December 29, 2007

Value Idea: Fixed Income

I think fixed income investing does not get its fair share in the individual portfolio level. I think it is a big mistake. Fixed income can enhance a portfolios returns and reduce risk. Fixed income market dwarfs the stock market in size and volume of transactions. Individual investors also see bonds as one category however the truth is farm from it. Bonds have many categories with different risk/ reward profiles and picking among them is as important as picking solid businesses.

I am always aiming to keep at least 20% of my portfolio in fixed income and again picking which debt to include is a matter of perceived value. Debt can be over or under valued similar to a stock, so you have to be a picker of the ones that represent a margin of safety and large upside value. In this post I am thinking of some ideas about different fixed income categories that can enhance my returns going forward and possibly give you some ideas to research further.

Inflation indexed Bonds

Real Return Bonds in Canada or TIPs / Inflation protected bonds in the US can return a great value going forward. These bonds are government issued so there is no additional credit risk to treasuries. These bonds pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation. RRBs pay interest semi-annually based on an inflation-adjusted principal, and at maturity they repay the principal in inflation-adjusted dollars. For more information on Canadian real return bonds you can view here.

An investment in TIPs is call that inflation going to increase going forward. There is a strong case for inflation to increase, which I am not going to discus here, so if you are not worried about inflation obviously forget this category as a potential investment.

Emerging Market Debt (EM)

Emerging market debt is more attractive to me than their equities due to recent run up. Emerging Market governments are awash in cash due to solid economic performance that is expected to continue forward. Refinancing risk is low as sovereign wealth funds are ready to invest significant amount of money in emerging market debt, which is no longer dependent on North American and European investors. More importantly these bonds have come down in price due to the credit crises with no change to the risk profile in my opinion.

And the way I choose to monetize this idea is through closed end bond funds rather than individual bonds for two reasons:

  1. Closed end funds are selling at large discounts currently and those discounts widened significantly over the summer.
  2. Closed end funds offer a diversification form issuer's risk.

I have went through several Emerging Market closed end funds and found the following to have the most liquidity and best operating history compared to others.

Alliance BernsteinAberdeen Asset ManaFranklin Templeton
As of12/28/200712/28/200712/28/2007
Closing Share Price$12.54$5.82$8.42
Closing NAV$14.22$6.62$8.83
Average Premium/ Discount (1 yr)- 8.18%- 5.98%+ 3.65%
Current Yield7.76%7.07%5.37%

Banks and Corporate Debt

US/ Canadian bank bond debt, in particular, have gone down in value due to the credit crises, however some institutions have solid financial positions that will enable them to meet their obligations going forward.

Corporate bonds are cheap and a better investment than many stocks or government debt currently. Investors in investment grade corporate debt are demanding 180 basis points extra interest compared with similar-maturity government notes, up from 99 basis points in July. The investment grade bonds are good as treasuries as their credit quality profile has not changed significantly and will reprice higher once this crises behind us. The spreads have already began to reprice as evident from table blow.

Current YieldYesterdayLast WeekLast Month
spread 10yr AAA0.961.041.131.07
5 yr AAA1.
2 yr AAA1.

Municipal Bonds

Although US Municipal bonds offer higher yield now, I would not touch them. Several analysts and managers have been recommending munis due to their higher comparativeve yields. See graph below to see the shift in munis yield over their yields earlier this year. A typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni. On 30-year bonds, the muni and Treasury yields are virtually the same—4.7% and 4.6%. To beat the 4.7% muni, an investor would have to get more than 7% in a taxable bond. However the risk of owning munis have gone p and I do not care what rating they hold, as we all know rating means nothing as evident of all AAA rate subprime debt out there:

  1. high housing foreclosures will stress municipals cash flows as they collect less taxes from empty houses.
  2. credit risk insurance is not so dependable as MBIA and other insurers have trouble raising capital, their ability to honour their agreements to insure munis against default is suspect.
  3. Some concerns about their investment funds holdings as some may have subprime debt as was the case in Florida.

As a Canadian investor these do not make sense at all as you get taxed on the income.

Government Debt

US, in particular, and Canadian, to a lesser extent, Government bonds are overvalued because investors have flocked to them as safe heaven and bid up their prices due to the credit crises. As you can see from the graph the yield curve have shifted downwards on all points since the beginning of August. And if you factor inflation running at 4% according to latest figures, you are really losing on most points except the 30 yr maturity where you will be earning a solid return of .5%, lucky you!!

When the crises subsides look for these to come down in price as investor switch to equities dumping loads of treasuries and bonds. Although they are safe but their risk/ reward profile is not enticing.


Sources: Yahoo Finance, BusinessWeek, Bloomberg,

December 28, 2007

Valuation Technique: Earning Power Value (EPV)

I have discussed in a previous post the discounted free cash flow valuation method. Another technique I use and prefer is the Earning Power Value and reproductive asset value (EPV). The reasons why I prefer this technique are many among them:

  1. It ignores growth and future projections of sales. Growth projections are always faulty and if they materialize it is by sheer luck.
  2. Discounted cash flow models ignore the balance sheet and this one incorporate it as part of the valuation.
  3. This method is more conservative.
  4. It gives me an indication if management is able to exploit effectively its assets and competitive advantages.

In the following I will give an overview step by step guide to conducting the valuation. Valuation is conducted in two separate steps:

  1. Estimation of asset reproductive value
  2. Determination of EPV

1. Asset Reproductive Value

Asset reproductive value is the cost of assets needed by a new entrant to compete in an equal manner with an incumbent in the industry. This step can be very involved and need some industry and company insight. You need the company's most recent balance sheet to begin. Valuation will be easiest for current asset and liabilities in general, however more involved with the fixed assets portion of the balance sheet.

