Nintendo for Free?!

I haven't really followed Nintendo over the years as I really don't like businesses that are dependent on recurring hit products.  That is my reservation with Apple, too, but at least Apple is a bit more broadbased than Nintendo (Nintendo is just a game whereas the Apple has laptops, desktops, phones and iPads that function as e-readers, music/media players etc...  and the eco-system is much wider and deeper than a Nintendo).

But as I was reading something (forget where...), I noticed someone mention that Nintendo is trading at 2.5x p/e.  Well, that got me interested.  Granted, I have to say that Nintendo is a stock that I wouldn't buy even if it was cheap because of the boom/bust nature of the game business (look at how quickly the game console business seems to change over the years.  At one time it was Atari, and then Sega versus Nintendo, and then Sony came out of nowhere and buried Sega, and then Microsoft came out of nowhere and put a dent in the Playstation.  And then the Wii came out and changed the world.  And now it seems like the iPad is a game changer, not to mention social gaming on social networks.  There is no doubt that this is new competition for the old gaming businesses even though they still say that there is no impact from the new up and comers.  But it is still early.

In any case, if you use the Buffett rule and try to see what the industry is going to look like in ten years, then the game console business is one of the first industries that I would say it is impossible to visualize.  I remember people saying that the PC games will catch up in graphics and speed with the game machines, but that never really happened.  I don't think PC games got as big as people thought.  Things like the Wii really kept the game console business going.

On the other hand, the iPad is a different story, I think.  When people sit down to think about what they are going to get their kids for the holidays, I really think things like the iPad become a worthy alternative to game machines.  Should we get a Wii or an iPad?  And for parents, the iPad has tons of games, but even better, it has all those other applications like learning programs, ebooks and other things that they would love to have not to mention the portability of an iPad (versus a game machine plugged into the TV set at home.  Of course, there is the DS and PSP, but I still think the iPad can cut into that market too).

There is a nice presentation at the Nintendo website that shows that the 3-D version of the DS is selling very fast, basically proving the naysayers wrong.  Again, it is early in the game.

I have no real insight into short term trends in the sales of these things.

But anyway, let's take a quick look at this thing.

The first thing you notice about Nintendo is that it is trading at around 10,000 yen/share, and that's down from over 70,000 yen/share back in late 2007.

This is kind of nuts.  The stock took off on the release and sales momentum of the Wii, which was released in 2006, and sales really took off in 2007.   EPS in the year ended March of 2008 was 2,012/share, so Nintendo was trading at a whopping 35x current year (at the time) earnings.  The peak EPS came the following year at 2,182/share, so the earnings growth didn't fill in the valuation gap (earnings failed to catch up to the stock price).

Earnings have been trending down ever since, and the stock is now trading at 10,000 yen/share, or down -85% from their peak. 

As an aside, this is one of the reasons why I dislike growth stocks, and expensive stocks in general.  It doesn't take much for people to lose a lot of money. 

Anyway, let's take a look at some fundamentals going back to 1998:

You can see why Nintendo stock was trading up at 35x p/e.  Using the March 2008 year figures, investors were looking at five year sales growth of  +27%/year and net earnings growth of +30%/year, and EPS growth of 33%/year.  How can you not like the stock?  It had decent returns on equity, tremendous growth, tons of cash and short term investments on the balance sheet.

Of course, the problem is that the Wii was a huge hit.  We know from the history of game console manufacturers that each cycle represents huge risks to these makers.  Some new generations will be hits, others will flop.  It's not the same as, say, Microsoft's upgrade cycle.  They have such a dominance that even if one upgrade flops (Vista), they still have a large base to depend on for future upgrades (the cost of switching is very high).

For game makers, I don't know how 'sticky' users are on next generation.  I'm sure all the manufacturers will have their own tables and charts showing how the current user base will most likely buy the next generation product.  But the math wouldn't work if there wasn't some decay in stickiness due to the increasing alternatives out there (to gaming in general).

Let's take a look at some of this stuff in the table

ROE
ROE for Nintendo is actually pretty reasonable.  It averages 12% for the 14 years in the above table.  However, this grossly understates the return on their business as much of the net worth of the company is actually invested in cash, deposits and short term investments.   As of March 2011, net assets of the company was around 1.3 trillion yen, but it had 1.2 trillion yen in cash and short term investments.  And those cash and investments don't earn much at all.   

If you average it all out (deduct cash and short term investments from shareholders equity, get the average 'real' operational net worth and calculate the 'adjusted' ROE), I think you get something like 250% return on adjusted equity over the past 14 years.

That's astounding.

What is the Current Valuation of the Business?
So let's take a look at what the market is valuing Nintendo's operations excluding cash and short term investments. 

To update the figures, I looked at the December 2011 figures: Cash and short term investments were 928 billion.  With 128 million shares outstanding, that comes to 7,250/yen per share.  The current stock price is 10,340 yen/share.  So ex-cash/investments, Nintendo is trading at 3,090 yen/share.

OK, so not quite free.   I lied. 

Now going back to the above table.  What has Nintendo earned in EPS in the past?  The peak EPS was 2,182 yen per share in the year ended March 2008.  If Nintendo can achieve that again some day, then Nintendo is trading at a p/e ratio of 1.4x p/e!! 

Well, I personally don't think that's going to happen.  I think 2008 was really a perfect storm of an incredibly strong global economy with the U.S. economy at the peak of a major housing and overconsumption bubble, and Nintendo rode that like a world champion surfer with their super hit Wii and momentum of DS.

So let's look at a more modest scenario.

Benjamin Graham used to use average earnings over a period of time to smooth out the ups and downs of the economic cycle.  Here, we can do that to smooth out the booms and busts of the game generation cycle.

On that basis, Nintendo earned an EPS on average of 938 yen/share over the entire 14 years.  So at 3,090/share (net of cash and short term investments), Nintendo is trading at 3.3x this average EPS.

OK, so the Wii is a superhit that is unrepeatable you say.  So let's take a look at the EPS average for the period 1998 - 2006 so as to exclude the years where the Wii took the sales and EPS figures over the top.  The EPS average from the years 1998 - 2006 was 576 yen/share.   So at 3,090/share, Nintendo is trading at 5.4x this figure.  It is trading at 5.4x what it typically earned BEFORE the Wii megahit.

Now this is starting to look really cheap.

