Marc Langefeld's Investment Ideas

Insights from 2011 Asset Allocation Summit

2011-06-13T14:34:00.000-04:00

I had the opportunity to listen to very interesting discussions about the role of emerging markets, commodities, hedge funds, small cap equities and ETFs in global investment portfolios at the Asset Allocation Summit and ETF & Indexing Investments Conference. The conferences were held at the Princeton Club in New York from May 16th to May 18th 2011.

Emerging Markets: Benefiting from Urbanization, Growing Middle Class & Infrastructure Spending

The emerging markets panelists were all very positive on the longer term prospects for emerging markets based on their lower debt levels and stronger economic growth relative to developed markets. Frank Brochin, Managing Partner of StoneWater Capital, runs an Asian focused Fund of Fund (FOF) and a broader Emerging Markets focused FOF. Mr. Brochin is looking for best of breed investment managers in Asia whose investments will benefit from the rise of the urban middle class or from huge expected infrastructure spending. The urbanization rate in China is currently in the 40%-50% range and Mr. Brochin expects that 400 million more Chinese people will move from the countryside to urban areas, bringing the urbanization rate to 80% over the longer term. About 15 to 20 million Chinese people are moving to the cities per year and after they move, their incomes tend to increase three to four times, which will drive Chinese consumer spending growth. In Brazil, Mr. Brochin feels that middle class consumer spending will benefit from rising income levels, as well as more access to credit cards, auto loans and mortgages.

Vidak Radonjic, Managing Partner of the Beryl Consulting Group, is also focused on finding the best investment managers in emerging markets that can deliver alpha (outperformance relative to benchmark index). Eight years ago, Mr. Radonjic said that most of the managers that he met in Asia were long biased, but in recent years, he has had more success finding quality alpha-focused hedge funds. In Brazil, he has predominantly found managers who are long-biased so he is not investing in Brazil right now. Mr. Brochin and Mr. Radonjic both stressed the importance of finding local managers that can discover the smaller, undercovered names that are cheaper and have stronger growth prospects.

The panelists were asked about inflation creeping higher in China and Mr. Brochin said that he expects inflation to come down to 4% range in 2nd half of 2011 vs. 5+% current level based on the government slowing down lending activity. He also thought that 12x average forward price / earnings valuation ratio of Asian stocks overall was not expensive relative to their high expected growth rates and that his Asian managers were finding many quality investments trading in the 10x to 12x range, especially in the small cap universe. In response to a question about the “right” allocation to devote to emerging markets, Mr. Radonjic mentioned that 10%-15% of global investment portfolios were invested in emerging markets currently and that he thought that percentage would increase given the more positive fundamental outlook for emerging markets relative to developed markets.

Commodities: Active New Products, “Right” Weighting and Favorite Segments

There are exciting “third generation” commodity investment products that have been and will continue to be introduced that should allow investors to maximize their returns from their commodity investments. “First generation” commodity ETF products were focused on tracking the performance of the Dow Jones AIG (now Dow Jones UBS) and S&P GSCI commodity indices. These indices have fixed weightings that are only rebalanced once every year. They use 1st month futures contracts that are rolled over every month. The problem with rolling over 1st month futures contracts every month when they expire is that in order to replace the exposure, new futures contracts need to be purchased. Negative roll sometimes occurs, in which the investor who is long the spot contract needs to roll to the next contract and has to sell the lower-priced contract and buy the higher-priced contract. Negative roll occurs in “contangoed” markets.

New “third generation” commodity investment products take a more active, fundamental approach to commodity investing. One of the most popular new 3rd generation products is the US Commodity Index ETF (ticker: USCI) that tracks the performance of the SummerHaven Dynamic Commodity Index Total Return. The SummerHaven Index was created based on work done by Yale University Professor Geert Rouwenhorst, who discovered that the shape of the futures curve and whether the futures curve is in “backwardation” (which means that forward months trade at a lower price than the spot month) or “contango” (which means that the forward months trade at a higher price than the spot month) has a significant impact on the return of a commodity futures strategy. A normal commodity index owns a broad group of commodities, some of which are in contango and some of which are in backwardation. USCI, on the other hand, only owns 14 of the 27 eligible commodities at any one time and selects the commodities it invests in monthly, based on the 7 commodities exhibiting the steepest backwardation and the 7 with the greatest price momentum. A contango reflects a well supplied market carrying a high level of inventory while backwardation reflects a tight market with a low level of inventory. Kurt Nelson, Partner of SummerHaven Investment Management, noted during the commodity panel discussion that inventories are the most important fundamental driver of commodity markets.

Since USCI started trading in August 2010, it has outperformed DJP, the ETF that seeks to replicate the Dow Jones UBS Commodity Total Return index, by about 10%.

USCI vs. DJP since August 2010

The commodity panelists were asked what the appropriate weighting was for commodities in a global portfolio. Mr. Nelson said that larger investors’ portfolios tended to have 7%-10% allocated to commodities and he expected that percentage to increase over time. Tim Pickering, Founder and President of Auspice Capital, thought that a 20% allocation to commodities would be a good weighting. John Hyland, Chief Investment Officer of United States Commodity Funds, said that commodity investing right now was like REIT investing was in 1995 and that he expected asset flows into commodities to increase over the next decade.

Some larger investors have also become more interested in adding commodity segment exposure instead of, or in addition to, exposure to a broad group of commodities. Martin Kremenstein, CIO and COO of DB Commodity Services, and Mr. Nelson both thought that agricultural commodities were the most interesting segment in the next year. Mr. Pickering felt that natural gas might be interesting at some point, but not yet.

There was a thought-provoking discussion among the panelists about physical commodity ETFs. A physical gold ETF purchases and stores the equivalent amount of gold bullion in a bank to match the assets under management in its ETF. Investor demand for physical gold ETFs will make gold increase in price over the next few years more than it would otherwise because these ETFs take gold out of the market, making less gold available for jewelry and other uses. Shortages might lead to price spikes as buyers who really need gold will bid up the prices. This dynamic could be even more dangerous for other commodities, such as copper, platinum and palladium, when their physical ETFs are introduced. These commodities are primarily used for industrial purposes and real world companies need these commodities. If these physical ETFs buy and store these commodities and take them out of the market, there is a greater possibility that shortages will develop, leading to price spikes as industrial buyers pay whatever price necessary to get the commodity.

Hedge Funds: In Low Return World, HF Assets Should Grow

Don Steinbrugge, Member of the City of Richmond Retirement Fund Investment Committee, believes that hedge fund assets will grow strongly over the next few years because pension funds and endowments will need hedge funds to try to meet their 8% expected returns. A greater percentage of pension funds and endowments will have a hedge fund allocation and those that already have an allocation, will increase it. Mr. Steinbrugge is cautious about investing in larger hedge funds since it will be much harder for them to generate the same great historical returns going forward with their larger asset size and reduced flexibility.

Wendell Weakley, President and CEO of the University of Mississippi Foundation, was satisfied with the results of the long/short hedge funds that he invested in prior to the 2008 crisis and said they “did their job” of reducing volatility and not declining as much as traditional equity funds. Mr. Weakley said that his foundation is more nimble and opportunistic now than prior to the crisis. His foundation has decreased its allocation to Fund of Funds (that invest in basket of best of breed hedge fund managers) and increased their allocation to investing in hedge funds directly.

Small Cap Stock Funds: Generating Alpha in Less Efficient Market

Stephen Rich, Equity Portfolio Manager at Mutual of America Capital Management, gave an interesting presentation highlighting the outperformance of small cap equity managers relative to their index. In the last ten years, the median small cap (SC) value manager generated 254 basis points (bps) of alpha (outperformance) before fees on an annual basis relative to the benchmark index. In the same time period, the median large cap (LC) manager only generated 55 bps of alpha before fees on an annual basis compared to the index.

Sources: PSN Enterprise, Mutual of America Capital Management Corporation

According to Mr. Rich, it is easier to outperform the SC equity index since the market is less efficient due to fewer research analysts covering the securities and lower liquidity. Whereas the average LC S&P 500 stock has 19 analysts covering it, the average SC Russell 2000 stock only has 6 analysts following it. Similarly, SC stocks are also less than 1/10th as liquid as LC stocks based on average daily share volume, which prevents some larger investment companies from investing in this market.

As a SC portfolio manager, Mr. Rich emphasized that he tries to avoid the most volatile SC stocks because investors have not been compensated for the risk of high volatility in the SC equity market. The 20% most volatile SC stocks underperformed the median SC stock by 7.5% on an annualized basis over the last 16 years. In contrast, in the LC market, the 20% most volatile stocks only underperformed the median by 1.1%.

Sources: FactSet, Mutual of America Capital Management Corporation

ETFs: Active Portfolio Management, Popular New ETFs and ETFs in the Pipeline

Douglas Wolfe, Managing Director of Saddle River Capital Management, actively manages five ETF portfolios. These portfolios are based on risk, and range from an aggressive growth portfolio to an income and preservation portfolio. Mr. Wolfe’s firm determines which underlying ETF categories to invest in based on relative strength analysis. His firm then analyzes the fundamental and technical indicators of individual ETFs within the categories that the firm would like to invest in and creates a score for each ETF. Saddle River then looks at how the best ETFs based on their scoring system rank on scoring systems of outside firms before making their final investment decisions.

Mebane Faber’s firm, Cambria Investment Management, has created a Global Tactical ETF, GTAA, which tries to preserve and grow capital by producing absolute returns with reduced volatility and manageable risk and drawdowns. GTAA invests in 50 to 100 ETFs, ETNs and other exchange-traded products in global asset classes including U.S. equities, foreign equities, U.S. bonds, foreign bonds, U.S. real estate, foreign real estate, currencies and commodities. The firm uses a long-term trend following strategy with strict risk control methods. Basically, the portfolio owns ETFs that are going up and holds them until they are no longer appreciating. Its portfolio will be rebalanced to target allocations at least monthly and as often as weekly. GTAA has appreciated 4.6% since it started trading in late October 2010.

