November 30, 2007

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Other: / Lex / Macroeconomics & markets - Saving subprime homeowners / Lex / Macroeconomics & markets - Saving subprime homeowners

As efforts gather to save those who consumed and speculated, I begin to hopelessly think that the US financial system will never be whole again. The fed talks about cutting rates, the government talks to the banks about freezing interest payments to sub prime borrowers, banks talk to the US Treasury about a super fund to save the credit market. All patch solutions that are good in theory but will fall short in practise and the financial system will be even in a worse situation down the road.

The pain of today's environment is necessary to reprice and vet the system for its excess's. without this repricing of risk and excess, all solution will come back to haunt us.

The article below from the financial times sum it all.

As a general rule, the more grandiose the title, the less achievable the objective. The White House wants its “Hope Now Alliance” initiative ready by the end of the year. This aims to alleviate the worst effects of an estimated $500bn of subprime mortgage rate resets in 2008.

Hope Now will apparently focus on delaying rate increases for some loans. In theory, this will reduce defaults, alleviating pressure on the housing market and wider economy. But how to make it work? Right now, the talk is of helping only those borrowers who fall in the middle ground of being able to afford a house at current rates but not so viable they can do without help. Who decides, and how? If the plan is too narrow, it will not be effective enough. Too wide and it becomes an indiscriminate bail-out.

There is a logistical issue, too. Assessing a borrower’s eligibility for modifying terms involves some effort. The joke is that this time, lenders might have to go to more trouble and expense than they did when many subprime loans were originated. That means hiring more people, not cutting headcount as many mortgage servicers are doing.

That reduces the potential gains to be made by modifying loans rather than foreclosing against them. On top of this, what little data there is – modifications have hitherto tended to be small-scale – suggests 35 per cent or more of such loans default within two years anyway. It is also unclear what effect this would have on mortgage-backed securities. Lower default rates upfront might help, but lower payments and longer schedules on underlying loans could affect ratings and cash flows.

Beyond this, moral hazard raises its ugly head. Using the wonders of securitised finance to bring people into the ranks of homeowners who could not really afford it created the subprime mess. Keeping them there by putting off the day of reckoning does not sound like the best way of restoring long-term stability

Home Builders are not a value idea!

I have discussed home builders as value idea, but I was wrong.

I have been researching the industry and its economics and I have arrived to the conclusion that home builder may have gotten cheap but I do not see any value in the long run. I base my conclusion on the premise that Home Builders have no sustainable competitive advantage and do not display any characteristic of being a franchise business, ala Buffet definition. In addition all players in the industry have no barriers to entry against competition. Some may have limited barriers to entry to a specific location but it is very costly to reproduce on consistently.

I will go through some of the competitive advantages that can lead to a franchise with wide moats:

  • Commodity Business: Houses can be argued to be commodities with no particular builder offering a unique and compelling proposition to customers, except for location, otherwise it is a commodity.
  • No economies of scale: Real Estate is very localized so size and economies of scale is not a factor to compete. A local property developer can compete equally with a national business. Both will have the same cost to acquire new customers, as national businesses can't leverage advertising and therefore must localize to each market at the same rate as the local builder. In addition, their cost will be similar to produce as labour is localized as well and supply and demand will determine their wages rather than bargaining power.
  • No network Effect: The network effect wide moat is established when you create a business where the more people use your product, the more valuable that service becomes for other customers. If i buy a house from a builder it does not make the second house they sell any more valuable to customers.
  • Brad Name: There are no Brand name loyalty in this industry. consumers will value the home and location only rather than the builder. They will not display any loyalty to any brand name. Houses from a local builder and national builder will have similar traits and value. What is important is location and no builder have a monopoly over locations.
  • No buying habits: customers are not locked or prefer any specific builder for their next home. And more importantly it is a very infrequent purchase.
  • Patent and Trademarks: none.

As further quantitative evidence, I have calculated Home Builders Return on Invested Capital (ROIC) for the last 10 years, see chart below. I have adjusted for depreciation by using Earning before Interest taxes depreciation and Amortization (EBITDA) and also used the enterprise value as the denominator rather than total assets. As a group, the result was not a surprise, their ROIC is very anemic and very sensitive to the economy and the cyclical nature of the industry. The average ROIC for home builders over 10 years is just 11%. The industry invest a lot in fixed assets and working capital to produce its products. And in many circumstances, it sits on loads of land with no economic benefit derived from it during downturns. Also, the investment in assets is not turned quickly as builders have to wait months and months to deliver and close on new developed products. The heavy investment in fixed assets combined with learning ow margins tend to produce lower ROIC.

However, to get a proper picture of home builders true economic value we have to combine ROIC with their cost of capital. ROIC by it self is not sufficient to judge the health of a business. however, I did not want to go through the research and time to do the calculation as it is not needed. Suffice to say that any business operating in today's environment will not have a cost of capital less than 9-12%, and that's being generous. Home builders will have higher cost of capital as they are higher beta group and very cyclical. therefore, the economic value generated by home builders is not worthy of investing in this business and I suspect that in many years home builders would have destroyed shareholder value.

Some builders may rally, actually today they have rallied in a big way. Some may be are trading below breakup value and that may attract some investors. However they lack what is needed to be franchise in my analysis. Do you think differently?