You start with book values of the balance sheet, generally it is easier to value the top items and it gets harder as you go down the account list. In the following I will present a table with each major category of assets and the needed adjustment to be made to arrive at a reproductive asset value.

Cash and marketable securitiesGenerally there is no adjustment needed as cash is cash and marketable securities are marked to market and represent fair value
Account receivables (AR)the reproduction cost is greater than the book value generally, as companies write off bad debt and apply doubtful debt allowance to AR. At a minimum you add the allowance of bad debt to book value of AR as any new entrant will experience defaults and such expenses.
InventoryIn a liquidation scenario it is valued at zero but at an operating level you have to value it at FIFO basis. If the firm is valuing it using LIFO then add the LIFO reserve back to the balance sheet number to arrive to reproduction value.
Deferred tax assetsPV of cash savings if the company is anticipating to use them if the company is in no position to use these assets then value them at zero.
Building & Land

Generally this item will never be replaced at less than original cost. If the land and buildings are a critical then you have to asses the market value and it is usually upwards as land are booked on the balance sheet in historical terms and undervalues current market values. For example retailers like Home Depot and Sears have purchased all their location years ago therefore their balance sheet value understates the true economic cost for a new competitor that want to compete against them.

To get proper value you need to apply similar transaction values to the company's buildings and land on a location by location basis. This can be one of the hardest steps in the process and the more research intensive.

Plants & Equipment

In general there is a long term trend of equipment efficiency and advancement so historical value of plants and equipment may be higher than what a new entrant into the industry might have to pay. Here a familiarity of the industry production method and technologies will help.

On going plants use the price for unit production capacity value. What is the market value or production price per unit of output for other comparable companies. Example, what is the price of tonnage of aluminum in the market multiplied by how many tonnage does the plant produce gives a reproductive value for the aluminum plant.

  1. How many years in R&D spending to reproduce a product? Depends on the industry, in consumer it takes 3 years, in car business it takes 6 years.
  2. Brands: what is the cost to reproduce the brand? What is the comparable acquisition price of brands in the same industry? The acquisition price of some deals per each dollar of sales of the acquired brand and apply that multiple to the company sales you are valuing. Or simply 3 years of marketing and sales expenditure of the firm
Deferred taxes liabilitiesPV of cash to be paid in the future if the company is profitable. But if it is anticipated to generate losses then you have to push payment into the future further and will be valued less.
Accounts payable Book value is a good reproductive value for this account and no adjustment is needed.
Long term liabilitiesMarket value of debt as a new entrant will have to issue debt at current interest rates which may be different than the historical prices of the company debt. You can look these up using yahoo finance.

Please note that if you are attempting this valuation on a viable industry then it is reproductive valuation. However if the industry is not viable then liquidation values should apply, in other words serious discounts should be applied to the assets.

2. Earning Power Value

Earning power value: is the second aspect of the valuation of a business. Basically EPV is...

A business's ability to generate profit from conducting its operations. Earnings power is used to analyze stocks to assess whether the underlying company is worthy of investment. Possessing greater long-term earnings power is one indication that a stock may be a good investment.

or in a mathematical equation EPV= Adjusted Earrings/ cost of capital

The calculation assumes no growth and current earning is sustainable over the long run. This is one of the great advantages of the technique as it does not muddy the valuation process with future predictions. It evaluate a company based on its current situation. However to arrive at EPV there are several adjustments to be made to the Earnings figure as follows:

  1. Operating earning or EBT is the start point.
  2. You need to adjust EBT for the business cycle and cyclicallity by taking a 7 year Average of operating earning, which will include at least one economic downturn. You can do this by averaging the company's EBT margin over 7 years and apply it to current year's sales, and viola it will adjust for cyclicallity and business cycle.
  3. Next deduct the 7 year average of non-recurring charges or normalize these expenses to reflect their economic nature. Non recurring charges are part of doing business and they will arise in the future so I do not see why you need to exclude them.
  4. Apply Tax rate the figure derived in step 3, which is the average tax rate of the company over the last 7 years. Alternatively use the general 33% corporate tax rate to avoid tax schemes implemented by different companies.
  5. Add depreciation of the most recent year.
  6. Next deduct adjusted Depreciation: true depreciation is the cost to the company to make it at the end of the year in the same situation at the beginning of the year. Accounting depreciation is irrelevant as it can be higher because capital goods prices go down due to technology advancement, or it can be lower in inflationary environment where reproduction costs is higher then accounting depreciation underestimates true economic cost, so you have to adjust for it by using maintenance capital expenses (CAPEX) as the true measure of depreciation. You can calculate maintenance CAPEX by:
  • Calculate the Average Gross Property Plant and Equipment (PPE)/ sales ratio over 7 years
  • Calculate current year's increase in sales
  • Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
  • Maintenance CAPEX is the Capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company
  1. Cost of capital estimation: estimate by judgment or use company cost of capital as discussed in my earlier post here.
  2. Divide the adjusted earnings calculated in step 6 by cost of capital in step 7 to get EPV.

The final step is to compare the per share reproductive asset value in step 1 (Assets-liabilities/ # of shares) to EPV per share calculated in step 2 and you got a value of the business. Companies with sustainable competitive advantage should have a higher EPV than asset value and the difference is the franchise value. If the reverse is true management is destroying shareholder's value by earning less that the assets capability and you can conclude that the business is a commodity business with no attractive ROIC profile.

If you require more details on this technique, I recommend buying Bruce Greenwald's book: Value Investing: from Graham to Buffett and Beyond. I also recommend watching the following lecture by Prof Greenwald about the subject, you can view it here.

