Tuesday, August 25, 2015

The Charles Schwab Corporation (SCHW)

So, it looks like Lou Simpson added a bunch of Charles Schwab (SCHW) to his portfolio, making it the top holding as of the end of June; he increased his position almost 50%.

I am not stalking Simpson in particular, but I just happened to notice this and SCHW is a name that I am sort of familiar with and have been a fan of for a long time.  Putting those two together, I figured it's worth a post.  We all know who Lou Simpson is, but in case you don't, here is a look at his past performance during his time at Berkshire Hathaway with some quotes by Buffett about him:  Brookfield Asset Management post

I'm not going to go into too much detail about the business as I think most of us are familiar with SCHW; a discount broker that grew into a more full service financial company.

Quick Comment on Markets
I have no idea what's going on in the markets, and have no idea what will happen going forward.  But I had a conversation with someone very concerned.  My answer was that if it's going to be a major problem if the market keeps going down, you simply own too much stocks.  But this is something you have to think about all the time, not when the market is down 1000 points. That is the worst time to think about what to do (unless you want to buy!).  Why do people think about this only when the market is down?  The market goes down and the first instinct always seems to be, "Should I sell?!".

If a declining market is a problem for you, don't own stocks.  Or only own enough so that this sort of volatility won't be a problem.

As for what will happen going forward, I still stick to my view that the market is not that overvalued given the interest rate environment, and we have plenty of cushion even if long term rates rise. They can go to 6% and we'd still be in a zone of reasonableness in terms of valuation.

As for China, yes, the U.S. market is tanking on news out of China, but I still think the world need not go down with China.  I don't worry too much in that respect.

Oh, and by the way, for those interested in stock screens of the Superinvestors' stockholdings (as defined and tracked by Dataroma) I have updated the screens Friday and last night.  I automated the process completely so I just need to type a single line in the command line for the spreadsheets to be updated (I initially had it set up to update an Excel spreadsheet which I cut and paste later to a Google spreadsheet since it was a hassle to directly update a Google sheet from a program; I got over that hump...) so I can update it every time the market has big moves.

See the spreadsheets here:
     Superinvestor Stock Rankings
     Superinvestor Stock Ranking (Small list)

I do intend to add spreadsheets that show year-to-date winners and losers of those stocks too.  Stay tuned for that. (My recent hobby is programming so I did all of this for fun and thought it would make a nice addition to the blog so just put it there...)

Anyway, end of digression and back to SCHW:

Solid Management
I've always been impressed with the customer service and the conservative nature of the management there.  There are some things that I don't like, like their dependence on trading frequency; the more people trade, the more money they make.  The more margin loans people use, the more money they make etc...

But there seems to be a lot of integrity there.  There isn't much I can say other than that I've been following and reading about SCHW for years, and they tend to be very conservative and client focused.  I've never had a bad experience, and never read anything I didn't like about them.

One thing, though, is that a lot of this is due to my faith in and respect for Charles Schwab, the founder.  He is 77 years old now.  Who knows what will happen post-Schwab?   The business itself doesn't depend on his talents on a day-to-day basis so there is a good chance that they can continue to do well as long as they keep their culture.

The only reason I've never owned the stock is that it has always been a growth stock.  The P/E has always been far above 20x.  And there has been growth to support that, except in the past few years.  But we'll get to that in a second.

When an investor you highly respect makes it the top holding in his portfolio, even larger than Berkshire Hathaway, a company he knows better than anyone in the business (as an investor,  former employee and Buffett friend), you have to pay attention.

Interest Rate Normalization Bet
So let's get to the gist of the idea here.  In short, this is an interest rate normalization play.  This doesn't sound right because investors like Lou Simpson don't make macro plays or 'bets'.  But in another sense, value investors make  "earnings normalization" bets all the time.  When a company is going through hard times, we look at what the business can earn in a more normalized environment.  We slap a multiple on it and then buy the stock if it is meaningfully lower than that.

In that sense, this is sort of the same thing so not really a macro play.  Macro plays are often time-dependent.  People make bets about this or that, and when it doesn't happen within a year or two, they are in trouble.  But in the value investing world, playing for normalization is not as time-dependent.  We often don't know when something will happen, but only need to be confident that it will some day.  And if the underlying business can continue to grow and pay dividends in the meantime, that's great.  This is not the same as making a macro bet, like shorting bonds or whatever.