Current Year Guidance
Of course, every story has a big "but".  Recently, Nintendo management revised down their estimates for the full year ended March 2012.  Sales are expected to be down 35% or so and they will LOSE money for the full year.   This hasn't happened in the past 14 years (by the way, I chose 14 years to look at because annual reports are available at the Nintendo website only going back that far).

Management likes to blame the economy and the strong yen and seems to minimize the impact of the iPad, social gaming and other alternatives.

I have my doubts about that.  But if they can manage expenses so they don't lose too much money over time even without big hit products, the cash on their balance sheet combined with the cheapness of the stock may make this an interesting 'option' on the future of Nintendo.

Here is their revision in forecast for sales, from the January update:

What about the Cash?
Nintendo has paid out dividends over the years as you can see on the table above.  So they are not completely shareholder unfriendly.  However, I find it highly unlikely that this cash will be distributed, or that there would be any sort of leveraged recap or other financial engineering on this stock as that almost never happens in Japanese corporations.

It seems like they like to keep a lot of cash on the balance sheet.  This 'sum-of-the-parts' valuation; the value of the operating business plus cash on the balance sheet is only really relevant, I think, when there is a chance that the cash will be distributed in some way to realize value to the shareholder.

Otherwise, if it is just going to sit there and not generate any returns, then the ROE of the company would have to include all of this excess cash and 'unproductive' asset.

Yes, the cash is a valuation cushion on the stock for sure, but I wouldn't lean too hard on it as many value investors seem to do in Japan (to great frustration).

I think it's safe to see it as a valuation floor, and then whatever comes from a weakening yen, improving global economy and the 3DS really taking off is the optionality.


Conclusion
Nintendo is certainly cheap, and it is cash rich.  There is no risk of Nintendo disappearing any time soon.   However, this company really needs the 3DS to be a hit for this stock to work.   For fans of Nintendo, however, this is not a bad price at all to get in.  It is cheap.

For me, I have to get over the fact that I can't predict the evolution of gaming devices over time, which is going to be a big driver of the stock price in the future.  Will Nintendo still dominate in a world where gaming is getting increasingly diverse (iPads, PC social gaming, Xbox and Playstation integration with other multimedia etc...)?

I have no clue about that.  For those who do, though, this is a great opportunity!

GSVC: Facebook Play Update

Last year I took a quick look at GSV Capital Corp (see here) as it was a play on Facebook. 

Now that the Facebook IPO is right in front of us, I thought I should take a look at this thing again and update some figures. 

Since the end of the September 2011 quarter, GSV Capital (GSVC) added 125,000 shares of Facebook and now own 350,000 shares which constitutes 14.3% of the net asset value (NAV) of GSVC.

GSVC also added 330,000 shares of Twitter for a total of 735,000 shares owned, which is 16.6% of NAV.  GSVC added some other investments, but these are the two that seem to be the most promising from an IPO realization point of view.

Anyway, more details of Facebook will come out soon but for now I googled around and found that it is estimated that around 2.35 billion shares of Facebook is outstanding, and that the recent close of Facebook shares (in the secondary market for private companies) was $34/shares as recently as a week ago.

That gives a valuation of around $80 billion for all of Facebook.  The IPO valuation talk is that Facebook will list at a valuation of around $75-100 billion.

At $34/share, GSVC's holdings in Facebook would be worth $11.9 million, versus GSVC's cost of around $10.5 million.  That's a gain of $1.4 million or $0.25 per GSVC share.  If Facebook was IPO'ed at $34/share and closed unchanged, that means GSVC will get a $0.25 unrealized gain on the Facebook holding, or 1.9% gain in NAV.

Here's the basic info:

• GSVC NAV:                               $73.2 million   (September 2011 10Q)
• GSVC NAV/share:                      $13.26    (September 2011 10Q)
• GSVC shares outstanding:          5.5 million  (September 2011 10Q)
• Facebook cost basis:                   $10.5 million (January 6, 2012 registation statement)
• Facebook cost per share:             $30/share (Total cost basis divided by total number of Facebook shares owned by GSVC)

If Facebook was listed at a valuation of $100 billion, or $42.55/share, the gain in NAV/share for GSVC would be 6%. 

The following is a table of what NAV of GSVC would be given various valuation levels of Facebook.  This assumes only the Facebook position and all other holdings unchanged.

GSVC current NAV/share is $13.26/share (as of September-end 2011).

GSVC NAV According to Facebook Valuation:

Facebook                      Facebook                     GSVC                 GSVC
valuation                       Price per share             NAV/share         NAV gain (%)
$75 billion                       $31.90                          $13.38                  +0.9%
$100 billion                     $42.60                          $14.06                  +6.1%
$150 billion                     $63.80                          $15.41                +16.2%
$200 billion                     $85.19                          $16.77                +26.5%

In other words, if Facebook was IPO'ed at $75 billion total valuation and then the stock price stayed there, the NAV/share of GSVC would only increase by about 0.9%.  That's because GSVC has paid around $30/share for their Facebook investments.

If Facebook comes out at the upper end of the range of $100 billion, that would cause a 6% increase in the NAV of GSVC.  If the Facebook IPO came out at $100 billion but then rose sharply after the offering, then the GSVC NAV can go up anywhere from 16% to 27% if the Facebook stock price popped up 50% or doubled (after coming out at $100 billion valuation).

That's not a bad return, of course, on a single event.   (I should also mention that the above analysis doesn't take into account that the management company will take 20% of any gains so are pre-incentive fee figures)

But the problem is that GSVC's stock is already trading at $17.26/share, above even the above aggressive scenario where Facebook goes on to a $200 billion valuation after the IPO.

However, this only looks at Facebook.  The other 'promising' position is Twitter and some of this exuberance may reflect the potential increased valuation of Twitter and potential IPO. 

Groupon (GRPN) is the other promising holding but they had an IPO in November 2011 and the stock price hasn't done too well.  The IPO came off at $20/share, closed the first day at $24.90/share and now trades at $19.90/share.

Looking at the Septembet 2011 10Q, GSVC owned 80,000 shares of Groupon at a cost of $2.1 million, or around $26.25/share. 

If this is correct, it seems that GRPN was IPO'ed at a price *below* what GSVC paid for the shares in the private secondary market.