November 29, 2007

Value Ideas

Can we find value amongst this carnage in financials and the credit market?

As the market is filled with fear from losses and declining prices, this period can be rewarding for those who look at the big picture. In the angst of the stampeding and fleeing investors, there is got to be something of value. I can look in areas where I have some expertise in, those would be retail, real estate and banks. I am very sure there is value in other pockets of the market, may be in the Collateralized loans and Mortgage backed securities area, as Citdal fund have scooped $3 billion worth of paper for $800 million just today, but I do not have the expertise nor the information necessary to assess and understand their value.

The areas of potential value that I have researched, as I can asses it relatively well, are the following:

  • Bank of America (BAC): the bank has a large national branch network that have a solid competitive advantage compared to others. BAC has the economies of scale to be a low cost leader compared to other under capitalized, less represented geographically. It has minimal investment banking exposure, which is the source of all evil in this market. The problems of under capitalized lenders will drive business to BAC earnings, as BAC can withstand liquidity crunches due to its large capital base and size. The bank has an earning yield of 9% plus its dividend yield of 5.75% to equal an expected return of 15.6% superior to the industry and the S&P as in the schedule below. The bank also has a ratio of equity to to total assets of 8.77% that will be increased once its mark to market its holding of the China Construction Bank. The increase in value will be $19 billion which translate an equity to total assets of 10%. My analysis regarding BAC is forthcoming, but I have managed to take a position in the banks two days ago at a price I am happy with.

BACIndustryS&P 500
P/E Ratio (TTM)10.1710.8920.35
Price to Book (MRQ)1.471.614.43
Price to Tangible Book (MRQ)3.434.048.82
Price to Cash Flow (TTM)8.819.6114.77
Dividend Yield5.71%4.88%2.26%
Earring Yield9.83%9.18%4.91%
Expected Return15.54%14.06%7.17%

  • Lowes Home Improvement (LOW): LOW have a good predictable earning in the long term. I have already invested in LOW, see my analysis here. LOW will recover when the housing situation corrects, that will happen maybe in 1-2 years, all the same I am willing to wait that long.
  • Corporate bonds: 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, see chart below ( 10 yr spread of corporate bond to 10 yr Treasuries, source: yahoo and dow jones) . 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 premium for high-risk, high-yield bonds has increased even more to 4.95 percentage points.

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.
A good example is UBS's FDI fund. The discount has widened to 12.39% while its average year to date discount was 8.7%. The funds yields 5.65% which translate to a spread of 1.65% over 10 year treasuries, a very respectable return for a majority of investment grade portfolio.
FDI Premium/ Discount Profile
However, a bad example is the likes of BlackRock core bond trust (BHK). The fund is offering 6.58% yield, a little more than 2.5% over the 10 year treasury. The fund is currently is selling at 10.5% discount to it NAV (Net Asset Value. The discount has widened considerably since this summer, when its averaging close to 6%, see chart below. However I would stay away from such funds as they are filled with mortgage papers. You have to go through the individual holdings of these funds to realize if it holds any value.
BHK Premium/ Discount Profile
I would stay away also from High yield issues, although their discounts and yields offer very very attractive returns. High yield issues will have higher defaults during economic slow downs and their prices usually plummets. So if you think the economy is going to do well in the next few quarters, these funds will offer a very attractive opportunity.

Where I do not see any value is in investment banks and large money centre banks in general; I have written about banks previously and I always come to the an uncertain conclusion about their future. Banks face some unfavorable possibilities in the future that probabilities can't be assigned intelligently and even unknown outcomes. Assets quality and valuation are not easy to measure and understand. Earnings are extremely volatile and can't be assessed over the long run.

Here is an expert from an article from the today's financial times that convey my thinking about banks:

The last thing a buyer wants is to rush in and buy cheap-looking companies[banks] if the value of mortgage- backed instruments on their books could fall even further. Also, there is growing fear that the US economy could weaken significantly into next year. If that is the case, financial companies could suffer bigger loan losses and become even cheaper. Finally, they might prefer to raise pricey new capital to stabilise their businesses, rather than selling out completely at a price distressed enough to attract a buyer.

Getting the timing right is tough. Witness Bank of America. It injected $2bn into Countrywide in August. The mortgage lender’s shares have since slumped.There will be ample opportunities for canny investors willing to inject capital into US financial groups. But do not expect a run of mergers or acquisitions unless the uncertainty subsides.

It is going to be very interesting over the next few quarters.

Will Leveraged Loans go the way of Sub Prime Loans

In my effort to asses how far and wide the credit problems will reach, I started to looking at the possibility of a parallel situation in the corporate borrowings to what happened in the house mortgage markets. The housing sub prime market has been hit with a wave of defaults and repricing that has caused severe losses in banks and hedge funds. The sequence of events, although extremely condensed, is as follows:

  1. Low interest rates and abundant liquidity in the economy encouraged borrowing and real estate investment.
  2. The increased activity in real estate reached a mania level and a bubble in the housing market has manifested.
  3. As soon as interest rates began to creep up, housing prices began to decline and real estate activity slowed down.
  4. The housing bubble bursts leading to high level of mortgage defaults and house foreclosures
  5. As defaults began to increase, Collateralized Debt Obligations (CDOs), a pool of home mortgages that issue debt and pays interest to their holders, began to decrease in prices and their investment grade credit quality has been questioned.
  6. As CDOs began to reprice, SIVs and Hedge Funds started to show losses and difficulty to finance and borrow against these deflating assets.
  7. The combination of slower borrowings, increase defaults and foreclosure and crash in CDO values lead to massive bank write downs, so far to the tune of $50 Billion, see here.
  8. Capital ratios, which allows bank to extend and originate loans, began to suffer and as a result banks began to tighten credit across all lending activities.

