Thursday, December 22, 2011

YHOO Deal?

There is talk out there that Softbank and Alibaba is going to bid $17 billion for Yahoo's Asian holdings in some sort of tax free deal.  I don't know what the real term sheet looks like, it was just on CNBC.  But let's take a quick look to jot down some of th facts.

Here's the basic information:
(grabbed from the CNBC screen)
  • 40% of Alibaba ($12 billion)
  • 35% of Yahoo Japan ($5 billion)
  • Yahoo keeps 15% stake in Alibaba
  • Tax-free, cash-rich split
  • Yahoo "core" valued at $6/share?

I don't know what the last item valuing Yahoo's core business at $6.00 means. The stub value after deducting the $17 billion on the deal is $2/Yahoo share.

Actually, dividing $17 billion by the 1.24 billion shares I think is outstanding gives $13.70/share, and Yahoo is trading around $16/share so that gives the Yahoo operation a value of $2.30/share.

But actually, the 3Q figures show that Yahoo has cash, cash equivalents and bonds worth $2.87 billion on the balance sheet.  That's $2.31/share, so the market is actually giving the Yahoo "core" business a value of zero.

So here's my math:

Yahoo's Asian holdings:  $13.70/share
Cash, cash eq and bonds on balance sheet at September-end 2011: $2.31/share
Total:  $16.01

Stock price: $16.00

Implied value of core business: $0.00

What is this business actually worth?  Here's some info for the last four quarters of Yahoo's core business:

For the last four quarters through September 2011, Yahoo had total revenues (excluding traffic acquisition costs) of $4.4 billion and operating income of $778 million.  Using a 35% tax rate, that is a net income of $506 million or so and with 1.24 billion shares outstanding that's around $0.41/share in EPS.  This is also very close to free cash flow per share.

At a 10x p/e ratio, that would value Yahoo's core business at $4.10/share giving a total value of $20.00/share or so for the whole of Yahoo (including the Asian holdings).  I think I heard an analyst mention the value of Yahoo at $20/share, so this calculation is not far off.

If you assume a 10% free cash flow yield for Yahoo's core business, we can get a similiar figure. With free cash flow in the past four quarters of $560 million, that's $4.51/share, so not too far off from using a 10x p/e multiple (which gives a $4.10/share value).

As of the end of the third quarter, Yahoo's guidance for the 4Q 2011 was:

Revnues: $1,125 - $1,235 million
Operating income:  $200 - 260 million

Using the midpoint of this guidance, you get 4Q 2011 revenues of $1,180 million and an operating earnings figure of $230 million.

So doing the above exercise using a 2011 fully year projection would result in a figure that is pretty close to the last four quarters.

The problem with the above analysis is that revenues at Yahoo has been declining 4-6% year-over-year in the past four quarters.  If this trend continues, it's possible that Yahoo may not be worth the above.  It may well be worth much less.

Tuesday, December 20, 2011

JEF Up 20%

So it's nice to see Jefferies Group (JEF) stock up 20% today to just over $14.00 after dipping below $10.00 at one point in November.

Despite the panic and near-run on JEF due to a faulty report be Egan-Jones, JEF managed to make money in the quarter.  The market is relieved and the stock price is showing it.

I won't get into details on the quarter or yearly earnings announced today, but there was an interesting comment on the conference call:  JEF said that this 'issue' of misinformation and misunderstanding in the quarter really disrupted their business and that if this didn't happen, they might have had yearly earnings of $400 million and revenues of $3 billion or so.

That would have been $1.81/share giving JEF a valuation of less than 8x p/e even at the current price of around $14/share, and an ROE of 11.7% and a return on tangible book value of 13% which is not bad at all in this environment.

Of course, there is no guarantee that that is what JEF would have earned.  I think they just looked at the run rate revenues and earnings up until the panic set in when they had to take measures to shrink the balance sheet and deal with a market where customers fled and counterparties hesitated etc...

Anyway, I don't own JEF but I am still bit shocked at the incompetence and carelessness of Egan-Jones in publishing such a sloppy report and his refusal on live TV to admit the error.  An admission of error would be a blow to the credibility, of  course, to Egan-Jones but his refusal to admit a simple mistake to me is much more enlightening and scarier.

Again, this sort of really explains some of what happened during the upside of the credit bubble, and now these same organizations threaten to cause panics and runs at totally viable institutions.

I am more in favor of restructuring this industry than ever before having been supportive of them over the years (even though I would never depend on their research or opinion of anything).

BRK at a Discount?

Every once in a while, I hear this idea where you can buy Berkshire Hathaway stock at a discount.  There are apparently some closed-end funds (CEF) that own a lot of Berkshire Hathway (BRK) stock and they trade at large discounts to net asset value (NAV), so therefore you can buy BRK at a discount.

I usually respond the same way I respond to most CEF ideas; most of them deserve to trade at discounts, or even at deep discounts (see "Hedge Funds at a Discount? post).

The funds I'll look at here are the following:

BTF:  Boulder Total Return Fund
BIF:   Boulder Growth and Income Fund
DNY: Denali Fund

What all of these three have in common is that they are run by Boulder Investment Advisors and own a lot of Berkshire Hathaway stock.  Boulder Investment Advisors is run by a guy named Stewart Horejsi who is a Berkshire almost-billionaire.  He inherited the family welding business but instead of reinvesting the profits into the business, he used the profits to invest in BRK, starting in the early 1980s.

He sold the business in 1998 or so and has been a financial guy ever since.  One article said that he owns $400 million worth of BRK stock and another said he owns $600 million worth and is the tenth largest BRK shareholder.  Either way, that's a lot of BRK stock, and he has done well for himself. 

One of his things is to buy closed-end funds at a discount and then replace the investment advisor with his own company, buy a lot of BRK and other value stocks.

Buying CEF at a deep discount is certainly not a bad idea, but it really works great when you take over the investment advisor function because then you get to pay yourself advisory fees.   But more on that later.

First of all, let's take a look at how these funds have done.

Here are the long term return figures from the recent annual reports for these funds:

For years ended May 31 (annualized returns):

                                   3 year         5 year           10 year
BTF                           -0.2%          +3.0%           +4.6%
BIF                            +2.8%         +6.5%

S&P 500 index          +0.9%         +3.3%           +2.6%
BRK                           -4.1%         +5.2%           +5.6%

For BIF, since the new advisors took over in January 2002, they list the annualized return since then which was +6.5%/year versus +3.9% for the S&P 500 index and +5.2% for BRK for the same period.

Since DNY has a different year-end, I will list it separately below:

For the years ended April 30:
                                  3 year           5 year                                
DNY                         +2.3%           +1.4%
S&P 500 index         +1.7%           +3.0%
BRK                          -2.3%           +7.0%

So from the above, we see that these funds have outperformed the S&P 500 index in some time periods.  I was initially impressed that the BTF outpeformed the S&P 500 index over ten years; +4.6% versus +2.6%, but then realized that of course BTF is going to outperform the S&P 500 index if it owns a lot of BRK.  And if BTF is going to be a way of buying BRK at a discount, then the relevant comparison must be against BRK, which anyone can buy in the market without having to pay advisory fees. 

This is where this idea sort of starts to fall aparts.  BTF over ten years returned a decent looking 4.6%/year, better than the S&P 500 index, but did worse than BRK itself.  So the question is, why bother?

BIF has seemed to do better; +6.5%/year for five years versus +3.3% for the market and even better than BRK which returned 5.2% during the same five years.  Since Boulder took over management of this fund in January 2002, they also outperformed both the S&P 500 index and BRK (+6.5%/year versus +3.9% for the market and +5.2%/year for BRK).

BIF does look slightly better than BRK over this time period, but with such high fees, I would still go for BRK instead of BIF if you want exposure to BRK.  Cost will kill you in the end, and there is no telling what BIF will do in the future.   Over time, it looks like BTF did no better than BRK, and it is really not very clear why BIF would do better; I haven't really dug into what drove the difference in  returns between these funds.  I am more interested in looking at these as proxies for BRK at this point.

