Portfolio Update: Recent Sell

September 2018 – Sale of Flower’s Foods, Inc. (FLO)

Over the past couple of weeks I have spent time checking on the health of my active equity portfolio. This included a review of my asset allocation to see if it warranted any rebalancing, as well as individually scrutinizing each of my holdings. While this will not  be a post that delves into my overall strategic asset allocation decisions,  it is a review of why I made some recent tactical moves. I recognized that my cash position was a bit light given current equity market valuations, and at roughly 5% of my portfolio I did not feel as though I had enough fire power to take advantage of a sell off.

I have no interest in timing the market and realize that it is a sucker’s game for most. I do not believe I have the time, nor resources at my disposal to do the type of due diligence necessary to make informed “market-timing” decisions. Even then, it would most likely be a horrendous attempt. I do, however, pay attention to the macro-environment that I am investing in and make tactical adjustments in an attempt to manage risk. After a decade long bull-market I have noticed that it is becoming harder to find value in today’s equity market.

The economic indicator first made famous by Warrant Buffet, and now one that is used consistently by value investors, known as the “Buffet Indicator”, or total market cap (TMC) relative to gross national product (GNP), is pointing to a stretched US equity market. At the time of writing, the Wilshire 5000 Total Market Index sits at 30,091.3 billion, or 150% of the latest report on US GNP. That is the highest that the ratio has ever been dating back to 1971, reaching only 141% just prior to the bursting of the tech bubble in 2000. There are reasons one could point to in an attempt to explain why the equity markets are at these levels. Analysts point to strong earnings growth, low unemployment and tax cuts, and, while speaking out of both sides of their mouth, remind us of trade wars and geopolitical risks that could derail the economy. Furthermore, the schiller ratio for the S&P 500 currently sits at 33.1x, much closer to  the 43x it hit just before the tech bubble burst, than the 7x level seen in the early 1980’s. In my opinion, US equities seem rich and prices could revert if there is a significant shock to the economy. I can’t say for certain what will happen when a significant amount of liquidity is pulled out of the market by a Fed unwinding their balance sheet after the last financial crisis. What would be the impact of a rise in interest rates have on the portfolio? Investments compete for investor money and if rates rise, other assets will adjust accordingly. At 2.9%, the 10yr yield has been bumping up against 3% for some time now. What if the yield curve were to adjust and rates move to 5%? 7%? Should we be worried about inflation? What would hyper-inflation, or even stagflation do to the equity markets? Quite frankly we don’t know which direction equity markets or interest rates will go, but I’m seeing that there is a lot more room to the downside and I want to be prepared to put money to work at more favorable implied returns.

As such, I have decided to take some chips off the table and increase my cash holding. I sold all my shares in Flowers Foods, Inc. (FLO), netting a solid 17% annualized return since I purchased the stock in Late 2016. This will almost double my cash position to roughly 10% of the portfolio, giving me a decent war chest, relatively speaking. I only held FLO for about 2 years and was sitting on a 35% total gain. Typically, I don’t like to sell my holdings at the first sign of trouble or overvaluation because I believe that letting the winner’s run has worked for several successful investors. It’s simple, good company’s continue to produce quality earnings that fuel growth.

But the decision was two-fold. The first consideration being my desire to increase cash and the second being the fundamentals of the company. The company has now been moved to my watchlist and I’ll continue to check back on it from time to time. Here are some of the main drivers that lead me to believe the company’s growth may be tepid moving forward:

·       Revenues have been pretty flat over the last 3 years

·       Operating margin has declined roughly 2.6% annually over the last 5 years

·       Net Margin has fallen to its lowest point since 2005

·       Dividend payout ratio has steadily climbed and is currently greater than 100%

·       FCF as a percent of revenues has declined over 200 bps, falling to 4.5% on TTM basis

·       ROE & ROA have steadily declined over the past couple of years

·       P/E and P/FCF ratios are stretched at 30x and 23x respectively

This was not what I had anticipated when I bought FLO. Essentially, growth has slowed, margins are being compressed and this is having a negative impact on free cash flow. The dividend isn’t as sustainable as I had originally thought and could potentially be frozen. Without much growth in the business or the dividend, my returns are susceptible to a compression in multiples, which are on the higher end of the company’s averages from the last decade. I’m comfortable taking profits here to de-risk and not to chase other investments. 

One last piece to note is that I do intend to hold roughly a 10% cash position for the foreseeable future. This means that new purchases will need to come from fresh capital that I save or that is provided through my dividend income. I will have an updated portfolio displayed in the author’s section.

Thoughts? Questions? What does your cash position look like? How do you decide when is a good time to sell?

 

A Quick Gain on Rubicon Technology, Inc.?

Disclosure: I have no position in any securities mentioned below.