(None of the above NAV calculations adjusted for GRPN, but it seems like there is not much of a market-to-market gain or loss in percentage terms as a whole)

The GRPN example illustrates what can go wrong with the GSVC strategy.  The private secondary market allows insiders to sell stock in their company to qualified buyers before an IPO, but the prices tend to be very high in this pre-IPO market for big companies close to an IPO.  This really takes the 'pop' or potential huge gains out compared to true venture capital firms that get in on the ground floor. 

This secondary market is far from the ground floor.

In any case, even though the whole world will be looking at Facebook this week and I can't possibly imagine what I can add to it by looking at it myself, I will take a look and possibly post something if I find anything interesting.

Conclusion
Either way, the GSVC stock price at this point at over $17/share seems to more than discount a huge gain in Facebook post IPO.

I should mention that GSVC did file a registration statement in early January to offer up to 3.6 million share (and up to $50 million).  That's a huge offering as GSVC only has 5.5 million shares outstanding currently.

This is usually good news for owners since GSVC seems to be trading at a nice premium to NAV, but one should be aware that such offering would highly dilute the impact of holdings in Facebook and Twitter; they will become a much smaller percentage of the GSVC portfolio.  I suppose that's not a big issue now that Facebook is close to an IPO; people will soon be able to buy it on their own in the public market.

But I would be cautious GSVC going forward as it is highly uncertain whether GSVC will be able to find other investments as promising as Facebook; these tend to be very rare as most venture businesses don't pan out too well.

In any case, if you want to play Facebook with GSVC, it doesn't look like a good idea at this point.   As a long term holding for people interested in post-venture, pre-IPO tech investing, this may be interesting but I will stay away myself.

America's Favorite Store?! (Part 2)

So I listened to the second day presentation.  This was more of an investor day with financial details.  Much of the presentation was done by Michael Kramer, the COO of JCP.  He too comes from Apple retail where he was CFO of the retail business, he became CFO of Abercrombie and Fitch and then later CEO of Kellwood, a supplier to department stores.  So Kramer has a lot of retail experience.  This is good.

Like yesterday, Kramer started off talking about how department stores have dropped the ball and how that doesn't make any sense.

He offered the advantages that department stores have compared to specialty stores.  Below is a table that shows the advantages in two of the major expenses of  a store.  Department stores spend a lot more on marketing, and have rent expense that is way lower than specialty stores.

How can this be?  How can department stores lose so much market share with such advantages?  Over the years, see how department stores have lost share:

Johnson showed this chart yesterday, but a little more detail shows that of the 69% that is not department store sales, 37% of the total is actually specialty stores (the rest are discount retailers etc...).

So what happened?  Johnson yesterday spoke of the deterioration of the 6 P's.  Kramer says that department stores have basically lost sight of their customers.

As an example, he spoke of his experience as a supplier to department stores.  One unnamed department store had unproductive brands sitting on their shelves and Kramer asked for that space for his better products.  The department store said no.  Why?  Because those unproductive products made as much money as the other products due to vendor kickbacks.

Kramer said this is one of the problems that department stores have.  They think financially that the unselling product is OK to have in the stores as they get paid back by the vendor.  But what happens to the customer?  If you have stuff they don't want on the shelf and you are OK with that because someone else is paying you, that's not a good long term strategy.  Eventually, the customer will stop coming.  (They did say that JCP does not have this problem).

As Johnson said yesterday, Kramer said they will simplify pricing and stop confusing customers.

How will all this 'change' be paid for?  They already talked about how they can redirect all that money they spent doing the 590 promotions that nobody responded to to better, more effective and less frequent promotions.  The press reported that $80 million will be spent on promotions but failed to mention that this is cost that is coming out of the 590 promotions they did before, so I don't think there is a net increase in spending there.

Costs
Kramer pointed out that corporate overhead at JCP is a bit higher than Kohl's (KSS), a competitor, and they feel they can bring JCP's cost down to KSS's level.

By bringing SGA level down to KSS's would be worth $1 billion in savings.  That's pretty big for a company with $18 billion in sales (that would lift operating margins by more than 5%).

They can't do this overnight, so they will cut costs over time towards 2015.

Where will the savings come from?  They have identified areas of savings in the following areas:

(I know I am getting a little trigger happy with the Windows 7 "Snip" function.  I have to admit, it's pretty convenient!).

They can also save labor costs by increasing labor productivity.  The amount of labor hours to operate a store at JCP is much higher than at KSS, and they think they can get it down to KSS's level.   If they do, that can amount to a lot of costs saved:

Advertising cost is also a bit higher than the competition and they think they can get that down too. They believe that events, brand/store announcements and things like that will offer a lot of free publicity over the next few years as they develop their stores.

Also, corporate headquarters is inefficient with too many layers of management that they plan to cut down:

Span of control is basically how many people directly report per manager.  Increasing this, (or cutting layers) can save $90 million.

Another example of cost saving Kramer mentioned was the number of cashier stations in the store.  There are currently a lot of them where they are not utilized at all except during peak times (he said they are "rarely used") and yet the stations are still staffed even during off peak hours.  By shutting these stations, they can save $100 million.

So with these and other initiatives, they expect $900 million in savings over the next two years.   They plan on getting SGA down to less than 30% of sales by 2013.  They will spend $800 million in capex in 2012 for the transformation which includes the development of the first 10 shops in their stores, investments in store infrastructure, IT and inventory for changes in the store (movable walls etc...).

How Do They Lift Sales?

Shops in the stores and partnerships with brands should increase traffic and help sales.  When Sephora was put into JCP stores, it lifted sales +2% in the rest of the store. 

Some argue that Johnson was able to create the great Apple store because Apple had great products, but the fact is that throughout the existence of Apple stores, they were never the cheapest seller.  Customers were always able to buy the very same Apple products for less at Best Buy or on Amazon.  And yet the Apple stores have done so well.  The Apple stores also never got preferential treatment despite begging by Johnson. 

By December 2015, they will have 100 shops in their stores and the transformation will be complete.  At this point they expect:

• 40%+ gross margins
• 27% SGA to sales
• 13% contribution margin (operating margin)

Also, there is potential for more JCP stores.  The number of stores in the top 50 MSA's (market service area) are as follows:

             JCP            398

             Macy's       517

             Kohl's        722

This implies that there is potential for 300 more stores.

JCP believes that with better, simpler pricing, partnerships with key brands and instore shops and their Market Square concept will drive traffic and help boost sales.

Investor Updates

JCP going forward will only provide annual guidance, and sales will be announced only quarterly instead of monthly.

EPS guidance for 2012 is for $2.16 (before pension expense).  They expect to meet or exceed their 2011 EPS.

