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Posts Tagged ‘Value Investing

Sensitivity Analysis for Simulations Plus

with 32 comments

Introduction

In the midst of grading season, I don’t have much time to blog or respond to comments, but, as I have in the past, I want to respond to a comment on a discussion board, and use this as an opportunity to do a little teaching.  The discussion board comment questioned whether Simulations Plus (a small pharmaceutical-research software company) has run up too much to still be considered a value stock.  When I first purchased it on October 21, 2008, I bought in at $1.06 and $1.07 a share and estimated that it was selling at more than a 50% discount to intrinsic value.  Today, the closing price was $2.35, and it is natural to wonder whether it is time to sell.

To answer this question, it is important to understand that my shares in SLP are not in a tax-efficient account, and, despite a market that appears to be marginally over-valued, my inclination is to hold stocks until they are demonstrably overvalued when they reside in this account.  Otherwise, the 15% capital gains tax hit reduces my proceeds on the investment by 15%.  Additionally, if selling, I would confront the dilemma of finding a replacement investment about which I am less familiar and, consequently, less comfortable.  So, if SLP is fairly-valued, I’ll hold, and, if it is overvalued, I’ll sell.

Background

Now, it should be understood that the stock hovered for sometime following purchase around the delisting price of $1 and eventually appreciated in value until hitting strong resistance around $1.80.  It meandered for a time at this level and just recently moved up strongly on increased volume, as it began to receive increased press and showed up on technical-analysis screens — where traders identify stocks that are trending higher, based on the stock-price movement and volume.  The catalyst for this appears, in part, to be attributable to the company hiring an investor relations PR firm — a move which was criticized by some on the discussion boards, with the assertion that doing so was tantamount to squandering investor value.  Personally, I take the view that you, either, trust the management or you do not, and, if you do not, then it is time to sell.  At minimum, you can buy US Government Bonds, where management can be trusted to print the money necessary to make good on its obligation to you as the bondholder.

In any event, the recent run-up was based on what seems to have been institutional buying; although, share repurchases may account for some of this move:

So, the question is one of whether recent buyers who began purchasing at an 80% premium above my entry price know a good thing when they see it or have been suckered into the stock at a fair or, for that matter, a rich price.

Weighted Cost of Capital (WACC)

To get at this, lets perform the analysis using a technique not previously covered on this blog.  Due to time constraints, I won’t explain the math, but the intrinsic value of the company can be calculated by multiplying the accumulated equity per share times (ROC-G)/(R-G), where ROC is Return on Capital, G is the growth rate, and R is the cost of capital.  To be conservative, I’ll use Cash Return on Invested Capital (CROIC) in place of ROIC (Return on Invested Capital).  CROIC is calculated as Free_Cash Flow/(Total Equity+Total Liabilities-Total Current Liabilities).

Weighted Average Cost of Capital (WACC) is normally considered the cost of capital, which I have calculated as follows:

Now, let’s look at WACC more closely.  There are two portions to this — a debt portion and an equity portion.  The debt portion takes into account the tax benefits of  debt (from the company’s perspective), but SLP has no debt and hasn’t for some time.  This means the bulk of the 13% WACC is attributable to the equity portion.

Is WACC the Best Measure?

Well, the equity portion of WACC is curious.  The company pays no dividend, so there is no cost to the company related to stock ownership when it comes to financing yearly operations.  The “Opportunity Cost” of the equity is just the investor’s required return, which, in the absence of a dividend, is the stockholder’s expected/desired price appreciation as shares are bought and sold in the market — something management can eventually influence with profits, retained earnings, growth, and increasing equity but, otherwise, management is largely powerless to guarantee a specific level of stock-price appreciation.

This 13%, however, is not a number pulled out of thin air — the air was more thick than that, even if just marginally so.  That 13% is based on the Risk Free Rate of Return (RFRR), which is the current yield on the 10-year bond, plus a buffer that accommodates market risk (8.6% is the number I use, and, by most accounts, it is indefensibly high).

Indeed, for a company with no debt and a nice cash stockpile, 13% or more strikes me as too high, and, for companies with a much weaker balance sheet, 13% strikes me as too low.  Given SLP’s strength, it seems reasonable to substitute the 20-year Single-A corporate bond yield of 6.25%.  Why?  Well, with no debt, ownership of the company is uncontested beyond just us stockholders, in that no creditors, preferred stockholders, and warrant-holders enjoy a senior claim on the company, and this makes the corporate bond yield a more reasonable measure of the true cost of equity capital — especially, since I am not using the lower rates (yields) associated with Triple-A bonds.  This seems (to me, at least) to represent a better balance between the opportunity cost of equity and the negligible effect of equity on the cost-burden faced by the company in its daily operations.

Would Warren Approve?

Now, you may assert that Buffett famously requires a 15% rate, but Mr. Buffett is notorious for allowing common sense to trump general rules of thumb, even when those rules are of his making.  In other words, he does not check his brain at the office door upon arrival each morning.  By his own admission, the purchase of Coke was made at a fair price (rather than a DCF-based cheap price) — allowing the franchise value of the company to serve as his margin of safety.  In the case of SLP, the company is the single producer of its leading product and the government, in addition to many leading pharmaceutical firms, is literally sold on it.  So, I’ll use 6.25% as the cost of capital, and, if you (dear reader) disagree, feel free to substitute any number you prefer.  In fact, that is one of the strengths of performing sensitivity analysis, as will soon be evident.  Sensitivity analysis will allow you to select your own inputs and quickly identify your own estimate of intrinsic value, based on your preferences.  Having settled on a cost of capital figure, we will, however, need to identify ranges for Growth and CROIC.

Returns on Capital and Growth Rates

As for which numbers we will use for return on capital and the growth rate, we want to lower both since this method of estimating intrinsic value seeks to identify the long-term rates.  In the case of growth, we will start with the average rate of inflation over the past decade (3%) and increase that up to Mr. Buffett’s maximum expected rate for the broader-market (6%).  While he hasn’t fully explained why he believes this is the maximum for the broader market, he has implied that this has to do with the US’s current account deficit, and, indeed, some economists expect inflation to rise to 5% due to increased government spending.  If expecting that SLP will earn returns that do nothing more than keep pace with inflation, we can use sensitivity analysis to calculate intrinsic value at different rates of growth, and our span of considered rates will run between 3% and 6%.

As for the return on capital, the yearly figures over the past decade are:

If we calculate the median of the rolling five-year and seven-year medians for CROIC, we get:

So, we will adjust off of 15.59%, and our adjustment will be downward.

This raises the question of just how far down we should adjust.  We know that, over time, the returns on capital will move down to meet the weighted average cost of capital, since the spread between them will attract competition.  While a price war may lower it further, a negative spread will promote industry consolidation in order to increase pricing power and a return to reasonable profitability.  While WACC was not appropriate when calculating the cost of capital (because investor expectations are not relevant to how the company operates daily), WACC is the appropriate measure for estimating the low-end of long-term returns on capital — because rates lower than that will bring on an investor up-rising (in the form of proxy fights, the arrival of activist investors, etc.).  Consequently, we will use 10% as our bottom returns on capital estimate and 15% as the top-end estimate.