Short post here…

Rubicon Technology, Inc. (RBCN) sold off their Batavia, IL property today (8/20/2018). They are expecting to receive $6.35 mil after paying various expenses related to the sale of the property.[1]

After adding this figure to their June 30th, 2018 net cash position, we arrive at a per share price of around $9.05. The stock last traded hands after hours at $8.55.

RBCN

Be very wary of stocks trading below net cash, as there is likely a reason for this. Optimally, the cash proceeds from the sale of this property would be allocated towards profitable projects. The market clearly does not think that this will be the case. On one hand, you have a company with a ton of cash on hand with a new CEO and a plan to liquidate its assets related to LED manufacturing to focus more on the optical and industrial sapphire markets. On the other, you have had a company that has had negative cash flow from operations for the past 4 years.

Another risk is the risk that the company’s balance sheet changes significantly from this quarter to the next.

Can this company make a turnaround?… who knows… but I think it at least warrants further attention at this valuation.

– Eddie

[1] https://www.sec.gov/Archives/edgar/data/1410172/000121390018011430/f8k082018_rubicontechno.htm

Calloway’s Nursery, Inc.

Disclosure:

I own CLWY. I do not own any other securities mentioned in the below article.

Idea generated from DTEJD1997 via cornerofberkshireandfairfax.ca.

Hypothesis

Calloway’s Nursery, Inc. (CLWY) is a retail gardening company that has 19 stores in the Dallas-Fort Worth area and 1 store (Cornelius Nurseries) in Houston, TX. They provide a large variety of plants and flowers that are not found in the big box stores while also giving their customers expert opinions via their knowledgeable employees. The plants and flowers are purchased from a wholesale distributor.

Calloway’s has experienced a significant turnaround due to activist investor Peter Kamin. CLWY is currently undervalued due to the fact that they are not very transparent when making financial disclosures. But, a business is a business… and if Calloway’s keeps performing as it has under the leadership of the new board of directors, I believe that there is significant upside potential with limited downside. A major catalyst is the sale of shares from major shareholder, Peter Kamin. Kamin owned 56.7% in February of 2016. According to the 3K website, they are still a holder of Calloway’s and I have no reason to believe that their percentage ownership in the company has changed since 2016. In my opinion, Kamin will try to find an exit strategy within 3 to 5 years. In doing so, he may do one of two things:

  1. Generate more liquidity by re-listing on a major financial exchange – this will require much more financial statement transparency due to SEC requirements.
    1. In my opinion, by listing on an exchange while filing more transparent financial reports, CLWY will see new types of investor clientele investing in its shares, which will substantially increase liquidity. This will allow Kamin to exit his investment and deploy capital where he sees fit for 3K.
  2. Sell the company to a third party.
    1. Shares will be bought at a premium due to controlling interest.

The Story

Calloway’s board of directors recently went through a massive transformation due to activist investor, Peter Kamin, of 3K. In May of 2013, Kamin proposed to have a shareholder vote to replace the current board of directors with a new slate of directors, as determined by Kamin and 3K. Calloway’s current board obviously did not appreciate this move and actually filed a lawsuit against Kamin and 3K, stating he had no authority to propose such a thing (as he only had 18.4% ownership of the company at the time). The thing is, Kamin had good reason to suggest the board should be replaced. The agency issues were out of control. The board of directors was comprised of executive management, so there was no incentive for the board to act in the best interest of shareholders. Management/the board lined their own pockets by giving themselves excessive stock options and bloated salaries. Something needed to change.

In July of 2013, Calloway’s and 3K reached a settlement. Calloway’s agreed to change the number of members on the board from five to eight. The board added Kamin, Alan Howe (a 3K elected member), and David Straus to the board… this was just the start.

In 2016, Calloway’s and 3K announced a joint tender. Under the terms, they would both buy back a significant amount of stock from existing shareholders. Following the expiration and completion of the tender, 3K offered to purchase nearly all the shares of common stock held by then CEO James Estill and John Cosby (former Co-Founder). Kamin was not messing around. By purchasing these shares from both Estill and Cosby, on top of the tender offer, Kamin would own over 50% of the business.

Estill and Cosby agreed to the terms offered by Kamin, giving Kamin a 56.7% ownership of CLWY on February 19th, 2016. After Kamin obtained control of the company, a number of board members (James Estill (CEO and chairman of the board), Dan Feehan, Alan Howe, Daniel Reynolds, and David Straus) resigned from the board, giving Kamin and shareholders the opportunity to elect a new board that would act in their best interest. I believe that the 56.7% ownership that Kamin has works to keep shareholders’ interests aligned with the board of directors. The post-recapitalization board of directors consisted of Peter Kamin, David Alexander, Marce Ward, David Schneider (a 3K recommendation), and Terry Shaver (a 3K recommendation). Marce Ward was then appointed as president and CEO.