There was a question from an analyst with respect to some suppliers/vendors saying that orders from JCP are down 10-15% for the spring season.  The question was whether JCP is expecting sales to be down.  Johnson said that this is not the case; that their inventory turns are a bit lower than the competition and they are just managing their inventories down a little bit to get the turnover up to more competitive levels.

JCP does not expect sales to slump during the transition, nor do they expect the new pricing scheme to reduce sales.

I noticed that the press were writing things like "every day low price" or that JCP will deeply discount to get sales up, but that's not really the case.  As you can see from the slide in the JCP presentation yesterday, they expect to sell things at the same price they have been selling it at; just not with sales and promotions so much.  The impact on revenues should be zero (all else equal).

(for reference, the sales-to-inventory ratio at KSS was 5.6x compared to 4.8x at JCP on a last four quarters average basis).

Back of the Napkin

So those are my notes from the presentation.  I just jotted down what interested me, so it's by no means a summary of the whole presentation.  Anyone interested should listen to the presentation.  It is very interesting and there is something to learn from a well-prepared presentation. 

So what does this all mean to the investor?  What we know is that they want to get to a 13% operating margin by 2015 by maintaining gross margins above 40% and getting SGA down to 27%.  If we assume sales to be flat (just to be conservative), what kind of EPS are we looking at?

Let's assume:

• debt remains unchanged so interest expense remains the same at around $231 million/year
• total shares outstanding is 213 million, which is the average shares outstanding for the quarter ended October 29, 2011  (since the transformation is planned to be completely self-funded, this is not unreasonable)
• Sales of $17.8 billion, which is the sales for the most recent full year
• 40% tax rate (which is a little higher than the 37-39% range it's been recently)

So, with sales of $17.8 billion and a 13% operating margin, that's operating income of $2.3 billion, less $231 million in interest expense is $2.1 billion pretax income, and with a 40% tax rate that's a net income of $1.26 billion.  With 213 million shares outstanding, that's an EPS of $5.92/share.

At the current $41.00 or so per share, JCP is trading at 6.9x what JCP could earn in 2015.  If JCP succeeds in this transformation, then a p/e ratio of 15x is not at all unreasonable, as even mediocre retailers have traded at that multiple in normal times.

So that would put the possible value of JCP in 2015 at $89.00/share.  From the current $41/share, that's more than a double and over the four years through the end of 2015, that's an annualized return of 21%/year.  Not bad at all.  You can see why Ackman might be excited.

If they really do well, then maybe they get a 20x multiple.   That would take the stock price to $120/share by the end of 2015.   But for JCP to get a 20x multiple, they would really have to do well.

Retailers tend to be cheap now, so even if we assume that JCP will only get a 10x multiple on their $5.92/share EPS in 2015, that's still close to a 10%/year return through 2015.

The great thing about this analysis is that it assumes zero sales growth when in fact, if the transformation is successful, it is more likely that sales will grow over time.

Here are the trailing and forward p/e ratios of some similar retailers now (pulled from Yahoo Finance):

                          trailing                

                          12-month             Forward

Macy's               12.4x                   10.5x

Saks                   24.0x                   19.4x

Kohl's                10.9x                     9.4x

Nordstrom         15.7x                   13.6x

Dillard's               6.1x                    9.5x

I think Saks p/e ratio is high due to their depressed earnings so it may not be an indication.  Morningstar's industry average p/e ratio, however, is around 15x.

Sanity Check

Of course, the other big question is whether JCP can actually achieve a 13% operating margin by 2015.  Retail is a very competitive business.  What does a 13% operating margin look like versus the competition?

I just grabbed some operating margin figures from Morningstar and created the below table so we can see how the 13% operating margin compares to other department stores and over time.  Is it doable?

I don't see anyone achieving 13% operating margins in the department store sector even in the good times of 2006-2007.  Peak margins even at Kohl's seem to be around 11.7%.  So JCP is aiming for something even better than what Kohl's did during the best of times.  But then even Macy's achieved a 10.8% margin in 2006, so maybe it is doable.

Conclusion
The 13% margin does look aggressive given the table above, but these guys are really overhauling JCP in a major way so it may happen.  If it does, there seems to be plenty of upside in the stock price, even after the close to 20% rally on the presentation.

I don't own any JCP at the moment; these things are very hard to evaluate.  Who knows if they will succeed or not?

But it seems like they do have an active shareholder that has a strong interest in seeing JCP succeed (including Vornado's Roth who would love to see JCP do well as it would enhance the value of Vornado's Manhattan Mall).  It seems like they do have a solid, experienced retail team that is energetic and motivated to succeed.

An interesting point is that since this makeover doesn't include anything drastic on the balance sheet, like huge debt increase or massive financial engineering, like repurchasing shares (or leveraged recap) at the expense of capex and store maintenance, there might be little risk involved.

If the makeover fails, what happens?  JCP goes back to being what it was; a mediocre department store?  This may not be such a disaster on the downside.

JCP stock has traded in the range of $20-40 post crisis (excluding the 2009 panic low) before Johnson came on board.  So let's say that if this doesn't work out, JCP goes back to $30/share.

That's a 25% drop; not a complete disaster.  And on the upside, you have a potential double or more.  So that's $11 downside risk ($41 down to $30) and $48/share upside potential ($41 up to $89/share); not at all a bad risk/return profile if you think there is at least a 50/50 chance of the makeover succeeding (in fact, it can be interesting even if there is a less than 50/50 chance of a successful makeover).

Not bad at all.

As usual, this is not a stock recommendation.  I don't have any more insight than anyone else on whether this 'transformation' will succeed or not, which will be the primary driver of the stock price going forward.  I may buy and sell this stock in the future according to how things develop.  

America's Favorite Store?! (Part 1)

  (JCP's new logo)

Ron Johnson joined JC Penny (JCP) as CEO back in June 2011 from Apple with great fanfare.  He is the guru that was behind the amazing Apple stores.  Ron Johnson was brought in after Bill Ackman (of Pershing Square Capital) and Steven Roth (or Vornado Realty Trust) took a large stake in late 2010 and got elected to the board of JCP. 

Of course, JCP doesn't have the products that Apple does, so it's hard for me to imagine what Ron Johnson can do to transform this place.   What's he gonna do?  Install a glass staircase so people line up outside to buy...  jeans?

