the future seems clearer, now is the time to buy. In other words, "Wait to buy it until it goes up." This is the exact opposite of when an analyst should be recommending a "Buy." I'm glad I don't have an account with them.
These analysts wanted to see evidence that a turnaround is in place before issuing the upgrades. This C.Y.A. mentally may have cost their clients a great opportunity, as Dell is a company whose stock over the past few months has presented a tremendous value. And today it’s up around 10%. Where were the “buy” ratings before? Unfortunately for the firms’ clients, waiting until the point when everything is clear can reduce the eventual profits they earn. Uncertainty creates opportunity.
Dell will continue to invest in customer service, new product introductions, and international expansion. In the press release, management says future operating and financial improvements will be “nonlinear.” This simply means that capital expenditures will sap some near-term earnings and cash flows. As a long-term investor, I feel great when a business invests in its future growth, especially when incremental investment returns are as high as Dell’s. Managing with too much focus on the short-term can impair a company's competitive advantages and be detrimental to shareholders.
Dell is generating massive amounts of free cash flow, enjoys 40%+ returns on equity, has almost no debt, and carries significant insider ownership. The company finished the quarter with almost $12 billion in cash – this amounts to 20% of Dell’s market value as of yesterday’s close. There is still quite a bit of upside from here.
Disclosure: I own shares of Dell.
Thoughts From W.B.
"Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.
- Warren Buffett
- Warren Buffett
Dow Approaching Overvaluation?
The Dow and the S&P 500 made new highs again today, continuing the theme of the last month. After another record day I think it’s prudent to look at where valuations stand. The Dow currently trades for over 19 times forward earnings, assuming a consensus 12% growth rate from present levels. This translates to a forward earnings yield of just 5.18%. This happens to be lower than the Fed Funds rate and about on par with the yield on money market accounts. Given the option between a fully priced market and a virtually risk free money market account yielding the same amount for the year ahead, the choice seems clear. From a Fed model standpoint, stocks are fairly valued.
By the way, the S&P 500 looks a little more reasonably priced at around 17 times projected earnings, translating to an earnings yield of around 6%. It seems the Dow fetches a richer valuation than the S&P on this basis but neither metric looks cheap.
If you have the ability to hold cash, it seems prudent to wait to invest new monies at this point. The market may rise further in the short-term, but it looks like the risk-reward balance is out of equilibrium at this point. Volatility has been low and enthusiasm high; a reversal in either could lead to a better entry point.
Home Depot Rallies on Bad News
Home Depot (HD) shares were down this morning on the heels of an earnings release but ended up sharply higher by market close. Revenues, same store sales results, and earnings all came in below expectations. Yet the share price rose by over 4% today. What gives?
Low expectations have depressed the shares, but Home Depot’s financial position remains very strong. The company carries prudent levels of debt and generates very high investment returns. Management reported 22% returns on invested capital for the quarter (after considering operating leases the real number is in the high teens). These are admirable returns to post in this environment. Despite a slowing business climate, the company has been using its free cash flow to buy back shares. CEO Bob Nardelli knows a bargain when he sees one. Investors must have noticed.
EPS is still expected to grow by 4% and sales should be up around 12% for the full fiscal year. Frankly, I would expect worse. But the valuation is far from demanding: the shares sell at just around 12 times forward earnings and operating cash flow. For a premiere franchise like Home Depot, there seems to be a margin of safety built in to the current valuation, though not as much after the recent run-up.
One problem I had with their reported results today: no cash flow statement. It’d be nice to see a cash flow statement in the press release. This would help us gain a clearer picture of what went on during the quarter and first nine months of the year. Maybe next time, Bobby.
Disclosure: I own shares for clients as well as personally.
Low expectations have depressed the shares, but Home Depot’s financial position remains very strong. The company carries prudent levels of debt and generates very high investment returns. Management reported 22% returns on invested capital for the quarter (after considering operating leases the real number is in the high teens). These are admirable returns to post in this environment. Despite a slowing business climate, the company has been using its free cash flow to buy back shares. CEO Bob Nardelli knows a bargain when he sees one. Investors must have noticed.