The company has experienced a significant turnaround since these changes have occurred, and most changes are in line with what Kamin said he would do when he first proposed that the board of directors should change in 2013. The company is currently undervalued due to lack of transparency in financial reports, which I believe will be remedied when Peter Kamin seeks an exit strategy.

How has the company done since Kamin has taken over?

Let us now take a look at what Kamin said he would do in 2013[1] to change the business around versus what he has done with the new board (2016). Kamin doing as he said is indicative of whether or not he will be acting in the shareholder’s best interest in the future.

“…if 3K is successful in obtaining control of the CLWY board, we plan to take the following actions:

  1. Elect a new chairman of the board an implement best corporate governance practices for the operation of the board going forward.

Kamin successfully took control of the board in 2016 after the recapitalization and elected several independent board members after the resignation of James Estill (CEO and chairman of the board), Dan Feehan, Alan Howe, Daniel Reynolds, and David Straus.

  1. Undertake performance reviews for each senior manager of the company and review their performance against industry benchmarks; attract new talent to the company where necessary.”

Since Kamin’s arrival, senior management has changed drastically. This was highlighted when Kamin bought most of the shares from former CEO/Chairman James Estill and Co-founder/Executive John Cosby.

  1. “Review and adjust compensation arrangements for senior managers so that their incentives are clearly aligned with the interests of shareholders.”

As stated in the last paragraph, many former executives resigned from the company when Kamin gained control over the board. The results since Kamin first proposed this action in 2013 can be seen in the decrease in the amount of SG&A as a percentage of sales (implying that excessive salaries were cut) and in the decrease in the amount of diluted shares outstanding:

SGA Diluted SA

  1. “Consider the strategic value of each asset of the company; analyze direct store profitability and results for each location; consider strategic alternatives for underperforming retail location.”

Since this statement (July 10th, 2013), Calloway’s has closed several stores and properties that it owned and leased:

  • 1200 North Dairy Ashford (Cornelius), Houston, TX – Sold in December, 2014
  • Undeveloped land in Southlake, TX – Sold in December, 2014
  • Undeveloped land in Frisco, TX – Sold in January, 2015
  • 723 South Cockrell, Duncanville, TX – Closed in Mid 2015

It is especially important to consider the present value of each property as a going concern versus what Calloway’s could get in return if they sold it, as the market value of property in Northern Texas has significantly increased over the last few years.

  1. “Review and develop the growth pipeline for potential new retail locations in the core Dallas-Fort Worth market.”

Since this statement (July 10th, 2013), there have been several stores that have opened up within the Dallas-Fort Worth market:

  • 1801 F.M. 423, Little Elm, TX – Opened in late 2013
  • 311 East Debbie Lane, Mansfield, TX – Opened in early 2016
  • 3936 N. Tarrant Parkway, Fort Worth
  • 2415 West Parker Rd., Hebron, TX – Opened April 6th, 2018

I believe that they will focus more on opening stores in the Dallas-Fort Worth market, rather than other markets, due to brand recognition and the failure of past ventures in San Antonio, Houston, and Austin markets. This isn’t a bad thing though, because the Dallas-Fort Worth market is one of the fastest growing areas in the country… plus they always have the real option of expanding their geographic presence if they wanted to try again.

  1. Undertake a best practices study to set goals for the organization against benchmarks developed for leading operators in the industry. 3K believes that CLWY has operated for far too long under a non-independent board of directors with a significant lack of focus on profitability and returns for shareholders.”

Profitability has increased significantly since Kamin has gained over 50% ownership (February, 2016). I list normalized net income below… this figure takes out the effects of non-normal items, such as recapitalization expenses, gains/losses on the sale of property, gains/losses on the prepayment of debt, proxy contest expenses, and impairment of property held for sale:

Margins

It is worth noting that 2017 was an exceptionally strong year for profitability, and also the first full year Kamin had control of the company (his board was in place for all of 2017).

The balance sheet has also improved significantly, which I believe is extremely important for future growth. I believe that the excessive amounts of debt and low interest coverage ratios significantly hindered growth in the past. The financial health of the company has improved as Kamin’s involvement has increased:

Solvency

Everything that Kamin said he would do in 2013, he has done… and has succeeded fantastically. For this reason, I believe that he will continue to be a good steward of capital in the future and act to increase value for shareholders. Although this turnaround has been extremely impressive, there are significant risks within the business that one must be aware of.

Risks

Although Calloway’s is well positioned for growth, there are certain risks that may significantly impact the business. These risks include an increase in competition, recession, and weather. It is also worth noting that there is significant risk in regard to the current financial statements, which plays into why I believe the company is undervalued.

Competition

The Dallas-Fort Worth area population growth is one of the fastest growing in the country. Although more population growth is generally a positive for Calloway’s due to increased demand for gardening items, this should also lead to more competition, which could put downward pressure on profits. Although competition may increase, Calloway’s already has a strong presence within the Dallas-Fort Worth area and has for over 32 years. On top of their brand name recognition, their superior product line and service expertise should set them apart from their competitors.