But you have to take a look when good investors like Ackman and Roth get involved with something.  Of course, most of the time you will take a good, hard look and still have no idea how this will work out.   Initially, I think the view was that Ackman and Roth were interested in JCP's real estate, but Ackman insists that is not the case at this point.  Roth is a retail guy (Vornado Realty), but he does have an interest in seeing JCP succeed as it is an anchor tenant in Vornado's mall in NYC (Manhattan Mall).  A revival in JCP would be very good for that mall.

One thing right off the bat we can say is that this is not Sears all over again.  The Sears trade was a great one initially (K-Mart bought out of bankruptcy on the cheap etc...), but didn't go too well after Lampert, a hedge fund operator and not a retail guy tried to run the place.

With JCP, Ackman and Roth are not at all involved with the retail operations.  They were involved with selecting and getting a good retail CEO.

Some may argue that an Apple guy can't run a department store, but Johnson started his career in retail (Target) so that's a good thing.

Over the past two days, Johnson unveiled their new strategy to transform JCP and turn it into a "America's Favorite Store".  

I listened to the presentation online and thought it was interesting, even though I have no idea how much impact it will have on sales.  The stock price didn't react at all on the first day, but popped +19% today on the financial presentation.  I haven't heard that yet so I'll make another post after I listen to that.  Obviously, there were things there that got the market excited.

Anyway, Johnson started out by analogizing his moving to JCP with his quitting Target to go to Apple back in 2000.  People around him were surprised, wondering why he would want to leave such a hot retailer like Target to go to a non-entity like Apple.  He points out that his move to Apple was not a bad decision. 

He says he sees the same thing now that he saw back then with Apple.  And when he told Steve Jobs that he is going to leave Apple to go to JCP, Jobs was surprised and didn't understand why he would leave such a hot company to move to a mediocre retailer.

Here are some tables from the presentation:

He says that when he quit Target to go to Apple, Apple had 3% market share and was losing money.  Apple now has 30% market share. 

Interestingly, JCP now has 3% market share and is actually making money.   He says that with a 3% market share, if you gain one point of market share, that's a 33% increase in sales and that's tremendous opportunity.

Johnson believes that department stores have made mistakes and that it doesn't have to be this way, and that department stores can do well if they improve their business.

Here is an example of what JCP has done wrong over the years.  He first mentioned the P's of retailing:

• Product
• Place
• Presentation
• Price
• Promotion
• Personality

It is said that if you can get one or two of these really down, you can do really well in retailing.

Anyway, first, he talked about how department stores were in the old days.  Way back when they dominated, department stores always promoted their own brand.  They didn't promote products; they promoted the stores;  Santa Claus for Christmas etc...

But what has happened with JCP is that they have really discounted their brand by their poor pricing strategy.

Here is an interesting chart Johnson put up to demonstrate this.   Between 2002 and 2011, JCP's retail prices have risen 43% while the cost of their products remained the same.

It looks like this should lead to higher margins and profits, but what actually happened?  Due to all the promotions, sales, specials and discounts, these prices were never realized.  Below is an interesting chart that shows that the real sales price for JCP products (I think he said this includes all items in JCP stores) have not changed at all over those years:

So raising prices only served to increase the "discount" rate that the products were sold for.  Johnson believes that this dilutes, or discounts the value of the JCP brand, the store.

Above is a chart that shows the average discount of items sold in JCP stores.  And below is a chart that shows the distribution of sales according to discount rates:

This shows that nothing is ever sold at the marked price,  and an astounding 72% of items are sold at a discount of more than 50%.   I guess that does look bad, as it looks like the store is going out of business if things are so marked down all the time.  At best, it makes the store look really bad in inventory management, having to mark prices down to clear inventory (this is not a discounter or off-price retailer like TJX/Marshall's).

So Johnson's new pricing strategy is to stop with the frequent sales and promotions and simplify the pricing strategy to three types below:

Johnson also presented his concept for JCP in the future.  One of them was to create more floor space by getting rid of the old fixtures; those old racks that have been used to hang clothes for decades.  He wants to use movable wall units to create wall space where images can be displayed with products hanging next to them; this will create more floor space instead of having the floor cluttered with racks like in old department stores.

Also a major new idea (for JCP, at least) is to break up the store into little stores.  JCP has had great success with Sephora stores;  Sephora stores inside of JCP stores have sales per square foot of $600 versus $200/square foot for the rest of JCP.

The idea is to create, eventually (by 2015) 100 stores within JCP stores.  They will start with brands they own that are popular, like Liz Claireborne, Izod and others. 

I didn't think that was a particularly new concept, but I suppose it's new for JCP.  (Higher end department stores have had stores-within-a-store for a long time, I think)

JCP will also have Martha Stewart stores inside of them, and Johnson announced that Ellen Degeneres will be a spokesperson (or whatever you call it) for JCP, being featured in TV commercials, and stores being promoted on her show. 

The other new concept was to move jewelry and watches out of the center of the store, which has been the standard forever.  They will move jewelry somewhere else and replace it with a Town Square.  He didn't give much information about what the Town Square will be, but the hint was that at Apple stores, a good half of the floor space is devoted to services and activities other than selling products.  What can this be in a department store?   Someone to patch torn jeans?  Repair shoes?  Probably not, lol...   Maybe some virtual/technological fashion advisor?  Play area for kids?  Who knows.

Anyway, I'm not a retail guy so I have no idea what all of this means so I will just have to watch as the story unfolds.

I have to say that this stuff does actually make me want to go to JCP, even though I hate shopping, just to see how it goes.

I will listen to the replay of today's investor day presentation later and will post my comments about that tommorow.

Gold: Interesting Chart

So, I was flipping through some annual reports, catching up on the ever increasing pile of stuff to read.  Occasionally, something comes out and grabs me and I have to investigate.  The great thing about annual reports is that you learn all kinds of things reading them, not just about the company.

This chart came from the 2010 annual report for Barrick Gold, (or I suppose it's just called Barrick now) in the letter to shareholders section written by chairman and CEO Peter Munk.

He said that there is a lot of talk of gold in a bubble and showed this chart to prove that gold is not in a bubble.  He said that in 1980, gold rallied 250% in a single year and that gold recently has done nothing close to that.  The gradual rise in gold prices over the past decade has been orderly and not at all bubble-like.

I thought that was interesting for sure.  But I still couldn't get over the parabolic-ness and one-decision-ness of the gold story so I decided to take a quick look at other bubbles in the past.

