Tuesday, November 29, 2005

Sporadic Thoughts: Retail, Consumer and First Data

October 28, 2005 - Minyanville Retail swell?
This weekend when I heard about the 22% increase in shopping activity over last year, I could not help but wonder - have I seen this movie before? After all, auto companies tried to stimulate their demand by cutting prices, and we know how that story ended. It seems what attracted consumers to the stores were the great discounts, not the increase in their real income. Are retailers stilling their future holiday sales with early deep discounts? Time will tell.
Rushin' promotion roulette?
On the BJ Wholesale (BJ) conference call, management made a very interesting comment that may explain the Black Friday rush to buy the latest must-haves: "There are a lot of earlier promotions and everybody is trying to pull in these sales before the first heating bill arrives in consumers' mailboxes. " Need I say more?
Wish you were here
First Data Corp's (FDC) stock was up $2 on the news of its CEO Charlie Fote leaving for personal reasons. I never looked at Charlie as a liability at FDC, thus I am surprised by today's price action. Several months ago when I met Charlie at FDC investor day, he said that he was dissatisfied with FDC's price and that he'll have to do something within a couple of months if the price doesn't move - well, I never thought this would be his solution to the problem.
Positions: BJ, FDC
Vitaliy N. Katsenelson, CFA Copyright Minyanville.com This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Newspapers look flimsy in a digital world

November 29th 2005 - Financial Times
This article was published Financial Times on page 14. Ironically I originally wrote this article about six months ago, but it was pushed back by my other pieces. It was a product of my research on Gannett (GCI), which we decided not to buy--the stock has declined almost 30% since. Google’s (GOOG) incredible top-line growth which is approaching GCI’s very quickly is a sign that there is more pain for newspapers to come. Newspaper stocks are way down from last year's highs, looking cheaper than lowest grade dirt relative to their past premium to the market valuations. Gannett, Knight Ridder and Tribune are trading at a 10-20 per cent discount to the market PE. But "brand" name newspaper stocks - Dow Jones, Washington Post and New York Times - are still trading at a premium PE in spite of their declines. This might look tempting to value investors. But the situation is more dangerous than it appears. Newspaper stocks at the moment represent a "value trap". If the direst predictions are fulfilled and newspapers turn into payphones in a cellphone world, current share prices do not look good. There are several short-term reasons why newspaper stocks are down. First, they are facing tough comparisons with last year's numbers that were bloated by political advertising. Second, although employment advertisements have rebounded, car ads took a plunge because of tough comparisons with last year's numbers and a general decline in spending by car dealers. Finally, circulation has continued a decline that began in the mid 1990s. Much of this will soon reverse. Unfortunately for the rest of us, and fortunately for the newspapers, political advertising will be back next year. And, in the absence of making good cars, US carmakers will have to lure consumers with increased advertising. Thus the softness observed over the last several months should be short-lived. But the news is not that good for circulation, where decline may prove to be a long-lived, secular phenomenon. The internet is changing the way we read. Old habits die hard, and thus the decline in circulation has been in very low single digits. It has not fallen off a cliff. But the decline has taken place when population and gross domestic product have been growing. The internet is a perfect vehicle to deliver news and editorials to consumers. The incremental cost of delivery is virtually free and delivery is instantaneous, benefits not shared by "pulp-made" newspapers. The internet has commoditized news, through services such as Google News, subsequently driving the price of that commodity to zero. Only a handful of newspapers are able to charge for online content and readers are not paying for the "news" content, as there are plenty of free sources of news on the internet. They are generally paying for interpretation and editorials. Local newspapers, once considered a sweet spot in newspaper business as they traditionally had a quasi-monopoly on local print advertising, are still charging advertisers a fat premium over national newspapers. But things are about to change. Google is already luring dollars away from traditional forms of advertising. It is likely to take things a step further by localizing and customizing search technology - a direct threat to the fat profit margins of local newspapers. The recent rush of large newspaper organizations to throw huge sums of money at online properties is an indication of confusion and panic rather than a clear strategy. In Rupert Murdoch's speech to the American Society of Newspaper Editors he indicated that newspapers have not worked out how to embrace the internet and are rapidly losing younger readers. The New York Times' web traffic fell 23 per cent in the last year, according to Mr Murdoch, not a figure you would want to see in a world where online advertising is growing in double digits. It must have been unwelcome data on the eve of the Times' attempt to start charging for some content. Newspapers are not going away. Century-old habits will keep consumers reading them for quite a while. But this doesn't necessarily make newspapers a good investment; the internet creates an unwelcome headwind, and earnings growth is uncertain. Until now, the industry has masked the declining circulation by raising advertising prices. Advertisers are a number crunching bunch and at some point they will realise they are forced to pay more for less every year. Thus increases in advertising rates are not sustainable. Given the new competition from the internet, that trend is likely to reverse. In the short run ad revenues may get a boost from the resumption of car and political advertisements, and acquisition chatter - as has already been seen in Knight Ridder - may lift an interest in newspaper stocks. However, the long-run prospects are a lot less certain, setting a likely value trap for bargain hunting investors. Will newspapers become payphones in a cellphone world? This possibility is already discounted to some degree in the shares of Gannett, Knight Ridder and Tribune. But the "brand" papers' valuations still don't reflect that plausible outcome. Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Friday, November 18, 2005