Also, DNY looks like it is underperforming both the S&P 500 index and BRK over the past five years.  Again, if there was some more consistency in outperformance by Boulder Investment Advisors, there may be a reason to own these funds.  But a quick look shows that if you want to own BRK, you should just own BRK.  Deep discount?  I will look at that later.

Here are some basic information about the funds:

                 Net                expense           BRK as %             Horejsi ownership
                 assets             ratio                of fund                  percentage
BTF          $247 mn        2.11%             37.1%                   42.15%
BIF           $202 mn        1.93%             25.3%                   33.88%
DNY           $81 mn        2.72%             18.5%                   18.50%

You will notice that these funds have large ownership positions by Horejsi and their affiliates.  This is how Boulder Investment Advisors became the advisor for these funds in the first place.  There is nothing wrong with that, but there is an issue of conflict of interest which I'll get to in a second.

Also, these funds do own a large position in BRK.  This is no surprise as Horejsi is a big fan of BRK and has done well with it over the years.  No problem owning what you like, of course.

Deep Discount
OK, so now we get to the gist of the story.  What makes this interesting to people is the discount that these funds trade at versus net asset value.  Mutual funds, of course, are bought or redeemed at net asset value; whatever the fund was worth on a per share basis on the close of the date you buy or redeem. 

However, closed-end funds typically can't be redemmed and can only be bought and sold on the stock exchange.  Therefore, what you get upon selling simply depends on what someone else is willing to pay for it.   Most of the time, this price will be much less than net asset value (ETF's are slightly different; there is a share creation/redemption feature that keeps prices closer to the NAV due to active arbitrage).

The discount to NAV of these funds as of now are (current price versus NAV as of Friday's close as NAV is published only once a week) :

                                                               current             3-year
                       NAV           price            discount           average discount
BTF                $18.54        $15.00           -19.1%           -18.06%
BIF                   $7.18          $5.61           -21.8%           -18.50%
DNY              $17.35         $14.40           -17.0%           -17.01%

These funds do trade at a discount to NAV.  Just off the top of my head, I tend to think CEF's typically trade at anywhere between 10-20% discount to NAV, so this doesn't look any different. 

Some will argue that the holdings in these funds are highly liquid and include high quality stocks like BRK, so it shouldn't trade at such a deep discount.  However, the last column shows that this is very typical of these funds; these funds (like most others) trade at a discount to NAV.

Will the Discount Close?
So here's the question:  How and when will this discount close?   First of all, going back to my contention that CEF's deserve to trade at a discount due to their high fees, that seems to be the case with these funds.  The expense ratios on these funds are, from one of the tables above, anywhere from 2% to close to 3%.  Those are very high and I would slap an automatic 20%-30% discount just to cover those fees.

Activists have in the past bought large stakes in closed-end funds to try to force a liquidation.  Of course,  these funds too started their new life from an activist action:  Horejsi himself buying up shares and then voting himself in as the investment advisor.

With Horejsi owning so much of each of these funds, it is highly unlikely that an activist will succeed in forcing a liquidation of these funds.  Phil Goldstein of Bulldog Advisors (who specializes in buying up cheap CEF and forcing liquidation or some sort of value enhancing transaction) has tried with one of these funds back in 2006 or so and didn't succeed.

Why would Horejsi not liquidate these funds, buy back shares at a deep discount or distribute the BRK shares to shareholders?  Because all of these actions would reduce net assets of the funds.  So what?  Because a reduction in the net assets of the fund will reduce the fees his advisory company receives!  

They will do what's best for themselves, which is a status quo.

Now we begin to see why CEFs often do rights offerings even when it makes no sense (prices are below NAV); they just want to increase assets under management and increase fees.  I don't think any of these funds have done that, but others have done so and this also explaines why there is almost always a big discount to NAV for CEFs; the managers/advisors' interests and fundholders' interest are not aligned.

This is not to say that Horejsi is dishonest or unethical.  There have been some controversy on this issue (you can google the name and you will see some debate). 

For me, it really doesn't matter.  It is totally plausible that Horejsi is doing what he really thinks is right and thinks his fundholders will benefit, even after paying such hefty expenses.

But we can't really argue that this isn't a really, really good deal for Horejsi and his family; they buy a bunch of a fund at a discount, vote themselves in as advisors and direct business to themselves etc...

What happens? 
  • They still own the assets they want to own (they just own it through a CEF), so they don't give anything up by owning the CEF
  • They don't mind the high expense of the CEF because they are just paying themselves and
  • For the assets in the fund that they *don't* own, they earn the fees as an added income stream on top of their investments in the fund.
Sure they have some expenses to deal with as managers/advisors of the fund, but the additional fee income should more than pay for that.

So in a sense, they are leveraging their own investments through these structures and are building an increasing (as they do more of these deals) stream of income.  It's a very good business for them.

As for the rest of us?  We're probably way better off just sticking to BRK.

Friday, December 16, 2011

FOFI: Hedge Funds at a Discount?

I am not a big fan of closed end funds, but if something is trading at a steep discount, we have to take a look.  In general, a lot of funds have expense ratios in the 1%-2% range, sometimes higher.  So in my mind, they deserve to trade at a discount to net asset value (NAV).

I use a simple 10% for my discount rate for most things, and this 'expense' to me is worth 10%-20% of NAV (2% expense ratio / 1% = 20%).

Of course, if the fund is going to outperform the market or whatever index by at least 1 or 2%, then that's a different story; it may be worth it.  But most of us who have been in the business for a long time know that most closed end fund managers are not going to outpeform anything.

Anyway, this one is interesting because 50% of the assets are invested in hedge funds.  Now, when people say "hedge funds", people do tend to get excited imagining 20% or 30% performance uncorrelated with the stock market.  But we also know that *most* hedge funds won't do too well.  Only a handful of the top funds are going to do well over the long haul, and that lists tends not to grow as quickly as the ones that try and fail.

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

First Opportunties Fund (ticker: FOFI)
This fund is interesting.  Until last year, some time in the spring of 2010, this was a normal financial sector equity fund run by Nicolas Adams of Wellington Management.   And then at some point early last year they decided that they will reorganize the fund to be able to invest 50% of the assets into hedge funds (run by the same Wellington Management; I think one of the hedge funds is now run by Nicolas Adams).

And then the SEC apparently didn't like that a NYSE, publicly listed equity fund is going to turn into a sort of conduit for individual investors to be able to invest in hedge funds (you have to be an accredited investor to invest in unregistered private investment partnerships).  Apparently under pressure from the SEC, the NYSE delisted FOFI and now FOFI is a pink sheet stock.

Since at least one of the hedge funds is run by Nicolas Adams, let's see how he has done over the years.  I assume the return figures through March 2010 is the 'old' fund (before reorganizing), because the shareholder vote took place after that.

I cut and pasted a table from an annual report and it doesn't fit the width of this blog, so I had to just cut and paste the figures; the labels won't fit so I will place that on top of the table (don't know how to line them up side-by-side, sorry)

The bottom line seems to be that over time, this fund has done well, gaining 12.2%/year over a 10 year period compared to the S&P 500 index being down -0.7%/year.  This is not bad given the huge financial crisis which occurred during this period. 

However, the fund does seem to have lagged the S&P 500 index in all other periods.  But again, that is not suprising given the financial crisis that just happened.  In fact, the fund has outperformed the financial sector indices in all periods periods from 1 year, 3 year, 5 year and 10 years. 

To get more color on this fund going back, I pulled some performance figures going back as far as I can from SEC filings.  Nicolas Adams seems to have been the manager since the mid 1990s, at least.

So going back all the way to 1996, the fund has returned an average +7.74%/year versus an 8.22%/year return for the S&P 500 index.  It looks very volatile having had great years in 1996-1998 and then tanking hard, almost 70% in 1999-2000 and then coming back strongly in the early 2000s until getting hammered in the financial crisis.