Sensitivity Table/Analysis

The final preliminary step is to plug each of these assumptions into our equation for calculating intrinsic value.  Using 6.25% as the cost of capital, our two-way sensitivity table for growth and returns on capital becomes:

So, at 4% growth and 13% returns on capital, the stock is worth $2.49, which is a little above today’s price.  This suggests that recent buyers were not entirely delusional.  They may, in fact, expect a higher rate of inflation-driven growth, which would value the stock at $4.49 if inflation rises to 5% and long-term returns on capital decline to 13%.  With the company’s strong niche servicing the cost-reduction needs of the pharmaceutical industry (in this post-healthcare-reform environment), higher rates for either growth or returns may be warranted, depending on investor opinion about the company, its products, and their prospects in the competitive market.  A more important consideration for the institutional investor is calculating the down-side risk in comparison to the potential for appreciation.  Worst case (using 10% returns and 3% growth) is a price of $1.34 … unless expecting something worse to unfold over the life of the company.

Now, the table above color codes the cells based on whether the projected value is above (green) or below (red) the current stock price.

Down-Side Risk Graph

Raw numbers, however, are often difficult to visualize.  So, think about the graphing possibilities.

Want the ability to consider the down-side risk versus the up-side potential in light of these assumption?  How about:

In this case, the stock prices are listed along the y-axis, returns on capital are along the x-axis, and the diagonal colored lines are the various growth rates.  There are three horizontal lines.  The red-dashed horizontal line is my test assumption, which assumes 14% returns and 5.5% growth.  Do I expect this?  No.  It is just an example of what you can do with this sort of analysis.  The dashed-blue line is set at twice the current stock price.  As a deep-value investor, I tend to demand a 50% margin of safety when first buying a stock, and this line helps me determine the scenarios necessary to produce that margin of safety.  At 11% returns and 5.5% growth, intrinsic value doubles — both strike me as achievable, for the reasons explained earlier, but you may view things differently and this chart informs that consideration.  Lastly, for this chart, the black line is the current price, and, to the degree that the different growth rate lines are below the black line (compared to the degree to which they are above the black line) provides a sense of the down-side risk.  In this case, the upside seems abundantly larger than the down-side, but you may be exceedingly risk-adverse and see it differently … and that is fine.

Jacobi — Charlie Munger’s Hero, and Mine, As Well

Continuing with our graphical analysis, let’s do the Jacobi and invert:

In this case, the price remains along the y-axis, but the growth rate is along the x-axis.  Each of the variously-colored curved lines is the return on capital, and horizontal lines reflect the current price, double the current price, and the estimate — from bottom horizontal line upwards.  Note where the top and bottom lines cross the current price and the degree to which they are above and below it.  Next, do the same with the margin-of-safety price.  And, finally, note the change in slope as growth and returns on capital increase.

With some stocks, the slope becomes parabolic, asymptotic, and down-right exotic … and you never thought a graph could achieve such an alluring level of  sex appeal.  Well, if the graph seems too good to be true, consider the before and after pictures of May West, who was considered the sexiest woman of her era when she was young and became a real porker when the ravages of age struck.  The same is often true of fast-growing companies.  Attractive in youth, they tend to burn-out early through hard-living and, like Mae, unsustainable growth.  [Note:  The general rule is that growth in excess of 30% per year threatens detrimental burnout, but, as always, there are exceptions to this rule.]

Do I Need More Analysis or Am I Just Sensitive?

Another way to analyze this is the following:


Like the earlier table, this one is color coded.  It considers the projected intrinsic-value price in comparison to the current price and calculates the up-side return.  “Fair value” is the current price, and fair value equals 100%.  Below 100% is color coded as red.  The yellow squares range between 100% and 150%, and they are yellow because I consider this to represent an attractive valuation for only exceptional companies — where management walks on water, divides loaves and fishes, births babies, washes windows, and sheers sheep before the rest of us have had breakfast.  If Warren were younger or immortal, I’d buy Berkshire in the yellow zone.  The green boxes (without bolding and lines drawn around them) indicate an intrinsic value that is between 150% and 200% above the current stock price.  This would apply to much of the Fortune 100 in terms of their size, financial strength, market share, etc.  This tier is below my normal deep-discount threshold, and examples of recent purchases that fell into this range are Disney and Wal*Mart.  Lastly, the bolded and boxed-in green squares are 200% or above the current value.

A Final, But Important, Note

For the record, I tend to calculate these figures using several different methods of estimating intrinsic value.  Think of it as Sensitivity-Analysis-Squared.  Here is one of many possible examples, using the SLP data:

Credits and References

Finally, for a more complete explanation of the math behind the equation, read Value Investing:  From Graham to Buffett and Beyond by Bruce Greenwald and Judd Kahn, Paul Sonkin, and Michael van Biema.

The charts and graphs do not appear in the Greenwald book.  For good or ill, they represent my effort to incrementally improve on Professor Greenwald’s brilliance.

The purpose of this posting, beyond responding to an online comment, was to teach the concept of sensitivity analysis and take it a step beyond earlier efforts that focused on the Ponzio approach to Discounted Cash Flow analysis:

Example of Sensitivity Analysis Using Ponzio DCF Approach and SLP

The original idea for addressing this topic followed from a recent conversation with Bill Ellard.  Bill has written and published for a number of online investing Zines, while the Ponzio approach can be found at FWallStreet.com, where professional money manager Joe Ponzio is the chief cook and bottle-washer.  [Joe also runs Ponzio Capital and is the author of F Wall Street.]

Disclaimer

Now for the disclaimers, which have not been approved by any competent legal mind.  First, be an adult and do your own analysis and due diligence before investing.  I am neither perfect nor clairvoyant when it comes to investing, and I’ve made my fair share of errors in the past.   While not intending to fool anyone, I have made mathematical mistakes before (starting in first grade and continuing uninterrupted to the present day).  Consequently, there is no guarantee that the math presented here is perfect (I’ve checked it thrice or more, but I am, both, writer and editor, and, therefore, violate the tenet that no physician should have himself as a patient).  So, do your own thinking and ciphering, make your own decisions, and be adult enough to withstand the consequences of a mercurial market, an imperfect writer, and the potential that the financial Gods just might smote us both, no matter how good looking or worthy of wealth the two of us might be.  Please know that it is my preference that you not invest in any stock used as an example on this blog.  Instead, use the concepts to identify your own investment opportunities and send me a note with your best ideas … but only the ones that make a change of pants or panties necessary … and quantitatively explain your logic.  [Note: Good or bad, I will not post your recommendations.  Sorry, I shill for no one.]