According to Google, there are 210 nurseries, Home Depots, Wal-Marts and Lowe’s in the greater Dallas-Fort Worth area that are in competition with Calloway’s. In this same area, there are 19 Calloway’s stores… which is 9% of the greater Dallas-Fort Worth retail gardening market. Their plan is to continue to increase their presence within this market, which will help them capture the massive growth this area has experienced over the past few years. In my opinion, Calloway’s will be able to capture more market share in this market due to the size and scale of their operations when compared to many of the small “mom-and-pop” stores that will struggle to compete with Calloway’s, Home Depot, Lowe’s, and Wal-Mart.

But who’s to say that Calloway’s can compete with Home Depot, Lowe’s and Wal Mart? In my opinion, they differentiate themselves by providing more gardening options while providing excellent customer service. Each store is employed with at least one Texas Master Certified Nursery Professional. This is said to be the highest level of recognition in this field of business. In my opinion, the knowledge and expertise that these employees have will give customers a better experience than employees working at the big box stores. This is easily shown by the ratings and reviews of each store:

Stores

Customers love Calloway’s. They attribute this love to Calloway’s vast selection of flowers and plants, as well as the help and expertise they are given when looking to satisfy their gardening needs. This is their competitive advantage versus the big box stores.

Recession Risk

It seems that we have heard that another recession is right around the corner for the past 10 years. Recessions are almost impossible to predict, but there will inevitably be one. It is the economy’s way of liquidating malinvestments that occur within the economy due to poor allocation of resources.

Discretionary spending usually takes a hit during a recession. People will spend more money on what they need and then save the rest as a buffer in case of any catastrophic event.

In my opinion, sales will significantly fall for Calloway’s when a recession does eventually rear its ugly head. Spending money on making one’s landscape look nice will take a back seat to more important aspects in one’s life (food, shelter… etc.).

Weather

Bad weather is a significant risk to the margins of Calloway’s, in particular their gross margin. If there is a significant drought, suppliers and wholesalers of healthy gardening products will be able to charge higher prices due to there being less supply. It may be hard to pass these prices along to customers because they have a simple choice of foregoing gardening if it is too expensive to do so.

Financial Statements

The disclosures have been extremely limited since the Q1 2016 financial statement. The company simply gives the balance sheet, financial statement, and cash flow statement, with no disclosures about accounting policies, MD&A, and other significant factors found in 10-Qs and 10-Ks. Calloway’s was delisted from the NASDAQ in 2004 and suspended its duty to file public reports with the SEC at this time as well. In my opinion, this is one of the main reasons for the undervaluation, as I believe Peter Kamin will look to increase liquidity when he eventually sells out of his position. One way he could do this would be to list the company on an exchange and provide SEC required reports that are much more transparent than current reporting.

Valuation

I believe that the price per share for CLWY is somewhere between $10.71 and $13.06, representing a 33% minimum upside potential from the current price (8/7/18) of $8.00 per share. To obtain this appraisal, I used three measures.

The first measure was a simple EBITDA comp between HD and LOW. The average EBITDA multiple between LOW and HD, when applied to the EBITDA of Calloway’s, give an implied share price of $11.88. CLWY is obviously much more illiquid than HD and LOW, but it also has more growth potential in my opinion. For these reasons, I determined that discount for lack of liquidity and premium for growth on the share price for CLWYs when compared to HD and LOW would offset each other.

The next two methods of appraisal were done by discounting the future cash flows of the firm using two different scenarios with various costs of equity. The present value of the future cash flows was then added to the net property value + cash. In this context, net property value is defined as market value of property minus total liabilities. This figure came out to be $9,007,270.00, or $1.22 per share. Market value of property was obtained from several county central appraisal districts websites for tax purposes, which I believe to be a conservative valuation.

The first scenario was if CLWY’s sales continued to grow at its 5-year same store sale growth figure. By my calculations, same store sales have increased 2.94% over five years. The terminal value was found using the Gordon Growth model. I believe this scenario to be extremely conservative due to the fact that one of Kamin’s plans was to increase Calloway’s presence in the Dallas-Fort Worth market. This is one of the fastest growing markets in the entire United States. I obtained a base price of $10.91 for this scenario, representing a 36% margin of safety from the current price (8/7/18) of $8.00 per share:

No Stores Pessimistic

No Stores Optimistic

No Stores Base

*Optimistic, base, pessimistic refers to the discount rate, not projections.