I hope the above helps.


Sources: Value Investing: from Graham to Buffett and Beyond by Bruce Greenwald, Security Analysis by Graham and Dodd,

Citi to sell assets

Heard on the Street -
The article in the Wall Street Journal reports that Citi is planning to sell assets to shore up capital. It is a very logical approach for the struggling bank. But the question is which assets? And at what price?

Any financial institution in this current environment will find it hard to locate buyers. So in order to generate funds it will be forced to sell quality assets at a steep discount. Citi has tried to unload non strategic bank branches earlier with no success. Now with the cedit crises at full swing citi has to offer two things: 1. great assets, and 2. steep discounts to find buyers.

Selling assets is a welcome move but it will take place at the wrong time. I think Citi is better holding those assets for the time being and selling them later when it can get better value for them. For Citi to shore up capital, it needs to do the following:

1. cut costs by streamlining the "empire"
2. cut jobs
3. cut dividends

Once I see some of the above happen in Citi, it can be a turnaround investment candidate.

December 26, 2007

REITs: Value idea?

Due to the bad presentation of the last post I make it available here to read in more friendly manner.

I will try to find a better template to accommodate graphs and tables, as the blogger templates are limiting and will lead to bad formatting.

If anyone has any suggesting I would appreciate it.

REITs: Value idea?

I always like to sift trough sub indices of the market and see what are the poorest performing and under stress sectors and sift through them to see if any value ideas can be generated. I was going through the TSX sub groups and I can find two sub indices that performed badly: REITs and Energy Trusts. I will focus this post on REITs and I will tackle energy Trusts some other time.

Real estate businesses in general have performed badly this year. REITs in particular have been hammered this year for several reasons among them credit crises, expectation of economic slowdown, rising interest rates and rising defaults in the US housing markets.

The Canadian REITs space is no exception. Real Estate is one of the poorest performing indexes in the TSX composite index, see figure. Canadian REITs have returned -15% for 2007. However, Real Estate is very local and diverse in its categories that a recession in US housing might not mean a any thing for retail real estate for example. I believe you can find value in some areas of real estate that can do well while the US housing markets corrects itself. Even in the US housing market, there are areas that doing quite well right now. Take a look at North Carolina, Seattle, and Texas home price appreciation this year in the midst of housing slow down; it is impressive.

I would like to look at the retail REITs in Canada for several reasons:

  • Canadian Economy and housing market are not experiencing the same woes of the US. Canada did not experience the high level of speculation in houses and more importantly lending practices are conservative and more traditional. there is no subprime here.
  • retail locations are getting dearer in high growth urban markets. therefore established retail centres have competitive advantage by virtue of its irreplaceable locations.
  • retail space owners have a competitive advantages over other types of real estate, that I will go through later in the post.
  • the Canadian retail development did not go through a building boom like in the office and apartment sectors.
  • National retailers including Wal-Mart have big appetite for large chunks of properties, Lowes is entering the Canadian market as well, so demand for retail stores remain strong across Canada. Retail transactions volume and price have appreciated steadily in last few years based on CB Richard Ellis statistics. However, if the economy slows down this demand will be curtailed and real estate prices will slow.

A listing of Canadian retail reits can be found here. A sift through that list and screening through the assembled metrics I have chosen to analyse RioCan Reit. RioCan is one of the oldest reits in Canada and therefore it has accumulated better and cheaper properties than its rivals. In addition, it is the biggest, more conservatively financed, has better cash yield and lower payout ratios.

RioCan Real Estate Investment Trust (RioCan) (Google Finance):

... is a Canada-based, closed-end estate investment trust (REIT) trust. At December 31, 2006, the Company had ownership interests in a portfolio of 196 shopping centers. RioCan’s income properties are comprised of two components: long-lived income properties, including leasing costs and intangible assets, and properties held for resale, including properties acquired or developed directly and indirectly with partners.

Competitive Advantages
  • RioCan is one of the oldest reits in Canada. It began purchasing properties in the later half of the 1990s. No other public reits began operation until the early 2000, s that gives RioCan a leg on competition. It allowed RioCan to buy primer locations at lower prices.
  • Retail Reits in general have a competitive advantage in its ability to lock tenants into long leases, therefore securing steady cash inflow over longer periods of time compared to, for example, apartment or storage reits. RioCan, in particular, has, in addition to 97.6% occupancy rate, long term leases with tenants as more than 60% of its leases expire after 2012.
  • Moving out of an apartment can be a hassle, can you imagine moving a retail store. Retailers have invested heavily into their locations from advertising and logistics infrastructure, so moving a retail outlet is no easy task. This is one of the most important advantage of retail real estate owners is the high switching costs tenants can incur compared to rent increases.
  • RioCan have a financial scale and debt capacity that is larger than its peers. It is conservatively leveraged and has adequate size to take advantage of large opportunities and to withstand market deterioration.
  • RioCan properties are located in high population growth areas mainly: Toronto, Ottawa, Montreal, Calgary, Edmonton and Vancouver. There is a strong migration trend toward urban centres around the world and Canada is no exception. RioCan's properties will benefit greatly from that.
  • Stable large chain retailers occupy the majority of RioCan locations. RioCan generate 50% of it revenues form these retailers. So credit risk of tenants is small.

Financial Quality

FFO/LTD Debt9.74%

FFO (Funds From Operations) is a measure that adds back depreciation and gains from property sales to come to a figure that represents cash flow generation.

RioCan has above than its peers average coverage of 7.91% and its closest competitor CWT.UN of 6.47%. However the level of coverage is low compared to a globally accepted coverage of 15%.