The situation is similar to housing crises in the corporate borrowing market, where, again, cheap credit has fueled another bubble as well. Home owners were not the only one who were buying assets on cheap credit. Private equity funds were on a tear for the past few years. Those funds bought every thing and any thing at huge premiums to their market prices. You can argue that the stock market record highs earlier this year was a direct result of the private equity LBO activity. The game plan was simple, take private a company that generates good cash flows and leverage it to the tilt. Banks then sell these loans, junk loans as they are highly leveraged and covenant lite, to hedge funds, SIVs and in the form of Collateralized Loan Obligations CLOs, see chart below the level of issuance of these loans.

Both situations saw feverish activity predicated on cheap credit. In the situation of highly leveraged homeowners, they buckled under high interest rates and declining home prices and the ensuing mess began. My question is will highly leveraged companies from private equity activity in the past few years get affected by higher interest cost and tight credit?

The leveraged companies bought by private equity has no room for error due to the maximum debt they took on. Banks now are tightening their lending practices and more realistically they have shut down any lending to sub par borrowers, ie., highly leveraged balance sheets, as evidenced by high LIBOR rates (lending rate between banks) see chart below.

The matter gets worse by the added complexity of slowing economy and possible rescission. In slower economy junk bond issues and highly leveraged companies experience high level of defaults, (see chart for corporate default rates from 1985- 2007). Defaults in corporate loans can hurt holder of CLOs and junk bonds, which may be found in the hands of hedge funds and on the books of banks. Banks have held the bag for over $300 billion of leveraged loans from private equity transactions that was completed through the year (source wall street journal) and could not get sell them due to lack of interest from investors, as evidenced by the failed sale of $4 billion Chrysler debt earlier this month, see article here.

If leveraged loan issuers began to default with slowing economy, bank will have another crises of write downs on their hands. / Lex / Financial services & property - Banks and balance sheets / Lex / Financial services & property - Banks and balance sheets

The tale of two banks and their SIVs. HSBC have provided the needed liquidity and consolidated their SIV onto their balance sheet, while Citi is waiting for the Super Fund to kick in.

It appears that Citi is in no position to do a similar move. Its capital ratio is so depleted taking on the massive exposure will cripple it. The evidence is the high cost of the $7.5 billion financing it took from Abu Dhabi.

MY worry is that the SIV will be too little too late. Huge expectation is being place on the super fund to fix the credit problems, it may not do so and the market will be in for another rude awaking.

November 28, 2007

Investment Beliefs

In this post I want to share with you some investing policies, if I may say, that I adhere to, I try to anyways. These policies, protocols or wisdom, whatever you may want to call it, is a foundation of my investment process, in addition to analysis methodology and investment process and procedures, more on those later.

This list is not an absolute list, but it is what suits me and suits my personality and my goal of being long term capital appreciation. You should always find something that suits you and not work in an opposite way to your natural intuition and thinking, so use this and try to develop one of your own. These beliefs or lessons, I hope, will keep you from making a big mistake, although I will always will make mistakes and I accept that. But to do well in investment I hope I can achieve with this list 1. consistency and 2. avoiding big pitfalls.

I have compiled this list from reading Warren Buffet shareholders letters and reading other famous investor philosophies. Also, I have learnt from some of the mistakes that I have done in the past, so this list will be always a work in progress.

  1. "Investing is where you find a few great companies and then sit on your ass" - Charlie Munger
    Invest for the long term. Most billionaire investors held their positions for multi year holding period.
  2. Invest in the same way as you buy anything in life, your house, car...etc, research and look for a quality item and then find a good price to buy it. Buffet looks for companies with solid financial performance managed by seasoned and savvy executives and have strong competitive advantages.
  3. Invest against the common trend. Significant opportunities arise when things are negative. This is where great value investments can be made. Ignore other people fear of losses. Buy When no one will — The big players on Wall Street are very short-term focused. They’ll often dump stocks just for missing one earnings estimate. Fear motivate their selling decision and not logical thinking. But investors who favor a longer-term view can find hidden value in stocks that may be down as much as 30%, based on small news items and diligent research.
  4. Investment is about a process, find one and stick to it, deviation means losses because it means you acted on emotion and not on a logical analysis.
  5. Beware of the "value trap" —Don’t be fooled by judging stocks on price alone. Just because a former high-flying stock is selling for half-price doesn’t mean it’s a good value. The stock may have much farther to fall and may never recover. Without knowing its intrinsic value, or possible catalysts for turnaround, you can’t know if a low price is a good value or not. (hope is not a strategy)
  6. Know the True Value —Price is what you pay, value is what you get. Cash flow is the real health of the business. As Buffet says, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” Discounted Cash Flow (DCF) is a powerful tool to help you know whether to buy, hold, or sell. (We offer our subscribers a unique DCF calculator on our website that makes this simple to do.)
  7. Tune out TV analysts recommendations and never buy a stock at analyst recommendations alone as their motivation for a recommendation may not be in your best interest. Never buy on another person recommendation or analysis, even though they may have a solid argument, because you will not know when should you sell.
  8. Never buy a stock at its 52 week high price to avoid getting caught in making an emotional decision.
  9. "When the neighbours tell me what to buy, and I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble" peter lynch, one-time mutual-fund manager for fidelity investments, the world's largest fund company.
    When press or the average Joe start talking about an investing theme, like technology, China, India, do not bother investing in said themes as it reached a mania level.
  10. Look for the right information. People think information is going to take them over the top. But it's not information that helps them; it's wisdom. It's the ability to measure the information, to give it the proper weighting and to think through the big picture. I think you can really see that people need to learn more about themselves. That constant availability of information, if anything, all of that can be more damaging. How can more information be bad? People who get so close to their investing tend not to do very well. You show me someone who looks at their stock every day and I'll show you someone headed toward trouble.
  11. Never become too positive or too negative in the markets. In the longer term, assume asset appreciate will always revert to the mean.
  12. It is OK to do nothing. I do not feel obligated to invest in any idea I am fine with doing nothing.