Clip from 2014 Annual Report
SCHW has been talking about this for a few years now, but I never really paid too much attention to it as I was in the camp that the U.S. interest rate environment might follow Japan's.   Well, yes, I do own JPM and they too are a great interest normalization bet, but JPM was trading very cheaply while earning 15% return on tangible equity even with rates very low.  SCHW is not really trading cheap in that sense.

But anyway, here is a clip from the 2014 annual report that is the key to this whole idea:

SCHW earned $0.95/share in EPS in 2014.   The stock is trading at around $30 for a P/E above 30x.  2015 estimates is $1.05/share (Yahoo finance) so that makes it 29x P/E.  Expensive.

But notice the above; due to low interest rates, they waved $751 million in money market fund management fees.  Since they are incurring the expenses to manage the funds, getting that back should go right back into pretax profits.  Using a 40% tax rate and 1.3 billion shares outstanding, that amounts to $0.35/share in EPS.  Adding that to the $0.95 EPS in 2014, that would get us a normalized EPS of $1.30/share bringing the P/E down to around 23x.

Now look at the net interest margin (NIM).  NIM was 1.64% in 2014, but as recently as 2008, it was 3.84%.  Back then, returns on cash averaged around 2.5%.   If NIM went back to 3.84%, that would be a 2.2% increase in NIM.  With $140 billion in earning assets on the balance sheet (as of year-end 2014; as of the end of June, there was more than $150 billion), that would add $3.1 billion to revenues.  This should also fall straight down to pretax profits.  If that is the case, and assuming a 40% tax rate and 1.3 billion shares, it would add $1.42/share to EPS.

Adding $1.42 to $1.30 gets us to a normalized EPS of $2.72/share.    At $30/share, SCHW would be trading at a normalized P/E ratio of 11x.  Now, that is really, really cheap for SCHW.   Using a 3.00% NIM, you get 13.6x P/E.

The question, of course, is if interest rates will normalize.  The 'when' is not so important here, I don't think, because the underlying business is growing nicely so if normalization takes place later than people think, it will just have a bigger impact on EPS by then.

I thought about making this post last week, before the market got messy.  So maybe interest rate normalization is not at the top of investors' minds right now.  Maybe the scenario is pushed back a little.  But if you can wait, and you think rates will eventually normalize to some extent, this is certainly an interesting idea.

And keep in mind, the average yield on cash in 2008 when NIM was 3.84% was around 2.5% so we're not talking about short rates needing to go back up to 5-6% or anything like that at all.

More Detail on Rate Normalization
This is a slide from their summer business review presentation.  They take a closer look at how interest rates will impact revenues.

SCHW is a Growth Stock
Looking at recent trends, SCHW doesn't look like a growth stock.  It had EPS of $0.92 back in 2007 and only earned $0.95 in 2014.  But that is largely due to the above interest rate and fund fee waivers.

If you look over the ten years through 2014, EPS at SCHW actually grew around +14%/year, and going back twenty years to 1994, EPS grew +13.5%/year.   And it is still growing.  And keep in mind that these growth rates are with an unnaturally depressed endpoint (sub-normal NIM in 2014).

If we use a normalized EPS figure (assume NIM was 3.84% in 2014), then the growth rates would have been +26%/year over ten years and +20%/year over twenty years.  That's kind of insane.

Look at the slide below and you will see that the business is growing since the 2007 peak despite an unchanged EPS.

Client assets are up nicely even compared to the 2007 high.

Here is one of the drivers of SCHW's growth over the past few years. This trend seems to be continuing so there is plenty of runway for growth.

This is a nice chart that shows a trend that I believe will continue:

SCHW sort of feels like the organic food companies while the wirehouses are like the old, traditional food companies.