Ltd Debt/ Market Cap69.9%Another measure for debt quality shows the company is conservatively financed less than the average reit at 108%
Ltd Debt/ Ent. Value41.8%group average is 51.5%. under 50% is positive and acceptable sign for investment grade reits.
FFO/ mortgage pmts(interest+ principal)1.15xThe figure is adequate but not high enough to provide me with extreme comfort level. I would liked to see at least 2x mortgage payments.
FFO Growth/ Distribution Growth5.46%/ 3.82%

over the last 10 years FFO and dividends growth have averaged 5.46% and 3.82% respectively, which is a good growth rate over 10 years. The long period assures me that it has covered several real estate cycles and at least one economic rescission.

Cap rate8.97%Current cap rate (NOI/ property book value) for the the entire portfolio is on the high range of market rates. CB Richard Ellis market survey of Ontario cap rate is 5.75-7.25% in late 2006, while management estimate market cap rates to be 5.5-6%. Although cap rates have been coming down as indication of higher real estate prices, RioCan should not be affected as it did not do any major acquisitions in 2007. This is a testament to management capability to wait for value; a quality I admire.

The only concern from the analysis above is RioCan's coverage of payment obligations. I stress test the RioCan's coverage of its obligations by assuming expiring leases would not renew and a decline in the rental revenues for the reits as a result. The following table plots total obligations by year as well as lease expiry percentage. I assume no renewal to calculate how much income will the reit generate and if it is enough to meet its obligations. The result is enough coverage in this extreme scenario.

Mortgage pmts$ 36,492. $ 270,750. $ 267,591. $ 286,129. $ 108,809
Debenturepmts$ 110,000. $ 110,000. $ 100,000. $ 200,000
Total pmts$ 36,492. $ 380,750. $ 377,591. $ 386,129. $ 308,809.
Lease expiry1.40%6.90%10.30%10.40%11.80%
Rental revenue$644,383. $ 9,021.36 $ 44,462.43 $ 66,371.45 $ 67,015.83 $ 76,037.19
No renewal revenue$ 635,361. $ 590,899. $ 524,527. $ 457,511. $ 381,474.
Coverage times17.41 1.55 1.39 1.18 1.24

Overall RioCan has on better than average leverage but not so spectacular debt service coverage. Its FFO quality is excellent with steady growth rates and good cap rate compared to current market conditions.

Management Quality
The lack of transactions in 2007 and for the major part of 2006 indicates RioCan's management capability and quality. Reits should be patient enough to take advantage of miss pricing and low prices opportunities, which were not available in 2007 and 2006, so RioCan management did nothing. While capitalization rates were coming down, indicating higher prices, management stayed on the side lines. Making low cap rate transaction is a sure way to destroy value. If a reit cost of capital is around 6-7% and they make a transaction with cap rate of 5-6%, then there is no value added by management to its shareholders. As discussed above RioCan overall cap rate is about 8.9% and their cost of debt is 6.1% and management is cognitive that creating value in the long run is more important than focusing on deals and short term growth in earnings.

The Reit's ROIC (FFO return on invested capital) is higher than group; it stands at 7% while the group average is 4.89%. ROIC have shown a steady trend over the last few years indicating the quality of management decisions for investing prudently rather than doing deals for the sake of doing deals.

Management, other than directors, owns 643,625 units of the trust; an approximate ownership of .31%. On a diluted basis management owns 2.14% of the trust accounting for their options. You want reit's management to own a little bit more than that to ensure that their actions are aligned with shareholders interest. Although 2.14% is not a small ownership given RioCan size, I would have been more comfortable with an insider ownership position of 5%.

Insiders have been net sellers over 2007 to the tune of $20 million, in fact in dollar amount RioCan management tops all Canadian insiders in share sales. Not an encouraging sign, which can be an indication of continues price pressure on the units. The mere selling can be attributed to several reasons other than RioCan's financials but there were only two buys throughout the year for only $156,000. Not a ringing endorsement of what management sees in the future for the trust.


The most critical piece question is does the valuation make sense. I will be using several measures to value RioCan. I will use comparative valuation multiples both to the industry and to RioCan historical averages. In addition I will use a discounted cash measures and asset valuation measures. These host of measures have advantages and disadvantages, but combining them can give me a good yardstick for the true intrinsic value of RioCan.

Dividend Yield6.2%dividend yield is comparable to the group average, although you can get higher yields in this space it will be of lesser quality. The yield itself is not a good valuation tool even if it is high compared to others as it can be distorted. The good aspect of RioCan dividend yield is its payout of about 90%. The payout ratio is considered good for a reit as long as it does not exceed 100% on a long term basis. RioCan in its 10 year history exceeded the 91% level only once in 1998 its first year of operations.
FFO Yield6.81%The FFO yield is an alternative to earnings yield and it is the inverse P/FFO. It indicates that RioCan has a slight premium over the group average of 7.6%.
Entp Value/ FFO24.5xRioCan sells at a discount to the Canadian group average of 29.6x.
Div yield spread over 10 yr Bill2.42%

The spread of dividend yield to 10 yr Bill give me an indication of risk premium as as valuation if compared to hostorical figures. RioCan current spread is lower than its 10 yr average of 3.3%. However the spread has widened over the last three years indicating favourable valuation for RioCan. see figure below.

The company is rated BBB by S&P. So a comparison to similarly rated corporate debt yields a spread to 10 Yr TB of 1.7%, so a spread of 2.42% for a reit of the quality of RioCan is more than adequate.

FFO yield spread over 10yr Bill3.02%

A similar situation in FFO yield spread over 10 yr Canadian bond. RioCan valuation is getting cheaper but not as cheap as its long term averages. by way of comparison CWT.UN has a dividend yield spread of 2.54% and FFO yield spread of 3.67%. Indicating a slight premium for RioCan, which I think stems from a better leverage and capital structure.