November 27, 2007

Corporate as "Sub prime Borrowers"

The Big Picture Citibank Receives Emergency Cash Injection:

In his blog, see link above, the Big Picture, Citi bank was called "sub-prime borrower". A fitting description given the cost it has to pay for the $7.5 billion investment from Abu Dhabi investment fund (ADIA), 11% interest. The 11% yield is akin to junk bond status.

If Citi is given the label of "sub-prime borrower", what can be said about all junk bond issuers. It got me thinking about other junk issuers and borrowers that borrowed heavily and depend on credit for their operations.

The economy was buoyant since 2002 and in good economic times junk bond issuance usually spikes. These bonds were issued for a low risk premium as investors assumed more risk in search for yield. Junk bond issuers took advantage of that and issued more than $800 billion in 2007 with little spread to treasuries. Now the market repriced all these issues and spreads have shot up. Moreover, Private equity funds were on a tear for the last few years. Their funding and deals are predicated on covenant lite borrowing and highly leveraged capital structure. So the market is littered with "sub-prime borrowers" with very leveraged balance sheets that leave little margin for error.

The situation can be a repeat story of the implosion in the housing market. Companies leveraged their balance sheets, bought more assets on credit and issued debt similar to consumers who bought larger houses on cheap credit, which they could not afford once rate started to move upwards. Junk bonds is named "Junk" for a reason. Default in junk issuers in recessions shoot up to 47% for issuers within 4-5 years of issue. If the economy softens coupled with tighter lending and ceased credit markets, it could mean defaults in corporate "sub prime" or junk issuers will increase. And this will lead to another implosion similar to the housing sub prime.

If this defaults in Junk Bonds occur, then banks, again, will have more write downs in all sort of places. One of these areas is the credit default swaps. Credit default swaps are used by purchasers of debt to hedge their purchases of junk bonds as the counter party in the swap will pay if the issuer defaults on their payments. Normally the counter party will receive a premium to assume the risk, similar to insurance companies, which pay insurance claims and receive premiums from insurers. Banks have been a counter party in this $45 trillion market for about less than half of that market. If defaults increase claims against banks will rise to pay investor for their insurance.

We hope banks will be hedged against this risk.

Credit yet Again

For Bankers, Yet Another Credit Migraine

An overview from Business week about SIVs and the credit crunch to learn more about it click on the above link.

November 26, 2007

Home Builders as a Value Idea

MarketBeat Blog - : A Mea Culpa on Home Builders: ""

The Home Builders have been suffering during the housing slump. I do not usually consider price drops as value opportunity but there are several reason that may be interesting now:

  1. Most star analysts have thrown in the towel on the recovery in this sector, read wall street journal post above. most analysts have hold recommendation and the more cowardly "sector perform" rating on the majority of these businesses.

  2. Financial media have stopped reporting on home builders problems or speculating on a turn around.

  3. real estate have predictable cycle to it of depression, gradual recovery, boom, and down turn. We are moving through the process of filtering the excess and removing the speculative element in this sector.
These elements remove all the expectations of quick profit and takes it out of this sector. In turn it makes for some opportunities to be had. But first lets review a basic element of real estate cycles.

A typical real estate cycle is illustrated in the chart below.

I can argue that we are some where in late phase 4 or in early phase 1. I am not going to try to call where we are or how long these phases going to last; that is irrelevant. I know the industry is cyclical and eventually thing will get turn around. But this is the time to look for that business, which will prevail from phase 4 intact and in good position to take advantage of the recovery.

You need to look for a company that is not saddled with a lot of debt, does not have a lot of land on its books, have operations in markets where prices have held and demand is still relatively good, as real estate is local. Also you need to find a company that builds closer to large urban centres as migration towards larger cities is increasing.

These are some of the characteristics the I will be looking for, in addition to sound management and good economics. I am not saying that an investment now is wise but looking and doing some homework is needed. I will run some screens and begin my research, once I find something interesting I will report about it here.

Off Balance Sheet SIV Exposure

Accounting firms are preparing for the year end audits particularly for banks. A financial times article, view here, talks about how the big four accounting firms are meeting to discuss their approach to valuing all these CDOs, SIVs, and all three letter acronyms you can imagine.