Wal-Mart's Double Standard & Sin Stocks

November 17-18, 2005 - Minyanville.com
Wal-Mart's Double Standard
I talked to two friends of mine, both are money managers. Their firms will not buy Wal-Mart (WMT) because they’re afraid clients will be upset with them. One of the firms is located in Boulder – so that unwillingness to own WMT makes sense, as Boulder is a socialistic Californian city disguised by the Rocky Mountains (did I just call Californians socialists?). But the other manager’s firm manages north of four billion dollars and has several mutual funds. This leads me to believe that the headline noise about Wal-Mart’s immorality may force it into the “immoral investment class,” where money managers may be dropping the name from their portfolios due to client pressure, thus creating a buying opportunity in the shares.
I also had a client call me asking if I really believed in what I wrote about WMT, referring to the Wal-Mart – “Capitalist Pig” article. He could not believe that I meant every word; he thought I was just being “provocative.”
I really do believe that Wal-Mart is an incredible company and I don’t feel that it is committing any immoral acts. It is a retailer that is very good at what it does. Its only fault is that it is extremely successful; becoming the largest retailer in the U.S. and in the world. Its sheer size attracts the criticism, which has nothing to do with Wal-Mart but has to do with realities of capitalism, i.e. poverty of the lower classes, high medical costs and inability to afford health insurance etc… We don’t hear anybody discuss smaller retailers, i.e. Dollar General (DG), Family Dollar (FDO) and other businesses that pay minimum wage to their employees (Wal-Mart actually pays almost double the minimum wage) and don’t provide health insurance. It seems that there is a double standard by which Wal-Mart is judged upon.
Investors that have a social investing gene in them would be more upset about owning WMT than about owning a liquor (or any other sin) company. My view on social investing is very simple: it is an oxymoron. Investing is done to make money. Any company scrutinized enough won’t pass the “social” test. It is hard enough finding good investments, adding another very subjective criteria to the mix only makes it more difficult.
This is what Larry the Liquidator said about social investing: “Take the money. Invest it somewhere else. Maybe, maybe you'll get lucky and it'll be used productively. And if it is, you'll create new jobs and provide a service for the economy and, God forbid, even make a few bucks for yourselves. And if anybody asks, tell 'em ya gave at the plant.” Mailbag: Sin Stocks
I live in Colorado Springs….and if you don’t like living in Boulder I’ll trade places with you anytime. I think you’d find that living with the ‘socialists’ in Boulder is more tolerable (and more fun) than living with the ‘Focus-on-the-Family’ fundamentalists here in the Springs. But seriously, I don’t think screening out the biggest social culprits is that big of a hurdle. I find that most of our investors prefer not to invest in alcohol, tobacco, gambling, or military contractors. Actually, we’ve done several points better than the S&P 500 over the years without investing in those industries. So, the hurdle really isn’t that great. True, some social screens are much tighter than that, but then again, so are other fund screens based on market cap, value, growth, etc. I don’t hear Jim Awad complaining that he can only invest in small caps.
William William,
I live in Denver but probably would not mind living in Boulder. Though I've been told by my friends who live in Boulder that the liberal brush I’ve painted of the city may not apply to it any longer.

Avoiding sin stocks (i.e. defense, tobacco, gambling and alcohol) doesn’t severely limit an investor’s stock universe and is not very taxing on time and effort, as sin stocks are easily identifiable. That is not something I would do, it is an issue of personal values. As you mentioned, and I agree, following that strategy should not have significant consequences on the return achieved in the portfolio. However, social investing could be taken to an extreme if one decides to do so:

  • Political donations – A company is giving money to the wrong (another very subjective criteria, unless it is something black and white like Al Qaeda) cause or party.
  • Treatment of employees (very subjective) - Does Wal-Mart (WMT) treat their employees fairly? Do you start looking at employee compensation of every company you invest in?
  • Labor practices (use of child labor) - Do you avoid companies that use parts made in China or manufactured in China?
  • Environmental citizenship – Do you avoid oil companies and refineries? What about auto companies who make gas guzzling SUVs?