I actually don't really know what to think about this performance as it is a sector fund; Adams does seem to have outperformed the sector indices in the above cut and paste from the 2010 annual report.

So wht the reorg?  I don't want to get into the specifics of exactly what happened (advisors/subadvisors changing etc...), but I think the change occured lead by Stewart Horejsi, whose entities own (and have owned) 36.4% of FOFI.   Securities filings show that his entities have owned 30-40% of FOFI at least back into the 90s, so this is not something he picked up during the recent financial crisis.

I may research and write more about Horejsi later, but for now let's just say he is a value investor that likes to buy closed end funds at steep discounts and take over the management of the assets.

This reorganization too was presumably lead by him.  This may be due to the volatility of the fund itself; having gone down 70% once in the late 90s and by more than 50% again in the recent crisis.

There is obviously a little boom in non-correlation, and moving assets out of long only stocks into 'hedged' or non-correlated assets like hedge funds sort of fits that trend.

As I said above, one of the hedge funds is managed by Nicolas Adams, who has run this fund before the reorganization.  The difference is that he will be running it as a hedge fund, meaning that he will be buying and shorting financial stocks.

This can be a good or a bad thing.  Back in the old days, I've heard of many people go from mutual fund, long only strategies to long/short only to not do too well.  Short selling stocks is a very tough and tricky game and it does take a different kind of temperament to deal with it.

My impression over the years has been that I tend to think that this conversion from long only investing to long/short strategies don't usually go well.  As evidence, look at all those long/short funds that mutual fund companies offered over the years; I don't think too many of them have good performance track records even though the mutual fund companies have a lot of great research infrastructure to support that kind of business.  I think it's just a whole different mindset and it's hard to switch over.

I could be wrong about that.  I haven't done any research to prove this, so it's just a guess.  I wouldn't necessarily be wildly excited about someone who has managed long only for many years suddenly going long/short.

Of course, I have no idea how this Nicolas Adams is, so it might be that he has in fact been running a long/short portfolio for Wellington all along and may be very good at it.  But if that is the case, we don't have information to support that either.

The 2010 proxy does say that the board has been studying Wellington (and presumably it's hedge fund business) for eight years, so the performance must be pretty good. The proxy does state that the process to invest in Wellington's funds started in 2008 or so as they were looking for a way for FOFI to get more investment flexibility including being able to short. So the 2010 switch occured after a couple of years of work after figuring out how legally to get it done.

So How Has it Gone?
The new advisors took over in June 2010 and the realloaction process began then. Since then and through September 2011, this is their performance:

FOFI:         +1.8%
S&P 500:   +5.0%

This is the annualized return since June 2010 through the end of September 2011. Of course, this is way too short a time period to evaluate anything.

As of 12/9/2011 (closed-end fund companies only annouce NAV once a week) the net asset value per share of FOFI was $8.58/share and it is trading now at around $6.14/share for a discount of 28.4%.

Half of the net assets are invested in a group of hedge funds; I won't list them here as I don't have any information on them so it wouldn't mean anything (all holdings are listed in the FOFI reports to shareholders).

Going forward, this fund will no longer be a financial sector focused fund; the new advisor (entity run by Horejsi) is having Wellington Management liquidate the legacy portfolio (banks, thrifts and savings and loans) while Horejsi buys large positions in stocks like Johnson and Johnson.

If only I can figure out the return potential of the hedge funds, this can be an interesting idea, particularly at a close to 30% discount. It's important to remember, however, that closed end funds do typically trade at a discount of anywhere from 10-20%.

If exposure to hedge funds is the objective, I would prefer Greenlight Reinsurance (GLRE) now at a reasonable valuation as David Einhorn does have a very public, good track record.  Also, hedge fund operators often do better than the fund themselves due to the operating leverage of running a money management business.  As assets under management (AUM) grows and costs remain stable, additional fees can all fall to the bottom line.  I will look at some more asset managers in the future.

In further posts, I may look more into Stewart Horejsi and his other entities that people sometimes recommend as a way to play Berkshire Hathaway at a discount (Horejsi is an early Berkshire Hathaway shareholder; he made is wealth with it and has since become a full time value investor working with these entities. The entities, by the way, are ticker symbols BIF, BTF and DNY (and maybe some others).

Wednesday, December 14, 2011

So What is BRK Really Worth? (Part 4)

In Search of Premium to Book Value
So in the last post, we found that the deferred tax assets (unrealized capital gains on stock holdings) is deducted from BRK's total shareholders' equity and not from the insurance segment shareholders' equity.  So when figuring the total value of BRK, the deferred taxes can be added back.

Now we have to look at the other segments to see what the ROE's of those segments are.

Manufacturing, Services and Retailing (MSR)
This segment includes all of the wholly owned operating businesses outside of railroads (Burlington Northern), Utilities and Energy (MidAmerican) and Finance/Financial Products (mobile home loans, derivatives etc...).

This includes the retailers like Nebraska Furniture Mart, See's Candies, Dairy Queen, manufacturing like Marmon Group.  OK, here's a snip from the annual report:

There's a lot of stuff in there.
But at the end of the day, what really matters?  For his simple, base case analysis, ROE is what we want to know.  What is the ROE of this segment?  It's nice to know that See's Candies is an amazing company, and things like that, but let's see how this group as a whole performs financially.

This segment is included in the "insurance and other" on the balance sheet of BRK.  But further into the annual report, the balance sheet and revenues, pretax and net incomes are broken out.

Let's see how this segment looks overall in 2010:

MSR Segment
Shareholders equity:  $31.6 billion
Revenues:                  $66.6 billion
Pretax income:            $4.3 billion
Net earnings:               $2.5 billion

Segment pretax margin:  6.5%
Segment ROE:  7.9%

So this segment earns a 6.5% pretax margin and an ROE of 7.9%.     What would you value a company that earns 7.9% ROE?  I would typically *not* award that company with a P/B ratio of 1.0x.  I would demand a discount to book such that the return to me would be 10%.  Again, that is being conservative.

But after all this talk of how wonderful See's Candies is and how many businesses are worth way more than book, how come this segment overall has only a single digit ROE?  It is not so compelling.

It's true that the housing sector is in a 'depression', so the earnings there and others are depressed.  So just as a sanity check to see what the ROE might be in a more 'normal' environment, I went back to look at the ROE of this segment in the period 2005 to 2007.  By any measure, those were great years, if not bubble years.  When you look at most companies, you would expect their best performance in those years, especially ones that are dependent on the economy.

So here is the shareholders equity, net income and ROE of the MSR segment in those three years:

             Equity             Net income           ROE
2005     $16.8 bn          $1.6 bn                 9.5%
2006     $22.7 bn          $2.1 bn                 9.3%
2007     $25.5 bn          $2.4 bn                 9.4%

So we see that even in the best of times, the segment earns a little less than 10% ROE.  This is not bad, of course.  But does the business/segment merit a valuation higher than book value?

The conservative side of me says no.  Let's be generous and assume that the segment ROE will eventually get back to close to 10% and give the segment a valuation of no more than book value.

On that basis, this segment is not a source of premium to book value of BRK as a whole.

Railroads, Utilities and Energy (RUE)
The other large segment is this one.  I only break it down this way as this is the way it's broken down in the annual report balance sheet.  Railroads, of course, is Burlington Northern that BRK purchased recently, and utilities and energy is MidAmerican.

Both of these areas is highly regulated and capital intensive.  They are businesses with decent returns on capital, but not great returns.  Burlington Northern, for example, had a return on invested capital of around 10% or so before being acquired by BRK.  Utilities also are highly regulated and won't earn very high returns on capital, but they will earn decent returns.

The shareholders' equity tied up in this segment is $69.6 billion versus a total net income of $3.6 billion for a segment ROE of 5.2%.

This is not that particularly high, of course, because of the Burlington Northern purchase.