In the next scenario, sales growth was projected at the rate of growth as displayed by the Dallas business cycle index, which is around 5%[2]. As sales grew, I determined that Calloway’s would probably have to open more stores to keep up with the demand, which were included in the CAPEX projections. The terminal value was found using an H-Model, whereby sales growth declined from 5% to 3% over a 10 year period. The base price obtained from this scenario was $13.50, representing a 69% margin of safety from the current price (8/7/18) of $8.00 per share:

Dallas Pess

Dallas Optim

*Optimistic, base, pessimistic refers to the discount rate, not projections.

One major obstacle I ran into was determining the cost of equity for CLWY. To do this, I found the unlevered beta of Lowe’s and Home Depot, then re-levered this beta to reflect the capital structure of CLWY. The base cost of equity I used in my analysis was 11.41%. The cost of equity I obtained for CLWY using the private equity method of finding cost of equity was 7.60%. I then increased this figure by an arbitrary 50% to reflect liquidity issues. Please inquire for more detailed projections and analysis. I then ran two other scenarios where the cost of equity was decreased and increased by 100 basis points to reflect a different liquidity premium and found that even in the most conservative situation, Calloway’s was still undervalued by 14%.

Catalysts

Other than continued sales and margin growth, there are several large catalysts that relate to Peter Kamin’s exit strategy. Kamin runs a middle-market-esque private equity type firm. Typically, the holding period for this type of firm is 3-5 years.

As a large shareholder (56.7%[3]), Kamin will need to draw a substantial amount of liquidity to sell his shares, otherwise he’ll be taking a liquidity haircut. This can be done by becoming more transparent through re-listing on one of the US exchanges and providing more transparent quarterly and annual reports. Calloway’s is no stranger to the big exchanges, as they were listed on the NASDAQ for several years[4]. By listing on an exchange, they will provide shareholders more information through their reported 10-Ks and other filings, which will bring in a slew of different investing clientele. This should significantly increase the liquidity of the stock, which will decrease the liquidity premium that was added to the cost of equity, leading to a higher share price (all else equal).

Another exit strategy Kamin could undertake would be a sale to a strategic buyer, where a premium would be placed on the shares to represent control.

One other short-term catalyst could be another dividend payment. Calloway’s paid a $.50 dividend with an ex-date of 12/14/2017. Perhaps Kamin needed some holiday money for loved ones. Perhaps he will need some more this year.

Summary

Calloway’s has experienced a significant turnaround over the past few years under new leadership. I believe the stock is currently undervalued about at least 33% when compared to the current share price of $8.00 with several catalysts in place. These catalysts include relisting on a major exchange, a sale to a third party, continued sales and margin growth, and continued dividend payments.

– Eddie

[1] https://www.businesswire.com/news/home/20130710005900/en/3K-Discusses-Opportunity-Calloway%E2%80%99s-Nursery

[2] https://www.dallasfed.org/research/econdata/dalcoini.aspx

[3] https://www.prnewswire.com/news-releases/calloways-nursery-and-3k-limited-partnership-announce-final-results-of-joint-tender-offer-and-closing-of-recapitalization-300223175.html

[4] https://www.bizjournals.com/dallas/stories/2004/01/19/daily48.html

RECENT BUY: Starbucks Corp. [SBUX]

  • Decelerating growth and recent events surrounding the company have contributed to a drop in the stock price
  • Strategic initiatives will drive growth in revenues and cash flows moving forward
  • Attractive dividend yield of 2.5% and latest dividend hike of 20%

Starbucks Corporation [SBUX] has been on my radar for a while now and its stock price has finally reached levels that make it an attractive investment for my portfolio. The business of selling coffee seems to be investor friendly and I have admired the growth Starbucks has seen over the years. The coffee industry is the family-friendly version of a “sin stock” (tobacco, alcohol, etc.) and produces a very stable business model with strong margins. Like the so called “sin stocks” coffee is addicting and like many others, I look forward to a cup to jump-start my day. However, due to the popularity of the company I have not seen much value in buying their stock for my portfolio since I started building it in 2015. I would have paid a premium for a piece of the growth and the downside looked too great and all too possible. Sure enough, the stock is down 11% since the beginning of the year and about 12% over the last twelve months and has made its way on to my watchlist. This begs the questions, are recent events and media coverage affecting investor behavior and creating negative pressure on the stock price? Is there potential value for an investment? I have decided to take a further look.

Why did the stock price plunge?