_________________

Following publication of this piece, Mike wrote:

Thanks for a great report regarding Simulation Plus,Inc.. You inspired me to due my own due diligence in this company. I am new to investing but here are my results:
ROE over the past three yrs., 8.8%,14.3% & 14.5% ave. 12.5% Would like to see 15% or more;
Growth Rate for yrs 05/06 23.3%, 06/07 51.1%, 07/08 1.2%, and 08/09 1.89% Big drop here could be trouble.
Net Profit Margin is on ave., 15.6% not bad;
Asset Turn 0.76 cents,0,86 cents and 0.75 cents not good;
ROA last three yr. ave is 12.5 % could be better;
FCF 06/ -0.22,07/ +2.33,08/ +1.67 and 09/ +1.77 this seems lumpy;
Cash King Ratio for four yrs. is on ave., 15.11% which is very good;
Cash Conversion Cycle for Simulations is 116.7 days I don’t know if this is good or bad?
Because I am new at this I need your ideas if you still think SLP is still a good investment. Thank you for your time and consideration in this matter.
Respectfully, Mike

First, Mike, thank you for the compliment.  They are always appreciated.

Second, please recognize that I used SLP as an example to demonstrate an analytical approach.  While I own shares in the stock, SLP is a very small holding in a larger portfolio, and this strikes me as appropriate for a small value/growth company with a market cap significantly less than $100 million.  During a significant market down-turn, market liquidity could dry up quickly.  So, while the company is abundantly healthy (no debt, strong cash flows, etc.), don’t deploy your rent money or allocate Granny’s savings toward it.

Morningstar Data.  See Debt/Equity figures.

Third, your calculations differ from the Morningstar figures (marginally, in some cases, more significantly in others):

Now, let’s look at each of the items you mentioned, starting with Net Profit Margin.  At 15%, this is, indeed, healthy.  Next, you note that Asset Turnover is “not good.”  The reason we consider Asset Turnover is that it contributes to Returns on Assets when multiplied by the Profit Margin.  This tells us a great deal about the company’s pricing structure if you think of Asset Turnover as a surrogate for the volume of unit sales.  With a high profit margin product, you can sell a small number of units to achieve the same ROA as a low margin product for which you must sell a great many units.  This is the difference between Porche and bubble gum — one has high margins and low unit sales, while the other has low margins and high unit sales.  This, in fact, is recognized by Investopedia (the online dictionary of investment terms and concepts):

http://www.investopedia.com/terms/a/assetturnover.asp

Now, you note that ROA has a three year average of 12.5% (indicating that this “could be better.”)  Recognize that SLP is an early-life-cycle company in its formative years.  Consequently, the numerator (net income) will be depressed due to growth CapEx spending (plowing back into the company a greater portion of operating income to finance future returns), and the denominator of ROA (Total Assets) may be higher-priced (listed as more valuable or expensive) than for a longer-tenured firm.  For example, there is a great deal of uncertainty about the real estate value of Sears Holdings because much of the property was purchased more than 40 years ago, at much lower prices.  Credit Suisse values the real estate holdings at $4.7 billion today, while Sears lists them at $1 billion on the balance sheet.

Next, you note that the three year average ROE is 12.5% (the same as for ROA), and that you would like to see something greater than 15% by this measure.  The difference between ROA and ROE is literally the multiplier effect of debt:

http://www.investopedia.com/terms/e/equitymultiplier.asp

Recall from earlier that SLP has no debt.  Of course, debt can be a good thing or it can be a bad thing.  It is known as leverage for a reason.  It enhances profits and exacerbates losses.  Currently, corporations are stockpiling cash due to economic and tax-rate uncertainties, allowing them to reduce debt, and this is depressing ROE.  So, in this respect, SLP is not alone.  In fact, the company has indicated its interest in making strategic aquisitions, if the right deal comes along, and this explains why cash and short-term equivalents account for nearly 60% of total assets:

More importantly, the company should not take on debt if unable to convert that capital into new sales.  Doing so would depress ROA and ROE, and it would certainly depress any right-thinking investor.

The decline in growth rate is easily explained by the decline in the economy — the worse recession/depression since 1929 — and the uncertainties associated with healthcare reform legislation for SLP’s principle customers (the pharmaceutical and bio-med industries).  The question then becomes whether this represents a short-term condition or a long-term undermining of the company’s strategic position.  While this is largely a judgment call, note that SLP’s principle product significantly reduces R&D costs for its clients and the utility of the product is recognized by the FDA as a suitable surrogate for those R&D steps.  So, the question becomes one of whether you expect pharma and bio-med to cease R&D toward new medical advances — if so, be gentle when you break the news to their stockholders.

Next, you indicate that FCF is lumpy, and it certainly is.  Dive into the statement of cash flows, however, and the reason becomes fairly evident.  Note that the numbers are exceedingly small.  A change of $1 million in cash from investments can have a material impact on FCF, even though that $1 million expense was toward upgrading operating infrastructure, as happened a couple of years ago.  That decline in FCF, however, represented an internal investment toward future growth, for which the company and its owners should reasonably expect a future return on investment.  And, indeed, the new product announcements since then support this view — with one product already generating profits and the other new product just starting to enter the market, following the recently announced sales and distribution partnership agreement.

You note that the Cash King ratio (15.11%) is “very good.”  Candidly, I’m not familiar with this ratio.

As for whether SLP remains a value investment, I am of two minds about that.  At the current price it is fairly valued if expecting 6% annualized growth.  If, however, you anticipate a higher growth rate due to the company’s proven history of innovation, new products (generated internally), and the company’s past history of accretively successful and judicious acquisitions, then the stock is undervalued by 50% or more.  To see this most clearly, look at the Returns on Invested Capital and compare that to any reasonable measure of the company’s cost of capital.  The difference between the two reflects the franchise value of the company (what Buffett calls “The Moat”).

Now, I should offer two warnings to the approach you are using.

First, allow the ratios to help paint a picture of the company as a strategic entity in the market.  In other words, understand the strategic position of the company and its forward prospects and let the ratios support or disprove the mental picture you have of the company.  Because the ratios are backwards-looking (reflecting prior results), they will tell you about how management has positioned the company and whether the company is in financial distress, but they are often poor indicators of future performance.  This is especially true for early-stage firms.

During grad school, we did a case analysis of American Greetings.  The financial results and ratios were little different from one year to the next, and my team’s presentation of the case reached that conclusion.  Our professor (Dr. Doward Dowsma) then asked the key question — “Is American Greetings a stock or is it a bond?”  Well, of course, it is a stock, but its behavior was more akin to a bond — with a steady and predictable revenue stream and dividends.  Dr. Dow then asked whether it was easy or hard to value the company, and, because it behaves like a bond, we said it was easy.  “As investors,” Dr. Dow continued, “is there anything about the stock that you know that other investors do not, since the value is so easily determined?”  We could think of none.  “Is the stock fairly valued today?”  It was, we asserted.  “So, the market knows how to read a set of financials, calculate the ratios, discount the cash flows, and place a fair value on the stock?”  Yes.  “Is American Greetings a buy, sell, or hold?”  We said “hold.”  “Oh, really?” responded Dr. Dow.  “You can’t find a better use for your money than purchasing a fairly valued bond?”