GTAA Asset Allocation as of May 1, 2011

Source: AdvisorShares web site

Michael Johnston, Editor of ETF Database, presented an interesting overview of the ETF market. His presentation highlighted some of the most popular “new” ETFs, including the ALPS Alerian MLP ETF (ticker: AMLP), WisdomTree Emerging Markets Local Debt ETF (ELD), Market Vectors Rare Earth / Strategic Metals ETF (REMX), United States Commodity Index (USCI), Market Vectors EM Local Currency Bond ETF (EMLC) and WisdomTree Asia Local Debt ETF (ALD). Mr. Johnston also said that alternative ETFs have also been introduced to provide hedge fund replication exposure (including QAI and MCRO), long/short exposure (including GRV and RALS), managed futures exposure (WDTI) and short only exposure (HDGE). In the future, Mr. Johnston expects more advanced currency ETFs, more regional international bond ETFs and more alternative exposure ETFs to be introduced.

Finding and Using Alternative Investment Solutions Critical to Achieving Long-Term Return Goals

Overall, the conferences were very well organized and presented enlightening discussions about the roles of different asset classes in global portfolios. Clearly, institutional investors are focused on finding and using alternative investment vehicles to achieve their long-term return goals without taking on too much volatility and illiquidity. The following chart shows the average portfolio allocation for Cambridge Associates’ endowment clients at the end of 2010.

Average Endowment Portfolio Allocation as of December 31, 2010

Source: Cambridge Associates

Based on the discussions at the conferences, it appears likely that allocations to emerging markets, real return strategies (including commodities) and absolute return strategies (including hedge funds) will increase at the expense of developed market stocks and bonds.

DirecTV: Stock Buyback Will Drive EPS Growth

2010-12-22T11:35:00.001-05:00

DirecTV (DTV) should be considered for potential purchase based on its leading position in the U.S. and Latin American pay television markets, 30+% EPS growth in the next two years, aggressive stock buyback and strong free cash flow generation. DTV’s stock is currently trading at a discount to its fair value estimate based on discounted cash flow analysis and at a discount to its peers despite its better sales and EPS growth outlook. DTV’s discounted cash flow price target is $52, which equates to a 17x forward P/E multiple and a 7.5x forward EV/EBITDA multiple.

Investment Rationale

Growing U.S. Pay TV business

DirecTV’s market share is around 16% of all U.S. households today
Subscriber growth should be in the 1.5% to 2.5% range over the next several years, benefiting from its strong sports programming and its leadership in pay TV product innovation
Average revenue per user (ARPU) growth should be in the 4% to 5% range over the next few years, benefiting from its larger selection of video on demand movies and package upgrades, including Whole Home DVR (which allows families to watch downloaded movies from anywhere in the house)

Differentiated U.S. sports programming

DTV has established itself as the pay TV leader in sports programming
It renewed its agreement with the NFL to offer NFL Sunday Ticket to its subscribers through 2014

The Sunday Ticket package allows subscribers to watch all Sunday NFL games nationwide
About 10% of its U.S. customers subscribe to this package

DTV also offers extensive coverage of NCAA March Madness college basketball, European soccer, grand slam tennis and golf tournaments (including the U.S. Open and Masters)

Leader in U.S. pay TV product innovation

DTV has lead the industry in offering new video services, including the broadest line-up of HD channels, 1080P quality (same as Blu-ray) pay per view movies and Whole Home DVR
The company is also expected to lead the industry in offering 3D channels and services that allow its customers to watch recorded television on tablet computers and smartphones

Latin American growth opportunities

DTV LA should continue to generate strong subscriber growth due to increasing penetration rates in the Latin American pay TV markets

The penetration rate is now 16%, 34% and 67% in Brazil, Mexico and Argentina respectively

DirecTV LA is also well positioned to gain share based on its cost advantages (lower set top box costs due to its purchasing power with DTV US), exclusive Spanish soccer programming and technology leadership (able to introduce advanced video services quicker than competitors due to its relationship with DTV US)

DTV’s share in Brazil, Mexico and Argentina was 25% (#2), 29% (#1) and 6% (#3) respectively in 2009

DTV LA is expected to generate 17% of the company’s EBITDA in 2010
Management believes that the LA business will double its subscriber base and EBITDA over the next five years

Strong free cash flow generation

DirecTV generated $2.4 billion in free cash flow in 2009
Management plans to buy back shares over the next several years (as it levers up its balance sheet to 2.5x debt / EBITDA level), which will contribute to 30+% EPS growth in 2011 and 2012

Concerns and Risks

Intense competition

DirecTV competes with cable service providers, satellite competitors and telecom companies for subscribers in the U.S.

AT&T U-Verse and Verizon FiOS plan to expand their video presence in more geographic markets in the U.S., which will increase competition in the pay TV market
Currently, only about 30% of U.S. homes are able to receive telecom fiber television service
Industry experts estimate that telecom fiber television service will be available to 40% of U.S. homes by 2015

Higher U.S. programming costs

DTV’s annual payment to the NFL will increase 43% from $700 million to $1 billion when its new NFL contract begins in 2011
DirecTV’s programming agreements with CBS, Fox News and Discovery are also expected to reset higher at the end of 2011, 2012 and 2012 respectively
Programming cost increases have exceeded the rate of video revenue growth for several years and might become harder to pass through to customers given more competition and more budget conscious consumers

Change in television viewing habits poses threat

The biggest longer-term threat to satellite and cable providers is that consumers watch more television over the Internet through providers, such as Netflix and Hulu, and that subscribers drop their traditional cable or satellite television service

High end customers are unlikely to give up the better viewing experience available on their large screen LCD and plasma televisions to save money, but lower end subscribers might drop cable and satellite subscriptions as television content on the Internet becomes more ubiquitous
The fees television content creators receive from the current pay-television model provides a critical source of revenue and limits these firms’ eagerness to expand Internet distribution too rapidly

Comparable Valuation Analysis

• DirecTV is trading at a discount to its peers based on 2011 EV/EBITDA and P/E multiples, despite its stronger sales and EPS growth outlook

Source: Bloomberg 12/17/10

Discounted Cash Flow Analysis

Price Target

DTV’s stock price target is $52 based on discounted cash flow analysis. This price equates to a 17x forward P/E multiple and a 7.5x forward EV/EBITDA multiple.

Company Description

DirecTV is the largest satellite provider of multichannel video services in the U.S. with over 19 million customers. The company provided video service to markets covering about 95% of U.S. television households at the end of 2009. DTV US currently uses 11 satellites and has 1 under construction.

DTV is focused on delivering great customer service. DirecTV expanded its lead over Dish Network and cable providers in customer service in the most recent American Customer Satisfaction Index (ASCI) survey and has built up a lot of brand equity.

DirecTV has also focused on increasing the quality of its subscriber base in recent years. Customers with weak credit scores have to pay an upfront deposit of $200-$300 to sign up for DTV service, which discourages some from subscribing. This focus on high end customers allowed the company to be less impacted than the cable providers by the recession in 2008. DTV’s current churn rate is only 1.5% and its customers tend to be the biggest spenders on television services, as indicated by average monthly revenue per user (ARPU) approaching $90.

DTV wins new customers through direct sales (uses effective customer screening and target marketing campaigns), consumer electronic stores such as Best Buy, independent dealers and telecom partners. DTV has relationships with each of the three largest phone companies in the U.S. (AT&T, Verizon and Qwest).

DirecTV on Demand, its video on demand service, offered 6,000 movie titles at the end of 2009. DirecTV Cinema, one of its newest services, significantly increased the number of new release movies available for its customers to purchase.

Only about one million DirecTV customers in the U.S. have their set top boxes connected via broadband currently. DTV expects that 40% of its subscribers will be Internet-connected by the end of 2013. This will allow DTV to increase its revenue from pay per view movies as subscribers download video on demand movies to their digital video recorders.

DTV also owns satellite operations in Latin America: 93% of Sky Brazil (2.4 mil subs), 41% of Sky Mexico (3 mil subs) and 100% of PanAmericana (3.3 mil subs), which covers most of the remaining regions in LA. The company provides services in PanAmericana and Brazil from leased transponders on two satellites. Sky Mexico provides its services from leased transponders on a separate satellite.

DTV added three regional sports networks based in Seattle, Washington, Denver, Colorado and Pittsburgh, Pennsylvania, and a 65% stake in the Game Show Network under its agreement with Liberty Media in 2010.

2010 Estimated Geographic EBITDA Mix

Source: DTV December 2010 presentation

U.S. Competition

DTV’s largest U.S. competitors include Comcast (the largest pay TV distributor), Dish Network (other major satellite player), Time Warner Cable, Cablevision, AT&T and Verizon. Cable companies have aggressively promoted “triple play” bundle of cable television service, broadband Internet access and telephone service to attract and retain subscribers. Dish Network has been aggressive offering discounts in the past.

AT&T and Verizon have upgraded a significant portion of their infrastructure by replacing their older copper wire telephone lines with high-speed fiber optic lines. These fiber lines provide the telecom companies with much greater capacity allowing them to offer new and enhanced services, such as Internet access at much greater speeds and digital-quality video. Verizon FiOS has been a major challenger to DTV in the markets it serves since DTV’s customers tend to be attracted to the best video service. Its telecom competitors have become more rational on pricing since they launched their service several years ago and are more focused today on investment recovery.

2009 U.S. Pay TV Segment Market Share Mix

Source: JPM

Latin American Competition

Cable companies in Latin America typically offer analog services for lower monthly fees and with lower upfront installation and connection fees than DTV does. Furthermore, they are also upgrading their networks to provide broadband Internet and phone service and are rolling out “triple play” packages in select markets. DTV’s satellite competitors typically focus on offering lower-cost, limited services packages tied to their telephone and broadband offerings.