Both RioCan and CWT.UN follow a similar trend in valuation indicating the retail space is getting cheaper from last 3 years.

Price/ NAV.92

I have conducted a rough estimate of RioCan's properties market value to compare it to book value on their financials. I have done this by applying per sqr ft price of recent retail outlet transactions in similar geographic regions to RioCan's properties. RioCan has acquired 51% of its portfolio between 1996 and 2000, so a significant appreciation has occurred since purchase. RioCan's properties book value is $4.38 Billion, while my calculation has given me a value of $7.5 Billion.

The price to net asset value (estimated market value before depreciation less total debt) of RioCan is .92 indicating that the current market price trade at a slight discount to the true breakup value of the reit. This would be my liquidation value safety net, if the company to go bankrupt tomorrow, I know that I will roughly get what I invested.

Discounted AFFO Value$22.09Reits should not be valued on breakup value alone, however they should be judged on their cash flow generation. I have assumed no growth in RioCan's cash flows (FFO less maintenance capital), a proxy for free cash flow, and I choose to calculate it on a perpetual basis using their cost of capital of 6.79%. The figure is a slight premium to the market price of $20.5.

Based on several measures RioCan appear to be trading less than its intrinsic value ever so slightly. Currently market price is equal to a non growth stream of cash flows and I am given more than adequate protection of breakup value. The dividend yield gives me an adequate spread over comparable bond and yields have gotten cheaper historically.

Although the units are selling at a discount, it can sell at a bigger discount going further. Experts are calling for 50% chance of a rescission in the US and Canada will not be far behind. In that case reits prices will come under pressure, however their intrinsic value will expand as reits like RioCan will be able to buy new properties with higher cap rates. More deals at favourable cap rates will lead to higher cash flow or FFO growth than organic growth.

Investment Conclusion

Although valuation measures are positive and management did a great job creating value, I will take my time to accumulate a position. Given a slowing economic situation and 2 year trend of reits valuation decline, retail reits will come down in price further creating better margin of safety and dividend yield. However, I will be buy at will at a price of $19.5 and under.


Sources: Google Finance, Yahoo Finance, RioCan reports, Globe and Mail, CB Richard Ellis, Ink insider Research, Bank of Canada

Buffett says not eyeing financial firms but could: report | Reuters

Buffett says not eyeing financial firms but could: report Reuters
Buffett was quoted:
"We haven't seen any (investments) we want to move on. That doesn't mean we won't
in the next six months"

Is this a judgment call on the sector? May be not. Remember that Buffett has 37% of his portfolio in financial companies, bank or insurance. Earlier this year he purchased BAC, and added to his holding of US Bankcrop and Wells Fargo.

Also most of the capitulation happened in investment banks, which Buffett do not like due to earning volatility. He has made an investment in Solomon Brothers, which I think he regrets, indicating from his shareholder letters. Buffett did not like the selfish culture of traders and investment banking. And found that earnings are less than easy to read and evaluate. So when he says that no opportunity exists, in his mind the sector in good times is not a good one to won let alone in bad times.

December 24, 2007

Visa IPO

Visa is set to become a public company in 2008. It is expected to be one of the biggest IPOs in recent years. Although I do not like IPOs or investing in them, Visa offers a strong business that is worth the look.

You can find Visa prospectus here.

Most credit card companies, the big three anyways: Visa, AMEX and Master Card, are great businesses to own. They are what some investors dub them "toll bridges"; you have to pay every time you use them and in this case the merchant as well as the user pay.

Credit card companies have an incredible competitive advantage to new comers, if any dares to compete, look at the financial shape of Discover cards. The industry is almost impenetrable. Visa is one of the strongest franchises in credit card processing industry. It has one of the largest networks for card processing, a valuable brand name, and a large installed base of retailers and merchants accepting its cards. Visa is the largest credit card company of the three. It processed more than 44 billion transactions last year worth more than $3 trillion.

The company, no doubt, have the all the ingredients to be a value idea but at what price. Certainly people will trip over themselves to buy Visa sending its shares into the stratosphere. I think it is prudent to be patient with this one and look for an opportunity , as no doubt there will be some. Visa is locked in some litigations that can offer such an opportunity depending on its outcome. Another opportunity is the slowing economy and a possible rescission, which can send credit card defaults higher, which in turn will reduce Visa's earnings.

December 23, 2007

Unilever: Value Idea?

Unilever (UN) (Source: Google Finance):

... is a supplier of consumer goods across foods, and home and personal product categories. Group operations are organized into two divisions: Foods and Home and Personal Care. Unilever serves as a food company that meets everyday needs of people, through branded products. In Personal Care, six global brands are the core of its business in the deodorants, skin cleansing, daily hair care and mass-market skin care categories.

UN has a three broad product categories littered with well known brand names:

  • Foods:Lipton, knorr, Becel, Flora, Hellmann's, Slim-Fast, and others
  • House Care: Cif, Sunlight, Surf, Omo, and others
  • Personal Care: Axe, Dove, Lux, Pond's, Sunsilk, Vaseline, and others

Business Economics Quality

The company is lagging peers in margins. Unilever have a 13.7% operating margin compared with the likes of Heinz 16.4%, General Mills 15.9% and a sector average of 17%. The consumer category has better margins but still lags its peers like P&G; UN gets 17% operating margin while P&G earns 20%.