This, "gold is not in a bubble because there hasn't been a blowoff" argument vaguely reminds me of the housing bubble. Yes, housing prices are up a lot in the recent past, but they are not up like other bubbles in terms of magnitude.  Yes, it's expensive but it could get more expensive, just like Japan did; we are nowhere near where Japan was etc...

Well, anyway, let's take a quick look at this.

There is no question that compared to the 1970s, gold has done nothing and is not bubblish at all.  But I have to wonder if this is a good comparison as gold prices were pretty much fixed for most of the 20th century; the delinking of gold from money caused a catch up in prices to make up for 50, 70 or more years of inflation. 

This is certainly not the case now as gold has been freely traded for a long time. 

Other bubbles that people use as benchmarks is the 1929 stock market bubble, maybe the 1987 crash as a minor bubble, the Nikkei 1989 bubble and of course the 2000 U.S. stock market bubble. 

I'm way too lazy to do accurate work here, but just from eye-balling and grabbing quick prices off the internet, I came up with an approximate five year and ten year price change in these respective bubbles. 

Here is what I got: 

                                                             Price change  over 

                                                             Five years                Ten years    

1929 stock market bubble (DJIA):         4x                            6x (actually from 1918 low)

1987 stock market bubble (DJIA):         3x                            3x

2000 stock market bubble (S&P 500) :  3x                            4.4x

2000 NASDAQ bubble:                        6x                            11x

Nikkei 1989 bubble:                              4x                            6x

Current Gold:                                       3x                           7x

  (to September 2011 high) 

So looking at it this way, it does look to me like it is in line with other big bubbles.  Again, I would think that the 1970s-1980 gold bubble may not be much of a comparable due to the extraordinary event that preceded the delinking (fixed gold price). 

If we compare the recent gold price trend to other big bubbles, it looks pretty much in line.  The 7-fold gain in gold prices in the past decade exceeds the gain in stock prices in both the 1929 stock market bubble and the Nikkei 225 1989 bubble and easily beats the 2000 stock market bubble. 

In any case, I am not a big fan of gold at this point for the reasons I stated in my post back in October 2011   and I still think it is too much of an 'inevitable' investment; 

• great historical track record in five and ten year periods that validate the bull story which is...
• the inevitability of central bank easing, almost perpetually due to weak economies and debt problems; money printing can't and won't stop, therefore gold prices must go up
• even if the central bank scenario proves false and the economy picks up steam, that would lead to inflation so therefore gold prices must go up
• So therefore heads I win, tails I win and, again... 
• recent price performance confirms and validates above scenario (and gold sure beats the heck out of stocks and other assets on a five and ten year basis!)
• and we have all learned from the financial crisis that we can't have too much stock holdings or else we can lose money so we must diversify into other asset classes, like... [drumroll]  gold!, because of the (go back to first bullet point)

So when the above self-reinforcing cycle is in effect and the chart looks parabolic (I am parabolic-phobic), and people tell you that in almost any scenario gold prices has to go up, I just lose interest in it. 

Would I short it?  Heck no.  Am I convinced gold prices must crash or go down?  Absolutely not.  Can gold continue to go up?  Of course! 

When the bull case is that we are nowhere near the 1980-type of bubble and in order to make decent returns, such a bubble has to recur, it sort of sounds more to me like a gamble than a rational investment. 

There are a lot of people way smarter than me that like gold and that's great.  

For me?  Nah.   I want to own something that is unloved, hated, despised, and cheap. Gold right now seems almost the exact opposite. 

Notes 

Here is the 'rough' data I used for the above analysis just for future reference:

Nikkei 225 Index:  

            December 1979      6,570

            December 1984    10,000

            December 1989    40,000  (never got to 40,000 but that's what I used.  Sue me!)

Dow Jones Industrial Average:

            August 1977             860

            August 1982             900

            August 1987           2700  

            1918 low                    66

            1924                           90  (eyeballed chart, so not very accurate)

            1929 high                  382

S&P 500 Index:

            March 1990              340

            March 1995              500

            March 2000            1500

NASDAQ Composite:

            February 1990           430             

            February 1995           790

            February 2000         4700

Gold:

            September 2001        270           

            September 2006        744

            September 2011      1900

Staggering, Off the Charts

This is how Apple described iPhone demand in China on their first quarter conference call.  Demand is staggering.  It's "off the charts".  They could have sold more but were way too conservative.

Apple is pretty much one of the most widely watched stocks so there is no point in my going over the details here, but I'll just jot down some things that interested me, or maybe I should say blew me away.

First of all the eps came in at $13.87 and analysts expected something close to $10.00/share.  That's a double from the $6.43/share they earned last year.   Cash and investments are now at $97.6 billion, another staggering, off-the-chart figure.

So let's take a look at the quick trailing 12-months eps and p/e ratio net of this cash/investments.

EPS in the last four quarters were:
              EPS
2Q11      $6.40
3Q11      $7.79
4Q11      $7.05
1Q12    $13.87
             $35.13

The weighted average diluted shares outstanding for the first quarter was around 942 million, so the cash and investments is worth $103.60/share.

Apple stock promptly shot up today so let's say it's trading at around $450/share.   Net out this cash and investments and you have $346/share for the Apple business. 

So Apple stock is basically trading at 9.8x  p/e ratio on a trailing twelve month basis even after today's rally.  This is stunningly cheap. 

(This cash and investment doesn't take into account potential tax liability on repatriation; I think $64 billion or so is held offshore; after tax equivalent cash would be a bit less. This would be subject to a 35% tax hit, but there is a credit for foreign corporate taxes paid, so the actual liability would be less than that)

Growth is Widespread
I don't know if the above table is legible (you can see this table at the Apple Investor Relations website), but what is amazing is how broad the strength in the business is.  Even in the Americas and Europe, basically no growth economies, revenues grew strongly (+92% in the Americas, +55% in Europe).  Japan had revenue growth of 148%, Asia Pacific of +54%, retial growth of +59%.  All of these figures are year-to-year.

While PCs and laptop sales growth are in the low single digits, Mac desktops and laptops seem to be growing strongly.

Apple Stores
There are now 361 Apple stores and they seem to continue to do well.  Average revenue per store has risen to $17.1 million versus $12 million a year ago, growth of +43%.  Store traffic has also increased to 110 million versus 76 million a year ago, growth of +45%; this comes to 22,000 visits per week per store.