Now, ask yourself, “Is SLP so predictable in its results that it behaves like a bond?”  Then ask, “Do you know something the market does not?”  Personally, I know that the company enjoys significant barriers to entry, that management is earnest and honest, that it occupies an industry that is more resilient to market down-turns than most, has a new product that may revolutionize workplace efficiency for disabled workers, and has consistently posted returns on invested capital that exceed the imputed equity cost of capital (maximally, 8.6%).  I also know that it is a small company that is under-followed by Wall Street analysts.  So, yes, I know something the market doesn’t … and I know the company is so small that it represents a speculative investment.  Consequently, I want exposure to the company, but I don’t want a lot of exposure.  That was my thinking when I bought the stock when it was selling near its delisting price of $1, and that is my thinking today at $2.35.  The difference between then and now is that the company was cheap on a book value basis at $1.

Second, if relying so strongly on ratios and conventional measures for them, you need to consider more than three years worth of data.  Three years is statistically meaningless and, worse, misleading.  Under the central limit theorem, you need 30 data points to determine when a single data point is statistically outside the normal distribution (i.e., to reject the null hypothesis).  Walter Shewhart, in the mid-1920s, demonstrated that you could use as little as five data points if the data was accurately collected and reflected a standardized process.  Well, the distribution of economic results is not captured by 10 years worth of data (the prior decade’s data was unhelpful in predicting the crash of 2007/2008), and it is certainly not captured with 5 years worth of data, and 3 years data is 40% less data than five years data.

This is why Benjamin Graham advocated requiring a significant margin of safety.  That margin of safety can come in different forms.  It can be based on a discount to the company’s balance sheet (Graham’s approach), but this entirely ignores the compounding benefits of future growth.  You can use John Burr William’s DCF to get at the value of growth, but this requires making judgments about growth and discount rates.  You can discount DCF (a la Joe Ponzio and Monish Pabrai), but this provides little protection during economic crashes that exceed 30% (or less, depending on your growth and discount assumptions).  You can do as Buffett does and combine Philip Fisher with Graham and Williams and add a heavy dose of Michael Porter’s “Strategic Forces.”  Or you can modify Buffett with Bruce Greenwald’s methods — adding layer upon layer of safety margins, where the value of each margin of safety is accorded its appropriate weight depending on the strengths of the company — something I’ve barely touched on in this blog, but I’m working on it with the latest series of quality improvement postings (but that won’t be evident until the end, due to the complexity of the theory and philosophy behind it).

In any event, I hope this is helpful.

The key takeaway is not that SLP is or is not a stock you should buy, however.  It is right for my portfolio, because I can accommodate a significant loss from a small and speculative investment, and, having experienced and navigated the crash of 2007/2008, I know with relative precision my tolerance for risk.  As a new investor, your tolerance may be lower (most investors believe their tolerance is high, until the market hits them hard) or your invested capital may be less discretionary.  So, please do not read this as a recommendation to purchase SLP.  That is not my intent, and it was not why I used it as a case study originally.  In fact, I chose SLP as the example because I believed most investors would elect against buying, due to the small market cap, low share volumes, early-life-cycle stage, etc.

Thanks,

Robert

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Written by rcrawford

April 17, 2010 at 8:58 pm

AEO — American Eagle — Update [01/10/10]

with 2 comments

Well, I just noticed that today’s date is all ones and zeros.  Not as momentous as the Armistice that ended World War I (the eleventh hour of the 11th day of the eleventh month), but, for a numbers geek, this is what suffices for entertainment.

My last posting on American Eagle (AEO) was on August 29 of 2008; although, I did include the stock as a current holding in the Bull series completed this week.  Two acquaintances from one of the on-line forums made seperate assertions that prompted me to look at the stock and its performance more closely, and what I discovered was a surprise.  Amazing, actually.

The first comment asserted that the stock market and the economy are in the toilet and will soon be at the solid waste disposal facility.  The second questioned why the stock did not enjoy a boost in price with the most recent earnings announcement and higher guidance.  The easy conclusion is that the first comment answers the second, even though they were not presented in the same thread on the message board (i.e., line of discussion).  My take is dramatically different than either, but it is not dramatically different than prior assertions.  In short, the market is more than inefficient, it gets some stocks badly wrong over protracted periods.

Of course, you might expect that I would take this position, since I am long (own the stock).  Indeed, recent research into human psychology notes the difficulty we have admitting mistakes and reversing our prior positions; especially, those taken publicly.  Given this, allow me to repost my response from that message board but, unlike the original, provide the charts and graphs in support and a small number of additional comments (based on the ability to post the graphs and charts).

Question:  “Why is AEO trading down? I thought these results would cause AEO to [go to] at least go to $20. Yet it’s under $17. What am i missing?”

Response:

Why? Good question.

The current PE is 25.36. This puts AEO above 73.93% of all stocks current trading (the non-financial firms). Consensus for next year is $0.32 per share in earnings, which equates to a PE of 54.25, and that is above 99.50% of all stocks currently trading. (Percentages based on regression-fitted gamma distributions.)

On the other hand, AEO is currently selling at a price to net asset value of 2.37, which puts it among the cheapest 5.42% of the market (just 1.68 times replication value —  $17.36 (current price) divided by $10.32 (Replication Value).

So, the stock appears to be overvalued based on earnings, while it is undervalued based on assets. The reason for the difference (I suspect) is the uncertainty over of the consumer, for all the reasons my pessimistic friend mention.

It may be helpful to recall that the company guided above performance just prior to the market crash, with expansion plans into two new demographics and sales overseas, with sustained growth of 12%-to-14%.

Now, it is important consider the limitations associated with basing valuations on earnings. This is why Buffett looks at Owners Earnings, rather than GAAP earnings.  GAAP earnings include such non-cash items as depreciation, amortization, and changes to “Goodwill.”

For me, the bigger measure of management success is shareholders equity growth, since this more accurately measures the value of a company today.  Shareholders equity is calculated as total assets minus total liabilities.

To FULLY assess AEO’s shareholders equity, look at the percentages of free cash flows and owners earnings converted to shareholders equity.

The five year average is around 80%. This would have been higher if not for significant funds invested in upgrading operations in 2008 and 2009 (around $278 million in 2009, alone).

So, while some have complained about the company’s expenditures on growth, estimated maintenance CapEx appears to have dwarfed growth CapEx in 2007 and 2008 ($203 million and $278 million versus $84 million and $0 million), leading to $94 million and $105 million spent on maintenance CapEx above declared depreciation levels.

This is important because it informs free cash flows retained as shareholders equity and cash flows used to repurchase shares. CapEx represents the company’s investment in the future, while shareholders equity is the value of the company to which I (and you) are part owners.