Is this segment worth more than book value, the value it is held on BRK's balance sheet?  I may be missing something, but otherwise, an ROE of 5.2% doesn't seem to me to merit a premium to book value.  Using an annualized figure of the 9 months year-to-date figure doesn't change it much.  The equity in the RUE segment (which isn't actually a single segment) was $71 billion at the end of September 2011 and the net income for the first nine months of the year was $3.0 billion.  Annualizing that by multiplying by 4/3 gives an annualized net figure of $4 billion for an ROE of 5.6%, not much different than 2010.

So it may even be generous to give this segment a 1.0x book value ratio, but let's leave it there.  We can adjust down later.  Let's call the value of this segment $69.6 billion.

Finance/Financial Products
OK, this segment is a bit strange.  This is where BRK's odds and ends are put in, like the stock market index put options and credit default swaps.  But the main business here is the mobile home loan business and maybe some other stuff.  It looks like this segment earns around $440 million/year.  Oddly, the derivatives mark-to-markets and oddball bets like that go in a separate p/l line while the assets/liabilities are actually booked in the segment.

So instead of looking at book value,  I will just put a 10x multiple on the $440 million net earnings of this segment, which looks pretty stable for a value of $4.4 billion.

This ignores Buffett's oddball bets here and there and puts zero value on those.  Since it is not a major factor in the valuation of BRK, I think it's OK to ignore those bets.

Putting it All Together
So let's summarize what we just looked at. 

Segment           Value            ROE
Insurance         $96.4 bn        10.0%    (pretax assuming 10% return on stocks)
MSR                $31.6 bn          7.9%    (after tax, in better times this can be closer to 10%)
RUE                 $69.6 bn          5.2%    (after tax)
Finance            $  4.4 bn           --        (simply used 10x net earnings)
Total:                $202 bn

With 1.65 million shares oustanding and with the above analysis, BRK stock is worth around $122,400/share.

The stated book value per share as of the end of 2010 is $95,453/share around so the above intrinsic value is around 1.28x stated book value per share.  Much of that is due to the deferred tax asset that is deducted from BRK's shareholders total equity but not from the insurance segment equity (as discussed in that section of my comments), and a little bump up due to my valuing the Finance/Financial Products segment at higher than stated book value.  The stated book value is a strange thing as it includes marks as the assets and liabilities of derivatives are booked there.

With the above insurance segment ROE possibly being as low as 6.5% (after tax) and other low ROE segments, I'm sure many will assume this 1.28x stated book value valuation is high.

However, counter to that argument is that this doesn't at all incorporate float growth which can allow BRK to grow without adding equity capital.  This would be additive to the above ROE figures.

In any case, this is just another way to look at the valuation of BRK and I am comfortable that this level of $122,400/share or roughly 1.3x book is a good rough estimate of the intrinsic value of BRK.

So What is BRK Really Worth? (Part 3)

In Search of a Premium to Book Value
We looked at the two column method of BRK valuation and saw that yes, BRK is in fact cheap trading at 20-30% less than something like $150,000/share in intrinsic value.

However, we also noticed that if you value the investments held on BRK's books dollar for dollar, the expected return on that piece of BRK is not that particularly high. 

BRK followers often say that BRK is worth more than book value.  Buffett himself has said numerous times that BRK is worth far more than book value as book value doesn't take into account a lot of value created in the operating businesses over the years.  A favorite example is See's Candies, which BRK has owned for a long time and is obviously worth a lot more now than what it is valued on the balance sheet.  Another example is GEICO; Buffett says that GEICO is on the balance sheet at book value, but the goodwill of the business has grown dramatically and that is not reflected on the balance sheet.

However, I never really thought hard about the source of the premium to book value very specifically; for example, which segments deserve to be valued at a premium to book and by how much?

In order to figure this out, I decided to take a look at the ROE of each of the segments to see if in fact any of the segments should be valued at a premium to book, and if so, by how much.

The result of this digging has been a little surprising to me.

BRK, the Insurance Company
Here I'll start with the insurance company.  I have often wondered what the valuation of the insurance business should be if it was treated like any other insurance company.  Most BRK followers would tell you that it's impossible to compare as BRK is a different animal:  the investment side is run by the greatest investor of all time and the insurance underwriting side has managed to earn profits over time which is very rare in the insurance business.

I accept that argument, but let's see what the implied ROE of the insurance business is; how much is that investment prowess and underwriting excellence actually worth to shareholders?  What's the point if it's not going to earn a high ROE?

To figure this out, we can calculate what the expected returns on the investments are, assume some sort of underwriting profit and then see what the ROE of the insurance business is.  If the ROE is higher than 10%, then the insurance business may be worth more than book value, and if less than 10% it may be worth less than book value.  Anywhere around 10% would mean the insurance business is worth around book.

First, let's look at the various pieces of the insurance operation.  It's a little confusing at first because in the annual report balance sheet, the insurance segment is put into a section called "insurance and other" segment, but this includes the "manufacturing, services and retailing" segment.  So in order to look at the insurance business on it's own, we have to deduct the assets and liabilities of this segment in order to get the shareholders equity committed to the insurance operation.

Once we get that, all we have to do is add up the expected investment return on the investment portfolio held in the insurance business, add an assumed underwriting profit (it would be more conservative to assume breakeven insurance operations, but let's keep that in for now) and then see how much that amounts to compared to the insurance segment shareholders equity to get an ROE of the business.

From the 2010 annual report:

Shareholders equity in insurance segment:  $96.4 billion

Total investments
     Cash:       $25 billion
     Equities:  $60 billion
     Bonds:     $33 billion
     Other:      $19 billion
     Total:       $137 billion

Earned premiums in 2010:  $31 billion

So here is a sort of expected return on the investments:
    Cash:           $0  (0% interest rate)
    Equities:      $6 billion (10% return on stocks)
    Bonds:         $660 million (2% yield)
    Other:          $1.9 billion  (10% coupon on Bank of America preferreds etc...)
    Total:           $8.6 billion

BRK's underwriting profits since 1996 has averaged an after tax 2.2% of earned premiums, or a pretax 3.4%.

So using the a $31 billion earned premium figure for 2010, that's an underwriting profit of $1 billion.

Taking the two together, the insurance business would earn around $9.6 billion/year.  Compared to the shareholders equity of $96.4 billion, that's an ROE of 10%/year.  Some will argue that the 10% expected return on stocks is too high as BRK only owns the largest of the large cap names.  A figure of 6-7% is often tossed around.

If we take the expected return on stocks down to 7%, then the ROE of BRK's insurance business would come down to around 8%.

Is this business worth more than book?  Strictly speaking, I would think it's worth around book.  But keep in mind that this is a static analysis; it doesn't take into account things like growth in the business.  If the insurance business is overcapitalized and it can grow float and therefore increase investment and underwriting returns without raising more capital, that would obviously boost ROE.

However, when I value things, I like to look at returns on a static basis and get that 'growth' for free and not have to bake it into the cake.  So from that point of view, valuing BRK's insurance business at book value, to me, is very conservative, but not totally unreasonable.

Munger himself has also said that after growing float at such a high rate in past decades, it is unreasonable to assume that BRK can keep growing float like that.

Insurance Segment Taxes and Shareholders equity
The above analysis is a good sketch of how the insurance business works and how much BRK can make, but there are a couple of points to keep in mind.

First of all, the shareholders equity of the insurance segment would be reported differently at other insurance companies.  The fact is BRK reports $36 billion of deferred tax liabilities for unrealized capital gains on the stock portfolio.  This is not deducted in the above figures because BRK reports this liability outside of the insurance segment.  I think that's because BRK considers this liability an interest free loan from the U.S. government; it doesn't have to be paid until they sell stock with a very low cost basis.

If you deduct this $36 billion from the above segment shareholders equity, it would boost ROE, of course.  The fair value of the insurance business would then be 1.6x book value of the insurance business after deducting deferred taxes.  You can either call it 1.6x book value, or book value plus deferred taxes (which I prefer as this is the way the insurance segment is reported in the annual report; before deferred taxes).