Segment margin came in at $1.8 billion for a margin of 30.3% versus 26.2%. 

Of course, how stores do is going to be purely a function of Apple products; if they stop making hit products, the stores can quickly become a burden.   But at this stage in the game, the stores do seem to be adding value with decent margins and probably contributing to the brand value of Apple (the stores are easy to shop with plenty of help unlike typical electronics stores).

Outlook
They forecast second quarter eps of around $8.50, versus analyst consensus of around $8.00, so it seems the momentum is continuing.

A large contributor to this momentum seems to be enterprises starting to adopt the iPad.  It took a long time for corporations to start using the iPhone (as it was incompatible with the rest of the IT infrastructure at large corporations), but Apple is seeing quick acceptance and adoption of the iPad which is leading to a halo effect; once you get an iPad, you are more likely to get a Mac etc...

Thoughts
I do own some Apple stock.  It is pretty cheap with tons of cash/investments on the balance sheet and I don't think Apple is necessarily a 'fad' or short term hit product like the Motorola Razr or Rimm Blackberry (which did dominate for a long time).  Apple is a bit more than just a gadget as it does have a great ecosystem which the Razr and Blackberry and other hit products didn't have.

This is not to say that the Android and Microsoft can't eventually catch up.  Over time, these things will be standardized and I guess we will be able to listen to music, read books, play games and do whatever we want on all sorts of cheap gadgets with software and content provided by multiple players.

I will continue to own Apple and be interested in it as long as it is very cheap.  I would probably be a seller of this at a 'fair' price, like if it gets up to 15 or 20x p/e ratio ex-cash as over the long term it is hard for me to see where Apple would be in say, 10 or 15 years.

Anyway, I am a bit more optimistic about Apple than the skeptics but agree that over time it will be hard to imagine a world where a cheap Samsung, ASUS or Dell gadget won't be doing similar things to what Apple products do now.

Olympus, Nomura, Sony: What's Wrong with Japan

So we see every day why Japan has so much trouble getting out of it's long slump.  There was an article recently talking about how the lost decade in Japan is actually a myth, and that the reality is that Japan has done better than we all think since the bubble popped in 1990.  Yes, Japan has low unemployment, earnings are up and the economy avoided a depression, but that was done pretty much by government debt spending.

I wouldn't be too proud of that. 

Anyway, recent headlines further highlight the disfunction of corporate Japan.  We painfully realized how incompetent the government was in handling the earthquake and nuclear crisis last year and corporate Japan continues to shock us observers with truly bizarre developments.

Olympus sued current and former executives and directors for failing to deal with the fraud but strangely kept them on board.  Apparently, there is no support in Japan from shareholders to fire the board or replace the senior management.  How can this be?  It doesn't make any sense at all.  Woodford just gave up completely.  I don't know if he is the right guy or not, but the fact that there was no support for him in Japan and full support for current board and management is mind-boggling.

Nomura today also lost Jasjit Bhattal, the head of Nomura's global business apparently because Tokyo resisted Bhattal's call for deeper cuts in global operations (shutting unprofitable businesses, getting out of unprofitable countries etc...).  This is really bizarre too because I would think that more often, a head of a business would want to expand more than headquarters feels comfortable with and they leave.  Most bosses are empire-builders; they want to expand their empires, cost and risk be damned.  And Bhattal wanted to *shrink* and Tokyo said no, lol. Only in a Japanese company can this happen (?).

I have no idea if Bhattal is any good or not, but I get the sense that this is typical Japanese corporate mentality to resist change and resist firing people.  Also, Japanese are notoriously bad at cutting losses and admitting defeat (look at Olympus!).  They are also more concerned with market share and status than profitability (statements to the contrary notwithstanding).  You can be sure there are turf war issues too; intense lobbying by heads of unprofitable businesses to keep them going.

I don't know if this means that the Lehman purchase was a complete failure, but I bet that deep cuts would have been interpreted as such which probably scare the heck out of senior management in Tokyo.

Anyway, this is not a good development, I don't think. 

Nomura's legacy of failing internationally seems to be continuing and this might just be the latest iteration of it.

I still think for Nomura to realize value, they should focus on the domestic business and then eventually team up with a strong international bank.  Of course, this will never happen for the reasons I stated before.

Similar to this was the Sony comments that they will never exit the TV business because the engineers are very proud of their work.

I truly wish Japanese companies would really stop thinking this way and focus on profitability, returns on capital and things like that.  As Jack Welch says, firing people might be unpleasant and short term bad for the fired, but over the long haul it is good for everyone; the company (as they can cut cost and reduce the odds of bankruptcy which would be bad for everybody and reallocate resources to productive areas) , the fired employee (that can go out and find something that they can do productively instead of becoming corporate zombie employees like so many salarymen in Japan) and even the economy (as the newly unemployed find productive things to do including starting ventures.  Also more frequent firings would by necessity increase labor mobility).

Japan has a long, long way to go...   

*sigh*

Dimon on CNBC

Jamie Dimon, CEO of J.P. Morgan Chase (JPM) was on CNBC yesterday and reiterated that the current stress test banks are undergoing in the U.S. will be a non-issue for JPM.   This is not new news, but it is interesting that he said that JPM will have a Tier 1 common equity ratio of 7-8% versus the required 5% *after* the stress test.  This ratio was at 9.9% or so after the end of the last quarter.

The stress test was something like:

• Unemployment goes up to 13%
• Housing prices down another 20% from here
• Stock market down 50%
• Catastrophe in the U.S. and Europe (I assume financial problems, like sovereign defaults etc...)

So that's pretty solid; to be able to withstand all that with a 7-8% Tier 1 capital ratio.

Maria Bartiromo also asked Dimon if he thought the JPM stock price was trading at less than intrinsic value and he said "I think so, yeah".

He also said that investors may be surprised this year (by the market in general).  When people are this negative and bearish, when things clear up people might start flooding back into the markets again.

Anyway, his call is no better than anyone elses but I do listen because Dimon is definitely not a promotional type (he was bearish and calling for big problems *before* the financial collapse) and he does get to see a lot of what is going on in the economy and unlike most CEO's, he is as a straight shooter as there is (despite the seeming consensus to the contrary (everyone seems to think all bankers are dishonest, unethical etc...)).

Hot Stock Tip?!

This is apparently a real post card from Buffett according to Fortune magazine.  Buffett did comment on it so it's real.