I like to examine the cash to cash cycle, length of time to convert idle purchased inventory to cash in the bank, as another indicator of a business efficient economics. UN had a cash cycle of 35 days in 2006 down from 41 days in previous years, which is good improvement and should have additional room to bring it down further. They are yielding 40 days plus for account collection while it should be under 30 days. The company inventory days, length of days inventory is idle, is one of the lowest in the industry. However, on TTM basis there is a unfavorable trend developing, both AP and AR days have shot up. It seems that the company is not as efficient collecting from customers and as a result not paying its suppliers, it takes almost 90 days to pay suppliers which is very uncommon. The measure gives another dimension to the inefficient economics evident by the low margins noted above.

Unilever's management stated that its number one priority is growth -- competitive, profitable and consistent. The company plans to reinforce this with steps to accelerate performance; these are raising the bar for innovation, more aggressive shaping of the portfolio and cost and asset reduction to further enhance margins. The cost reduction programs include (1) "One Unilever", which management thinks can generate around $1.3 billion in yearly savings during 2008, (2) Shared services, which covers finance, information technology and human resources and should be completed in 2007 to 2009, (3) Global buying, which management expects to save, on average, over $500 million per year from 2005 to 2007, and (4) Strengthened Marketing & Customer Management, which is rolling out 2006 to 2008. Management says that these programs are apart from its "normal" restructuring.

Recent quarterly figures have not produced any significant improvement for UN margins over its historical record. Therefore the jury is still out on the competitive cost structure and the success of its restructuring efforts. A review of UN history reveals that the company has taken previous restructuring projects and its margins were flat over the years, which leads me to wonder if this plan will be any different. I think it will due to management commitment to the program and it is evident by the recent disposition of sub-par margin products.

In addition to the administrative restructuring and to further improve its margins, the company has set to dispose of non strategic products. Indeed, the company over the past few years has been disposing of mainly the low margin business of food products and North American products. UN in 2004 disposed of frozen Pizza, olive oil, in 2006 sold frozen food products, and in 2007 it sold off more food divisions mainly US cheeses and cooking products. I generally do not like packaged foods producing businesses, as I think they have no advantage over generics, have a lot of competition, and plenty of raw materials cost pressures. So the general direction and strategy of disposing of food is a positive one.

The positive aspect of UN operations is its strong geographic diversity: Americas constitute 37% of revenue, Europe 32% and Asia 27%, and, the most important growth segment, the emerging markets have more than 1/3 of its sales. Emerging markets constitute a great opportunity to grow and UN have already an established strong position in these markets that they can capitalize on. The emerging market represent a good opportunity due to: 1. emerging consumer class with spending power, and 2. positive demographics of young consumers.

UN spending on Research and Development (R&D) lags competitors like P&G. UN spends 2.27% of revenue of R&D, while P&G spends 2.76%. Even with additional spending, UN may be ineffective as it has more than 400 brands. Spending the R&D budget over this wide selection of products will not yield meaningful results. However, in their latest financial results the company is reshaping its R&D efforts "...we are focusing resources on world class R&D capabilities, working with clear innovation targets and concentrating on fewer – but bigger – projects", which combined with focused mission of "vitality" will help yield better results from their future R&D efforts.

Unilever has the foundation to have good economics and a tremendous upside once management successfully deliver on its restructuring and cost cutting plans. :

  • operations are inefficient but the company has ample room to improve and yield better margins,
  • disposition of low margin and non strategic assets,
  • better R&D focus, and
  • strong presence in high growth markets

Competitive Advantage Quality

Although Unilever is large but it is half the size, in revenues, of P&G and Nestle, the big gorillas in the industry. However size in consumer products, not foods, is not a competitive disadvantage; smaller players can compete effectively. What is critical is the quality of the product and an effective marketing effort. UN management possess good consumer marketing capabilities. The successful launch of their deodorant AXE is a testament to their capability. AXE campaign is one of the most successful product launches in the industry. UN neutralizes size disadvantage, if any, by possessing good marketing acumen.

UN has an advantage in their consumer brands only. Consumer are more personal than food. Users develop an attachment and a habit of using what they know and works for them best. UN has a host of strong and leading consumer and personal care products that give the company a competitive advantage over others.

UN has an established oversees market for a long time, its Asia and Africa markets was developed in the 90s, and this presence will yield two advantages:

  1. experience and established distribution network and efficient and effective logistics infrastructure that will keep competitors squeezed out from store shelves, and
  2. mind share of local users and better consumer research then rivals that will enable it to customize products to fit local environments.

The competitive advantage of UN is limited to its consumer products rather than foods. Actually UN is at a competitive disadvantage in foods as its operating margins is lower than rivals, probably due to size issues. However as we discussed above the company is paring down its food products, which will leave the company with the better protected and higher margins brands.


Valuation assumptions:

  1. increased cost pressures on foods going forward due to raw material inflation.
  2. growth rate of 3% for the next 7 years although the company is targeting a growth rate of 4-5%. and a perpetual growth rate of 1.5% in revenues thereafter.

The company discounted free cash flow is $48 per share, adjusting for 50% ownership and exchange rate, compared with market price of $36 per share. The market price represents a 26% discount to intrinsic value. Although a discount exists, is not sufficient to give me a margin of safety that will limit our downside risk. The company would have been a terrific buy 9 months ago at less than $30 per share. You can view valuation figures here.

The company has two separate and distinct operations: food and consumer products. The food valuation is distinct than the consumer product, as the consumer product is more akin to P&G operation and multiples and the food is more like Kraft and Cadbury. In fact the company's multiple is higher than the pure food company but lower than a consumer product company like P&G as displayed in figure below. Therefore a sum of the parts valuation is needed in addition to a typical discounted cash flow approach to ascertain to the derived valuation.