In Brazil, its major competitors are NET Servicos (49% share in 2009), Telefonica (offered satellite TV starting in 2006) and Embratel / Telmex (offered satellite TV starting in 2009). In Mexico, DTV’s major competitors include Televisa (20% share), Megacable (18% share) and Dish Mexico (satellite JV between Echostar and MVS). In Argentina, its major competitors are Cablevision (42% share), Super Canal (7% share) and Telecentro (4% share).

2009 LA Pay TV Market Share Mix

Sources: Citigroup, CIRA Analysis

DTV introduced new video services such as HD and DVR (digital video recorder) faster than competitors in Latin America. DTV launched HD in PanAmericana in late 2008, in Sky Brazil in first half of 2009 and in Sky Mexico in the first half of 2010. DTV LA has been expanding the deployment and marketing of pre-paid services to make the product affordable to more of the population. Management currently estimates that the payback period for pre-pay is only 9 months, as roughly 50% of the subscriber acquisition cost (SAC) is paid up-front by the customer.

Full Disclosure
Family accounts that I manage own DTV
I recommended DTV to Bolter and Company, a NY-based investment management firm, on December 21, 2010

Opportunity to Buy Exxon at Great Price and Collect 3% Dividend

2010-07-17T13:48:00.008-04:00

Exxon Mobil (XOM) should be considered for potential purchase based on its globally-diversified reserve base, excellent management team focused on maximizing shareholder value, industry-leading returns on capital and strong free cash flow generation. Exxon’s stock is currently trading at an attractive valuation based on historical and NAV valuation analysis.

Exxon’s stock price target is $86 based on applying a 15x multiple to its 2010 estimated earnings. A 15x target multiple is appropriate based on its ability to deliver double-digit earnings growth over the next several years and is in-line with its historical average.

Investment Rationale

Largest reserves of oil majors

Exxon had proved crude oil and natural gas reserves of about 23 billion barrels of oil equivalent (boe) at the end of 2009, enough to last 15 years at current production levels
The company also controls a 70% stake in Imperial Oil, one of Canada’s largest oil companies that holds 465,000 acres of tar sand leases in Alberta and has 2.4 billion barrels of proved reserves
In addition, Exxon had a total resource base of 75 billion boe, which the company will develop opportunistically

Production growth of 2%-3% annually until 2013

During 2009, Exxon started up eight major projects, which are expected to add 400,000 net barrels per day (bpd) of production in 2010
The company also plans to start production on 12 other major projects in Qatar, Nigeria and Canada between 2010 and 2012
Qatar has rapidly emerged as the world’s largest producer of liquefied natural gas (LNG)
Exxon is developing seven facilities, or “trains” in Qatar that will convert natural gas reserves into liquefied natural gas that can be shipped worldwide for the highest prices
When all seven hit peak output, they will produce the equivalent of over one million barrels of crude per day of which Exxon’s share is approximately 40%
Exxon expects its new projects to increase production by 1.5 million barrels of oil (boe) equivalent per day by 2015
Its new production growth is expected to exceed normal field declines over the next three years

Beneficiary of higher oil prices

Over the next decade, oil prices should increase based on higher demand in emerging markets and a challenging supply environment in which it will be difficult to increase production meaningfully over 85 million bpd level according to industry experts

Best return on equity ratio in industry

Exxon’s return on equity is 21%, the highest of its energy peers
The company evaluates projects from around the world against each another and only those with the most attractive returns receive funding
Historically, Exxon has excelled at adding low-cost reserves at opportune times
Its purchase of XTO significantly increases its exposure to unconventional natural gas at a time when natural gas prices are very depressed, which exemplifies its long-term strategy

Strong free cash flow generation

From 2007 until 2009, Exxon generated average free cash flow of $27.7 billion
The company plans to continue to use its free cash flow to pay for its share repurchase program of $3 billion per quarter and to fund its dividend
Exxon reduced its shares outstanding by 26% from 2005 until 2009 and increased its dividend by 57% in the same time period

Concerns and Risks

Risk of lower returns on new oil output

New oil discoveries are getting tougher to find and are more expensive to develop
Many of the exciting new oil fields are controlled by state-owned companies that offer less profit to production partners
Some industry experts believe that Exxon’s return on capital will be lower than in the past as a result of these factors

Refining industry overcapacity

Earnings in the refining segment peaked at $9.6 billion in 2007 and declined to $1.8 billion in 2009 due to lower refining margins caused by combination of weak demand for gasoline and heating oil, as well as excess global refining capacity
The worldwide glut in refining capacity should continue to pressure Exxon’s refining margins over the next several years
Unlike some of its peers, the company has no plans to sell any of its refineries

Cyclical chemicals business

Earnings in the chemicals segment also declined from $4.6 billion in 2007 to $2.3 billion in 2009 due to lower sales volumes and margins caused by the global economic downturn
In the next year, chemical earnings should rebound with stronger global economic growth

Political risk

Exxon operates in many high-risk countries, where its contracts are at risk of being altered whimsically by government officials

Valuation

Historical Forward P/E

On a forward P/E basis, Exxon is trading at close to the trough of its historical trading range in the past decade

Source: Raymond James

Historical Dividend Yield

Exxon’s dividend yield of 3% is the highest it has been since the stock market crash in 2002

Source: Bloomberg

NAV Analysis

Some analysts believe that Net Asset Value (NAV) estimates better capture Exxon’s fair value since NAV estimates incorporate cash flows from future projects that are discounted to present value

On an estimated NAV basis, Exxon is trading at a 33% discount to fair value

Comparable Valuation Analysis

Exxon stock’s historical premium to its peers has diminished over the past decade, providing an opportunity to buy a best-in-class energy company at an attractive valuation

Source: Raymond James

Exxon is currently trading at a 12% premium to its peers based on next year EV/EBITDA multiples and a 16% premium to its peers based on next year P/E multiples; in the past, Exxon’s stock has traded at larger premiums

Sources: Bloomberg (7/12/10), Thomson

Price Target

Exxon’s stock price target is $86 based on applying a 15x multiple to its 2010 estimated earnings. A 15x target multiple is appropriate based on its ability to deliver double-digit earnings growth over the next several years and is in-line with its historical average.

Company Description

Exxon Mobil is the world's largest publicly traded integrated oil company with operations in over 200 countries. In 2009, 81% of the company’s operating earnings were generated from upstream exploration and production activities, 8% from downstream refining and marketing activities and 11% from chemicals.

In the upstream segment, Exxon had proved crude oil and natural gas reserves of about 23 billion barrels of oil equivalent (boe) at the end of 2009. The proved reserves are approximately divided evenly between crude oil and natural gas, and are geographically diversified with 38% located in Asia and the Middle East, 17% in the U.S., 14% in Europe and 14% in Canada and South America. The company also owns 70% of Imperial Oil, one of Canada’s largest oil companies that holds 465,000 acres of tar sand leases in Alberta and has 2.4 billion barrels of proved reserves.

Source: Exxon Mobil

In 2009, Exxon produced 3.9 million boe/day, with 62% derived from oil and 38% from natural gas. Overall production increased 1.6%, primarily due to new projects in Qatar, Africa and North America. Approximately 20% of Exxon's global oil output is tied to production sharing contracts (PSC), with much of the company's PSC oil being produced in Africa. According to management, Exxon has replaced more than 100% of its production in each of the past 16 years.

2009 Geographic Production Mix

Source: Exxon Mobil

Exxon increased its exploration acreage by over 40% since 2003, bringing its total acreage to 72 million acres. Key exploration areas include acreage in Canada’s Horn River Basin Devonian shale gas play, additional positions in the Marcellus shale gas play and licenses in Norway, Germany, Poland, Turkey, Vietnam and Indonesia.

In the downstream segment, Exxon is the largest refiner and marketer of petroleum products in the world with 6.3 billion barrels per day of refining capacity and 27,000 service stations. The company’s market share (measured by percentage of total capacity) was approximately 7% globally (#1) and 11% domestically (#3, slightly trailing Valero and Conoco Phillips). Exxon’s refining capacity is geographically diversified with 42% in the Americas, 31% in Europe, Africa and the Middle East, and 27% in Asia.

Exxon is the only major integrated oil company that has maintained a significant commitment to its chemicals business. In the commodity petrochemicals market, Exxon is #1 in paraxylene and #2 in olefins. In the specialty market, the company is #1 in butyl polymers, fluids, plasticizers, synthetics, oriented polypropylene films, and adhesive polymers, and #2 in specialty elastomers and petroleum additives. The commodity petrochemicals market is intensely cyclical, while the specialty market generates more stable profits. Its chemical business is 90% integrated with the rest of its business divisions, especially in refining where the two divisions share plants and the refineries supply feedstock to the chemical unit.

Exxon closed the acquisition of XTO Energy, the largest producer of U.S. natural gas, in June 2010. Following the acquisition, Exxon’s percentage of overall production coming from U.S. natural gas increased from 5% to 15%. Management believes that demand for natural gas will grow as U.S. carbon legislation encourages power producers to build gas rather than coal-fired plants. The company also expects natural gas demand to grow 1.8% per year through 2030, exceeding oil demand growth of 0.8% per year over the next twenty years.

Capital Spending by Segment

Source: Exxon Mobil

Exxon plans to spend between $25 billion to $30 billion per year on capital expenditures through 2014, with the majority focused on its upstream segment. Exxon’s management has a long-term capital spending strategy that is essentially fixed regardless of short-term commodity price volatility.

Global Oil Outlook

Global consumption of oil decreased since 2007 due to slower global economic growth and weaker manufacturing activity. Oil consumption declined the most in the U.S. and in Europe. Over the next decade, global demand for oil should grow, driven by incremental demand from emerging markets, especially China, India and Brazil. Following World War II, Japan’s per capita oil demand increased significantly driven by rapid urbanization and higher living standards. Oil demand should grow rapidly in emerging markets based on similar dynamics.