Is it reasonable to not deduct deferred taxes?  Since BRK rarely sells stocks, it is not completely unreasonable.  If that is the case, then the fair value of BRK's insurance business is the segment shareholders' equity as reported on the balance sheet before deducting the tax liability (however, when valuing BRK as a whole, we would then have to not forget to add the taxes back as it is deducted 'below the line' in the annual report balance sheet).

Also, the above figures are pretax.  After tax, 8-10% ROE would translate into 5-6.5% returns.  This may be slightly higher as the equity portfolio would compound pretax as they don't have to pay taxes until they sell.

Either way, I think it is fair to assume that the insurance segment is worth 1.6 book value net of deferred taxes, or 1.0x book without deducting deferred taxes, or around $96.4 billion.

I am sure many will be surprised that it is not worth far more, but it's important to remember that back in the early 1990s BRK's equity holdings were 140%-150% of the insurance segment shareholders equity and even more than BRK's shareholders equity.  That's a lot of upside leverage to the stock-picking skills of Warren Buffett.  Just imagine, whatever he can pull off in the stock market lead to a levered return to BRK shareholders due to the size of the stock portfolio being bigger than the entire net worth of the company!

Now, however, the stock portfolio is only around 50% of the insurance segment shareholders equity (before deducting DT) and 38% of BRK's shareholders' equity.

It's easy to see how the expected return back in the early 1990s, just on this fact alone, was far higher than it is today. 

Conclusion to Part 3
So we decomposed the expected ROE of the insurance segment and we can put a value on it of around segment shareholders' equity of $96.4 billion.    The fair value book value ratio is lower (1.0x before deferred taxes or 1.6x after deducting deferred taxes) than we would have imagined largely due to a smaller stock portfolio as a percentage of net worth (less investment leverage from stocks) than in the past. 

In any case, here we find one source of premium to book value of BRK.  The insurance segment ROE as reported in the annual report is 10% or so, but that didn't deduct deferred taxes.  This means that the deferred taxes deducted outside of the segment should be added back in thus becoming one source of the premium to book value of BRK.   More on this later.

Tuesday, December 13, 2011

So What is BRK Really Worth? (Part 2)

Let's look at the basic model for valuing Berkshire Hathaway.  It's the model that is endorsed by Buffett himself in his annual reports.

BRK basically breaks down into two basic components: 
  1.     An insurance company
  2.     A bunch of wholly owned operating businesses.

In what is usually called the two column valuation method, the insurance business is assumed to be worth the total investments held in the insurance segment.  Since they do at least break even on underwriting insurance (float cost of zero or better), then the profits that the insurance company makes will simply be the investment returns on their investment portfolio.  Therefore, the insurance business is simply worth whatever investments it owns.

I will look at that in more detail in a later post, but for now let's just take that as a reasonable assumption.  Buffett is no promoter-type; he wouldn't advocate something that wasn't reasonable if not conservative.

So the insurance segment is valued simply as total investments per share held.

The other operating business segment is valued simply at some multiple of the pretax profits of the operating business; this includes all businesses that BRK owns outside of the insurance business and is not included in the total investments in the insurance segment (which is cash, bonds, equities and other securities).

So the instrinsic value of BRK is calculated simply by adding 1. the total investments per share and 2.  some multiple of the pretax profits of the operating businesses.

From the 2010 annual report, we see that investments per share representing the insurance operations was $94,730/share (per A-share).

Also, the pretax operating earnings per A-share was $5,926/share.  Just as a quick check, I looked at what the net (after-tax) profit was of the non-insurance businesses and that came to $3,964/share, or around 67% of the pretax number.  Some people use a 35% tax rate to adjust the pretax earnings number to get a quick estimate of the net figure and we see here that this is not far off.

What is the Intrinsic Value of BRK Using the Two Column Method?
With the above figures, it's easy to calculate the intrinsic value of BRK.  First, the investments per share is worth just that, investments per share.  That is:


To calculate what the non-insurance operating businesses are worth, we have to find a multiple to earnings.  Since people look a lot at p/e ratios and p/e ratios are based on net earnings, let's use the net earnings per share figure above, which is $3,964/share.  The long term market p/e and recent p/e ratio too of the stock market happens to be around 15x p/e, so let's say BRK's operating businesses are at least as good as the average company.  So using 15x p/e gives the non-insurance operating business the following value:

$3,964 x 15x = $59,460/share

So summing the two gives us an intrinsic value of: $154,190/share

With BRK shares now trading in the $110,000/share - $120,000 per share range, we see why many BRK fans see it as undervalued and attractive; it is trading at a 20-30% discount to it's intrinsic value.

But Here's the Problem
OK, so that's an overstatement.  This is not really a problem, but just something that I would like to point out.  We take it for granted that the investments per share are actually worth investments per share.  Well, of course it is.

But we have to look at what's inside of that.  I think some people assume that because Warren Buffett is investing those assets, that the return is going to be pretty high.  Others may assume that most of that is in equities so it can do well in a bull market.

This is true to an extent.  Buffett will outdo most others in investing the insurance assets.  But as we have seen in the other post, we know that BRK will not invest all investments into equities; they will own a lot of that in cash and bonds, and in this low rate environment, if it continues, will lower expected returns on this "investments per share" portion of BRK's intrinsic value.

The total investments in the insurance segment of BRK was $137 billion and that broke down as follows:

Cash:      $25 billion
Bonds:    $33 billion
Equities: $60 billion
Other:     $19 billion

We know that bond yields are as low as 2% out to the ten year, and cash rates are basically zero.  The "other" section has special securities, often with a 10% coupon (like the Bank of America preferreds, previously the GE and GS preferreds with 10% coupons etc...), so I will assume the "other" earns 10% pretax.

The equities is the stock portfolio.  Let's assume a generous 10% return on equities over time.  Since BRK only owns the largest of large cap stocks, some may argue that 10% is way too high.  Many are expecting 6-7% returns for large company stocks.

But let's just use 10% for now.  What is the blended, expected return on this total portfolio?

Cash return:   $0
Bonds:           $660 million  (2% yield)
Equities:        $6 billion (10% return)
Other:            $1.9 billion (10% coupons)
Total:             $8.6 billion

Total percentage return:  $8.6 billion / $137 billion = 6.3%

If you lower the equities expected return to 7%, then the total portfolio expected return drops to 4.9% or so pretax.

So if you value BRK using total investments per share, then that portion of the stock will return to you only something like 4.9%-6.3% pretax over time.

This is certainly not a bad return given that bonds yield only 2%, but I don't know that the average BRK investor expects such a modest return on the investment portfolio managed by Buffett himself.

Buffett and Munger will tell you that there is nothing wrong with 5-6% returns, and to expect more is folly in this low rate environment.   Fair enough.

But equity investors like to invest in businesses with high returns on equity.  With lower interest rates reducing the return on equity of insurance and other financial companies, I don't think it's wrong to value them a bit lower. 

Again, this is only relevant and an issue when low interest rates may persist for a long time like in Japan, and I am more and more leaning towards that scenario (this is the reason why I am doing this whole exercise in the first place).

If equity investors demand 10% return on their investments, which to me is not that unreasonable even now, then it would not surprise me in the least if the market didn't give full credit to the total investments per share at BRK (for example, the market may demand a discount to the portfolio such that the portfolio expected return does go to 10%.  In this case, a discount of as much as 50% would not be too surprising; with a 50% haircut on the investments per share, the BRK total intrinsic value would fall to $106,825/share.  This means if you paid this price, you could expect a 10% return on the investments per share portion of BRK and pay 15x p/e on the operating business).

However, all of this analysis is based on a static analysis.  Another factor that will *increase* the expected return over time will be growth in float.  As float increases over time, the investments per share will also increase on top of whatever is earned in terms of capital gains, interest and dividends.