In a sign of the seriousness of the situation, this is the first time the six have sat down and formally compared their internal practices in such a way.
Accounting firms have taken flask in the past for collapses in Enron and World com and others. You can rest assure that they will come out blazing for this year audits. They do not want another episode like Enron or they do not want the precarious position the rating agencies are in due to the whole sub-prime rating issues. The y want to be out of the spot light by being extra diligent.

A sensitive issue will be the SIVs ownership. banks have structured these to be off the books vehicles. But will auditing firms allow some of these SIVs to float off the balance sheet, like Enron did. Citi have $41 billion exposure to SIVs, HSBC have more than $45 Billion. These are large amounts to be taken back on thier balance sheets. This action may force some selling.

Banks structure these SIVs off their books so they can maintain a specific capital ratio to allow them to originate more loans. If these SIVs to be added back to their balance sheet, it will mean that these ratios are no longer satisfactory. A state that can lead to fire sales of assets to raise their capital ratios.

The wall street Journal have reported regarding the state of these SIVs, read here (subscription required):

The fate of the $41 billion rests on the outcome of a debate going on in accounting circles over what constitutes a "reconsideration event." Those who say Citi needs to put these securities, known as collateralized debt obligations, onto its balance sheet argue that because Citi acted over the summer to backstop some of them, its relationship with them changed, prompting a reconsideration event.

At the moment, it seems unlikely Citigroup will be forced to bring the assets onto its books. The bank doesn't believe such a reconsideration event is in order. A spokeswoman says Citigroup is confident its "financial statements fully comply with all applicable rules and regulations."

I believe that accounting firms will err on the side of caution and consolidate some of these amounts back to bank's financials. A move that can force more volatility in earnings and business activity for the banks.

HD vs LOW- Valuation- Part 3


In part 2 we looked at the economics of the home improvement retailers and the conclusion was that LOW looks more favourably than HD. Indeed LOW is the more focused, better opportunities for revenue growth, operationally lean and efficient and have better management. In this section I will deal with the financial aspects of the business and their valuation.

First, a look at the financial leverage of the two companies. LOW have better financial flexibility than HD. HD have recently declared a whopping $22.5 billion share buyback program. To undertake the initiative, HD financed the buybacks with debt. However, they have recently announced they are halting the buyback due to the credit problems in the market. HD is under pressure from activist shareholders to create shareholder value, which might not be in the best interest of HD in the long run. So far all the value created as a result of this pressure was of the financial engineering flavour that has no lasting effects.

In a head to head comparison (Source: Reuters):

Current Ratio (MRQ) 1.22 1.12
LT Debt to Equity (MRQ) 0.35 0.65
Total Debt to Equity (MRQ) 0.35 0.71
Interest Coverage (TTM) 26.18 13.73

I prefer less leverage generally, but in a credit market that is about to shut down, I prefer companies with flexible balance sheets. In this case LOW has far more flexibility in its balance sheet to deal with adverse situations. HD has painted itself into a corner particularly in an an environment of slowing sales and credit. For more on this issue read the following blog posts here and here, as it provides some perspective on the troubles with HD leveraged balance sheet.

Valuation: Price Ratios

A head to head comparison between the two companies on all price ratio reveals a cheaper valuation for LOW ( source: Company Financial statements and Reuters):

LOW HD S&P 500
P/E Ratio (TTM) 11.26 12.56 20.12
Price to Sales (TTM) 0.68 0.72 2.89
Price to Book (MRQ) 2.04 3.28 4.32
Price to Tangible Book (MRQ) 2.04 3.52 8.62
Price to Cash Flow (TTM) 7.46 9.12 14.4
Dividend Yield 1.44% 3.11% 2.31%
Earning Yield 8.88% 7.96% 4.97%
Expected Return* 10.32% 11.07% 7.28%
Dividend Yield - 5 Year Avg. 0.33 1.03 1.83
Dividend 5 Year Growth Rate 35.78 31.76 11.1
Payout Ratio (TTM) 12.88 39.81 28.12
*Expected return=Earning yield (EPS/ Price)+Dividend yield

LOW is relatively cheaper compared to HD and the S&P, particularly on the price to sales ratio, which has a better predictive ability of future performance. Both companies are well off the S&P 500 price ratios; it represent almost 50% discount to the S&P. And both companies have better expected return than the S&P going forward. HD have slightly better expected return than LOW due to its dividend yield. However as discussed before HD has paid compromised its financial flexibility to sustain this high yield. LOW has better growth profile of dividends and earnings than HD, so it is wise to retain earnings to grow the business.

At this time I will move forward focusing on LOW's valuation primarily, as it is the more attractive business opportunity between the two. So far HD did not present me with a compelling case to continue its valuation.

Valuation: Discounted Cash Flow

I make the following assumptions to value LOW:

  1. LOW will grow its store base at 8-9% for the next 4-5 years. LOW's recent new stores represented 12.7% increase and its average store growth over the last 5 years was 14%. But to be conservative over the valuation period I will assume a slower growth.
  2. LOW will have a negative same store sales of -3% due to the housing market for the valuation period. This is a very conservative estimates considering its sales will recover once the housing market corrects. My valuation horizon is 10 years and to have a negative comps for 10 years is unrealistic but it is ultra conservative.
  3. Pretax cost of debt is 9% based on its debt load and weighted average of Low interest cost.
  4. Equity cost is 19.6% based on its beta and Low risk profile.
  5. Terminal value is 10 times earnings close to the current Low PE ratio.