I probably missed a dozen categories, but you get the idea. When social investing is taken to the extreme it turns into a very taxing exercise and substantially limits the ‘investable’ universe. Best regards, Vitaliy Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Thursday, November 10, 2005

Cendant: The Anatomy of Sell and More

Minyanville.com - October 28, 2005
The Anatomy of Sell Buying stocks is easy, selling them less so. Therefore, in light of the Cendant (CD) news today, I thought it might be helpful to briefly look at the reasons we sold Cendant stock awhile back. Perhaps this short exercise can help illustrate the fundamental discipline involved in making sell decisions.We sold Cendant stock awhile back for the following reasons:
Wall Street did not care about company’s business model. The company was going through its “simplification” phase as it was shedding the uncomplimentary businesses, PHH and Wright Express, thus we were willing to wait. However, when CD sold its marketing business – the last “uncomplimentary” business, and Wall Street did not care (the stock did not budge) – that was a sign that Wall Street did not like CD’s business model, thus it will not price it at a higher multiple.
One of the premises for buying CD was P/E expansion – we did not feel that would happen. (I think this is in part what motivated CD’s management to break up the company... realization that the stock will be “cheap” forever as Wall Street doesn’t care for its business model. We did not like real estate business.
We never saw a synergy between the real estate business and the rest of the company. How does real estate relate to car rentals, travel and hospitality? Also, in the last quarter all growth in sales in the real estate franchise came from higher housing prices with no volume (number of houses sold) growth. Thus a decline in housing prices, something we expect a lot sooner than later, would cause a disproportionate decline in earnings due to operational leverage; remember leverage works both ways.
Reducing our exposure to discretionary spending. After stress testing our portfolio to the risk of a discretionary spending slow down, CD came out on top of the list as its travel and hospitality businesses have a very large discretionary spending component.

Minyanville.com - November 10th, 2005

Mailbag: The Spin on Cendant


I read the note that you wrote about why you sold Cendant (CD) prior to the announced break up. Now that the company is going to split into four parts and since you previously believed the company was grossly undervalued, have you thought about wading back in? I've come across some sum-of-the-parts valuations which place a value of $22 - $27 per share on the company and at its current price that would be a discount of roughly 20 to 35 percent. I believe it is undervalued; however, I worry about the combination of being at the peak of the business cycle, pricing pressure, and slackening demand in all of their businesses. Any general thoughts that you may have would be welcome.

Thanks, - Chandler

Dear Chandler,

You are exactly right. I can see how CD could work out - absolutely. However, I share the same concerns and I believe that time is CD's biggest enemy. Given enough time, the housing market may decline (arguably not far around the corner), thus creating more uncertainty about the price it'll get for its real estate business.

Economic slowdown, caused by weakening consumers, is likely to impact the travel business and the multiple it will receive when sold. The stock would not worry me that much at this level (not advice) but the upside you mentioned may or may not be there. Looking briefly at discounted cash flows, the stock does look very cheap, but my level of confidence about cash flows is not very high.

- Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Wednesday, November 09, 2005

Mailbag: Buybacks and Dividends

October 11, 2005 - Minyanville.com This mailbag is in response to my Nov. 4 article on Buybacks and Dividends.


Good stuff as always!... A minor point... near the end you say you object to a company leveraging its balance sheet to do buybacks. But technically, isn't paying out cash for a buyback changing (negatively) the balance sheet even if no borrowing is involved? In other words, you buy back stock and cash becomes a smaller part of total assets and overall shareholder equity shrinks. The enterprise now IS at more risk (smaller and less cash) than before, although admittedly not as seriously as one that takes on debt to buy back stock. Isn't it just a matter of degree, rather than a sharp difference?? Fully agree that buybacks are better and healthy dividends are second best, since management definitely does have their flights of egoistic fantasy and do some really dumb things in the name of growth. - Don

Don, great point! So let me clarify that: Buying back stock is leveraging anyway you look at it, because it lowers equity (cash balance declines – lowers equity and thus debt to total assets ratios rises) – it's hard to argue with that. Also, with this logic, paying a dividend is leveraging as well, as it forces cash balances to decline. However, the distinction I am making is that when a company increases debt (HIGH leverage scenario) – in absolute terms, by issuing debt to buy back stock, a company can only do so much of that because it has a finite borrowing capacity. Thus the growth of earnings that comes from issuing debt and buying back stock is not sustainable. Where stock buybacks that are sourced from free cash flows (LOWER debt scenario) result in a more sustainable earnings growth and arguably less risky (everything held constant), as they don’t raise the absolute levels of debt. As long as free cash flows keep rolling, a company can keep buying stock. From a credit analysis perspective, HIGH leverage scenario case does the following: raises debt to assets ratio and lowers interest coverage ratios; LOWER leverage scenario case does the following: raises debt to assets (but by lower degree than in first case) and has no impact on interest coverage ratios (alright, it has a very small negative impact as cash paid out earns interest). Best regards, - Vitaliy