I use Enterprise value to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) multiple to value the parts of Unilever, as it neutralizes leverage and tax situation between different companies. Using this method I arrive to an intrinsic value of $61 per share close to the discounted free cash flow range, therefore confirming my assumptions about the intrinsic value of the company.

All figures in US $ BillionsFoodConsumerSum of the parts
2007 EBITDA (TTM)$ 5,282.72 $ 4,500.09
EV/ EBITDA Multiple10.87 13.87
Enterprise Value$57,423.14 $62,398.28 $ 119,821.42
LTD Debt$ 14,100.00
Equity Value $ 105,721.42
Fully diluted number of shares1,714,000,000.00
Implied Value$ 61.68

The $48-$61 range represents a good upside, but I still do not view the range as enough margin of safety to make a purchase. Unilever along with all consumer staples have gone up in price so much during the last 4 months due to the credit crises. Investor have shifted their capital to these names due to the relative safety of their earnings and their low volatility. I expect once the crises have been stabilized these names along with Unilever will come down in price making a terrific buying opportunity.

In conclusion, Unilever has a host of good brands, some competitive advantages in the consumer products, a management that is improving operations costs and represent a discount to the current market price, however not enough discount to warrant a purchase at this time. So I will wait to see management future actions in selling lower margin products and monitor its price if the market gives me an opportunity to make a good purchase.


Sources: Unilever, PG, KFT, and COL annual reports, google finance, Reuters, S&P research


Organization structure of UN:
Unilever operates as a single business entity. However, there are two owners: Unilever (NV) and Unilever (PLC) are the two parent companies of the Unilever Group, having separate legal identities and separate stock exchange listings for their shares. You can find Unilever shares trading on NYSE as UN or UL representing NV and PLC respectively.

Please note that most financial sites like Yahoo and Google have UN dividend yield overstated. It still calculates the yield based on UN's old dividend policy. Since the restructure, UN declared two dividends through 2006 an interim and one-off. Their 2006 total dividend was $.625 making the dividend yield 1.7% much lower than Google Finance's 4% yield few weeks ago.

December 21, 2007

Chrysler in serious financial crunch: report | Reuters

Chrysler in serious financial crunch: report | Reuters

Is this a sign of things to come for most leveraged buyouts? My guess is yes.

the slowing economy and you have a Private equity firms have taken so many companies private over the last few years and loaded them with debt. However the debt used in buyout was never intended for business operations but to buy out shareholders and pay transaction fees for private equity firms. Add to the less flexible balance sheets of LBOs subprime implosion in corporate America similar to the one going on in housing.

Debt taken on by LBO companies are packaged in another three letter acronym entities, they are called collateralized loan Obligations (CLO) rather than the more infamous housing relation Collateralized Debt Obligations (CDO). SIVs and banks were left holding the bag with the housing mess, will they be holding another surprize for us with corporate subprime?

Brands and Competitive Advantages

Brand names are often linked to the existence of strong competitive advantage in business and in turn command premium valuation. Companies spend billions of dollars to create, promote and sell their brands to consumers. Developing a great brand can be a long and substantial process to gain customers trust and mind share. A company with a recognizable brand can gain significant economic benefits. Products with brand names can outsell their cheaper generic competitors. For example, Coca-cola's market share is far superior to any generic or store bough soda. In fact, Coca-cola is the most valuable brand in the world with a value of $63.4 Billion according to recent BusinessWeek research. Another example, is Advil, which outsells the generic and much cheaper Ibuprofen bottles.

In this post I want to examine the role of brands plays in valuing a business. Does a brand name lead always to competitive advantage? Do brands deserve a premium valuation? Brand names indeed may lead to competitive advantage, but not always. One need to evaluate the industry, pricing points, competing products and consumer usage to determine the brand value in creating sustainable competitive advantage.

There are several cases where brands do not translate into competitive advantages. Here are some cases:

  • Highly competitive industries: You can always bet that industries with too many alternatives of equal quality and product specification, brands do not translate into competitive advantages. Rarely that any company in similar industries has created sustainable advantages over its competitors. Here you can probably think of car brands. One of the most successful and quality cars is the Mercedes Benz, but the brand of Benz did not translate into leading market share or added value to investors as many luxury car makers followed into this segment and took customers away from Benz.
  • Commodity industries: Any firm that invests in branding in a commodity industry will destroy value. No one really cares what brand of plumbing, wires, screws...etc they are buying. You just buy the cheapest one.
  • Typically capital goods items where they are purchased infrequently and require large investment do not have brands with sustainable competitive advantages. Long lasting goods are purchased less frequently, often cost a lot, and you are therefore more likely to take the time to carefully consider your options before purchasing.

When do brands lead to Competitive Advantage?

Branding by itself is not sufficient to create a competitive advantage for a business. A new entrant to the industry with sufficient resources can create an equally competitive brand in terms of quality and reputation. In order for a brand to create sustainable competitive advantage, it has to be coupled with captive consumer behaviour that locks them into buying the same brand over and over. A business needs to be able to convert a product brand into something the customer connect with at many levels by coupling it with one of the following:

  • User Habit: think of a smoker and his preference for Marlboro cigarettes or a Coca-Cola drinker who got accustomed to the taste, Buffett can attest to that as he drink 5 cokes a day. It is very hard or nearly impossible to change consumer habits and behaviour. Products associated with habitual purchases create some of the strongest competitive advantage for a business that exists.
  • Switching costs: customer will be captive to a brand if it has high switching costs associated with changing brands, particularly for low cost and frequently purchased products.
  • Search costs: customer is tied to a specific brand if his search costs for an alternative is too high. Car insurance is a great example. Have you tried to compare quotes between providers? It takes too long and you come up with different policies that you can't you stick with the provider or the brand that you have. Also, brands that are frequently purchased are more likely to lead to strong competitive advantage. A consumer is more likely to be brand loyal with low cost items, since the cost and the effort to research alternatives outweigh the purchase itself, so you stick with what you know.