Float has grown tremendously in the past at BRK, but Munger has argued that it would be unreasonable to assume that float can keep growing as they get bigger.

In the next few posts, I will take a look at the book value of BRK by segment, the return on equity (ROE) by segment and see if it is reasonable to assume that BRK trade at over book value per share.  I myself find 1.5x book value a reasonable valuation of BRK based on some of the popular, basic models.

But I want to sort of look under the hood to see where this ROE is coming from, which segments should be valued above book value etc...

So What is Berkshire Hathaway Really Worth? (Part 1)

I've been thinking a lot about Berkshire Hathaway (BRK) lately.  It's still one of the best investments out there for most people.  I don't think it's the highest return investment around, but an investment in Berkshire Hathaway at the current price is far better in my mind than owning the S&P 500 index or most actively managed mutual funds.

There is really no need to elaborate on why BRK is a great investment; there are plenty of blogs, books, articles and surely tweets about what a wonderful thing it is.

But I got to thinking a lot about the current low interest rate environment, which lead me to think about insurance companies and then of course how that applies to BRK.

First, a quick look at the 'mechanics' of an insurance company.

How Do Insurance Companies Work?
I am no insurance expert, but basically insurance companies collect premiums from customers and then get to keep that premium until some event forces the insurance company to reimburse the customer for damages.  This amount of premium that the insurance company holds is called float. 

If an insurance company can price their insurance policies correctly, their losses will be covered by their premiums.  In other words, their underwriting profits will break even or make money.  Most insurance companies, though, don't make money over time, but lose it in underwriting.  But that's often OK as long as they make more money on their investments; in other words, if the insurance company invests the float profitably, that will often more than pay for the underwriting losses.

Most insurance companies hold most of this float in cash and fixed income investments for obvious reasons.  You can't be speculating with float; this needs to be liquid and ready to be paid out to policy holders when insurable damages occur.  Insurance is also highly regulated, so an insurance company can't just write a lot of policies, collect a bunch of premiums and build up their float and then invest it all in Apple stock, for example.

Anyway, investment companies are often pretty leveraged.  This means that their float is often a multiple of their shareholders' equity.  

This is sometimes called investment leverage.  The total investments an insurance company owns is going to be a combination of their shareholders equity and their float (or premiums held until it has to be paid out to cover insured damages).

One reason I was looking at this is that most insurance companies seem to be trading at or way below book value per share.  I was wondering why.

The answer is quite simply low interest rates.  Insurance companies are pretty much like leveraged bond funds. 

A typical insurance company can have investment leverage (total investments divided by total shareholders equity) of three to four times.

So let's say an insurance company has a net worth (shareholders equity) of $100.  Oftentimes, these companies will have investments worth $300 or $400.   The difference is usually the "float".

For simplicity, let's assume that this insurance company breaks even on the insurance business, so their profit is based on the money they make on investments.

In a world where interest rates are at 8% like much of the 1980s, this company can earn a return on equity of 24% - 32%.  Earning 8% on $300 worth of investments is a $24 pretax profit, and on $100 in equity, that's a ROE (return on equity) of 24%.

So it's easy to see why in this environment, the insurance business should be worth way more than book value.  A rule of thumb in investing in financial companies is that you want to earn 10% on your investment.  So to earn 10% return on investment, you can pay up to 2.4x book value for this business and still earn 10%.

Now here's the interesting part that illustrates what's going on right now.  Long term bond yields are now at 2% and the interest rate on cash is 0%.  How does the above math work?

Assuming the same $300 worth of investments (investment leverage of 3.0x) and an interest rate of 2%, the investment profit would be $6.  A $6 pretax profit on $100 in equity would be 6% pretax ROE.  Now that's not so exciting anymore.

If an equity investor demanded 10% return, we can easily see why this 'business' is now worth much less than book value.  To earn a 10% return, an equity investor must pay only 0.6x book!

This, in a nutshell, is what is happening in the insurance industry right now and why so many insurance companies are selling well below book value.  Not only is the insurance market "soft" (meaning a weak economy and excess capital in the industry is causing low prices for insurance policies) and insurable losses large, investment returns on insurance company investments are plunging.

Normally, I would not be too concerned with low interest rates.  Interest rates are not something anyone can predict with any certainty.  But since we are drowning in so much debt, and interest rates are a function of supply and demand (for loans), an extended period of low interest rates as seen in Japan is very possible.

In that case, I think it's very important to understand what the consequences of that might be.  Many smart people including Warren Buffett assumes this low interest rate environment is a bond bubble of historic proportions, but I've seen the same sort of comments made in Japan for years.  For as long as I remember, the JGB (Japanese government bond) has been a favorite short by hedge funds.  I've heard this Japan JGB bubble talk since at least 1993.   And the bubble has never popped, yet.

So What is Float Worth?
So as we see from the above, if you are an insurance company and you are good at underwriting policies, this can be very advantageous.  You get to use the float to make money before you have to pay it out to policy holders.

In the world of BRK, since they are so good at underwriting, we consider float to be as good as equity.  Why?  Because BRK has been able to *make* money in underwriting over time.  So the cost of holding this float has been negative over time.  That's like issuing a bond that has a negative interest rate.   Also, as long as the insurance company continues as a going concern, it never has to pay back the float (the reality is that the premiums paid out for losses and damages is replaced by new written insurance premiums).  Also, this float tends to grow over time at BRK.

So one big factor in valuing BRK over the years has been this factor of float.  Some people include float like equity in their intrinsic value calcuations.

But we have to ask, if this low interest rate environment continues for longer than we think, what is this float actually worth? 

First of all, we have to clarify one thing.  Many BRK fans, I think, assume that this low cost or negative cost float is invested in high return assets like stocks.  I used to think so too.   But when you look carefully at the BRK insurance segment balance sheet, you will notice that that hasn't been the case.

Partly for conservatism on Buffett's part, and also for regulatory reasons, BRK has invested the entire amount of float over the years in bonds and cash. 

To prove this, I looked at BRK's float over the past few years and also the amount of bonds and cash it held.  (For this, I looked at the "insurance and other" segment in the annual reports.  This segment actually includes the "manufacturing, services and retailing" segment, but that doesn't materially change the point here).

You will notice that BRK, like other insurance companies, collect premiums from customers and then invest that cash.  The total investments of an insurance company is roughly the float plus the company's own shareholders equity.

From the above table, you will see that BRK does in fact invest a large portion of their total investments in equities; much higher than is typical at other insurance companies.

But you will also notice that the amount invested in cash and bonds is rarely below the amount of float.   Buffett says bonds are in a bubble of historic proportions and yet owns $34 billion worth of it.  Why?  Because float needs to be invested in highly liquid assets; basically bonds and cash.

So when people assume that float is invested for high returns in stocks and the like, this has not been true in the past.  The entire float amount and often more has been invested in cash and bonds.

In a high interest rate environment, this is fine.  If bond yields were 8%, then this float can be worth a lot to an equity holder if the cost of float is zero.  That's a free 8% money; incremental to ROE.

But with cash rates at zero and bond yields at 2%, what is float worth to a shareholder?

Assuming zero cost of float and a blended 1% return on cash and bonds, pretax, that means float is worth to the equity holder the amount of (1%  - 0% cost of float) / 10% (equity discount rate) = 10%.

Float is worth approximately 10% of the face amount because this is the discounted value of the profits it will generate for the shareholder over time.

Sometimes in the world of BRK, you hear about this valuation model where you add the float to the shareholders equity of BRK because float is as good as equity.  While this is sometimes a good approximation of intrinsic value, it can be wildly off in an extended environment of low interest rates.

Conclusion for Part 1
So we looked at how insurance companies make money and why their valuations (namely price-to-book value ratios) are so low lately.   We learned that insurance companies act like levered bond funds, although that grossly oversimplifies reality in many cases.