First is the departure of the visionary and leader, Howard Shultz, as well as the retirement of the CFO Scott Maw, which has shaken up the management team. The company also announced that they’re closing 150 stores in FY 2019 as they look to reduce exposure to urban areas citing high rent and labor costs. This doesn’t worry me, in fact, I think it’s prudent given that the company has a store count in the US greater than that of McDonalds. Truth be told, it is extremely difficult for SBUX (or any company) to continue with 15 year, 10 year, and 5 year compound annual growth rates in revenue of 14%, 9%, and 11%, respectively. Eventually the market becomes saturated, growth slows, and the company needs to shift growth to new markets, develop new products, engage in M&A, strictly manage expenses, and/or return cash to shareholders. Having saturated the North American Market, this is exactly where SBUX finds themselves today. Here is a look at the top line dating back to 2000 and the downward trend has become fairly obvious.SBUX sales

But things aren’t actually all that bad and the business is still strong. Here are the Q2 highlights:

  • Net revenue + 14% to $6 billion
  • Americas revenue + 8% to $4 billion
  • Chinese revenues + 54% to $1.2 billion
  • EMEA revenues +15% to $34 million
  • Organic comparable store sales +2-3%

However, the company is seeing margin pressure with operating margins decreasing over 400 basis points. This is due to investments in growth markets, as well as restructuring and impairment charges. I expect margins to normalize in the medium term as management optimizes their sales mix in the US and immerses their business in international growth markets.

What is driving growth moving forward?

The largest driver of growth will be the company’s big expansion plans in China/Asia Pacific (CAP). In December of 2017 SBUX acquired the remaining 50% interest in East China joint venture and now owns over 7,500 stores in 15 countries throughout CAP. In 2017 revenues from CAP increased 10% to $3.2 billion representing only 14% of revenue. Also, operating margins (23.6%) are about 500 basis points better than that of the Americas business. China is known for its tea culture, but its people have begun to “wake up and smell the coffee”. The market is seeing double digit growth rates that look similar to Japan throughout the 60’s and 70’s. Japan is currently the 4th largest consumer of coffee. There is a vast amount of untapped potential as tea sales outnumber coffee sales 10-1 and with an estimated 450-600 million of people expected to join the middle class by 2022, SBUX only needs to grab a fragment of total market share in order to see significant growth in revenues. SBUX is also looking to improve growth in the US through their new partnership with Nestle to form a “Global Coffee Alliance”. This is an effort to expand the consumer packed goods segment, aka packaged Starbucks coffee for your home. This segment has seen its revenues increase by roughly 5% over the last year. The company also has a notably strong loyalty program that drives same store comparable sales. The rewards program membership rose 12% in 2017 and now accounts for 40% of same store sales in the US. According to their 10Q, management expects these strategic initiatives to boost revenue growth to 9-11% in FY 2018.

Cash Flow and Dividends

I expect my portfolio to pay me each and every month and for that income stream to grow. This can only be sustained if the company can turn revenues into cash flow in order to reward shareholders and invest in growth. SBUX has increased its Free Cash Flow (FCF) by 24.2%, annually, over the last decade. This has allowed SBUX to significantly increase its dividend, just recently raising it by 20% and showing a five year growth rate of 23%. The dividend is very healthy too, with an earnings payout ratio of only 40% and a dividend yield of 2.5%. Strong cash flow production is important because as growth eventually slows over the long-term, SBUX will have the ability to invest, buy back shares and boost the dividend to further drive returns. Here is a look at the dividend in relation to earnings and cash flow in the last few years.

SBUX Per Share

Is SBUX Undervalued?

SBUX is currently sporting a higher earnings yield and dividend yield than any previous point in the last decade, at 6.3% and 2.5% respectively.

SBUX yields

Furthermore, the company’s Price-to-Earnings and Price-to-Cash Flow ratios are below their 10 year averages (normalized) of 19.4x and 16.8x at 15.7x and 15.6x, respectively. This is down significantly from their 3 year average ratios of 29.9x and 20.2x. If these ratios revert to their 10 year averages then there could be share price growth somewhere in the 10-25% range, due to multiple expansion.

Continuing to attempt to value the company’s shares, I used the H-Model (DDM) and assumed that next year’s dividends would grow by 20%, then decelerate linearly over the following 10 years. Assuming I require a 9% return and the long-term growth rate is 4%, I reach a fair value estimation of $49.44. This shows the stock to be roughly fairly valued. As an avid follower of Warren Buffet, I am more than happy to buy shares of wonderful companies at fair value. However, I think that this is a very conservative estimate because it does not account for the potential growth rates that could be seen internationally, nor for any growth in the dividend payout ratio.

In order to be consistent with my thoughts on the company’s future I wanted to get an idea of potential upside. I ran a DDM with the assumption that cash flow will grow at 15% over the next 5 years, in which case it will drop to a steady long-term rate of 4%. I then made the assumption that the payout ratio increased linearly from 50-65% over the next 5 years, at which case it would level off at 70% of cash flow, as the business matures. Given a required return of 9%, I calculated fair value at roughly $62. This represents a margin of safety of 23.6%.

