Wednesday, April 28, 2004

Barron's is Wrong on Colgate

April 28, 2004 - Street Insight The most recent Barron’s contains a favorable article about Colgate by senior editor Jacqueline Doherty. The gist of the article is that Colgate is cheap, its recent quarter sub-par earnings growth just a short-term setback, and it should return to its long-term growth target of 11% next year. I disagree. Colgate will not be able to return to its historical growth rates. The stock is not cheap. It is reflecting a secular decline in Colgate’s growth. In fact, I would argue that the stock is overvalued, and has not fully discounted the diminution of Colgate’s growth prospects. This is a part of her argument: “At a recent $56, the stock trades at 21 times expected '04 earnings of $2.62 a share and 19 times next year's estimates of $2.92. That's far below the 29 P/E the stock sported three years ago and among the lowest multiples in the consumer-products realm.” Colgate is a top-notch company with strong, brand-name products. It is run by a well-respected management team which has created a lot of value for shareholders in the past. That is the first warning sign of a faith premium built into the stock. I don’t think that faith premium is warranted any longer. Yogi Berra said: “You can observe a lot by watching.” Lets watch and try to understand what were the drivers behind impressive earnings growth (over the past five years) – what I call sources of growth. · Sales grew only 2% a year. I am afraid to find out what that would be on the constant dollar basis since a large portion of sales comes from overseas. · Net margins expanded from 9.5% to 14.4%. That contributed another 8.8% to annual net income growth. Most of the margin expansion came from cost cutting since operating leverage only kicks in when there is meaningful sales growth. · Colgate was buying back stock consistently year after year, which contributed another 1.9% to annual EPS growth. Thus the company presumably paid as much as 33-34 times earnings in 1999 and 2000 for its stock. Great use of shareholder cash! · The growth rate in overall EPS was close to 13%. That’s a very impressive pace for a very mature company, but one I consider unsustainable. One cannot simply assume that the past growth will continue into the future. But that was the leap of faith that Barron’s made. There are very few organic growth engines fueling Colgate’s fundamentals. Sales growth is not there. And a company may increase margins only so far. It needs to pay its workers, suppliers, the government -- and its CEO/Chairman who was paid $10 million in salary and $131 million in exercised stock options in 2003. (It is hard say how the stock options came into the money considering Colgate stock underperformed the market considerably over the past five years.) It is unreasonable to expect that the past growth rate will continue into the future, since the major driver of past growth was the cost cutting. Colgate’s margins may expand more, but it is very likely that majority of cost cutting has been done. Buying back stock is the only growth engine that still has some fuel left in it. It is very likely that the future EPS growth rate will be half of what it was in the past five years. Colgate operates in very mature markets that have matured not only United States but overseas as well. The law of large numbers caught up with the company a while ago. If it were not for cost cutting and buying back stock, Colgate would have shown 1-3% single EPS growth a long time ago. The Barron’s article argues that stock is cheap since current PE is 21 times ’04 earnings and is low relative to where it was in 1999-2000. This argument holds as much water as arguing that 60 times earnings Yahoo is cheap since during the bubble it traded at 600 times earnings. Even a high quality company that “is” growing earnings at 11-13% a year doesn’t deserve to trade at 29 times earnings. Colgate is not a growth company. It once was, and management did a marvelous job growing earnings for as long as it did, but organic growth left the company a long time ago. At its current valuation, Colgate is grossly overpriced. A discounted cash flow model tells a very unappealing story: Colgate stock is factoring in either a very high single-digit sales growth rate or net margin expansion to over 20% (or a milder combination of both). Neither expectation is reasonable or achievable. Our discounted cash flow model shows that if reasonable (achievable) expectations are factored in, company should trade at a P/E around 15-16 time earnings at the most. That is after we factored in the quality and sustainability of Colgate’s cash flows. Colgate’s management team, no matter how smart and over-compensated, needs stop lying to themselves and face reality: growth is behind this company. It is time to double the payout from 33% of net income. The company’s focus should be on paying a decent dividend, not buying back overvalued stock. We owned Colgate stock four or five years ago, but when we realized the organic growth was gone we were out of it. I am still using Colgate toothpaste, but Colgate’s stock should be avoided. There is no safety, no growth, and not even a decent dividend in it.