LOW discounted free cash flow fair value is $41.25 per share. The value represents 87% premium over Low current price, so the margin of safety is satisfied. I have used owner's earning concept in calculating its value by discounting the free cash flow after accounting for capital expenditures and change in working capital to satisfy sales growth.

You can see all materials regarding the LOW free cash valuation valuation here.

For comparison sake I computed HD discounted free cash flow valuation using the same assumptions and risk premiums as for LOW, however adjusting for slower growth rate in stores count and increase of leverage due to buybacks, I arrived to a valuation price of $33 per share, representing only 14% premium to current stock price. Hardly the margin of safety required for a value idea.

Valuation: Earning Power Value

To ascertain to LOW valuation arrived above, I will use another valuation technology called Earning Power Value. Earning power value concerns itself with two issues: 1. replacement value that a competitor have to pay to regenerate the producing or the operating assets of the business, and 2. the current present value of zero growth in the company's current earnings on a perpetual basis.

First, I will begin by adjusting the book value of LOW's assets to what a new entrant to the market will pay in order to compete. Some of the current assets will have no adjustments due to the liquid nature of these assets. The biggest adjustment will be in its store assets and brand name value.

LOW owns the majority of its real estate. The price of real estate have appreciated some what than what historical prices on its balance sheet shows. A new entrant to the industry to compete with HD and LOW will have to pay current market prices for its stores. A simple way to do this is to find LOW's recent store opening costs, the book value of recent real estate transactions plus capex needed to prepare for a new store, and multiply it by the number of stores LOW owns. This approach, I will argue, is conservative for the simple reason that older location will have appreciated much more in value as they are harder to find and replicate than recent stores. The value of these real estate holdings come to $54 billion; the book value after depreciation is $18.9 Billion. The number is large but it is what a new competitor have to pay to gain access to the market.

The second adjustment I make is to the brand value of the business. Any new entrant to compete effectively have to establish the equivalent of LOW brand name. LOW have been in business since the early 1950s. LOW have build a huge brand through the years but I will assume that 3 years expenditures on advertising is what a new entrant have to spend in order to build a similar brand. That figure will come to $1.7 Billion a low number but to err on the side of caution.

The combination of the two adjustments increases the book value per share from $10.7 to $37.29. The $26.59 per share difference is what a new entrant to the market will have to spend more than what LOW did to gain entry to the market and replicate LOW producing assets now.

The second part of EPV calculation is to calculate the value of its earning stream. I assume no growth so I will have to strip all incremental money LOW makes to grow it business. Usually any business makes addition capital expenditure than the maintenance capex needed to maintain a stable earnings level. So I add the accounting depreciation, strip these extra capex amounts and only deduct maintenance capex. An additional adjustment is to adjust for advertising expenditure of LOW. A business spends on advertising to grow its business, but in this case I will have to add those amounts back to its earnings. The figure is discounted on a perpetual basis using 12%.And I add the adjusted book value to the value of its discounted earning to arrive at EPV.

You can find the detailed calculation here.

LOW value using this method comes to $50 per share. This figure is close to the discounted free cash from the previous section of $41. Both figures give a satisfactory margin of safety to LOW current price level. Using a validation valuation technique has assured me that the value in LOW's business combined with its competitive position and economies of scale represent a good investment opportunity.

Investment Conclusion

LOW is value idea and I am initiating an ownership position in the company. The risk to this position stems from the current housing market. Most housing recessions in the US have corrected with 18-24 months, this may take a bit longer or shorter , a call I am not smart to make. I base my decision on the following:

  1. LOW have solid management that knows its customer and its business.
  2. LOW enjoys a solid competitive position to HD in the eyes of customers.
  3. LOW have an economies of scale to compete effectively and shortly will match the convenience of HD to its customer in terms of its store locations.
  4. LOW have lean and efficient operations.
  5. LOW have a steady and predictable earning stream. And the industry is predictable in nature for the next 10 years.
  6. The pricing in this current environment is attractive and provides me with a margin of safety. The market crowd is abandoning all housing related businesses that makes a very good opportunity to buy for the long run.

November 24, 2007

Worth Reading

Spend some time reading this article from It is a worthy reminder of what is investing and what investors do to ruin their returns.

Like I said before, investing is not hard it is our actions and indiscipline that sour the experience.

LOW vs. HD Economics- Part 2

The home improvement industry is suffering some setback due to the housing market. But I would rather call it as an industry returning to normalcy after the speculating house flippers existed real estate. Please see part 1 for the analysis.

Now I want to look at the micro level of the two retailers. I want to look at the economics of their operations. Any successful retailer can be evaluated based on how good they manage 6 critical aspects of their operations mainly:

· Brand Management

· Site Selection

· Supply Chain and Merchandising

· Management and customer service

Brand Management

HD brand is associated with being an industrial store and can be intimidating for the uninitiated in home improvement. Also what reinforces this feeling is the store format; it is contractor friendly or perceived that it is designed for contractors. LOW on the other hand is characterized by its helpful employees; clean and friendly store format and a better female oriented shopping experience, as most home improvement decisions are made by the lady of the house. LOW understood its customer base and the decision making dynamics and therefore applied the appropriate store format.