On the supply side, global oil production has decreased slightly since 2005. In 2009, OPEC production fell by 1.9 million barrels per day (bpd). Of the largest 21 oil fields in the world, at least 9 are in decline. According to some industry experts, one Middle Eastern country that might be able to increase production is Iraq if the country becomes more stable over time. Non-OPEC supply has not been growing rapidly and is often found in “harder-to-reach” areas that are costlier to develop. In 2009, non-OPEC production only grew 0.2 million bpd.

Sources: EIA, BP

Over the next decade, oil prices should increase based on higher demand in emerging markets and a challenging supply environment in which it will be difficult to increase production meaningfully according to industry experts. In the next year, oil prices should be supported by global economic growth exceeding 4% and a six month deepwater drilling moratorium in the Gulf of Mexico.

Source: Bloomberg

U.S. Natural Gas Outlook

U.S. consumption of natural gas has remained fairly steady over the last decade based partially on stronger than expected coal demand for electric generation and excessive volatility associated with natural gas prices that has discouraged some power producers from switching to natural gas. In 2009, consumption declined 1.8% due to weaker industrial demand for natural gas. Consumption should rebound with stronger economic growth this year.

On the supply side, natural gas withdrawals from wells increased 1.6% in 2009. Cash flow requirements and potential damage to wells forced producers to continue to withdraw gas from wells. Increased LNG imports and development of gas production from shale reservoirs are expected to add to future supply this year.

Source: EIA

U.S. natural gas prices should remain subdued in the next year due to the high number of working natural gas rigs, which rose 43% from last year, and high U.S. storage levels, which were 12% higher in July 2010 than their five year average. Some industry experts expect a more active hurricane season in 2010, which might disrupt production in the short term and drive natural gas prices higher. Longer-term, natural gas prices are poised to benefit from new climate regulations and its reputation as a source of clean energy. Historically, oil has traded at a ratio of 9:1 relative to natural gas. The current ratio of 17:1 suggests that more energy consumers will use natural gas in the future to lower their cost base, which should help drive natural gas prices higher.

Source: Bloomberg

Full Disclosure

Recommended to Bolter and Company, a NY-based investment management firm, on July 13, 2010

Family accounts that I manage currently own XOM stock

Highlights from Asset Allocation Summit

2010-05-24T14:18:00.004-04:00

I attended the Asset Allocation Summit in New York on May 17th and May 18th 2010. The conference brought together investment officers of endowments, foundations and pension funds as well as leading portfolio managers. The following article discusses some of the topics and speakers that I found particularly interesting.

Tactical asset allocation gaining momentum

It was surprising to hear investment officers of endowments, foundations and pension funds stress the need for tactical asset allocation to take advantage of volatile markets. Endowments, foundations and pension funds have very long time horizons and in the past, took a longer-term approach to investing by not changing asset allocation frequently. Don Steinbrugge, Member of the City of Richmond Retirement Funds’ Investment Committee noted “institutional investors used to move glacially, but in the last two years, they have started moving more quickly to target inefficiencies in the markets”. He said that his investment committee used to make asset allocation changes over three to six month period and now make changes in one month. Several investment officers at the conference thought that it was important for investment committees to widen the asset bands that can be allocated to a particular asset class so that investment officers have more flexibility to act quickly to take advantage of daily opportunities.

The average holding period of stocks at mutual funds and hedge funds has declined in the past several decades due in large part to increased focus on outperforming benchmarks on a quarterly basis. If the majority of significant asset allocators, such as endowments and pension funds, adopt tactical asset allocation strategies, this will only add to more trading by direct investment funds and create more volatility in the markets.

Importance of liquidity for endowments

Yale University popularized the use of alternative assets in endowment portfolios to maximize long-term returns. Unfortunately, in 2008, this approach ended up hurting the returns of some leading endowment portfolios. The allocation to illiquid assets, such as private equity, was too high in some endowment portfolios according to many of the speakers, which forced investment officers to sell other liquid assets at inopportune times, exacerbating the decline in the public equity market. Michael Sullivan, Chief Investment Officer of the University of St. Thomas, noted that it was very important to communicate frequently with the treasury department of their school to ensure that the risk of the investment strategy was in synch with the liquidity and spending needs of the school.

Active vs. Passive discussion

Several foundation and pension officers mentioned that they had replaced their active large cap equity managers with index strategies because the active managers were not outperforming the index. However, these same managers noted that they still invest in a lot of active managers in small cap U.S., mid cap U.S. and international equity funds.

Importance of diversification for all investors

Peter Gunning, Global Chief Investment Officer of Russell Investments, said his firm was focused on finding the best global equity funds and adding alternative assets, such as commodities and infrastructure assets to benefit from low correlation with equities and income generation. Several panel participants emphasized that the major benefits of adding asset classes to a portfolio were higher portfolio returns and lower portfolio risk levels.

Louis Morrell’s thoughts and strategies

Louis Morrell is a Managing Director at the Wake Forest University Endowment where he is responsible for the management of approximately $300 million in multi-asset class investments following a dynamic tactical approach based on global economic factors. Mr. Morrell believes that “rocky periods lie ahead” and expects massive inflation in the future, but not in the short-term. He also stated that “central banks are not running the show, politicians are” and that political decisions will have unintended consequences. For example, Mr. Morrell is concerned that more bubbles will be created as a result of massive money printing. He also expects bubbles to occur more frequently than every 20 years like in the past.

Mr. Morrell does not try to time the market and remains fully invested in different asset classes, but his allocation to asset classes changes depending on where he sees opportunities. As a result of the tremendous volatility in recent years, his endowment has given him more latitude to tactically move within asset classes, by widening the asset bands that are acceptable. Mr. Morrell believes that it is dangerous to be too risk averse and that he needs to take risk in order to achieve 8% long-term returns for the endowment.

Mr. Morrell has about 28% of his portfolio invested in alternative investments, including 14% in commodities and gold, 8% in real estate and 6% in currency. He does not believe that gold is in a bubble and instead views gold as a currency hedge. Mr. Morrell noted that the number of U.S. dollars and Euros in circulation is growing much more rapidly than gold production. His current target price on gold is $1,400 / ounce. When the price of gold is appreciating, he prefers to buy gold miners and when the price of gold is going down, he prefers to purchase bullion.

Mr. Morrell views commodities as inflation hedges and plans to increase his exposure in the future when he sees inflation increasing. He targets commodities that will benefit the most from increased Chinese and Indian demand and sometimes obtains specific regional commodity exposure through equities. For example, Mr. Morrell mentioned that he was playing Ivanhoe Mines because he thought the company would successfully mine for gold in Mongolia.

Emerging Markets: Cautious in short-term, positive long-term

Peter Gunning stated that his company was slightly underweight emerging market equities in the short-term due to concerns about inflation rising and central bank tightening. Xiao Song, Emerging Markets Portfolio Manager of Contrarian Emerging Markets, echoed that emerging market equities were a little overheated. He said he was concerned with the rise of inflation in China to around 3% and about the bubble in the Chinese real estate market, emphasizing that real estate prices had already appreciated 30% in the first four months of 2010. Mr. Song expected non-performing loan ratios of Chinese banks to increase as the real estate market deflates. Furthermore, he stated that when one stock market in Asia goes down, the tendency is for every other stock market in the region to go down due to the exit of “hot money”. Both managers were confident in the long-term outlook for emerging market equities based on their abundance of natural resources, high level of infrastructure spending, favorable demographics, growing middle class and low sovereign and personal debt levels.

Commodity Investments: Should benefit from eventual rise in inflation

Andrew Karsh, Co-Lead Portfolio Manager for the Credit Suisse Total Commodity Return Strategy, summarized the benefits of adding commodity exposure to a portfolio, including protection against inflation and non-correlated returns with equities. He pointed out that although commodities and equities both declined in 2008, that was the first year since 1970 when both commodities and equities fell in the same year. Christopher Burton, who manages the fund with Mr. Karsh and who did not speak at the conference, was quoted in a news article on May 10th saying “Because commodities are inherently a driver of inflation, and are therefore positively correlated to unexpected changes in inflation, we've seen a growing number of investors increasing their exposure to the asset class over the past few months."

Adam De Chiara, Co-President of Jefferies Asset Management and Jefferies Financial Products, pointed out that although spot prices of major commodities have risen 10% to 15% on an annualized basis over the last five years, major commodity indices have generated flattish or even negative returns in the same time period. He explained that this was due to major indices’ use of futures contracts and explained that index returns were often hurt by “negative roll”. Every month, futures contracts expire and in order to replace the exposure, new futures contracts need to be purchased. Negative roll occurs when the price of the futures contract is higher than the spot price, so index managers have to pay more to regain exposure, which decreases index returns. It was interesting to see in Mr. De Chiara’s bio that he was involved with designing the Dow Jones AIG Commodity Index at his prior firm.

Mr. De Chiara recommended investing in CRBQ, an ETF that contains commodity-linked equities to gain exposure to commodity spot price appreciation. Although this ETF has a low correlation with commodity spot prices on a day to day basis, over longer periods of time the correlation is higher. He also recommended investing in talented active managers of commodities futures, who could add 5% to 15% of outperformance annually relative to passive futures strategies.

Hedge Funds: Positive attributes should result in greater inflows

The panel participants highlighted the advantages that long/short equity hedge fund managers have over long-only managers including the ability to short stocks, use leverage, trade more actively and not be tied to an index. Bruce Ruehl, Principal of Advisory Services Americas, said that the top tier of hedge fund managers add value and he is very positive on the long/short equity space right now.

It was interesting to hear several speakers mention that long/short equity hedge funds were no longer placed in a separate alternative investments “bucket” within institutional portfolios, but were instead placed in the equity allocation. This suggests that institutional investors will allocate more dollars to hedge funds going forward since the equity “bucket” in most institutional portfolios is significantly larger than the alternative investments allocation.