Good points; all agreed and understood... but even if the buybacks come from free cash flow (definitely the preferred scenario) they by nature reduce the financial robustness of the company from what it WOULD have been in their absence. - Don


Agree, but at a certain point cash sitting on balance sheet just takes away value (i.e. MSFT) – but your point is well taken.



Wouldn't you rather see management apply a very strict value standard to any share buybacks? Something along the line of Ben Graham's 30% below book? As a small investor I'll take a dividend over share buybacks any day. -Alex

Dear Alex,

As I mentioned before, I prefer dividends versus share buybacks. Your question raises a different issue: is management a good investor? More often than not, it isn't. Management has a bias - it is usually in love with its company. They spend an enormous amount of time to increase the company's profitability, to build a stronger franchise. This investment of time creates an attachment to its company leading to a loss of objectivity. The same way a parent loses objectivity of his child's drawing skills - I believe everything my four-year-old son draws is a masterpiece (it really is, LOL) - management believes that its company is extra special, thus usually overestimating its value and overpaying for the stock. In other cases management is aware that its stock is overvalued, but it still overpays for it to make their earnings numbers. I do favor dividends to share buybacks, the same way I favor Lloyds TSB (LYG) 7.7% dividend to US Bank Corp's (USB) 4% dividend at 3%+ a year share buyback - both banks have the same payout ratio (dividend plus share buyback) of 80%. Ben Graham lived in a different time, though his principles are still alive; 30% below book value means very little in most cases as the concept of book value is becoming more and more distorted (to a lesser degree for banks and insurance companies) by gigantic write offs, spin offs and share buybacks (mixture of cost accounting and market prices, take a look at Colgate's capital structure). Yes, management should only buy back shares when the stock is undervalued, they'll always argue that their stock is cheap, you should be the judge.


Vitaliy N. Katsenelson, CFA

Positions: USB, LYG Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Tuesday, November 08, 2005

Sporadic Thoughts: Aroung the Eearnings Block and Bargain Basement?

October 3-7 2005 - Minyanville.com
Around the earnings block... Becton Dickenson (BDX) is another darling of mine that reported 3rd quarter numbers today. Revenues grew 8% (excluding currency benefit) and performance was very solid across all segments - a sign of business quality. BDX's business lends itself to fairly good operational leverage, which was apparent in this quarter's performance as margins expanded, driving 20% EPS growth, INCLUDING stock based compensation EPS up 11.7% - still great performance. As I mentioned before, BDX is a good way to participate in rising healthcare spending without the risks and volatility that come with owning drug stocks. On a less upbeat note, BJ Wholesale (BJ) reported mediocre (to say the least) 2.9% same store sales for October; the Street was expecting 5.1%. The company blamed results on a shift of Halloween into its November reporting period and Hurricane Wilma in Florida. Interestingly, Halloween and Wilma did not have the same impact on Costco (COST), which saw its same store sales up over 8% in the quarter. Were BJ's customers the only ones that shifted their shopping into November? Though the company did not change its guidance and one month does not set a trend, I am putting BJ's on a double secret probation. Bargain basement? Not yet According to the Financial Times, 48% of VNU shareholders oppose the VNU / IMS Health (RX) deal - Halellujah! As I mentioned in this article, we sold RX on the merger announcement, as merger of these loosely-related businesses made absolutely no sense. Though I am happy that deal is unlikely to be consummated, I'll not be jumping into RX shares... unless RX visits a bargain basement price, and I have not determined what that may be yet. RX's management lost a lot of credibility in my eyes and, more importantly, in the eyes of investors.
Vitaliy N. Katsenelson, CFA