So, this is kind of an interesting idea.  There are a lot of interest rate normalization plays (like, all financials?).  But this one is a little different in that it has a lot of growth potential, unlike, say, the larger banks.  Plus, I have always liked the company, the management (well, at least the Chairman Charles Schwab) etc.  Recent events make interest rate normalization seem less likely to happen soon, but if you believe that it will eventually happen, then this is an interesting idea with a lot of potential.   Paying a normalized 11x P/E (or 14x P/E using a 3.00% NIM) for a high growth business with plenty of room to grow seems pretty interesting.

Friday, August 7, 2015

Mondelez International (MDLZ)

Bill Ackman apparently took a humongous position in MDLZ.   The stock price popped up 5%-7% at first but went back to unchanged as the market tanked.  And today, the stock is actually down a little.
I guess it popped up on comments that Kraft-Heinz/3G would be interested in making a bid for MDLZ, and then gave up the gains when people realized that 3G might be a little too busy integrating Kraft-Heinz at the moment to be making such a big bid so soon.  Also, the trailing twelve month P/E ratio of 33.5x (according to Yahoo Finance) looks a little expensive. 

MDLZ earned an adjusted EPS of $1.75 in 2014 and is guiding double-digit growth.  So let's say they grow EPS 10% for a 2015 EPS of $1.93.   With the stock around $46/share, that's 24x current year EPS.  Not really so cheap. 

When Heinz/3G bought Kraft, they said there would be $1.5 billion in synergies.  Kraft had $18.2 billion in sales in 2014, so that's 8.2% of sales in synergies.  But since Heinz cut so much in costs, much of that is probably expected cost cuts at Kraft.  8% of sales would be in line with other 3G situations. I looked at that here: Kraft-Heinz

When 3G/BRK bought Heinz, they boosted operating margins by 7% within a year, and in that case it was an outright purchase and not merger so there weren't any 'synergies' but just pure cost cuts.   Operating margins went from 14.4% to 21.5% in a year (check out Heinz Update: Who's Next?).

The post-synergy Kraft-Heinz operating margin is over 25%.

Back to MDLZ
So, looking at it this way and going back to MDLZ, if you think 3G (or someone else) can do something similar again, the purchase price including synergies would look quite a bit different.

Adjusted operating margins are up to 14% at MDLZ.  This is around the level of operating margins of HNZ before 3G took over.

Let's say they can get this up to 22%.  MDLZ had $33.4 billion in revenues in the last 12 months.  22% of that is $7.35 billion in operating earnings.  Interest expense is $750 million (company guidance for 2015).  That's pretax profit of $6.6 billion.  Using a 22% tax rate (company guidance for 2015 is for low 20s) gets us a net profit of $5.1 billion.  1.6 billion shares outstanding gets us an EPS of $3.20.

With the stock at around $46/share, MDLZ is trading at 14.4x P/E (post-3G-like-cost-cuts).

If they can get operating margins up to 25%, then the above math would get us to $3.70 in EPS, and MDLZ would be trading at 12.4x post synergy P/E.  (25% operating margin might be a stretch, though, but I just used it because that's the post-synergy operating margin of Kraft-Heinz.)

Now, that's pretty cheap.

(The above figures don't make any adjustments for the coffee business (which now goes through equity earnings and not revenues, operating earnings etc.); it shouldn't make a huge difference to this rough analysis.)

The interesting thing here is that only 20% or so of sales (and slightly more in segment profits) is in North America.  40% of sales is in Europe.  And they have a lot of exposure to the emerging economies.  This is good and bad, of course, depending on what's going on in the world.  But it seems like the U.S. is a step or two ahead of everyone in terms of the economic cycle.  Emerging markets have been in a down-cycle for a while now, and these things eventually turn.

It is possible that if Europe and other economies are behind the U.S. in the economic cycle, that they might turn which would be very good for a company like MDLZ.

MDLZ is a much growthier name than other food companies, like, say, Kellogg, Campbell's etc.

Still, it is highly unlikely that 3G will come out with a bid very soon.   That doesn't mean MDLZ can't do pretty well on it's own for a while.  Some stability in Europe and emerging markets, continued cost-cutting etc. can make MDLZ a decent stock to own until someone is ready to really take costs out of this thing, at which point if sales are higher, MDLZ could be even more interesting to 3G or someone else who can do something similar.

At it's current price, someone like 3G would be able to 'create' an investment with some real growth potential at 12-14x P/E.