Several speakers also pointed out the positive impact hedge funds had in a portfolio based on their ability to decline less in bear markets and therefore dig out of a smaller hole to recoup losses. Stephen Rich, Executive Vice President of Mutual of America Capital Management, said that if a fund was down 20% in a given year, the fund would need to generate 25% return to get back to breakeven point. However, if a fund lost 50%, the fund would need to generate 100% return to break even. Therefore, if a hedge fund manager can fall less in a down market, it will be easier for that manager to recoup losses. This point was confirmed by another speaker who stated that 65% to 75% of hedge funds are now back above their highwater mark.

David Bailin’s Views on Hedge Funds

David Bailin is Managing Director and Global Head of Managed Investments at Citi Private Bank responsible globally for alternative and traditional investments. Mr. Bailin said that the average hedge fund was down 18% in 2008 in a very challenging environment in which liquid public equities were sold indiscriminately to raise cash and the rules for shorting financial stocks were changed overnight.

Mr. Bailin noted that it was easier to conduct due diligence on hedge funds following the crisis because hedge funds are now more willing to provide information more frequently and have their results tracked via external services. He said that institutional investors from emerging markets, including sovereign wealth funds, were increasing their exposure to hedge funds, while ultra high net worth investors were slightly reducing their exposure. However, he expects more ultra high net worth investors to invest in hedge funds over the next five years.

Mr. Bailin estimates that hedge fund assets will double to $3.2 trillion in 2015 from $1.6 trillion currently. He believes that large institutional hedge funds with great risk management will gain assets and that new hedge funds will form locally in select emerging markets, including India and China. Mr. Bailin also mentioned the potential for hedge fund managers in developed markets to relocate to emerging markets, if regulation intensified in developed markets.

Real Estate: Watching and waiting for opportunities

Several panel participants said that they are watching the real estate market and waiting for opportunities. Mr. Morrell stated that the U.S. real estate market remains a disaster and that nothing has changed at Fannie Mae or Freddie Mac. Michael Dean, Senior Associate of Meketa Investment Group, noted that the U.S. represents 35% of global property stock currently. He expects the international proportion of global property stock to increase as a percentage of total over the next decade, providing exciting investment opportunities.

Private Equity: Timing and manager selection critical

Anjum Hussain, Director of Risk Management at Case Western University, said that the time to invest in private equity was after markets have blown up, not when markets are at their peak levels, like in 2006 and 2007. Several panel participants noted that one of the dangers of investing in private equity was the additional layer of capital that was required of institutional investors during times of crisis, such as in 2008 and 2009, to maintain their equity stake. Mike Hennessy, Managing Director of Morgan Creek Capital Management, stressed how important it was to find skilled private equity managers. He believes that a private equity manager with no skill will only generate similar return to the public equity market, while a skilled manager will deliver 500 basis points of outperformance relative to the public equity market.

Highlights from Columbia Investment Management Conference

2010-02-27T13:44:00.004-05:00

I attended the 13th Annual Columbia Investment Management Conference on Friday, February 26th, and had the opportunity to hear current views and insights from several esteemed value investors.

Martin Whitman, Founder and Portfolio Manager of Third Avenue Management, opened the conference by discussing his current portfolio, his largest holding and sharing interesting insights. Mr. Whitman’s current portfolio is 80% comprised of “Graham and Dodd Net Nets”, including Toyota Industries Corp., Brookfield Asset Management, Capital Southwest Corp., Investor AB, Henderson Land Development and Hang Lung Group. Third Avenue searches for companies with “super strong” financial positions that have excellent prospects of growing net asset value over the next five to seven years and that are trading at large discounts from readily attainable net asset value. Henderson Land is Third Avenue Value Fund’s largest holding and is well positioned according to Mr. Whitman based on its massive land holdings in Hong Kong and China, its 30+% stakes in Hong Kong and China Gas Company and Miramar Hotel, and strong management team led by Dr. Lee. Mr. Whitman also mentioned that his firm has found the most value opportunities in East Asia in recent years and that he does not worry about currency for foreign holdings, but that his portfolio will benefit when the Chinese Yuan appreciates over the next several years.

The first panel discussion focused on lessons learned from the financial crisis and the panelists included Wendy Trevisani (Co-Portfolio Manager of Thornburg International Value Fund), Matthew McLennan (Portfolio Manager of First Eagle Global Fund) and Thomas Russo (Partner of Gardner Russo & Gardner). Ms. Trevisani’s three major lessons from the crisis were the importance of remaining humble as an investor, of staying disciplined by holding on to great companies that you have done homework on during periods of crisis and of exercising risk control through purchase of diversified portfolio of assets when those assets are selling at discounts to fair value. Mr. McLennan said the main lesson that was reinforced was that human technology has advanced more than human emotions. He echoed that having humility and recognizing that the future is uncertain is very important to successful investing. Mr. Russo stated that the greatest lesson he took away from the crisis was not to sell a great company he was holding that was showing a loss only to replace it with a lesser company.

Bruce Greenwald, the moderator of the first panel, questioned the panel speakers about which parts of the world presented the most opportunity at the present time. Ms. Trevisani said she was finding value opportunities in Western European companies that have exposure to growth in emerging markets, but are more attractively valued than emerging market listed companies. Mr. McLennan expressed that he was finding little opportunity in China and was concerned with balance sheet growth and complacency about long-term growth prospects in China. He made a fascinating comparison that investors’ current love affair with emerging market stocks over developed market stocks reminded him of investors’ passion for “new economy” technology stocks over “old economy” stocks in the late 1990s and he said he is finding more value in developed markets, such as Japan, right now. Mr. McLennan also highlighted the attractiveness of a position in gold as a “scarce store of value for mankind.” He mentioned that annual gold production only equaled about 1.5% of total gold in existence so it was possible to determine the amount of gold that will exist in a few years. Many paper currencies are being printed at much faster rates in developed markets right now so it makes sense that gold would appreciate relative to those currencies. Mr. McLennan said that he looks at total value of gold compared to global income per capita to get a feel for whether gold is undervalued or overvalued and feels that gold is “slightly expensive” right now. Mr. Russo stated that he was spending less time on U.S. companies and that he was concerned by record deficits and dependence on foreign countries to roll over U.S. debt. He did not recommend a favorite region in the world to invest right now, but mentioned that he favors those companies that can deploy capital flexibly around the world, such as Richemont.

David Dreman, Founder and Chief Investment Officer of Dreman Value Management, presented an interesting overview of the political and financial landscape prior to 2008 that contributed to the financial crisis and then shared his current views. Mr. Dreman expects the U.S. to inflate its way out of debt just like it has in the past. He anticipates double digit inflation in the U.S. once unemployment falls to 6%, which he felt could take a while. In the inflationary environment he foresees, Mr. Dreman thinks that stocks will be one of best inflation hedges and perform well over time.

The next panel discussion centered on distressed investing and the panelists included Jeffrey Altman (Founder and Portfolio Manager of Owl Creek Asset Management), Daniel Arbess (Portfolio Manager of PWP Xerion Funds) and Jamie Zimmerman (Managing Partner of Litespeed Management). Mr. Altman is seeing pockets of opportunities right now at lower levels of capital structure, including some equities. His favorite investments are HMO equities, including Cigna and Wellpoint and he also mentioned that the risk reward looked favorable for Fannie Mae and Freddie Mac preferred stocks. Mr. Arbess felt that there was currently a lull in the distressed credit cycle and that ultimate restructuring of corporate balance sheets would occur over the next several years as debt comes due, which should provide more opportunities. His favorite idea right now is Ivanhoe Mines, which has strong gold, copper and coal assets. Ms. Zimmerman is finding one-off opportunities in which companies are repairing their balance sheets and mentioned the challenge in determining the right EBITDA estimates to use given the volatility in profitability in the last several years. Her favorite ideas are Smurfit Stone Container unsecured bonds and Lyondell bonds.

The final panel discussion focused on mental models in investing and the panelists included David Abrams (Managing Member of Abrams Capital), William Browne (Managing Director of Tweedy, Browne Company) and David Greenspan (Managing Director of Blue Ridge Capital). Mr. Browne stressed the importance of having a value framework to invest successfully and that investing is an exercise in probabilities in which he tries to get as many factors working in his favor as possible. Mr. Abrams mentioned the importance of “getting out of the noise”, referring to information overload, and he said that there was less noise in Boston, where he currently works, than in New York, which has helped him to become a better investor. It is interesting that Warren Buffet has echoed similar sentiment in the past about the advantages of working in Omaha, including not being overloaded with noise and just independently figuring out stock. Mr. Greenspan expressed that extending his time frame and looking out at potential profitability over the next few years has helped him to invest successfully. He said that sometimes stocks look expensive on near term earnings, but have strong return on capital and look inexpensive on earnings a few years out, providing investment opportunities.

Michael Mauboussin, the moderator of the final panel, questioned the panel speakers about position sizing and evaluating management. Mr. Browne said that his firm’s maximum position size for a new position was 4% and that if a stock appreciates to 6% or 7% of the portfolio, his firm cuts back the position. Mr. Abrams stated that his firm usually holds about twenty positions with an average size around 5% or 6% and that he uses concentration to make sure his ideas are really good. At the same time, he likes to diversify so that if any one stock loses 20% or 30%, the overall portfolio would only be down 1% or 1.5%. Mr. Browne felt that the best indicator of management was to look at what management has done in the past and he was skeptical about the usefulness of management meetings. Mr. Abrams reiterated the importance of looking at management’s track record, including prior uses of capital. He also mentioned that he likes to look at employee turnover and compensation levels of senior management.

Overall, the conference was very well organized and offered the audience the opportunity to listen to current views of leading value investors. I found the discussion regarding portfolio management in the midst of the financial crisis to be very insightful. In addition, Mr. McLennan’s bullish argument for gold over the next several years was also very convincing.