People often assume that BRK is different because the float is actually invested in equities and other high return assets, but looking at the data show that this is not necessarily the case.  BRK's insurance operations does indeed invest heavily in equities, but there seems to always be the float amount worth of bonds and cash on the balance sheet which limits the 'bang for the buck' that the 'free' float provides to BRK shareholders in a low interest rate environment.

If the low interest rate environment is more Japan-like, then this can be a relevant factor for BRK and other insurance shareholders.

My experience with watching Japan tells me that we should at least think about this as a possibility and be conservative in our valuation of even BRK.

Over the next few posts, I'll look at the typical way BRK is valued by BRK-heads.  I'll also pick apart BRK by segment, figure out their expected ROE's and see if BRK is in fact worth more than book value.

Tuesday, December 6, 2011

U.S. Corporate Profit Margins Headed Down?

I don't want to spend too much time thinking about where the markets are going to go, either up or down, but I do pay attention to what people say and see if there is anything useful in it.

There are all sorts of reasons why the market will be flat for the next decade or more and tons of reasons why the market will go down a lot from here.  There are a lot of problems in this world for sure; read the newspaper on any given day and you would have to be nuts to own any stock at all.  I know.

That's fine.  Fear in the market is a good thing; it's the opposite of 2000 and 2006 when there was no fear in the market.  I am more comfortable and happy today than either of those periods.

Stock market valuations seem reasonable to me, even though I'm not even too sure about what the correct valuation of the S&P 500 index is.  It really doesn't matter to me as I don't own the S&P 500 index, but I own individual stocks.  If I like the valuation of the individual stocks, I don't care what the valuation of the S&P 500 index is.

But still, I think about it and I pay attention to what people have to say about it.

One thing I keep hearing these days is that since corporate profit margins are at record levels today, they have to go down.  It is unsustainable up here so when people say that the S&P 500 index is trading at 11x p/e or 12x p/e, they say that's incorrect due to the unnaturally high profit margins.  When profit margins come back down to more normal levels, then the p/e ratios would look much higher than that.

That sounds interesting, and it is a valid argument in a sense.

But the problem I had with this is that as for the stocks that I've been looking at and that many value investors say are cheap, I don't see an abnormally high profit margin at all.

Anyway, first, let's look at what the bears are talking about:

Below are charts I cut and pasted from the internet that show corporate profit margins.  I think the top chart is corporate profits as a percentage of GDP in the U.S.

The lower chart is corporate profits as a percentage of industrial output calculated by the Commerce Department.

Both charts show the same picture; corporate profits indeed look way out of whack with the economy.  Profit margins, if this chart is accurate, does really look unsustainable.

In the early 2000s, the profit margin seemed to be well within historical range.

So out of curiousity, I jotted down the operating margins of some of the favorite value stocks and high quality blue chips since 2001 to see what the margins trends were. 

Here are the results of that:

Operating Margins History of Large U.S. Corporations:  2001 - 2010

I just picked these names off the top of my head so I didn't cherry pick names to support my case.

A quick look here shows that operating margin trends have been pretty stable over time.  I don't think there is any reason why these companies should suffer a decease in operating margin; they don't look spikey high and unsustainable to me. 

I thought that maybe energy companies would have abnormally high earnings and margins now but Exxon Mobil (XOM) shows pretty stable margins over the past decade despite high crude oil prices.  In fact, operating margins in the past couple of years look lower than in most of the past decade.

McDonald's, IBM and Disney all have seen higher margins over time, but these seem more like company level specifics; IBM moving out of hardware and more into software and services, McDonald's restructuring to refocus on the main business and eliminating distractions (Chipotle, Pret-a-Manger etc...) and adding new products like McCafe etc...

Big, high quality blue chips like Coca-Cola (KO), Proctor and Gamble (PG), Johnson and Johnson (JNJ), Kraft (KFT) have very stable margins throughout the past decade.  No bloated margins there.  Even the mega-giant Walmart (WMT) has very stable margins over time.

So where is this excess margin?  I don't have a data-base to figure that out.

I think one factor might be globalization.  Since big blue chips have been globalizing for a long time, many of them are starting to generate large profits overseas.  These profits wouldn't show up in margin trends on a company basis because there would be global revenues to go along with the profits.

However, in a macro calculation like the above charts, profits earned overseas would be compared to U.S. domestic GDP, which leads to a problem of comparing apples to oranges.

Anyway, there are a lot of reasons to worry about the stock market, but I'm less concerned about this 'abnormally high margin' argument.  First of all, I think globalization and other factors distort the numbers in the above chart where domestic company earnings are compared to domestic GDP (which completely ignores overseas revenues).  This would make companies look like they are taking more share of U.S. GDP than in the past when in fact they might just be taking the same share of some other GDP around the world.

Even if that is wrong, it still shouldn't concern people looking at individual companies.  Who cares if some macro chart shows excessive, spike-high margins if the companies you own don't.  This is the problem with these 'big picture' stories, sometimes.  

For example, some people were worried about the stock market (correctly) back in 1999/2000 when the p/e ratio of the market went up to 30x or 40x.  That obviously should be a concern to people who owned the S&P 500 index, but if you owned a stock trading at 10-12x p/e ratio, then there was no reason to sell that.  And in fact, many value investors did just fine in the years after that due to the presence of a lot of cheap stocks even in the late 90s.  The stock market went down by 50% after that, but what went down the most were the very expensive stocks. 

This may be similar, but I'm not even sure what the above charts tell us about the S&P 500 index because as my table shows, most large blue chips stocks don't seem to have unsustainably high margins and aren't trading at high valuation levels.

This is not to say that the market will go up or down.  I just wanted to point out something interesting because of the large number of comments I hear that U.S. corporate profit margins *have* to come down.  My quick analysis shows that maybe it doesn't have to necessarily, and certainly not for many of the high quality, blue chips.

So the above charts may be charts you don't have to worry too much about.

Thursday, December 1, 2011

Coca-Cola Hellenic Bottling Co

As usual, I was browsing the new lows list and noticed that Coca-Cola Hellenic (CCH) was hitting new lows every day.  Well, of course it's hitting new lows every day.  This is a Greek company.  But since it kept hitting new lows every single day, I decided to take a quick look as I really haven't looked very hard in Europe despite the meltdown going on over there.

First of All, Is it Cheap?
CCH is trading now at $15.30 or so compared to a high of close to $50 back in early 2008, so the stock is down close to 70% from it's high, and it's not even a bank stock.

But nominal price is not meaningful at all, of course.  So let's look at some comparisons.

Here's a quick look at CCH versus other Coke bottlers around the world (I exclude Japanese bottlers here as they seem to live in a different world altogether):

              ttm = trailing twelve months through September 2011
              Operating margin and ROE are also based on trailing twelve months.
              Data is from Yahoo Finance

From the above table, we see that CCH is indeed cheap especially based on next year's earnings estimate trading at 11.6x p/e versus 16.5x and 17.2x for Femsa and Amatil.  CCE is cheaper at 10.8x p/e, but CCE's markets are primarily mature markets in Western Europe (Belgium, France, Great Britain, Luxembourg, Monaco, Netherlands, Norway and Sweden) so their growth prospect is not that bright (it can still be a great investment here if they focus on returns on capital and returning cash to shareholders etc...).

Coca-Cola Amatil is the Australia/New Zealand bottler.  They have done well with very good margins, return on equity and decent growth but they are not particularly cheap.  Again, this is not to say that's a bad investment; we are just comparing things to CCH.  I haven't taken a close look at CCLAY.

Coca-Cola Femsa, of course, is the star of the the bottlers with decent margins and plenty of growth (sales have grown +15.5% in the last five years); a perennial favorite of fund managers around the world.

But if you look at CCH, even though their ROE and operating margin is a little depressed due to the current weakness in their European markets (they typically earn an operating margin closer to 10% and return on equity well into the double digits), it does seem to have good growth prospects compared to CCE.

CCE Was a Growth Stock
After the merger that created CCH (Hellenic Bottling and Coca-Cola Beverages) in 2000, CCH had a nice run of growth until the financial crisis hit.