EPS is still expected to grow by 4% and sales should be up around 12% for the full fiscal year. Frankly, I would expect worse. But the valuation is far from demanding: the shares sell at just around 12 times forward earnings and operating cash flow. For a premiere franchise like Home Depot, there seems to be a margin of safety built in to the current valuation, though not as much after the recent run-up.
One problem I had with their reported results today: no cash flow statement. It’d be nice to see a cash flow statement in the press release. This would help us gain a clearer picture of what went on during the quarter and first nine months of the year. Maybe next time, Bobby.
Disclosure: I own shares for clients as well as personally.
Expedia Still Looks Attractive
Expedia (EXPE) released earnings yesterday and results were essentially flat year-over-year. The international business continued its stellar growth and actually helped dampen some of the weakness in the domestic business. Hotel revenue was up smartly but air revenue was down significantly. Expedia cites “record industry load factors” as the problem there. What this means is that there is currently high domestic demand for air travel, resulting in fewer unfilled seats. And because of high demand the airlines don’t need companies like Expedia to help them unload hard-to-fill seats, as was the case a few years ago following 9/11. This trend is likely to continue for the foreseeable future, but should be mitigated by higher hotel revenues and continued growth internationally.
During the third quarter, they bought back nearly 5% of outstanding shares at bargain prices. The bulk of this was done in July at average prices of just over $14/share. This makes each slice of the pie bigger for shareholders who hang on. Expedia issued a small amount of debt (which is just 8% of total capital) to accomplish such a large buyback in a single period, but I think this was done opportunistically because management saw the shares as cheap. Look for more of this in the future, as an additional 20 million-share repurchase has been authorized. Barry Diller has a controlling (55%) interest in the business so you can bet he’s got shareholder’s interests in mind.
On the surface, Expedia does not look cheap, trading at nearly 17 times next year’s consensus earnings estimates. Yet reported earnings sometimes do not tell the whole story. I see the company as a cash machine that is being run for the long-term benefit of shareholders. The company’s free cash flow yield (free cash flow per share divided by the share price) is over 16%. This is the same as saying that Expedia trades for about 6 times free cash flow per share. The company also holds $946 million, or 17% of its market value, in cash on the balance sheet. A private owner looks at the cash the business generates, not the “earnings” the company reports. To a private buyer, these would be attractive figures especially given the growth opportunities that lie ahead.
Disclosure: I own shares for clients as well as personally.Biovail's Has a Strong 3Q - Can It Last?
Biovail (BVF) is up over 5% in pre-market, as the third quarter results came in better than expected. The company also raised its guidance for 2006 – EPS in a range of $2.50-2.60 and cash flow from operations of nearly $3.00 per share. Even at pre-market prices, this represents forward P/E ratio of under 7. And almost 25% of its market value is in cash. If you strip out this cash, the stock is trading at slightly over 4 times operating cash flow. Undoubtedly, if the numbers can hold up, this is a bargain. But management qualified these estimates by saying that the number assumes that they get no new generic competition and that their existing products continue on their present track.
That, as I’ve written about before, is the key question. For the first nine months, Wellbutrin XL revenues were up almost 40% and accounted for 72% of the company's year-over-year product revenue growth. In all likelihood, this key product, which holds a nearly 60% share of new prescriptions in its market and represents 41% of the company's product revenues, will have generic competition come on line that could seriously impair this position going forward. If not later this year, early next year seems increasingly likely. The conservative investor would factor a precipitate drop in Wellbutrin XL revenues into future cash flow and EPS calculations. How much is unclear, but when generic competition came online for Wellbutrin SR in Canada, prescription volume dropped 32%.
That, as I’ve written about before, is the key question. For the first nine months, Wellbutrin XL revenues were up almost 40% and accounted for 72% of the company's year-over-year product revenue growth. In all likelihood, this key product, which holds a nearly 60% share of new prescriptions in its market and represents 41% of the company's product revenues, will have generic competition come on line that could seriously impair this position going forward. If not later this year, early next year seems increasingly likely. The conservative investor would factor a precipitate drop in Wellbutrin XL revenues into future cash flow and EPS calculations. How much is unclear, but when generic competition came online for Wellbutrin SR in Canada, prescription volume dropped 32%.
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