How to value brands?

I always place a valuation on brands for companies that demonstrate some of the characteristics listed above. Brands in these cases are as or more valuable than fixed assets. There are no rules how to value brands and it is almost a judgment call to the strength of the brands. BusinessWeek does an annual survey for the best 100 global brands that can be a starting place if the company is listed there. If it is not, I usually take the sum of the last 5-7 years of marketing and advertising expenditure and capitalize it on a declining balance, i.e. reduce earlier years expenses by a percentage factor. The sum is added to my valuation on per share basis. This figure will replace whatever goodwill written into the balance sheet as it is more accurate and relevant than book value of merger and acquisition premiums.

Sources: "Competition Demystified" by Bruce Greenwald, Brands-vs-franchise by, "best Global Brands" by Businessweek

December 20, 2007

Margin of Safety: Citadel investment in E-Trade

Citadel investment in E-Trade is a perfect example of the idea of margin of safety. The press have reported on the cash infusion made by Citadel in E-trade as a life line. It is a savvy investment not only for the 27 cents on the dollar purchase of subprime assets, you can argue that this is their market value, but to the value Citadel will gain even in the case of E-trade failure.

In total Citadel invested $2.6 Billion cash in E-trade; $800 million for $3 billion worth of subprime assets and $1.8 billion in a stake in the company, a combination of debt and equity. Citadel injection of $1.8 billion represents a 20% share of E-trade. Still any gains on the subprime papers sale may at best case scenario offset the $1.8 billion invested, if E-trade failed completely. Citadel could not have made the investment if this their margin of safety.

Obviously there are two scenarios for this investment: E-trade will right itself and Citadel will earn interest and capital gain on on its investment. However, the more interesting one is the failure of E-trade: what will Citadel gain?

Citadel is not just a successful hedge fund but it has a large back room operations and institutional services that it markets to other hedge funds and institutional clients. It is one of Citadel competitive advantage over other funds as it lowers its trading costs and hides its training strategies and positions from competitors. Citadel ambition is to be a large diversified financial services firm similar to the likes of Wall Street firms. And some of E-trade assets can be its ticket.

Citadel have grown in leaps and bounds over the last few years and mainly in its back room operations and services. And here where I think the win-win case for Citadel. E-trade has a market making and significant back room operations that have many institutional clients. If E-trade fails, the federal deposit act can cover retail deposits losses and Citadel can gain control of the back room operations. Citadel will not have to pay cent for it in this scenario. So its newly acquired back room operations costing $1.8 billion is far cheaper than doing it on its own.

I can imagine that Citadel have much more detailed analysis and due diligence and i can't wait to read about it at one point in the future. Citadel is great value investor they will be making money no matter what and their downside is very limited.

December 19, 2007

What's another $9.4 Billion in write downs

Morgan Stanley reported its earnings today. Forget earnings look at its revenues. It reported negative revenues of $450 million, as it claimed $9.4 billion write down related to subprime and credit crunch issues.

With the latest write down the tally for bank's write downs is $78.6 Billion , see complete list here.
                                         Quarter Ended
Nov 30, Nov 30,
2007 2006 % Change
---------- --------- --------
Net revenues
Institutional Securities $ (3,425) $ 5,475 (163%)
Global Wealth Management Group 1,789 1,452 23%
Asset Management 1,252 973 29%
Intersegment Eliminations (66) (51) (29%)
-------- --------

Consolidated net revenues $ (450) $ 7,849 (106%)

December 18, 2007

A lesson in Valuation- Peltz letter to Cadbury Schweppes

I always like to read activist shareholders letters to company management. They reveal business thinking and I learn from them insight to the industry I am following.

In this case Peltz is prolific in his letters to companies he invest in. His letter is no short of a thesis for strategic plan. I urge you to look up his letters in Sec filing they are very informative.

Here is a link of a letter he sent to Cadbury Schweppes's board, my favourite candy, so do not skim on the chocolate to improve margins please, you can read it here.

My Game Plan for Value Analysis

A reader emailed me about how to research a business for investment. In this post I will share with you the steps I take to do so.

A lot of time I take few weeks and even more to research one company. Sometime it get boring just reading on one company, but I think it is worth the effort to understand the risk and rewards of the business. Many have said that value investors sleep tight at night, well it is true as I know precisely the risks involved with any particular investment I hold. That knowledge is critical to relate and analyze the slew of news and information that zip through the media and analyst recommendations. Therefore I do not panic when the stock price drops on news that will not undermine the business fundamental of the company.

So below is the steps i do to research a business and it is generally broken into two sections:
  1. Understanding the business, and
  2. Valuing the business



Understand business

Read Annual Report current year

Understand business

Read Annual Report previous year

Understand business

Read Current quarter earning report

Understand business

Listen to current quarter earning call

Understand business

Industry analysis: read latest annual report and latest quarterly earning for chief competitors in the industry

Understand business

Read management presentations and competitions presentations plus any research on the industry.

Understand Management Ability

Research management resumes and review latest proxy statement

Understand Business

Determine and list industry and company economic drivers

Is the business a sound and have value potential? If yes then

Understand Business Value

Gather financial data for analysis

Understand Business Value

Reclassify financial if necessary

Understand Business Value

Perform common financial and ratio analysis

Document Reason for Investment

Answer questionnaire

Understand Business Value

Create Revenue forecast model

Understand Business Value

Value business and determine if the price is favorable to buy?

Is the business trading at a price below determined value? By how much?

You value seeking investor,