So, has the company been investing in the future to our detriment? Well, before the crash, shareholders equity was $1.155 billion in 2006 and grew to $1.417 billion in 2007 (a 23% increase). It dropped to $1.340 billion in 2008 (the crash), rebounded to $1.409 billion in 2009, and is currently at $1.523 billion. This actually represents a 7% improvement over pre-crash levels, despite its CapEx expenditures.


That, however, doesn’t tell the full story, either. The company has bought back shares (from 233 million in 2006 to 208 million currently — just under 11%).

This is important because it alters the per share value of shareholders equity. It was $4.96 in 2006 and currently stands at $7.33.

That is a 10.26% compounded annual growth rate —

That is the result for those who have held the stock over the last several years.  Going forward?

This chart (above) provides the shareholders equity per share results with a trendline, a measure of the trend’s accuracy, and the equation for that trendline.  At R-Squared 0.9788, the line is pretty close to a perfect 1.0 (just 0.006 variance).  The bolded red figure is the slope (recall from school the equation for a line — Y = MX + B –, where M is the slope).  So, AEO is adding $0.65 to the per share value of shareholders equity, and this equates to 8.9% growth for the coming year if the trend continues.  That is more than double the rate generated by the 10-year US Government bond.

So, the company invested in growth, invested in current operations, bought back shares, absorbed losses due to auction rate securities, kept its current ratio at 2.60, maintained its total debt ratio at 0.27%, ***AND*** grew shareholders equity per share at more than 10% during the worst economic crash since the Great Depression.

Impressed?  If not, you never attended business school or didn’t pay attention while there.

So, did Wall Street get it wrong when not rewarding the company for better than expected earnings and forward guidance? I don’t know, but all of this does suggest they have been pretty clueless for the last three years.

Recall that Warren Buffett has maintained that the great lesson of Charlie Munger is a willingness to pay a fair price for a company possessing excellent management.  If needing evidence that American Eagle possesses excellent executive leadership, this posting should prove the point.

If not satisfied, the burden of proof is entirely yours.

Written by rcrawford

January 11, 2010 at 9:22 am

The Lorax Investor

with one comment

2002 Nobel laureates Daniel Kahneman and Vernon Smith used computer simulations to study behavioral finance, demonstrating that speculative bubbles arrive with greater frequency than most of us would otherwise expect. Those bubbles can be hedonistic or pessimistic, defying the “efficient market theory” — which argues that the market fairly prices openly-traded equities, commodities, and other goods and services with near-instantaneous accuracy. The mispricings associated with speculative bubbles often follow from a “herd mentality,” and this leads to the trading approach known as “technical analysis.” Eventually, however, bubbles deflate, no matter how analytical the technician.

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Written by rcrawford

November 8, 2008 at 8:08 am

The Start of Something Small

with 3 comments

I don’t know what the outcome will be, but I’ve posted a request to my friends on the best of the Yahoo! Finance boards (AEO), with plans to deliver the results here.

Okay, okay, I know, this is off topic, but in recent months this board has been about ideas, content, and investors (long, short, and agnostic) helping (or, at least, contributing) to the knowledge of others — sounds more altruistic than the reality, but it is a better model for these boards than the normal pump and bash found elsewhere.

Under the heading of “FWIW,” I indicated that AEO may (emphasis on “may”) be seeking a bottom during a time of economic turmoil. Steve accurately responded that AEO is subject to the steering winds of the broader market (retail and beyond) and White Sandy Beaches has (correct me if wrong) indicated that the macro controls AEO, as well. Both are right (in my view) if holding a short-term perspective.

Value investors, however, tend to argue (a la Buffett), that, when the market becomes depressed, that is the time to be greedy. Well, clearly, the market is depressed … and may become further depressed before euphoria returns. Under that logic, this may be the time to buy excellent companies at reduced prices. The market is on sale, but identifying the ultimate winners is problematic (making decisions difficult under the best of circumstances, and nearly impossible when the baby is being thrown out with the bath water).

So, the question naturally arises, what would you buy at these prices? What companies strike you as under-valued, led by great management, possess the strength to survive the current economic challenges, and seem likely to out-perform whenever sanity returns?

If you provide the stock symbols, I’ll run them through my screener — which performs the discounted cash flow analysis and a number of other tests –, and I’ll post the results on my blog. Perhaps Bill Ellard will do the same (left a message on his phone), and, if so, I’ll post those results, as well. And, if others have a method for identifying value investments, where the criteria for assessment can be described for a broader audience to understand, the invitation holds for you, as well.

I’d like to get the results in fairly short order — sufficient to run the screen over the weekend and in time for the start of trading next week. So, that means just one day to post your picks.

So, what are your best investing ideas? Just post the stock symbols (sorry, no penny stocks — my screen won’t accept them). No need to explain the reasoning behind your recommendation, either. I’ll post the quantitative results without comment.

This board attracts an above average group of investors, and there ought to be a way to share our best ideas.

Thanks,

Robert

PS. The data source used for my analysis is Morningstar, which doesn’t provide complete financials for financial firms (banks, brokerages, insurance). So, Dave’s preference for AIG, for example, will render incomplete results. My preference is to avoid financial firms, but I’ll post the incomplete findings if you submit them. My preference, however, is to focus on the rest of the market.

For those who are interested, I’ll do something similar with this blog. For those who can not wait, feel free to post your recommendations there — the American Eagle (AEO) message board in Yahoo! Finance.

I have, as well, promised to post the results of others who have financial screening and analysis tools used to identify value stocks, and, in the future, I’ll run the same screen for the most popular choices in Motley Fool CAPS — a larger community of investors.

The results should be interesting, if a sufficient number of recommendations are submitted.

Written by rcrawford

July 11, 2008 at 6:36 am

Market Meltdown Response Suggestion

with one comment

I spoke with a Wall Street analyst yesterday, prior to the market’s meltdown today. We were talking about news reports out of Europe, indicating predictions by Barclays Capital, the Royal Bank of Scotland, and Fortis of a major market event in the US and withdrawal of investments and capital by them from the US — as reported in the Financial Times and elsewhere. Reading this prompted me to move a third of my investments into cash (in addition to my mad money cash, set aside for investments as they become known). Another third has been pulled from a number of mutual funds and placed in S&P 500 index accounts, and the remainder is in a portfolio of stocks purchased due to the disconnect between market value and intrinsic value — a small number of which have been identified here.

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Written by rcrawford

July 10, 2008 at 3:38 am

Quality Systems (NYSE: QSII)

with 2 comments

It has taken several weeks to rebuild my computer system and the automated Excel files that allow me to screen stocks and identify each as, either, a value prospect or those which fall within the broad range of “other.” Just before the two crashes that represented a perfect storm of computer trauma, I looked at the out-of-favor sector of temporary staffing. For this effort, I decided to do the same, focusing on the confluence of two unloved sectors — IT and healthcare. Specifically, our focus this week is healthcare IT.