Between 2001 and 2007, unit case volumes increased +9.3%/year, revenues grew 11%/year, EBIT grew +20%/year and EBITDA grew 13.6%/year.  Return on capital improved over time from 3.9% in 2001 to 12.2% in 2007.

Here are some charts that show nice growth and operational improvements between 2001 and 2007 (this is from the 2007 annual report):

It shows nice growth between 2001 and 2007.  Then the financial crisis hit and things flattened out.  On back of this growth, in early 2008, CCH stock traded close to $50/share.  EPS in calendar 2007 was US$1.90/share so that's a P/E of 26x.  Not cheap.    

Here are some snips from the 2010 annual report:

Things have flattened out since 2007-2008, but CCH has maintained their return on invested capital and margins at least through 2010.  This year, volumes are flat and earnings are down but that's no surprise given the crisis occuring in Europe now.

The question is if this slowdown and ongoing European crisis is a temporary thing or a permanent one.  If it's permanent and you think Europe and especially the smaller economies will go into a long depression, then CCH is obviously not a good idea.

But if you think over time that GDP per capita will continue to go up over time, this is an interesting play.

Let's take a look at some of the markets CCH is involved in:

This is actually a pretty impressive portfolio; only 34% of volume and 42% of revenues come from mature markets and the rest from emerging and developing markets.  Some of these markets are markets where people were falling over themselves trying to get equity exposure; emerging market funds etc... (remember "frontier market" funds?)   There seems to be plenty of potential for growing per capita GDP in many of these markets, and Coca-Cola consumption tends to rise as GDP per capita rises.

Here is a great graph illustrating that from CCH's 2010 annual report:

For those worried about specific country exposure (some don't want anything to do with Russia, Italy, Greece etc...), here is a breakdown of the largest sales by country:

Again, this is certainly an interesting portfolio compared to other bottlers in mature markets. Of course that also means there are a lot of risks here.

Here's a look at per capita carbonated soft drink (CSD) consumption per capita in CCH's ten largest markets compared to the EU (Eurpean Union) and U.S. averages:

Of course it would be silly to assume that the rest of the world would increase CSD consumption per capita to U.S. levels, but it wouldn't be unreasonable to assume that many of these markets might move closer to the EU average.  Of course, in mature markets where Coke has had a long presence and GDP per capita has been stable over time, I doubt CSD per capital figures would grow much, but for countries with low GDP per capita, I find it totally reasonable to assume CSD per capita figures will grow with GDP per capita.

So What's CCH Worth?

The above table shows the return on equity of CCH over the past decade; I just divided the net profit of the year by the shareholders equity at the beginning of the year.  I also calculated the EPS over the past decade in U.S. dollars.  I translated the Euro into U.S. dollars using the currency exchange rate at the end of each year.

So we see that this stock that traded near $50/share at 26x p/e is now trading at less than 10x what they earned in both 2009 and 2010, and 11.6x or so of what analysts expect them to earn in the year ended December 2012.  This seems to me a very reasonable valuation.

A lot of growth stocks come crashing down from a high p/e ratio to a ratio that would attract value investors (like me), but many of those come down due to limits on their growth due to market saturation (fast food restaurants etc...), technological obsoletion (new technology obsoleting products and services), end of fads (Heelys etc...) and sometimes things just come down due to temporary macro problems. 

CCH might fall in the category of this 'temporary' problem.  I don't think CCH fits into any of the other categories. Is there a secular change in this business, technological or otherwise?  I don't think so.  I don't know if CCH actually deserves to trade all the way up at 25x p/e either, but 10x might be a bit cheap for a company that seems to have so much growth potential going forward with a proven business model that works and has worked over many years.  Their business model is also supported by a globally dominant company that has an interest in seeing them succeed.  That's pretty important, especially when looking for exposure (for investors) in some of the smaller more obscure markets.

Free Cash Flow
Let's look at free cash flow.  CCH provided their own free cash flow calculation and forecast in the November presentation:

This cash flow doesn't deduct interest expense, so either we have to look at this versus enterprise value (EV), or deduct some sort of interest expense to compare it to the equity (stock) valuation.

First, let's look at this versus the enterprise value.

The stock is now trading at around 11.4 Euros/share and there is around 366 shares outstanding for a market capitalization of 4.2 billion Euros.  Non-current liabilities on the balance sheet as of September 2011 was 2.4 billion Euros for a total enterprise value of 6.6 billion (out of conservatism,  I won't deduct the cash on the balance sheet for now).

The above figures are rolling 3 year sums so we should divide by three to get rolling three year averages.

According to that, CCH is trading now at a 6.9% free cash yield versus EV using the past three years.
That basically means that if you spent 6.6 billion Euros to buy the entire company and pay down their debt, your cash-on-cash return on this investment would be 6.9% if CCH earned the same revenues/profits as they did in the past three years.   (Importantly, this differs from EV/EBITDA as it deducts taxes paid and capex; so the 6.9% would actually end up in your hands).

Using the CCH forecast for the 2010-2012 period, they expect cash flow to be 1.4 billion Euros over the three years frmo 2010 to 2012.  That comes to 467 million Euros per year and a free cash yield on EV of 7.1%. 

Let's look at this from an equity investor point of view.  I will just deduct 83 million Euros from the above free cash figures and compare that to the equity market valuation (or on a free cash per share basis).  83 million Euros is what financing cost was in 2010 and for the first nine months of this year, it seems to annualize to the same run rate.

So using 83 million, then the free cash flow for the past three years was 370 million Euros (1.36 billion divided by three minus 83 million).  With around 366 million shares outstanding, that comes to around 1.00 Euro per share.

To make it easy to compare to the ADR, let's call that U.S. $1.35/share.   At $15.30/share, CCH is trading at a free cash flow yield of 8.8%

Using guidance from the presentation and doing the same calculation gives you 384 million Euros or $1.42/share, or a free cash yield of 9.3% which is not bad at all given current bond yields out there.

The most interesting aspect of this, still, is the cheapness especially relative to the growth potential.

Obviously, Europe is not at all out of the woods and there will be a lot more volatility in the financial markets going forward and CCH has exposure to a lot of the 'wrong' places in the current environment, so it wouldn't be much of a surprise if this stock went down a lot more on the daily headlines.

But if you assume that CCH doesn't require a bubble to make good returns and grow (this is not a housing stock or a bank, for example, that benefited greatly from the bubbles), then it is reasonable to assume that they can resume their growth and make decent money going forward in a more normalized environment.

In any case, if you are looking for something in Europe from this crisis, some will make some money buying European bank stocks and other more levered played (if they are right). 

This one looks like a more conservative way to play that.

There is good reason to assume that CCH might be oversold due to their being a Greek company; Even if Greece defaults, it will not have an impact on CCH's credit rating; both S&P and Moody's have affirmed that as most of CCH's business is outside of Greece.

Plus, even if Greece does default and there is a blowup over there, solid companies with good businesses should come through fine, as many companies have done in the various blowups over the years in South America (oftentimes, blowups or times of near blowups have been the best times to buy into their stock markets!  You want to buy when everyone is running away).

There is a risk, however, in that most of their debt is denominated in Euros and U.S. dollars; if the Euro completely breaks up, the 'new' Euro may be the strong core countries and therefore it would be very expensive versus the rest of the currencies.  CCH does have a lot of sales in the European countries that are not big and strong (France and Germany).  However, many of the smaller countries CCH serves is not in the Euro so foreign currencies declines are already in the numbers.

A breakup of the Euro, for this reason would be hugely traumatic to Europe overall so is probably highly unlikely in the near future.  One mitigating factor is that if there is a breakup of the Euro, weaker currency economies will see high inflation so the loss from the foreign currency revenues would be partly made up by higher prices in those countries.
I don't own any at the moment and I will be looking at this more and I may buy some at some point.  Even if I don't buy some now, at the very least will go into my "watch very closely" list.