Positions: BDX, BJ

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Friday, November 04, 2005

Dividends and Share Buybacks

November 4, 2005 - Minyanville.com /Bloomberg
Before the 1982-1998 bull market, dividends accounted for a very large portion of stock market returns. In fact, in the 1966-1982 bear market, they were the returns investors received while watching P/E compress under the market.
On a theoretical level, dividends are just a transfer from a company’s corporate account (an account partly owned by a shareholder but which he/she has no control over) to a shareholder’s brokerage account (an account which a shareholder has full control over.) Thus there is a transfer of “hypothetical” wealth to real wealth. Owning 0.0000005% of the $10 billion residing in the company's account is hypothetical wealth since it is NOT spendable; whereas $5000 in the shareholder’s brokerage account is real wealth as it is spendable wealth.
Since it was the shareholder's money to begin with, stocks usually drop by the amount of dividend paid, thus no value is created. That is exactly what happened to Microsoft (MSFT) when it paid its $30 billion dividend; though don’t forget the stock ran up substantially on the dividend announcement.
Interestingly, stocks have very little memory of the dividends which were paid out, thus the immediate decline is usually erased from investor memory in a NY minute.
This is where the theory and reality diverge: The majority of companies that don’t pay out a significant portion of cash flows in dividends (or stock buybacks, though I place more value on dividends, as stock buybacks could be postponed) more often than not end up destroying shareholder wealth in empire-building acquisitions or marginal capital investments (if they had better investments to begin with they would spend cash right away).
I’ve seen a study (I think it was presented by Cliff Asness at a CFA Institute conference, though I'm not 100% sure) which showed that there is very little correlation with dividend payout and a company’s growth rate. This goes against theory as theory doesn’t factor in destruction of capital by corporate management. A company that has a high dividend payout operates in a very different environment than the one that is swimming in shareholder cash, as rigid dividend payouts force management to maximize the value of every dollar retained.
Lloyds TSB (LYG) for example has a dividend payout of 80% - very few banks have that kind of payout. How is LYG different from other banks? It is not building a war chest to make an acquisition that will likely just raise the risk profile of the company and make management feel better about their ever-growing empire. LYG is looking for internal growth. It is focusing to better its relationship with its customers--a cheaper, higher-return-on-capital type of growth.
Cash that has not been paid out is often destroyed by management, thus making dividends a very important source of value creation. Microsoft’s large cash position did not create much shareholder value as it created incentive for MSFT to waste billions of dollars on “strategic” investments; a $5 billion investment in AT&T comes to mind. Or Mobil buying Montgomery Wards to “diversify its cash flows”--this qualifies as the dumbest waste of shareholder capital ever.
We are getting 8% dividend to wait for LYG stock to come back to “correct” (in our opinion) valuation. In the case of LYG, its super-sized dividend (as long as it is maintained) creates a floor under the stock, thus arguably reducing downside volatility in LYG shares. So I don’t see any problem with getting paid a dividend to wait.
My partner Michael Conn and I were discussing the issue of dividends and both came to one conclusion: A company that has a higher portion of total return coming from a dividend (everything else is constant) should trade at a higher multiple. Here is an example:
Company D (dividend) is growing earnings at 0% and pays a 10% dividend. Company G (growth) is growing earnings at 10% and pays no dividend, everything else is constant. Return from company G will be riskier relative to company D (read: lower P/E) as all of its return is expected to come from the market placing appropriate P/E (driven by a collection of external factors) on its growing earnings. Whereas all of company D’s return comes in the form of dividends--though its price is subject to the same whims as company G’s--its 10% dividend will produce a stable return in the interim. Thus company D is a less risky investment than company G.
Share buybacks are a trickier issue. I usually welcome share buybacks when a stock is undervalued. However, companies will often do anything to stimulate their EPS growth, even it means destroying shareholder wealth through share buybacks. For example, Colgate (CL) was buying back stock when it traded at 34 times earnings--that deed alone should have gotten its management and board fired.
Share buybacks when a stock is undervalued make sense as they help EPS growth and raise dividend yield at the same time. As the buyback lowers denominator, fewer shareholders own the same piece of pie. What is not to love?
Companies that have high return on capital and don’t have a very capital intensive business--our kind of companies--usually will have substantial free cash flows, which allows them to grow earnings organically, pay a dividend and buy back stock. I do not advocate leveraging the company to buy back stock for two reasons: First, higher return comes with higher risk, thus possibly putting downward pressure on a company’s P/E and offsetting any benefits from a share buyback. Second, leveraging a company’s balance sheet has finite limitations; the company can only take on so much debt. Whereas share buybacks from free (discretionary) cash flows are only limited by shares outstanding--a nice problem to have.
In addition, share buybacks (if done at appropriate valuation) and nice, fat dividends create shareholder value on another level as they reduce the risk the company has to take to produce a total return for shareholders. Share buybacks are not a substitute for organic growth, but are often an under-appreciated bonus.
Vitaliy N. Katsenelson, CFA Positions: LYG, MSFT This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.