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Written by rcrawford

July 8, 2008 at 4:31 am

Hansen Natural (NYSE: HANS) — 06/04/08

with 14 comments

Value investing represents a “Tale of Two Cities” — where the stock represents the best and the worst of times. On the one hand, we seek a company that is performing competently and growing. On the other hand, we seek a stock price that is in the toilet. At its core, value investing is a disconnect between the bipolar psychology of Mr. Market and the intrinsic value of the company. The efficient market theorist would have us believe this is impossible, but the market’s volatility in the absence of actionable information suggests otherwise. Hansen Natural (NYSE: HANS) seems a case in point — where the company is doing well but the stock price has been unreasonably hammered (thank you, Shorts).

I don’t know whether the stock was overvalued at its peak. That is not the subject of this analysis. I have every reason to believe, however, that it is undervalued at today’s price, and that is the subject of this article.

Company Description

SEC filing description of the company:

Hansen Natural Corporation, through its subsidiaries, engages in the development, marketing, sale, and distribution of beverages in the United States and Canada. It offers natural sodas, fruit juices and juice drinks, energy drinks and energy sports drinks, fruit juice smoothies and functional drinks, non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, and children’s multi-vitamin juice drinks. The company also provides energy drinks under the Monster Energy, Lost Energy, Joker Mad Energy, Unbound Energy, and Ace brand names, as well as the Rumba brand energy juice. In addition, it markets and sells Java Monster non-carbonated dairy-based coffee drinks; natural sodas, premium natural sodas with supplements, organic natural sodas, seltzer waters, sports drinks, and energy drinks the under Blue Sky brand name; and non-carbonated lightly flavored energy waters under the Hansen’s brand name. Further, the company provides vitamin and mineral drink mixes in powdered form under the Fizzit brand name. Its customers include retail grocery and specialty chains, wholesalers, club stores, drug chains, mass merchandisers, convenience chains, full service beverage distributors, health food distributors, and food service customers. The company was founded in 1985 and is based in Corona, California.

Fundamental Overview

The company enjoys a strong financial posture. Yahoo Finance reports the following:

The forward price-earnings multiple is expected to come in at 14.02, with a price-to-earnings-to-growth (PEG) ratio significantly below 1.0. It should be noted that the price to sales and the price-to-book values exceed the normal value investing thresholds. In other words, Hansen is not undervalued based on these metrics.

The profitability and management effectiveness results, on the other hand, are exceptional — especially the return on equity, which exceeds 45%.

The key figures in the previous graphic are the year-over-year results for revenues and earnings, posting 27.9% and 42.6%, respectively. While the core data provided (below) will focus on the year-over-year results, these figures provide shorter-term investors with an indication that earnings and revenues are growing intra-year.

The company’s total debt/equity ratio, at 0.001, is abundantly healthy, and the current ratio at 3.966 provides our first indication that the company is an unlikely bankruptcy candidate. This is confirmed by the Altman-Z Score:

At 27+, the company significantly exceeds the 1.81 threshold indicating a bankruptcy threat, to say nothing of the top-end grey-zone figure of 3.0.

The short ratio of 4.1 (25.5% of the float) represents an increase of shares short from 17.8 6 million last month to 19.9 6 million as of May 12. This serves to explain the recent price decline in the stock. To fully understand this, it is helpful to recognize that insiders accounted for 16.99% and institutions accounted for a further 88% of the outstanding shares. Therefore, a relatively small number of shorts have the ability to move the stock price disproportionately on any given day. Neither, insiders nor institutional holders are known for day-trading. Our goal, as value investors, is to allow the market to exercise its depressive psychosis to our benefit — providing buying opportunities that would not otherwise be available if the market were truly efficient.

Financial Analysis

Turning to the 10K figures:

Gross Profit.

Revenues have been parabolic, and gross profit exceeds cost of goods sold.

Operating Expenses

The decline of sales, general, and administrative expenses in 2006 and the commensurate rise in “other” represents a change in accounting methods. The increase in this category, however, is consistent with the increase in sales. For those who require further evidence, the company describes their allocation of capital as follows:

Operating Expenses. Total operating expenses were $237.0 million for the year ended December 31, 2007, an increase of approximately $79.0 million or 50.0% higher than total operating expenses of $158.0 million for the year ended December 31, 2006. Total operating expenses as a percentage of net sales was 26.2% for 2007, slightly higher than 26.1% for 2006. The increase in operating expenses in dollars was partially attributable to increased out-bound freight and warehouse costs of $8.7 million primarily due to increased volume of shipments, increased expenditures of $18.4 million for sponsorships and endorsements, increased expenditures of $10.3 million for commissions and royalties, increased expenditures of $4.9 million for sampling programs, increased payroll expenses of $12.1 million, increased expenditures of $8.6 million for professional services costs, including legal and accounting fees, and increased expenditures of $2.5 million relating to the costs associated with terminating existing distributors. Included in legal and accounting fees are costs of $9.8 million (net of $2.5 million insurance reimbursements) in connection with our special investigation of stock option grants and granting practices, related litigation and other related matters. Total operating expenses, exclusive of expenditures of $15.3 million and $12.7 million for 2007 and 2006, respectively, attributable to the costs associated with terminating existing distributor and exlcusive of expenditures of $9.8 million (net of 2.5 million in insurance reimbursements) and $3.8 million for 2007 and 2006, respectively in connection with our special investigation of stock option grants and granting practices, related litigation and other related matters, as a percentage of net sales, were 23.4% for both 2007 and 2006.

Taxes

Taxes paid are in-line with expectations and growing at a rate below earnings.

Cash Flows From Operations

This is as expected; although, it did marngally separate from net income in 2006. All other contributors were not material.

Cash From Investments

Cash flows used in investing activities Net cash used in investing activities was $194.7 million for the year ended December 31, 2007, as compared to $95.2 million used in investing activities in the comparable period in 2006. For 2007, cash used in investing activities was primarily attributable to purchases of short- and long-term investments, particularly available-for-sale and held-to-maturity investments. Cash provided by investing activities was primarily attributable to sales and maturities of held-to-maturity and available-for-sale investments. For both periods, cash used in investing activities included the acquisitions of fixed assets consisting of vans and promotional vehicles and other equipment to support our marketing and promotional activities, … .

Cash from Financing

Exposure to Financial Liquidity Crisis

The company does have exposure to the recent financial-market liquidity “crisis.”

At December 31, 2007, we had $12.4 million in cash and cash equivalents and $290.2 million in short- and long-term investments.