Philip Morris International: Great Company but Fairly Valued, Accumulate on Pullbacks

2009-12-01T09:14:00.022-05:00

Philip Morris International (PMI) should be monitored and considered for potential purchase in the future at more attractive valuation levels. PMI is an attractive holding based on its strong pricing power, exposure to growing emerging markets, double digit earnings growth, strong free cash flow generation and attractive dividend yield. However, the stock is currently trading in line with its international peers based on EV/EBITDA multiples and a slight premium to its international peers based on P/E multiples. On a forward PEG basis, PMI’s stock is also trading at 1.2x its next five year estimated EPS growth rate of 11%, which appears to be a fair valuation.

Investment Rationale

Emerging market growth should drive top line growth

PMI generated 33% of its revenue from emerging markets last year
The company should continue to benefit from price increases in emerging markets
Management believes that cigarette prices are still very low by international standards in emerging markets and have a lot of room to increase (which is confirmed in the table below comparing prices of 20 pack of Marlboro to Big Macs)

Sources: Economist, JPM

Furthermore, PMI should benefit from stronger emerging market economic growth that should drive per capita income growth and cigarette volume growth
PMI is also well positioned to gain market share in emerging markets based on the strong brand name of its premium Marlboro brand, which is very popular with younger smokers

Strong pricing power

PMI is the price leader in markets that contribute 70% of its operating income according to industry experts
The company should be able to raise prices in all markets, which should allow the company to generate mid single digit revenue growth

Revenue growth from acquisitions

Following the spin-off from Altria, management was interested in increasing its M&A activity
PMI acquired Rothmans, Canada’s 2nd largest tobacco producer, for $1.9 billion last year

This acquisition gave the company control of a third of Canada's cigarette market and the leading share of its fast-growing discount category

PMI acquired Swedish Match’s South African operations for approximately $220 million in July 2009

This acquisition gave the company control of roughly a third of South Africa’s tobacco market

Management will continue to explore accretive acquisitions that can expand its presence in key international markets

Beneficiary of weaker U.S. dollar

Since PMI generates all of its revenue outside of the U.S., its revenue growth benefits from U.S. dollar weakness
Many currency experts believe that the U.S. dollar will continue to depreciate relative to international currencies over the next several years based on the U.S.’s record budget deficits and higher rate of money printing

Cost cutting opportunities

PMI initiated a plan to cut $1.5 billion in costs from 2008 to 2010 based on moving production facilities to European plants, eliminating lower margin product lines and reducing SG&A costs by maximizing efficiency of shared services and reducing back office operations
These cost cuts should be partially offset by cost increases of tobacco leaf procurement and higher direct manufacturing costs that should total around $500 million

Strong free cash flow generation

PMI generated $6.8 billion in free cash flow in 2008
The company plans to continue to use its FCF to buy back shares (the company has over $3.5 billion remaining on its current share repurchase plan) and to fund its 65% dividend payout ratio
At the end of the third quarter of 2009, the company’s net debt / ebitda ratio was 1.2x, which is very conservative for a leading consumer staples company

China optionality

The Chinese tobacco market is currently predominantly controlled by China National Tobacco Corporation, the Chinese state-run monopoly
China’s estimated annual cigarette sales are $100 billion vs. $70 billion in the U.S.
PMI currently sells Marlboro cigarettes in China through a licensing agreement, but it does not control a very large percentage of the market
If the Chinese tobacco market opened up more over the next five years, PMI’s volume growth would benefit

Concerns and Risks

Market share losses in Europe

PMI lost 1%-2% market share in the EU over the last two years (bringing its total share to ~39%) due to down trading (which has been increasing with higher unemployment levels) and aggressive price competition in select markets from British American Tobacco
As a result of these factors, PMI will probably not raise prices as aggressively in Europe over the next several years to help stabilize its market share

Susceptible to price wars

PMI lost about 4% of its EBIT in 2006 due to a price war in Spain according to industry experts
Gallaher and Altadis were former competitors that were most aggressive in discounting prices in the EU and Eastern Europe to gain share
Both companies have been acquired, which should reduce the risk of a future price war
However, British American Tobacco remains aggressive in select markets

Tax increases

PMI has limited control of tobacco tax increases in international countries that can come in the form of excise taxes, sales taxes and import duties
Taxes can impact PMI’s price competitiveness relative to local brands and can result in down trading
According to management, the excise tax environment has generally become fairer and more reasonable over the last five years

Earnings Model

Valuation

Historical Valuation Analysis

PMI’s stock has only traded as a separate entity for under two years, which limits the usefulness of historical valuation analysis
On an EV/EBITDA basis and on a forward P/E basis, PMI is trading close to the middle of its historical trading ranges

Source: Capital IQ

Source: Capital IQ

Comparable Valuation Analysis

PMI’s stock is trading in line with its international peers based on EV / next year EBITDA multiples and a 10% premium to its international peers based on forward P/E multiples

Source: Bloomberg

Company Description

Philip Morris International was spun off from Altria in March 2008 to protect its international earnings from U.S. litigation. Cigarette related litigation is rare overseas due to a higher tolerance for smoking.

The company is one of the largest international manufacturers and sellers of cigarettes and other tobacco products. It is the market leader in Europe, Eastern Europe, Turkey, Mexico, Argentina and Indonesia.

PMI generated 45%, 35% and 20% of operating profit from the European Union, emerging markets and Asia respectively last year.

Geographic EBIT Mix in 2008

PMI’s portfolio comprises international and local brands. Its primary international brands include Marlboro, Merit, Parliament, Virginia Slims, L&M and Chesterfield. Marlboro represented 36% of PMI’s volume sales in 2008 and the Marlboro brand has helped PMI gain control of 53% share of the international premium cigarette market.

PMI purchases tobacco leaf of various grades throughout the world, primarily through independent tobacco dealers. Its largest sources of supply are the U.S., Brazil, Indonesia, Turkey, Greece and Argentina. The company also contracts directly with farmers in several countries including the U.S., Argentina, Mexico, Indonesia, Ecuador, Dominican Republic, Poland, Colombia and Portugal.

Volume and Pricing Trends

Sources: Citi Research (10/23/09), PMI, CIRA

PMI’s volume trends deteriorated in the third quarter of 2009 on the back of very challenging year-over-year comps. The company was able to increase its average prices significantly, particularly in emerging markets, to generate respectable top line growth of 4.1% in the third quarter.

Marlboro Retail Price, Tax and Net Proceeds in Select Countries

Source: Citi Research (10/23/09)

Tobacco Industry Consolidation

There has been significant consolidation in the tobacco sector in recent years, including Japan Tobacco’s acquisition of Gallaher, Imperial’s purchase of Altadis, PMI’s acquisition of Rothmans, and British American’s purchase of Tekel. The following table highlights major M&A deals in recent years. Consolidation should result in less price competition, which favors the major players.

Source: JPM Research

Competition

PMI’s major international tobacco competitors include British American Tobacco, Japan Tobacco and Imperial Tobacco. PMI also competes against several regional and local tobacco companies as well as government-owned tobacco companies, principally in China, Egypt, Thailand, Taiwan, Vietnam and Algeria.

PMI controlled 16% of the international tobacco market and 26% of the international tobacco market excluding China in 2008.

Source: PMI Presentation

Tesco: Consistent Earnings Growth at Attractive Price

2009-09-05T07:57:00.042-04:00

Tesco (ADR stock ticker: TSCDY) should be considered for potential purchase based on its leading position in the UK retail market, its expansion opportunities in international markets, its ability to improve operating margins and its attractive dividend yield of 3.6%.

Tesco’s ADR stock price target is $21.30 based on applying a 13x multiple to its earnings next year. Tesco deserves to trade at a premium multiple to its high single digits / low teens long-term earnings growth rate based on its consistent earnings execution, its focus on maximizing shareholder value, its best in class EBIT margins and its strong return on equity.

Company Description

Tesco is the largest UK retailer and the 3rd largest global retailer. Tesco controlled 30.8% of the UK grocery market as of May 2009 and ~9% of the UK non-food retail market. The majority of its sales and profits are generated in its 2,282 UK stores, which are segmented into the following formats:

Tesco Express – neighborhood convenience store that focuses on fresh products, 961 stores
Tesco Metro – city center convenience store, 174 stores
Tesco Superstore – conventional supermarket, 448 stores
Tesco Extra – hypermarket that serves an entire community, 177 stores
Tesco Homeplus and One-Stop account for its remaining stores

The company also sells general merchandise through Tesco Direct, it’s online and catalog businesses.

Tesco’s management focuses on customer satisfaction by giving them more choices where to shop and by offering them attractive prices on its products. In the fourth quarter of 2008, Tesco began selling new discount range of products to compete more aggressively on price against discounters. Its prices are generally perceived to be at a small premium to Asda and a small discount to Sainsbury and Morrison.

Tesco’s UK Like-For-Like (LFL) Sales Growth Trends

Sources: Tesco, Cazenove

Tesco has built a significant international operation by entering JVs with local partners and ended its fiscal year with 1,911 stores. Non-food represented about 30% of international sales. Tesco has leading market share positions in Hungary (#1), Thailand (#1), Ireland (#2), S. Korea (#2), Malaysia (#2), Slovakia (#3), Poland (#4) and Czech Republic (#4).

The company entered China several years ago and plans to open more hypermarkets and shopping centers over the next decade. The Chinese retail market remains very fragmented and the top three players each control less than 1% market share.

In 2008, Tesco announced its plan to enter Indian market with its own cash and carry (wholesale) operation and a franchise agreement with Trent to support their Star Bazaar hypermarkets.

FY 2009 Geographic Sales Mix

Source: Tesco 2009 Annual Report

FY 2009 Geographic Profit Contributors

Source: Morgan Stanley

In 2008, Tesco purchased Royal Bank of Scotland’s 50% stake in Tesco Personal Finance (TPF). Tesco plans to take advantage of consumers’ distrust of UK banks to increase its deposit base and financial service activity meaningfully in the next several years.