Vitaliy N. Katsenelson, CFA

Copyright 2004

Thursday, April 01, 2004

The Hidden Risk in Risk

April 1, 2004 - Street Insight We look at risk differently than most investors do. Rather than considering risk to be volatility or beta, we distinguish between “observed” risk and “hidden” risk. Hidden risk is not much different from observed risk – except it has not yet surfaced. Yogi Berra put it very eloquently: “It ain't over 'til it's over.” Just because risk has not surfaced yet doesn’t mean that it never will – or that it’s not there. Let’s say that the CEO of a company with its operations on Grand Cayman decides that the company can save a lot of money by canceling its hurricane insurance. There is no hurricane that year, and the money saved causes the company’s earnings to go through the roof. Should investors praise the CEO because he enhanced the company’s profitability? Or should they reprimand him for exposing the company to grave risk – a risk that would have put the company under if there had been a hurricane? Based on the observed history, the CEO should get a big bonus and be sent to Disneyland, since there were no hurricanes and company’s profitability improved. But this conclusion completely ignores the hidden risk. To understand hidden risk one needs to understand the concept of alternative historical paths. Nassim Nicholas Taleb did a marvelous job describing this concept in his book “Fooled by Randomness.” Alternative historical paths are the alternative outcomes that would have occurred if the event were relived many, many times. “Reliving” the past with analysis of alternative historical paths exposes hidden risk and distills randomness. As Mark Twain said, “History doesn’t repeat itself, it rhymes.” If we gain an understanding of possible alternative historical paths (even if the specific outcome we’re looking at was a success) then we will be able to assess the past more accurately – and thus gain a better understanding of the future. In this example, one of the alternative historical paths is that there is a hurricane, and the company is wiped out. Since 1871, hurricanes hit Grand Cayman every 2 ¼ years: fifty-nine times to be exact (according to The company’s improved profitability came with substantial hidden risk. Maybe giving a bonus and sending the CEO to the Disney Land is not a good idea after all. One should never evaluate results solely on the outcome – the observed risk. The hidden risk must be closely scrutinized. In Russian there is an expression: Winner’s success is not to be judged. This is a very common attitude when executive decisions, company performance or investment results are analyzed. In late nineties the thinking was: If internet stocks and Janus mutual funds (the hallmark of dotcom investing) are only going up, where is the risk? Until March 2001 there was no observed risk in internet stocks or Janus funds, but there was plenty of hidden risk. By analyzing results in the context of only observed risk we subject ourselves to the mercy of randomness -- since it is randomness that decided how much risk to show. When evaluations of results are based solely on observed risk, success is often attributed to the skill of the investment or corporate manager, when the credit should have gone to Lady Luck. We consider alternative historical path analysis a very important part of the assessment of risk residing in the company’s operations. Our objective is to own companies that have the lowest degree of total risk (observed plus hidden) and the financial strength to handle sudden disasters. The importance of hidden risk becomes very clear in looking at a company like Guidant. Back in 2000, we were considering investing in Guidant. Their performance had been very impressive: in the previous five years, Guidant’s earnings and sales had grown twenty-plus percent a year. That company had little debt, impressive cash flows, a good management team and traded at a reasonable valuation. It was in an industry that was growing very rapidly and projections were that growth would continue. The end users of Guidant’s products were doctors: 47% of sales were from implantable defibrillators and pacemakers, 32% from stents, 15% from angioplasty and accessories and 6% from other products. Implantable defibrillators and pacemakers are highly differentiated products. If doctors want to start using a device from another manufacturer, they need to overcome a substantial learning curve in programming a new device. This is a very high implicit switching cost. Usually doctors specialize in devices from two or three manufacturers. A new device from another company has to be significantly superior to the devices that doctor is already trained to use for a doctor to make the switch. Stents are a very different matter. A stent is a wire mesh tube used to prop open an artery that's recently been cleared using angioplasty. Performing an angioplasty is the same no matter what stent the doctor uses, so the doctor will use the best stent on the market. In early 1990s, J&J owned the stent market. When Guidant came to the market with a much better (flexible) stent, J&J lost its market share overnight. Guidant was able to take market share from J&J so quickly because there were no switching costs for the doctors. There are 800,000 stent procedures done in the United States every year. In 15-30% of cases, the patient’s artery becomes clogged again within the year (according to the FDA), a condition called restenosis. Restenosis occurs because the stent damages the walls of the artery at the time of insertion. The artery’s walls try to heal, thus clogging the artery and the stent. The clogged artery has to be treated with another angioplasty or bypass surgery. Dick Cheney was hospitalized with restenosis a couple of years ago. Rumors were he had Guidant’s stent. In 2000 Guidant, Medtronics, J&J and Boston Scientific were all working on a solution to this problem. Guidant chose a path of applying a small dose of radiation to the stent. Other companies were working on drug-eluting stents (stents are coated with a drug that prevents the walls of the artery from clogging). It was obvious that the company that made the best new generation stent would own the stent market, but it was impossible to tell which company will come up with the best technology. Guidant was just one of several (J&J, Boston Scientific, Medtronics, etc…) very savvy, financially strong companies competing to dominate this fast growing, very lucrative market. The stent business was Guidant’s to lose if it was not the one with the best coating technology. That was a problem, because more than 40% of Guidant’s cash flow came from stents. Guidant had very little observable risk – its operational performance was flawless – but it had significant hidden risk. The range of possible alternative histories was very wide, and there was a good chance that some of them would be devastating to the company. By buying Guidant the investor was gambling on an unpredictable outcome. Our analysis of hidden risk showed us that owning Guidant would require a lot of praying to the stock market gods. That is something we are not willing to do for any stock. Epilogue Now, four years later, J&J and Boston Scientific are the only companies that have drug-coated stent technology. Guidant and Medtronic are not expected to bring drug-coated stents to market until 2006. For now, Guidant is reselling J&J’s Cypher stent. Guidant’s share is down to 10-15% of the total stent market (30-40% share in bare stents), a sad fall from their market domination in 2000. It is expected that in two to three years the majority of stents sold will be drug-coated, as more drug-coated stent sizes will become available. Guidant’s already-minor market share is likely decline even further as drug-coated stents gain even greater popularity. In contrast, Boston Scientific brought their drug-coated stent to the market just three weeks ago, but already has close to a fifty percent share of the drug-coated stent market (which is 60-65% of the total US stent market). Boston Scientifics’ stent sales are expected to be around $1.5-1.8 billion this year versus $300 million last year. In fact, Boston Scientifics’ stent sales will account for 25-30% of their total sales – and an even greater part of their cash flows (since stents carry a 90% gross margin). Those sales are coming at the expense of Guidant and Medtronic. Should I buy Boston Scientific? Yogi Berra’s wisdom never ends: “It's deja vu all over again!" Copyright 2004