Their exposure to auction rate securities (ARS) has been shifted from short-term to long-term. At $237 million, operating expenses are more than covered by gross profits of more than $468 million (for a 51.7% gross operating profit as a percentage of net sales). If seeking to determine the impact on capital expenditures, I came up with the following estimates:

These calculations are designed to segregate growth and maintenance capital expenditures as a check against declared depreciation. The net difference over the past decade amounts to less than 1%. With declared cash of over $12 million and a current ratio of 3.966, the company appears to have sufficient working capital to accommodate the recent liquidity issues within the broader financial markets, as indicated by this graph comparing free cash flow is to capital expenditures:

Moreover, free cash flows of $131 million provides complete coverage of current liabilities ($76 million) plus capital expenditures ($4.1 million), combined, with a margin of safety of more than $50 million ($131 – $76 – $4.1).

Assets

Total current assets leveled off from 2006 to 2007, as the company evidently invested in growth through inventories and accounts receivable with a decline in cash and cash equivalents. The cash and equivalents decline was also due to added plant, property, and equipment and the conversion of ARS investments to long-term assets from short-term assets.

In addition to the ARS conversion, the increase in other long-term assets includes expansion of the company’s unique emphasis on trial marketing, which is described in the 10K filing:

Our sales and marketing strategy for all our beverages and drink mixes is to focus our efforts on developing brand awareness and trial through sampling both in stores and at events. We use our branded vehicles and other promotional vehicles at events where we sample our products to consumers. We utilize “push-pull” methods to achieve maximum shelf and display space exposure in sales outlets and maximum demand from consumers for our products, including advertising, in-store promotions and in-store placement of point-of-sale materials and racks, prize promotions, price promotions, competitions, endorsements from selected public and extreme sports figures, coupons, sampling and sponsorship of selected causes such as cancer research and SPCAs, as well as extreme sports teams such as the Pro Circuit – Kawasaki Motocross and Supercross teams, Kawasaki Factory Motocross and Supercross teams, Robby Gordon Racing Team, Kawasaki Factory International Moto GP Team, Kenny Bernstein Drag Racing Team, extreme sports figures and athletes, sporting events such as the Monster Energy® Supercross Series, the Monster Energy® Pro Pipeline surfing competition, Winter and Summer X-Games, marathons, 10k runs, bicycle races, volleyball tournaments and other health and sports related activities, including extreme sports, particularly supercross, motocross, freestyle, surfing, skateboarding, wakeboarding, skiing, snowboarding, BMX, mountain biking, snowmobile racing, etc., and we also participate in product demonstrations, food tasting and other related events. In store posters, outdoor posters, print, radio and television advertising, together with price promotions and coupons, may also be used to promote our brands.

Liabilities

The increase in current liabilities is consistent with the increase in inventories, designed to drive sales expansion.

While current liabilities accounts for the majority of the increase in total liabilities, other long-term liabilities increased from $5.4 million to $20.5 million from 2005 to 2006 and from $20.5 million to $39.6 million from 2006 to 2007. The 10K indicates this is primarily due to a canning contract with Rexam Beverage Can Company, having a maximum $6 million liability. The remainder is primarily attributable to leases:

The $50 million in excess free cash flows (described earlier), should be sufficient to cover the $37.5 million due in the current year. Lease obligations decline thereafter.

Shareholder’s Equity

The company’s strong operating margins are best put into perspective with a chart that compares the growth of liabilities to shareholder’s equity.

Investment Ratios

With each of the investment ratios, we will consider the results from two perspectives.

The first will provide the yearly results, with overlaid process control charts. Process control charts consider the level of performance variation and apply one, two, and three standard deviations above and below the mean. The process control results for the first five years of the 10-year results are not trended, while the results for the most recent five years is. This will allow us to do things. First, I will provide an indication of whether the most recent multi-year performance exceeds the norm by a statistically significant amount. Second, it will allow us to put the most recent year’s performance results into perspective.

The second chart considers the year-over-year rate of growth or decline and contrast it with the company’s long-term rate.

The first item to consider is Owner’s Earnings — a Warren Buffett measure. Owner Earnings adjusts reported earnings for a number non-cash items and maintenance capital expenditures. In the Berkshire filing of 1986, Mr. Buffett describes it as follows:

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since( c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”

The most recent owner’s earnings results significantly exceed the range established over the first five years. The 2007 results, which represent an increase over 2006, falls marginally below the trended one standard deviation line, indicating that the most recent results are consistent with the trend and would be expected in 68 percent of yearly results (or more). The year-over-year chart indicates a return to the 50 percent growth range — which significantly exceeds Buffett’s reported preference for growth in excess of 15 percent.

Having provided the logic behind reading these two charts in combination, I will provide similar charts for other investment measures, starting with book value.

Book value follows owner’s earnings for a reason. We expect that owner’s earnings will translate into book value, which should translate into shareholder’s equity. In this case, owner’s earnings translation into book value is exceedingly efficient. In fact, the 2007 book value growth results exceeded the upper one standard deviation line.

And the translation of book value and owner’s earnings into shareholder’s equity has been impressive, as well. Note that the year-over-year growth in the last four years has trounced the 10-year average.

Diluted earnings per share may be getting a head of itself, as it approaches the trended two standard deviation line (96.8 percent of expected events). This is most likely due to the accounting anomalies described by Buffett, where net earnings consider a number of non-cash items that are not germane to investors or the company’s senior leadership. Earnings per share, however, are what uninformed investors use as a measure of company performance, and, if these results revert to the mean over the short term, the stock price may take a temporary hit.

The Securities Market Line chart is similar, in that it considers the stock’s volatility as a measure of whether the equity return exceeds the broader market’s. Stock price volatility, however, is a market circumstance that may have nothing to do with the performance of the company. Nevertheless, when a company’s results are above the securities market line, the investor is rewarded for the stock’s price volatility. In the case of Hansen, the results are exceptional, even through the volatility is well above the norm for the broader market.

Return on invested capital is not a market effect, and the Hansen results are impressive.

Benjamin Graham sought ROIC results for stable and established firms in excess of 6 percent. For all others, he demanded 10 percent. Hansen exceed both in every year for the past decade. Moreover, the most recent results have been above the five-year and ten-year averages.

Stock Valuation

Discounted Cash Flow Analysis

Discounted Cash Flow Analysis projects bankable profits in the future and discounts them back to today’s dollars. DCF is only as good as the projections, however. Nevertheless, it provides a basis on which to arrive at an informed estimate of per-share value.

We start with the relevant financial information.

Consider free cash growth rates by calculating the median over rolling five-year and seven-year time frames:

And take the median of the rolling medians. For Hansen, this comes in at a whopping 59 percent growth rate. Is this sustainable? Not according to what I was taught in business school.

So, let’s cut that growth rate by 25 percent over the next three years and reduce it further by 10 percent increments as follows:

This gives us out-year free cash projections of:

We would ordinarily discount these future cash flows back to present dollars at a 10 percent Net Present Value rate. To be exceedingly conservative, however, we will increase that by 50 percent and use 15 percent as the discount rate. This would, however, identify the value of the company without consideration of cash flows beyond twenty years or the accrued value of the company, its savings, or assets today. The be conservative, we will use current shareholder’s equity as the residual value of the company and add it to the net present value of the projected cash flows over the next 20 years.