HD strategy has been to cannibalize its stores by over saturating any geographic area by as many stores as possible to prevent competition. Therefore a deterioration in availability of employees in older stores is noticeable. HD purposely cuts labour hours in older stores and allocates them to newer ones. As a result of these cuts to its labour force the image and brand of HD has suffered. The University of Michigan's annual American Customer Satisfaction index shows Home Depot slipped to dead last among major U.S. retailers, 11 points behind Lowe's.

HD does a worse job at brand reinforcement than LOW, as HD advertising has lagged behind LOW. HD spends considerably less than LOW as seen in the chart displaying advertising expenditure as percentage of sales over the last 5 years. The recent trailing 4 quarters saw HD spends 1.21% on advertising as percentage of sales, while LOW spends 1.86%. The affect is noticeable if we construct a chart displaying the year over year change in sales with the year over year change in advertising. The relative advantage of advertising expenditure for LOW may explain the year over year change in sales advantage it enjoys over HD as seen in chart 3.

Overall LOW does a better job in managing its brand and its focus on the shopping experience of its customers and reinforces this by spending on advertising and promotion. HD have been distracted by its foray into the HD supply division and its more commercial aspect of building its business that neglected the retail shopping experience and allowed store formats to go stale hurting its brand image with customers. HD has recently sod HD supply to refocus on its retail operations, its road to recovery will be slow as retail turnarounds is slow by nature.

Site Selection and Management

HD has more store locations than LOW. As of the end of the latest fiscal year HD had 2147 stores compared to LOW's 1385. HD also has more geographic reach than LOW in Canada, Mexico and China. LOW has just began its expansion into Canada and Mexico. The number of stores and the size is of a significant advantage for HD. Customer convenience in the home project is paramount. Consumer in the midst of a project need a close location to buy the necessary items to carry on with their project, even though they know that a better shopping experience can be fond in LOW.

LOW have been increasing its pace to match HD store count as its pace in opening new stores is higher than HD curently. One can argue that HD had reached a saturation point in the US for new stores and this is a valid arguments. Chart 4 compares number for new stores opened in the last 5 years between the two retailers. LOW has overtaken HD in absolute number of new store openings and this trend is expected to continue. LOW has more room to grow the number of its stores than HD.

Another issue in site management is store appearances and updates. Although LOW is the smaller of the two, LOW spends more on the updating store layout than HD. Store format is such a critical aspect of retail that it can sour the shopping experience for the customer. We can measure store update and attention to appearances by the magnitude of CAPEX each store receives. LOW CAPEX per store is much higher than HD; in fact LOW spends on average $2.82 million annually on each store it owns compared with $1.65 million for HD based on latest financials, this number includes store opening expenditure and is used to illustrate the magnitude of the difference between the two. HD chronically underspend LOW on store updates as seen in chart 5. Even worse the trend point to an overwhelming deterioration in this category for HD, while LOW has opted to increase its spending. This explains the difference in the strong yr-over-yr sales change for LOW at the expense of HD. The discrepancy between the expenditure might explain also why LOW stores appear neater and more friendly to its customers.

Overall the convenience of HD locations have helped the company, but LOW is closing the gap and has better handle on a more critical aspect of retailing in the customer shopping experience and store format.

Supply Chain & Merchandising

Supply chain is another critical element to a retailer success. Supply chain management is not about cost control but it is about increasing revenue to the retailer. Good management of a supply chain can be the difference in availability of hot product for sale or matching a retail promotion that the company undertakes. For this category we look at some indication of a good supply chain management between the two mainly: inventory turns, cash to cash cycle, inventory as % of sales and percentage of products shipped from the company distribution centres.

LOW ships much more products from its distribution centres than HD. This is a sign of better and superior management of merchandising as the retailer can assure that stores get the merchandise it needs much quickly and avoids empty shelves and customer turning away. The higher the ratio the better. LOW currently ships 75% of it merchandise from its distribution centres as oppose to HD's 40%. This would explain why many HD customers complain that store shelves are empty from the products they need.

HD has fared better than LOW in the inventory management as evident in the percentage of sale ratio and inventory days, a measure of how many days inventory is held before being sold, the lower the number of days the better for the company. However, LOW has undertaken a supply chain initiative called R3 to improve its operations and as a result it has closed the gap on HD in this regard as seen in Chart 6 below. More importantly I think both ratios indicate a slowing sales environment for both. However HD has fared worse than LOW in the slowing environment. HD ratios have deteriorated much worse than LOW. In the trailing 4 quarters ratio HD inventory days has shot up significantly to out pace LOW and it inventory as percentage of ales have shot up more than LOW.

The cash to cash cycle time, a measure of the number of days a company takes to turn its investment in inventory into on hand cash, a measure of lean operations and efficiency, indicated that LOW fares better than HD. LOW has improved its cash-to-cash ratio in recent quarters better than HD. LOW's ratio stands at 43 days while HD is 46. LOW has improved its operations significantly compared to HD as seen in chart 8.

The ratios overall indicate several things:

  1. A slow sales environment in the future. The increasing inventory on hand for both companies, as they are not able to move it as fast as it used to.
  2. LOW is paying attention on its operations and exercising more control. this will lead to better expense management.
  3. HD is the lesser efficient operations of the two.