Competition

Tesco’s primary supermarket competitors in the UK include Asda (17.3% share of UK grocery market), Sainsbury (16.3% share), WM Morrison Supermarkets (11.2% share), Waitrose (3.7% share), Aldi (2.9% share) and Lidl (2.3% share). In recent years, some of its major competitors have turned around their struggling stores, which will make it more challenging for Tesco to gain significant share in the UK market going forward.

Asda’s management improved its stores’ product offering (organic and premium foods as well as non-food offerings) in 2005, which has helped the company’s LFL growth to increase. In the past two years in a more challenging UK consumer spending environment, its discount prices have also helped the company to gain market share. The German discounters Aldi and Lidl have also benefited from the tougher market in recent years.

Morrison took several years to digest the acquisition of Safeway stores in 2004 and offer the right products in its stores. In September 2006, Marc Bolland took over as CEO and improved stores’ product offerings and promotion-based marketing efforts. Since late 2007, its LFL sales growth rates have led the industry.

LFL Sales Growth Trends of Major UK Food Retailers

Sources: Companies, Deutsche Bank

Tesco also competes against multiple local companies in the international markets in which it operates as well as major global players such as Carrefour, Wal-Mart and Ahold.

Earnings Model

Income Statement Summary

Tesco’s UK LFL sales grew 4.3% last year (3% ex gasoline) and its net new stores contributed 2.7% to growth. Its UK sales also benefited from a 53rd week that represented 2.1% of sales and the first time contribution from the consolidation of Tesco Personal Finance. International sales grew 30.6% (including FX benefits) and 13.6% at constant exchange rates benefiting from square footage growth and strong sales growth in Asia.

The company’s operating margin was flat at 5.9% in fiscal 2009 as unfavorable sales mix was offset by increased productivity and good expense control. Its EPS growth was only 2.6% last year, hurt by 26.7% tax rate vs. 24% in fiscal 2008 when it benefited from tax reimbursement and lower UK corporate tax rate.

Balance Sheet Summary

Tesco has an impressive property portfolio that the company’s management and industry experts value at approximately £30 billion (that represents ~75% of company’s enterprise value). The company ended the year with £9.6 billion in net debt, £3.4 billion more than in the prior year, due to acquisition of Homever in S. Korea, purchase of stake in Tesco Personal Finance and unfavorable currency movements. Tesco plans to reduce its net debt by £1 billion this year through lower capital spending, property sales and improvement in working capital. The company has £300 million in bond maturities this fiscal year.

Cash Flow Statement Summary

Tesco generated £5 billion in operating cash flow last year, benefiting from improvement in working capital efficiency and good inventory management. Its capital expenditures were £4.7 billion last year (£2.6 billion in UK and £2.1 billion in international). The company expects its capital expenditures to decline to £3.5 billion this year through spending less on mixed use development land and purchasing fewer existing stores from UK competitors.

Investment Rationale

UK retail market leader

Its leading position allows it to receive attractive pricing from its suppliers and benefit from economies of scale in distribution and marketing
Tesco’s UK business should continue to grow in the mid-single digits (~50/50 contribution from LFL growth and net new space growth) over the next decade and its cash flow from this business should support its international expansion

Strong international growth

Tesco has established leading retail market positions in S. Korea, Thailand, Malaysia and Hungary
In 2008, the company acquired 36 Homever hypermarkets in S. Korea, which increased its presence significantly in Seoul, where ~50% of S. Korea’s population lives
Tesco converted the acquired stores into Homeplus stores and saw average sales uplifts of 50%
During fiscal 2009, Tesco added 63% to its square footage in S. Korea, including the converted Homever stores
Tesco currently has 110 stores in S. Korea and plans to add 5 this year and 10-15 in subsequent years
Tesco controls about 9% market share in Thailand and should continue to gain share at the expense of the independent market that controls 76% share
The company plans to increase its square footage 8% this year in Thailand
In total, Tesco plans to grow its square footage 10% in international markets this year and LFL growth should improve to low single digits in global economic recovery

Tesco Personal Finance growth opportunity

TPF generated 65% of its profit from insurance and 35% from banking products, credit cards and fees from its ATM network last year
The company grew its deposit book to over £4.5 billion from £2.5 billion in the last four months of its fiscal year, benefiting from its trusted brand name and consumers’ distrust of major UK banks
Tesco aims to double profits over the next five years from TPF (from £244 million last year) by leveraging its store network and customer base and by opening up new full service branches

Operating margin expansion

Tesco’s operating margin should increase 20 bps this year benefiting from:
200 new Express store openings, bringing total store count to 1,161; Tesco benefits from ~4%-5% higher gross margins on its Express stores due to lower operating costs
Increase in international sourcing of non-food products
Additional distribution cost savings estimated at £100 million this year

Property sales

Tesco plans to continue selling portions of its £30 billion property portfolio over the next several years

Fresh and Easy expansion opportunity

Tesco entered the U.S. market with its Fresh and Easy stores on the West coast in 2008
These convenience stores offer organic, ready-to-eat food and low prices
Tesco ended the fiscal year with 115 stores and plans to open 60-70 new stores this year
Last year, these stores generated losses of £142 million and management expects similar losses in the upcoming year
However, longer-term, the U.S. has the potential to be an important market for the company and could increase U.S. interest in its stock if the Fresh and Easy stores become popular

Concerns and Risks

Market share losses in UK market

Tesco lost market share for the first time in several decades in 2008 hurt by turnarounds at competitors and consumers’ migration to discounters
It will be difficult for Tesco to gain significant share going forward, but it should be able to maintain its 30+% leadership position

Sources: TNS, Morgan Stanley

Sizable debt load

Tesco ended the year with £9.6 billion in net debt, up £3.4 billion from the prior year
About 40% of the company’s debt is denominated in Euros and US$ so Tesco was hurt by the depreciating GBP in 2008
Nevertheless, its interest coverage ratio was 8.9x last year and does not appear too aggressive

Exposure to weaker European economies

Tesco is exposed to weaker economic growth in Ireland, Slovakia and the Czech Republic
Management said that it has recovered in Hungary (which entered recession in 2006) by continuing to expand its store base and by offering attractive pricing. Tesco plans to follow the same game plan in other European countries that are currently struggling.

ADR shareholders exposed to potential GBP depreciation

The British Pound depreciated from 2.0 USD/GBP in summer of 2008 to roughly 1.4 USD/GBP in first quarter of 2009 on weaker housing and financial markets and higher deficits
In recent months, the Pound has recovered to 1.6 USD/GBP as housing market has stabilized, but any deterioration in economic outlook for UK would have negative impact on the currency as well

Valuation

Historical Valuation Analysis

Tesco is trading at attractive P/E and EV/EBITDA valuation levels compared with its historical valuation levels
However, since its growth rate in its core UK market will not be as high as in the past, it might not be appropriate to use peak historical valuation levels to determine fair value
Tesco needs to demonstrate success in one of its big new markets, such as China, India or the U.S. to revive its sales growth to the double digits and earn a valuation multiple close to its historical peak level

Tesco’s P/E Ratio 1999 - present

Sources: FactSet, Cazenove

Tesco’s EV/EBITDA Ratio 1999 – present

Sources: FactSet, Cazenove

Comparable Valuation Analysis

Tesco is trading at a 16% discount to its peers based on current year P/E multiples despite its stronger sales growth, EBIT margins and ROE
Tesco is trading at a premium to its peers based on EV/EBITDA and EV/Sales. This can partly be explained because Tesco operates in many international markets where the tax rates are lower than in the UK and Europe so this benefits its earnings, but not its EBITDA or sales.

Source: Bloomberg (09/01/09)

Price Target

Tesco’s ADR stock price target is $21.30 based on applying a 13x multiple to its earnings next year. Tesco deserves to trade at a premium multiple to its high single digits / low teens long-term earnings growth rate based on its consistent earnings execution, its focus on maximizing shareholder value, its best in class EBIT margins and its strong return on equity. Tesco needs to demonstrate success in one of its big new markets, such as China, India or the U.S. to revive its sales growth to the double digits and to earn a higher valuation multiple.

Full Disclosure

Recommended to Bolter and Company, a NY-based investment management firm, on September 2, 2009
No current positions in family accounts

Hansen Poised to Benefit from New Products and International Expansion

2009-08-14T13:02:00.023-04:00

Hansen Natural Corporation ("HANS") should be considered for potential purchase based on its #2 position in fast growing global energy drinks market, its ability to gain market share in the U.S. through introduction of innovative new products, its opportunity to expand in international markets, its cash-rich balance sheet and its strong cash flow generation.

Hansen’s stock price target is $39 based on applying a 15x multiple to its earnings over the next year and adding its net cash per share of $3.46. A 15x target multiple appears appropriate based on its ability to grow its sales and earnings in the low to mid teens over the next several years.

The stock should be accumulated in stages (25% or 33% of planned total position size purchased initially) given its volatility and potential overreactions associated with its short-term sales results in current challenging economic environment.

Company Description

Hansen Natural Corporation develops and markets energy drinks, natural sodas and juices and is headquartered in Corona, California. Hansen has two reportable segments: Direct Store Delivery (DSD), whose principal products are energy drinks, and Warehouse, whose primary products include natural sodas and juices. The DSD segment utilizes distributor networks and the Warehouse segment sells directly to retailers. The distribution of its energy drinks in the U.S. and Canada are almost equally divided between Anheuser Busch distributors (to on premise retailers, including bars and nightclubs) and Coca-Cola bottlers (to traditional food and beverage retailers).

The company is the #2 player (28% market share) in the $6.5 billion U.S. energy drinks retail market. Its energy brands include Monster Energy, Monster Khaos, Monster Assault, Monster M-80, Monster Heavy Metal, Monster MIXXD, Lost Energy and Joker Mad Energy. Approximately 90% of Hansen’s sales and 95% of its operating profit is generated from its energy drink products.

Hansen outsources the manufacturing and packaging of its products to third party bottlers and contract packers. The company purchases concentrates, juices, flavors and packaging materials and delivers them to its bottlers and contract packers. One of the benefits of outsourcing is that the company can introduce new products quickly at a fairly low cost since it does not have to build manufacturing capacity and bring on more workers. Hansen has a small labor force of about 900 employees, 700 of which are in sales and marketing.