Divide the results by the current shares outstanding and the company is worth $103.87 per share.

At various points, our calculations have been exceedingly conservative. We reduced expected cash flows by 25 percent over the next three years and made additional 10 percent cuts thereafter. We took the median of the median, rather than employing averages. We used a 15 percent NPV rather than a 10 percent NPV rate. And we used current shareholder’s equity as the residual value of the company beyond the next 20 years. To add another layer of conservatism, we demand a 50 percent discount from the per share value in identifying our maximum purchase price. Half of $103.87 is $51.94. With the stock selling at my personal purchase price of around $32.80 ($32.99 to be precise), the actual discount to intrinsic value ($103.87) was around 68 percent, and the potential gain on the purchase is over 300 percent.

Of course, it may take the market a while to fully value the stock. So, we should consider the compounded rate of return at various time frames.

Even if it takes 5.5 years, the return is above 20 percent and far exceeds the norm for the stock market.

All of this, however, assumes a growth rate that is beyond the maximum sustainable level of 30 percent. To calculate the degree to which the stock us under- or over-valued at different growth rates, we perform sensitivity analysis:

This indicates that the stock is under-valued by 31 percent if the growth rate is 30 percent for the next three years, followed by the same 10 percent reductions, and it is undervalued by 11 percent if that growth rate drops to just 25 percent. Breakeven is a growth rate of 22.73 percent. Growth, therefore, can decline from 59 percent to 22.73 percent before stockholders have overpaid for part ownership of the company, if purchasing the stock at $32.80.

Replication Value

How much would it cost a new competitor to enter the market and achieve the equivalent stature and market share of Hansen? Yahoo Finance lists the book value at $4.83 per share. Using the Graham approach, replication value comes in at something around $5.08. The current stock price is, therefore, selling at 6.46 times its replication value.

This price-to-adjusted-book value is very high, and it would be a concern if Hansen were an operations intensive concern — high in plant, property, and equipment. With an infrastructure value of just $8.6 million out of total assets of $544.6 million, price-to-adjusted-book is not the way to value the company. Clearly, Hansen’s value is driven by the end product and its popularity among consumers.

To get at this, it is necessary to consider the company’s earnings power and franchise value.

Earnings Power and Franchise Value

The earnings power of the company is the company’s earnings divided by its cost of capital plus the difference between cash and debt. To get at this, we must calculate the weighted average cost of capital:

WACC, which considers the cost of debt (and the tax shield benefits) and the expected return on equity financing, should be less than the cash return on invested capital — otherwise, growth degrades the stock value. In this case, CROIC exceeds WACC by nearly one percent, and the entirety of WACC is attributable to equity. This provides a measure comfort for the company and stockholders due to the low level of leverage. We will, nevertheless, use 13.37 percent as WACC for calculation of earnings power.

The table above provides the concluding figures for the calculation of Earnings Power Value, with sensitivity analysis on top and a comparison of EPV to Replication Value (RV) below. As long as EPV exceeds RV, the company can grow profitably and franchise value exists … in the current year, at least. EPV must typically exceed RV for a number of years for this strategic and financial benefit to be reliably reflected in the stock price, according to Professor Bruce Greenwald of Columbia’s Business School. Here are the yearly figures:

And a chart that graphically depicts the relationship:

So, What is this Stock Worth?

My friend Joe Ponzio at Meridian in Chicago has produced a chart that compares two methods of calculating intrinsic value and comparing it with the stock price movements. While I am proud to say that Joe and I worked on this together, the concept, design, and layout are his creation. Both use Discounted Cash Flows as the basis but make marginal changes to the calculations. The first is founded on the original approach created by John Burr Williams and modified by Monish Pabrai, and the second is Joe’s approach — which is typically more generous. The benefit of considering both is that they provide a range of intrinsic value and neither requires more than 10 years of data for calculation of intrinsic value in the early years.

Here are the initial assumptions:

Note that we have reduced the growth rate for the first three years to a more sustainable 30 percent.

By this measure, the stock is significantly undervalued, even though it did get ahead of itself in the middle of 2006 and October of 2007. At 30 percent free cash growth, intrinsic value is $57.79.

If we reduce the initial growth rate to 20 percent, the stock is fairly valued today.

It should be understood that fair value is not a negative if the company is growing and/or generating profits for the owners. That is why our earlier consideration of operating margins and free cash flows was important. In the case of Hansen, where profits are strong and growth is abundant, both provide another measure of comfort for stockholders.

Investment Thesis

Hansen’s principle growth driver is energy drinks which provide a punch to the system that is stronger than coffee. Those wagering on the stock’s decline maintain that energy drinks are a fad and that, with a declining economy, consumers will be less willing to devote dwindling discretionary incomes to energy drinks. In past recessions, however, several themes have emerged which suggest this pessimistic thesis may be wrong.

The US consumer and the US worker are one and the same — with both possessed of the same competitive spirit. We may complain about combating foreign competition on an uneven playing field, but we are loath to exit the stadium of competition. That was our response during the 70s and 80s when the Japanese were purchasing Rockefeller Center and threatening to buy Hawaii, when we were compelled to ramp up our productive infrastructure at the start of World War II, and, more recently, in the face of European economic consolidation and the creation of the EU. I expect the same response to the economic emergence of China, India, Brazil, and Russia. In this more competitive climate, where low wages and cost of production in emerging markets will confront the competitive spirit, practical ingenuity, and efficiency of the US market and workforce, workers will seek to produce more in less time, and, just as the coffee break has been long viewed as a benefit to office productivity, the stronger power of energy drinks will be perceived by workers seeking to retain employment in a down economy as a differential advantage. And this bodes well for Hansen — especially, as our overseas competition does likewise.

My only concern about this thesis is the number of new energy-drink offerings introduced by the company — believing that these may serve to cannibalize Monster (Hansen’s leading product) market share and profitability while increasing the cost of production for this expanding menu of offerings. During a talk with students at the University of Florida, Warren Buffett indicated that Coke is one of the few drink products where the consumer never tires of the taste … and he is right. If viewed in this light, the new offerings by Hansen may well serve to expand market share with limited cannibalization. The customer is unlikely to purchase an other Hansen product in place of Monster if seeking an taste alternative in the first place.

Moreover, product segmentation is a natural and beneficial market progression — seeking to more fully satisfy customers and cultivate buyer loyalty to their preferred brand. Intelligent branding and market segmentation (especially for growing segment categories, such as energy drinks) represent a potential positive. As Hansen seeks to expand market share and consumer loyalty, the franchise value of the company should grow and deepen its moat — barriers to competitor entry –, where share of mind becomes more important than share of market as a predictor of future success.

Conclusion

Hansen is buy below $52 a share and a strong buy below $45.

Written by rcrawford

June 5, 2008 at 11:39 pm