There are obviously many ways to model out a company to determine what price is fair value. The array of possible assumptions that fit one’s idea of what will happen to the company are essentially endless, but after completing my analysis and creating some perspective on the stock price, I have come to the conclusion that SBUX is slightly undervalued. I don’t see much downside from here considering the vast amount of people that are going to get up and head to Starbucks on their way to work tomorrow. I have decided to initiate a position in SBUX at $50.19. This is a quality company that should be able to provide my portfolio with strong returns and dividend income for many years to come. SBUX will now represent just shy of 3% of my portfolio and I will look to add more over the coming quarters if the stock continues to drop and/or future quarterly reports describe an even better story.

What do you think of the purchase?

-Mike

Deep Value via Hidden Land Assets

Disclosure: The author has no position in any securities mentioned in the below article.

Finding a company with a net property value (market value of property – total liabilities) greater than the market cap of a company should be a screaming buy… but there are a few issues that come along with finding this type of hidden gem that the investor should be wary of. Land assets are deemed “hidden” because they are held at cost on the balance sheet. If an older company has held land for decades, chances are that land is worth significantly more than is reflected on the balance sheet.

The first problem with these types of investments is that the balance sheet simply reflects a snapshot in time. Best case scenario, the company liquidates all of its assets and pays off all of its debts and you are left with a hefty profit… but most companies are a going concern. Their balance sheet and fundamentals could and should change over time. A good management team will monetize the property to fund profitable capital projects, which leads to the next issue.

The second problem is the management. Why is the company’s share price depressed below its liquidation value? Why hasn’t the management borrowed against the property to fund capital projects? Are there even profitable opportunities to undertake? Are the managers really acting in the best interest of shareholders given these questions? Probably not.

Third, as with any value investment, is timing. If you happen to find a company like this, the timing is unknown as to when the actual value of the property will be reflected in the market price of the stock. Given that the market is forward-looking and the balance sheet is simply a snap shot in time, perhaps the market believes that the company is likely to borrow against the value of the property (which they should do if profitable projects exist), which will decrease the total net property value of the company. If the company does borrow against the property, you (as am equity holder) are now in the back of the line when it comes to liquidation.

However, these opportunities do arise and sometimes with even the right prospects in place. For example, Caloway’s Nursery (CLWY), a small retail gardening chain based out of Texas, recently went through this type of situation. The company was experiencing a management shakeout due to activist investor Peter Kamin of 3K. Management was giving themselves bloated benefits due to a serious agency problem. The management was essentially reporting to a board comprised of themselves! This resulted in excessive salaries and favorable insider stock purchase plans to the detriment of current shareholders. The company was trading underneath its net property value in 2016 for a few months before this value was realized in the market price.

If you find a company trading for less than its net property value, then you are essentially getting the business for free. Just be aware that it may take time for that value to be realized, and you will likely need good temperament and patience to bear through several periods with bad management.

– Eddie

2018 Market Outlook: Part I

As the New Year begins I like to take a look at the general landscape of the market as we embark on a new year of investing. As mentioned in my bio, my portfolio is diversified on an asset-class level and my strategic asset allocation decisions are based on my risk tolerance, time horizon and liquidity needs. Prevailing asset valuations will drive my tactical asset allocation decisions and where I invest fresh capital. Because of this, I like to make an annual macro assessment to help me create a picture of the current investment environment.

I am not an economist and I do not have the time, nor energy, to look at every fundamental market driver, so my macro-approach is very simple. I will let the quants crunch the numbers and make predictions while I just want to develop context and get a feel for the market sentiment that I am investing in. There will be many that disagree with my assessment and can lay out a very insightful argument to the contrary. I invite disagreement and discussion and think it is healthy to hear many perspectives. By no means am I an expert in predicting the best return drivers or where the largest risks lie in the current market. However, I believe that having a somewhat clear view of the market landscape will help me stay honest with capital decisions and avoid making un-educated investments. I expect that staying invested over many years, holding a diversified portfolio, and investing with a margin of safety will allow me to avoid excess exposure to tail-risks.

In 2017 the fed continued to stay the course on a rate-tightening cycle, the republicans passed a new tax bill, corporate share repurchases and IPOs continued to demonstrate strong volume, the yield curve has flattened, credit spreads tightened, volatility and inflation remained minimal and assets in general seem, at least at first glance, to be fully valued. Since I look to create alpha with my active investments in the US Equity markets, I will begin my assessment with the S&P 500.

US Equity Markets – Running of the Bulls

The U.S. economic outlook remains healthy according to many key economic indicators. GDP is expected to remain somewhere between 2-3%, coming in around 2.5% in 2017 with the same forecast for 2018 based on the most recent release at the Federal Open Market Committee meeting on December 13, 2017. Unemployment is expected to continue to drop to about 4%, and a successful Republican tax overhaul is expected to bring down corporate tax rates and improve earnings throughout 2018. Furthermore, low interest rates have left investors seeking higher yields outside of the fixed income markets (more on this in another post) and have encouraged investors to search for higher returns and yield in the stock market.