Hansen markets its Monster Energy drinks to target demographic of 18 to 30 year old males who are into action sports and rock music. The company does not use mass media marketing, such as television ads or billboards. Instead, Hansen focuses on sponsoring athletes, artists, tours and events to target its young male demographic. Hansen recently signed Valentino Rossi, the world champion MotoGP racer, to a sponsorship deal, which should help the company gain market awareness in Europe and Australia.

Its customers include Coca-Cola Enterprises, Wal-Mart (11% of sales), AB Distributors, Kalil Bottling Group, Trader Joe’s, John Lenore & Company, Costco, The Kroger Co., Safeway and Albertsons.

2008 Customer Mix

Source: Hansen 2008 10K

Competition

Hansen’s competitors in the energy drink segment include Red Bull GmBH, Pepsi (Amp, SoBe No Fear, SoBe Adrenaline Rush), Rockstar, Coca-Cola (Full Throttle, NOS) and Anheuser Busch (180). Rockstar is distributed by Coca-Cola and Pepsi has decided to focus its resources on Amp, at the expense of its SoBe energy products.

Its competitors in the natural soda category include Coca-Cola, Pepsi, Cadbury Schweppes, Jones Soda, Clearly Canadian Beverage Company and Crystal Geyser. Hansen’s competitors in the juice segment include Tropicana, Tree Top, Mott’s, Martinelli’s, Welch’s, Ocean Spray, Minute Maid, Langers, Apple and Eve and Juicy Juice. Its competitors in the coffee beverage market include Starbucks, Rockstar Roasted, Caribou Coffee and Godiva.

Industry Overview

U.S. retail sales of energy drinks have more than tripled since 2003 to $6.5 billion in 2008 according to Beverage Digest.

Monster's U.S. market share in the energy drink category increased by 0.8% to 28.4% while Red Bull’s market share dropped 0.2% to 35% for the 13 weeks through June 27, 2009 according to Nielsen Reports. Rockstar's market share decreased 0.8% to 10.7%, Amp's market share decreased 0.6% to 7.3%, Full Throttle's market share decreased 0.5% to 4.3% and NOS's market share increased 1% to 3.6%.

Monster is the #2 leading energy drinks product trailing only Red Bull in the majority of international markets in which it participates.

Sports drinks, such as Gatorade and Powerade, nearly doubled sales volume during four year period from 1992-1995. The category continued to grow at 9% rate over subsequent 13 years, significantly faster than 2%-3% growth in overall non-alcoholic beverage category. Some industry experts expect energy drinks to follow similar course and predict that energy drinks will resume mid-to-high single digit growth following recovery in U.S. economy.

Earnings Model

Financial Results

Sales Growth

In 2007, net sales grew 49.3% benefiting from volume sales growth of 35.3% and price per case increases of 10.3%

Net sales growth was driven by Monster Energy, Java Monster (coffee drinks) and new energy products including M-80, MIXXD and Heavy Metal

In 2008, net sales grew 14.3% benefiting from volume sales growth of 4.3% and price per case increases of 9.6%

Net sales growth was driven by Monster Energy, Java Monster and new energy products, including Shooter, MIXXD and Heavy Metal

In 2009, I expect sales to grow 10%, in line with growth in the first half of 2009

Net sales growth should be driven by Monster Energy, Java Monster, Monster Expresso and Monster shot products in the U.S. as well as growth in international markets

Margins and Profitability

In 2007, gross margin decreased to 51.7% from 52.3% in the prior year due to sales mix (increased sales of certain energy drink packages with lower gross margins) and to higher raw material costs. Operating margin also decreased to 25.5% in 2007 compared with 26.2% in 2006 owing to lower gross margin and slightly higher operating expenses (warehousing, marketing and payroll) as percentage of sales.

In 2008, gross margin increased to 52.1% from 51.7% in the prior year due to accelerated revenue recognition associated with termination of certain distributors during fourth quarter and sales mix benefits, both of which were only partially offset by higher raw material costs. Operating margin decreased to 15.8% in 2008 compared with 25.5% in 2007 due largely to costs associated with terminating existing distributors. Excluding these costs, operating margin would have increased to 27.2% in 2008.

In 2009, I expect gross margin to increase to 52.5% from 52.1% in the prior year benefiting from lower raw material prices. I expect operating margin to increase to 29.4% benefiting from gross margin improvement and lower operating expenses as a percentage of sales.

Investment Rationale

Gaining market share in U.S. energy drink market

Hansen’s market share increased to 28% in the second quarter of 2009 according to Nielsen Reports from 19% in 2005 according to Beverage Digest
The company has been able to gain share over Red Bull due to its strong new product introductions, unique marketing strategy and its distribution agreements with leading players, such as Coca-Cola and Anheuser Busch
Hansen should continue to gain share in the second half of 2009 due to introduction of Monster Expresso, Monster Import and Nitrous products

Source: UBS

Good growth in energy drink market

The energy drink market should continue to grow more rapidly than the overall non-alcoholic beverage market over the next several years following the growth path of similar innovative product lines in the past, such as sports drinks
Although growth in the blue collar segment (truck drivers and construction workers) has decreased in the past year due to the economic downturn, demand should reaccelerate with economic recovery since Monster products provide energy that traditional drinks do not

International expansion

Hansen announced a distribution agreement in Europe with Coca Cola Company and Coca-Cola Enterprises in October 2008
The agreement covers France, the United Kingdom, the Netherlands, Belgium, Luxembourg and Monaco
Initial results have been extremely positive in all regions except for the UK where alternative energy products are already well established
The company also has distribution agreements in Spain, Italy and New Zealand with smaller distributors
Hansen recently entered a distribution agreement with Comercializadora Eloro, a subsidiary of Grupo Jumex, for exclusive distribution of its energy drinks throughout Mexico
Jumex is the largest juice producer and distributor throughout Mexico
Monster is currently the #2 player in Mexican energy drink market
The company also recently signed new distribution agreements in Australia and Brazil and expects to start selling in these markets in the second half of 2009
The international energy drink market is estimated to be approximately $5 billion in size, so Hansen’s presence in this market nearly doubles its addressable market
During 2008 and the first half of 2009, international sales accounted for 8% and 12% of its respective sales

Opportunity to gain share in higher-margin, faster-growth energy shots market

The energy shots market is approximately a $500 million market according to Beverage Digest
Hansen entered the market in September 2008 with its Hitman Energy Shooter product and introduced Monster Sniper and Monster LoBo shooters in the first quarter of 2009
The company should continue to gain share in this category in upcoming quarters

Strong balance sheet

Hansen does not currently have any debt and has $313 million in net cash
The company’s stock price could appreciate $5 to $10 per share if Hansen decides to take on debt depending on the amount of debt it takes on and the number of shares it repurchases

Potential acquisition target

Coca-Cola and PepsiCo have already looked closely at acquiring the company and Dr. Pepper Snapple’s CEO recently commented that the company has been for sale for a while

Concerns and Risks

Declining sales growth

Hansen’s net sales have grown in the single digits in two of the last three quarters owing to deteriorating U.S. economy and weaker economy in California that contributes roughly 20% of sales
I expect sales growth to improve in 2010 as the economy recovers

Increased competition

The alternative beverage segment, which includes energy drinks, is the fastest growing category of the beverage industry
Strong growth rates have attracted attention and introduction of copycat products by major beverage players
Fortunately, the two biggest players in energy drinks, Red Bull and Monster, are not discounting and want to maintain premium pricing
Hansen’s CEO said “Red Bull has done a very good job of keeping its pricing premium and keeping the category premium. We don’t believe Red Bull will resort to discounting and we don’t think we will” at a shareholder meeting in June 2009

Volatile stock price sensitive to short term sales results

In the last 2 weeks of May 2009, Hansen’s sales were disappointing due to slower than anticipated sales growth in international markets and challenges associated with new distribution system in U.S. (shifted some distribution to select Coca-Cola bottlers and new Anheuser Busch distributors)
Its stock fell 11% as a result and might be prone to similar overreactions in the future

Higher commodity prices

It gross margin might be hurt by higher aluminum, apple juice, milk and sugar prices as global economic growth improves
Packaging costs account for about 70% of total costs of goods sold and aluminum is primary packaging component

Valuation

Comparable Valuation Analysis

Hansen is trading at a 17% discount to its peers based on 2009 EV/EBITDA multiples and an 8% discount to its peers based on 2009 P/E multiples despite its stronger estimated sales growth and similar profitability ratios

Source: Bloomberg

M&A Valuation Analysis

Recent beverage acquisitions include Tropicana (acquired at 12.4x EV / trailing EBITDA multiple), Snapple (13.1x EV / trailing EBITDA multiple) and Glaceau, manufacturer of Vitamin Water (30x EV / trailing EBITDA multiple)
Cascadia Capital conducted a survey on beverage M&A activity between 2006 and 2008 and determined that the mean EV / trailing EBITDA multiple was 11.8x
Hansen’s current EV / trailing twelve months EBITDA is 10.6x
The following table shows the potential upside to Hansen’s stock price associated with different EV / trailing EBITDA acquisition multiples

Price Target

Hansen’s stock price target is $39 based on applying a 15x multiple to its earnings over the next year and adding its net cash per share of $3.46. A 15x target multiple appears appropriate based on its ability to grow its sales and earnings in the low to mid teens over the next several years.

The $39 price target would also equate to a 12.4x EV / trailing EBITDA multiple, which appears to be a fair acquisition multiple for Hansen based on past deals.

The stock should be accumulated in stages (25% or 33% of planned total position size purchased initially) given its volatility and potential overreactions associated with its short-term sales results in current challenging economic environment.

Full Disclosure

Recommended to Bolter and Company, a NY-based investment management firm, on August 12, 2009
No current positions in family accounts