LOW's Management came from within. The CEO and other executives came through the ranks of LOWs. Most of the management is seasoned and have spent years with LOW. An organic management is a strong plus for this company as they hold an understanding of the company’s operations and customers. The CEO has been with LOW for 12 years and his compensation is far below averages for the industry.

HD had a newer management team that came with ex CEO Nedrelli from GE. Over the years with the new CEO seems that some store and district management increased its turnover. Since 2001, 98% of Home Depot's 170 top executives are new to their positions. A high turnover create a discontinuity in retail initiatives and customer research and knowledge.

HD's new CEO Frank Blake is a lawyer by trade and has limited experience in retail. He like Nardillie came from GE. He is not the leader you want at the helm if you want to change things, that off course i HD board sees there is no need to make any changes. You can read a Business Week story regarding Blake here.

Another indicator to the superiority of LOW management is revenue and income per employee. LOW management know how to utilize resources better than HD. LOW generate far more revenue and income per employee than HD. The following compares latest trailing year revenue and income per employee between the two retailers:

Revenue/Employee (TTM) LOW: $307,707

Revenue/Employee (TTM) HD: $219,416
Net Income/Employee (TTM) LOW: $19,191

Net Income/Employee (TTM) HD: $12,250

To illustrate the difference between the two managements and their knowledge of retailing, I will give you an example of how the two see the self checkout technology. HD insists on the notion that self checkout as expense reduction in labour and staff hours. They have highlighted this initiative in all their conference calls and presentations to investors over the last few quarters.

LOW on the other hand saw the self checkout as a customer service initiative and not a cost saving play. In a conference call the CEO has highlighted this to analysts by saying" we do not see this as an expense reduction but as a customer play". If you have visited the store you would know that unless you have small sized items, the self checkout will work fine. However if you have a large sized items, you need a cashier and the line ups in some HD stores are irritating as less cashiers are open.


To conclude this part of the analysis, LOW emerges with the better operations than HD. LOW has better associated brand image with its customers, invests more in its operation with a focus on customer experience, and has a leaner and more control on its operations and mechanizing. All of these factors are good to increase its market share and maintain profitability particularly in a slowing sales environment. The excellent infrastructure in LOW enabled it to improve margins even in slowing sales environment as in chart below.

In part 3 I will look at the valuation of both companies.

November 23, 2007

Credit Again

Many analyst now are jumping on the band wagon that more write downs are in store, could not they have told this before. Each is coming with their own estimates...and boy those numbers are scary ranging from $100 billion to more than $300 billion. I have discussed in a previous post that I think more write downs are coming only if a further deterioration in jobs and the economy occur.

Goldman Sachs, the super doper money management firm, expect another $108 billion in write downs. If this is to happen expect no loans what so ever to take place to consumer or business, exaggeration but you get the picture there will be fewer and fewer loans originated by the system, as banks try to increase their capital requirements ratios. Other ways are discussed in this article by the economist found here, none is good.

For those businesses and companies that depend on financing and credit for their operations they will be hurt, badly. Their intermediate future is not good. Banks will shut financing no matter how attractive the proposed business opportunity, instead banks will look at the strength of the balance sheet.

So screen your holdings and pay attention to companies with high leverage or dependence on short term borrowings. Pay attention to their Accounts Receivables balances, are their customer paying up on time? If companies can sustain the next period on their own, some of the possibilities or the results will not be very favorable.

On the other hand, there is opportunity for companies with deep pockets and cash on hand to pickup strategic assets cheaply.

November 21, 2007

Commodity as long term investments

Again another question to Bill Miller regarding commodity investing: Globe Investor Magazine: "A lot of investors in Canada are obsessed with mining and energy. Why have you been a skeptic on commodities? Well, we were wrong. There's two things. One of them is the secular case and the other's a cyclical case. Secularly, we have not been fans of commodities, broadly defined. That's because the empirical evidence and theory, both together, would indicate that commodity prices decline in real terms over time. Extractive companies, by and large, don't earn their cost of capital over the cycle. They can be cyclically attractive-buy them when the cycle's bad and sell them when the cycle peaks---but generally speaking, they tend to be trading vehicles, versus investing vehicles. In trading vehicles, you've got to be right on both sides. We prefer things that we can invest in for five, 10, 15 years and earn large amounts of money. The question now is, are we at a cyclical peak, or, as the bulls would argue, is it a secular change-that is, energy prices and copper prices and lead prices and wheat prices will now not decline in real terms from here. I think the jury's out on that."

That matches my belief about the whole "commodity super cycle" notion that explains the skyrocketing prices of most commodities. As a result you see red hot returns in commodity producing companies lately predicted on the Emerging markets demand fueled by their economic growth.

If you think about it why would you invest in a company that has no control over the price of what it is selling or its ability to create demand for its products for that matter. One of the most fundamental aspects of value investing is to find companies that is free to pass along increase in costs to its customers and to expand its markets. Commodity producing companies are a miss on both aspects. They can not price their products at all, it is left to market forces. Also commodity producing businesses have no ability to increase demand for their products by executing on their business strategies, primarily demand is left for economic forces that is outside of the company control.

I do not see commodity as an investment from any aspect. Value investing in commodity producing stocks is an oxymoron sort of speak.