Notice on the list is the stock Google!   Charlie Munger has spoken very highly of GOOG in the recent past and Buffett has become less anti-tech (with his $10 billion+ purchase of IBM) so who knows.

Anyway, I too think GOOG is a good stock; I have posted on it here before.

2492: Infomart

Here's another "Mothers" market stock I came across in my little CEO book (book of 40 or so "Mothers" market entreprenuer CEOs).  Only this time, something stood out so I decided to look into it a little bit.  In this case, the news isn't good.

When you dig through thousands of tiny stocks, 99.8% of them are going to be garbage so there really is no point in commenting on them.  Trash is trash, so what?  Already, on the Mothers market, I see so much junk; mostly internet related businesses with weak business models etc...  It's also remarkable how all the price charts look the same; like skateboard ramps, only in reverse (start high and comes down like the opposite of a parabolic price chart).

But this one stood out just because of the accounting.   I am no expert on accounting nor am I an expert on software companies, but this one was sort of interesting.  I'm not trying to sniff out frauds and find shorts either (I doubt you can even short most small caps in Japan).

I initially dug into this because it was a profitable company with decent margins and decent returns on capital; something rare in Japan and even rarer in the world of tiny caps.   And the stock price seemed reasonable.

At first, I thought this was an interesting company.  Of course, right from the get-go there is a problem with it as it is a B2B internet business.  They match buyers and sellers in the food industry in Japan, between manufacturers, distributors/wholesalers and restaurants/retailers.  This sounds like a good idea, but there is no telling who will dominate this category in five or ten years.  A lot of B2B's were born in the U.S. too with good-sounding ideas and concepts, but I don't know that any of them have turned into big, viable businesses.

Anyway, the company is Infomart (exchange code 2492) and it looked interesting.

Here are some metrics over the past five years that caught my attention (2006 - December 2010):

              ROE       profit margin           p/e ratio
2006      21.9%     25.7%                      37.9x
2007      18.7%     27.4%                      26.0x
2008      18.0%     25.7%                      14.4x
2009      19.4%     25.9%                      19.6x
2010      18.8%     26.2%                      11.3x

The profit margin here is the ordinary profits (sort of like operating profit).  So you see how this company is worth a look: decent ROE and margins and a price valuation that seems to be coming down.

Sales grew 11.6%/year in the last four years to 3 billion yen and ordinary income grew 12%/year to 795 million yen.  

Here are some charts from a recent investor presentation:

The above chart is the number of users of their B2B platform in the food industry.

And this table shows the trend in sales and ordinary profits over the years.

The current stock price is 139,000 yen/share with a 5 billion yen market capitalization ($65 million), so it's pretty small.  According to Yahoo Finance Japan, it is trading at a dividend yield of 4.8% and a 13.8x p/e ratio and 2x BPS.

Other than the fact that this is an internet B2B business, the figures look pretty good.  So despite my reservations about the business itself, I took a little peak under the hood and then nearly fell out of my chair.

The first thing I noticed was that this thing was eating up a lot of cash.   Here is their cash flows from operations and cash flows used in investing for the last five years:
               
               Cash from              Cash used in
               operations              investing
2006       626                         -320                               
2007       565                         -786
2008       572                         -340
2009       743                         -655
2010       755                         -888

Why is their cash spending so high for an internet business?   I was wondering if the cash used in investing was used to buy marketable securities or something like that, but then saw that most of it was going into purchase of intangible fixed assets.  I scratched my head on this one and then noticed that there was capitalized software assets on the balance sheet to the tune of 2 billion yen as of the end of September 30, 2011.

This 2 billion yen capitalized software expense stood out like a sore thumb because the total net worth of the company at the same time was 2.6 billion and total assets was 3.8 billion!  So a large chunk of the net worth of this business was simply capitalized expense.

In the first 9 months of 2011, ordinary income was 438 million yen and net income was 245 million yen.  Because of this capitalizing of expenses, of course, these figures to me were immediately suspect.  So I looked at the cash flow figures and sure enough, these profits were pretty much 'phony'.

Depreciation in this period (first nine months of 2011) was 453 million, but cash used in investing (purchase of intangible fixed assets) was a whopping 802 million yen.   So net that out and the total capitalized expense comes to 349 million yen.  So if Infomart 'expensed' their software develepment costs, their real profit would have been only 89 million yen.

Suddenly, the high ROE and margin story goes out the window.

Because there is a whopping 2 billion yen of software capitalized on the balance sheet, we already know that this has been happening in prior years.

Out of curiosity, I dug back a little in the filings to see how much of the past earnings might be 'phony' (I put 'phony' in quotes as this is only my opinion; this accounting may be totally valid.  But I looked at some software companies in the U.S.; AMZN in the earlier years, MSFT, CSM, N and I don't see anywhere near this kind of magnitude in terms of capitalizing software expense).

Here are the figures from 2006-2010 (millions of yen):
                        
               Pretax                                  Purchase of intangible       Capitalized              "Real"
               income       Depreciation     fixed assets                        software expense      profits
2006       596             499                   866                                     367                           229
2007       697             388                   544                                     156                           541
2008       660             317                   520                                     203                           457
2009       624             236                   557                                     321                           303
2010       496             157                   291                                     134                           362

So from the above, we see that Infomart earned 3 billion yen in profits over the past five years, but 1.2 billion of that came from capitalizing software development expenses.  This means that the earnings *might* have been overstated by 1.6x if software development was expensed rather than capitalized.

An early Amazon annual report showed that all software development costs were expensed.  In later years, they seemed to have started capitalizing some software costs, but they are nowhere near this in magnitude; at least the capitalized software is not a huge presence on the balance sheet.

I looked at Netsuite too, as it seems to be a similar type of internet based service provider, and they too don't have any capitalized software on the balance sheet.  Salesforce.com (CRM) has some, but again, nothing so big stands out on the balance sheet as it does here.

While this accounting may be totally valid, and Infomart may go on to be a huge success, I don't know.  I would be a bit cautious on this one. 

If you look at the "real" profits in the above table, you will notice that their earnings trend is not as wonderful as it seems on a reported basis.

Also, the figures for the first nine months of 2011 show even more deterioration (more capitalized software expense etc...).

Again, I didn't type this up as a short recommendation or to claim that Infomart is a fraud. 

I am looking at everything this year and when I find something interesting, even if it is negative, I will post about it as a diary of sorts in my 'adventure'.