Last year was good for equities as the S&P returned about 21% (includes a 2% dividend yield). With most of the returns coming from price appreciation I think it’s important to ask the question – did valuations stretch further or did earnings keep up with the price appreciation? Earnings growth was 17.6%, thus returns by stocks this year were mostly led by earnings growth, which is a sign that the stock market appears healthy.

2018 Market Outlook - Yields

The P/E ratio increased slightly (earnings yield decreased by 19bps) and the dividend yield decreased 15bps but maintains a healthy payout ratio of 39.80%. Let’s see how some of these numbers stack up in a historical context:

2018 Market Outlook - Historical Graph

Looking at data going back to 1960 (57 years) it looks to me like stocks in the S&P 500 are bit on the expensive side. Both the earnings yield and dividend yield are sitting at the low end of the data series, while the PE ratio is becoming stretched – though not reaching the astronomical levels seen during the tech bubble. This concerns me a little bit as returns moving forward may be soft, however, we have been hearing a similar tune from the likes of many market professionals for quite some time now and if you have been sitting on the sidelines during this bull market I’m sure you not happy with the results.

My investment philosophy for my active equity allocation is mainly built around liquidity and safety of principal. As a result, most of my holdings are mid to large cap companies that have a competitive advantage in their industry and pay dividends. One way I like to measure dividend health is by analyzing cash produced by my potential investment in a company and ensure that cash flow is being sustained at a healthy level. I like to see companies use their cash flow to invest back in the business while also providing dividend growth to shareholders without being forced to tap the capital markets to raise funds. Here is a look at net income, free cash flow to equity, and cash returned to investors in the form of dividends and buybacks. These numbers are in millions.

2018 Market Outlook - Cash Return

Cash returned to shareholders as a percent of net income and free cash flow to equity is 87% and 98%, respectively. Anything over 100% is unsustainable, so it good to see cash returns below net income, and even better to see cash returns below free cash flow.

After comparing some basic fundamentals to historical numbers and getting idea of cash being returned to investors, I wanted to generate a forward looking estimate of the growth being priced into the current S&P 500 share price. Considering the US market is a developed and fairly stable economy, not currently experiencing an economic boom, I used the Gordon Constant Growth Model to back into an implied growth rate. Using the price and dividend at the end of 2017 (Price = $2,723.39 / Div. = $49.93) and a discount rate of 9% (average required return I use on my individual stock analysis), I get an implied growth rate of dividends of 7%. Does the growth rate justify the price? Well, there’s the obvious argument that if GDP is only growing at 3%-4% per year – than a 7% growth rate in dividends is unsustainable. You also must keep in mind there are inherent flaws in the GGM method as well as the fact that there is room left for the payout ratio (39%) to grow. The average annual growth rate in dividends going back to 1960 is about 6% -so we’re not that far off. Perhaps tax reform and the fiscal growth promised by politicians, combined with a year of healthy fundamental growth has left investors feeling good about future earnings growth. But you can make the argument that even though valuations are lifted in a historical context, investors aren’t pricing the S&P 500 at a euphoric level. (FANG stocks might be a different story!)

Currently, while somewhat healthy, US equities are not providing a sensational margin of safety. It seems like growth and risk are priced in and the market is fairly valued to slightly overvalued. However, I don’t think it makes much sense to look at the stock market in a vacuum and not take a look at what the credit markets are signaling. In Part II I will take a look at the equity risk premium and the prevailing interest rates to further develop context of the environment in which I am investing.

Comments or questions let me know…

-Mike

 

Contra-Index Portfolio: Part I

It is December 1st, 2017. Tax loss harvesting season is almost upon us and has got me thinking a lot about forced selling and the types of situations that can force an investor to sell. The most obvious answer to that question is a stressed liquidity event (e.g, recessions), where an investor would be forced to sell his securities to fund current consumption. One problem: we’re not in a recession (at least according to government numbers).

So, I asked myself: Is there anything right now (aside from tax loss harvesting) that could potentially bring about a value opportunity? …One where an institution is forced to sell a security? Then it hit me. With the rise of passive investing, any constituent security that was booted from an index would force the ETFs that try to replicate that index to sell (assuming no tilt).

So, I formed a hypothesis: Due to the increased popularity of ETFs, when a constituent security is dropped from the S&P500, forced selling from ETFs could potentially send the price per share of a company below its intrinsic value.

Over the next few weeks I will be examining this hypothesis by collecting data and back testing returns. The first item on the agenda (and perhaps most important) is the choice of an appropriate start date for the back test, which will come in part II of this project.

– Eddie

 

P.S. I’ve been told that this is a strategy that has been used by Baupost and I’m sure by numerous other asset managers (Who wouldn’t try to implement a strategy followed by Seth Klarman?). I intend to keep my thoughts original, and therefore am not looking into any of their thoughts on this strategy due to the fact that they may influence my analysis.