Tuesday, September 21, 2010

MCO - Moody's Intrinsic value

I had written a piece about Moody's earlier this year and this is good time to revisit. It is well known that Moody's future business environment will not be the same as it's past. Some changes are

1. Increased regulation and legal exposure is inevitable. In essence the business will not enjoy as much regulatory and legal protection as before.

2. The profitable structured finance business is drying up and will not come back. After 2 years, management is expecting this part of business to have further declines.

3. We are in a period of long deleveraging cycle and low growth environment.

But, Moody's will still be a good highly (but less than pre-credit crisis) profitable business. It boils down to valuation.

But lets value the business. The earnings expectation for Moody's for 2010 is around$1.85. The current market price is between $25 to $26. It also has debt. This essentially means that the enterprise value is around $30 including debt. So, P/e based on enterprise value is around 16. This is not very high for a capital non-intensive company if future growth prospects are good. Warren Buffet is selling for the past few quarters and this can be justified only if he thinks future earnings prospects are not very good. There are enough uncertainities about future of credit rating agency but they have been very good cash producing machines. But deployment of this cash was not very great. Considering poor stock repurchase choices of the past, I expect minimal value creation based on allocation of capital.

Disclosure: I currently own Moody's and am thinking of selling.

Please leave your thoughts...

Wednesday, September 8, 2010

Car max update

I had written about Car Max on May 2008 and an update is due. For those, who are new to Carmax, my earlier blog (from May 2008) is worth brushing up!


I will not repeat the strengths/weakness of Carmax in this blog. The focus of this blog is to evaluate it's current position.

Updates of interest from 2010 annual report:


1. A big plus is that there is no other retailer that follows CarMax's business model. One potential competitor Lithia motor had a similar strategy to sell 'One price auto' but abandoned the strategy after 2008 recession. This shows the difficulty in copying the model. I guess this business model operates against the human nature to not make more money on a car when possible and go for fixed pricing and flat commision per car.

2. The recession has caused some used and new car dealers to close. This is positive for Carmax as well.

3. High unemployment and fragile economy are definite minus.


1. In the annual report, same set of figures are highlighted whether business results are good or bad in any given year. Numbers of particular interest are ROIC and comparable store unit sales. I have not seen that consistency of focus and highlighting ROIC by many managements in annual letter.

2. Management evaluation of new ideas using ROIC is impressive. For example, Management is planning to open more car buying centers and will decide to expand based on ROIC of the project. The very fact of using ROIC to evaluate projects and mentioning it in annual report provides a good comfort feeling!

3. Equity based compensation is negative strike against management but is expensed due to accounting rules. So, it is neutral for now.

On the whole, Management seems to be focussed on right things.


1. Growth resumes: A key attraction of CarMax for investor is that it is a profitable retailer that has good amount of geographical growth left. CarMax had suspended it's growth efforts in the wake of credit crisis. Recently, CarMax has stated that it will open 8 to 15 stores over Fiscal 2012 and 2013 (i,e before Feb 2013). This is not huge growth but is in the correct direction. If market improves, this will accelarate further. This has important bearing on valuation.

2. So, why is growth important? CarMax does not provide dividend and keeps all the earnings it generates. So, the return that CarMax produces depends on how well it utilizes it's cash. Car Max return on invested capital is around 10 to 12% if you remove 2008. So, the capital compounds at least at that rate if it retains and opens new stores. Plus with some leverage, ROE is between 15 to 18%. So, if it uses cash wisely and opens profitable stores, earnings can compound around 15% which is a good return. If new store opening stagnates, it will not be able to compound earnings and hence the valuation multiple will correctly be lower.

3. Let's value the business.In Fiscal 2010, the eps was $1.26 with around 100 stores. It can possibly expand to 175 stores over say next 5 years if economy picks up. This will more than double the earnings as recently opened stores mature. Lets say eps of $2.65. Having a P/E of 15 at that time would cause price to be $39 to $40. This is under good to moderate economy. If economy does not pick up much and rolls around same levels, then the stores opened will be much less (lets say store count of 130 over 5 years). The eps will be $1.6 and p/e of 18 is appropriate as more potential exists and price is around $28. So, price after next 5 years can be between $28 to $40 depending on economy. At the current price of $23, it does not provide cushion for new buy but seems like a solid hold waiting for economy to recover.

I bought Carmax at $18 couple of years back.

Please leave your comments. Of late, I have not updated blog regularly but will try to do so in future.

Monday, April 19, 2010

American Express - 2010 - Stock analysis and valuation

I reviewed the 2009 annual report that Amex sent. I had written in detail about changes in Amex business model last year and it's implications. You may want to refresh that first and here is the link.


Here are some thoughts from this year's annual report and it's valuation.

1. First, credit loss is decreasing and write off rates are improving. This is a combination of better underwriting of new cards, closing some cards and agressive action to react to the market (like credit line reduction where appropriate etc). Also, some of it is due the location in credit cycle and some general improvements even though risks like high unemployment remain.

2. In otherwords, the crisis seems to be past to say the least. That is, credit losses is unlikely to require raising equity capital. This is very important for shareholder. It makes no sense to buy back shares at peak prices during good times only to issue shares at bargain basement price when economy falls like some companies have done. On this score, AMEX escaped the worst even though had their share of mistakes in underwriting like issuing cards in areas with peak real estate boom. This point is very important and meaningful good news.

2. Amex hinted at making some subtle shifts and this is good for long term shareholder. Amex is planning to issue lesser number of new lending based cards and limit it to certain premium and co-branded cards where credit performance is better. So, AMEX should get back to better credit underwriting when the next down turn arrives. This impacts the premium market places on AMEX earnings (P/E multiple). In last year's comments, I had serious doubts if AMEX will become a more conscious underwriter and hence suggested a P/E of 14. After this shift, likely AMEX's multiple (P/E) will be better and correctly so. This is good news. We will get to specifics in valuation section.

3. The downside of lesser new card members is it's negative impact on earnings growth. AMEX plans to improve earnings by focussing on spending in it's existing cards. However, the new Normal environment means lesser spending by consumers. The impact on earnings growth may be compensated at least partly by multiple expansion and lower risk.

4. Another negative and less advertised fact is higher capital standards from this point on due to new regulation and AMEX becoming bank holding company etc. AMEX is thinking this will result in ROE of 20%'s as opposed to past ROE's of 33%+. This is a significant impact to long term share holder. Basically more capital is required to create the same earnings growth. This causes AMEX to move from superb economics to one that is very good.

5. AMEX is considering to look for growth in other fee based services in payment industry. AMEX seems to be serious about this and has reorganized accordingly. This action may be a direct result of shift in plans to limit issuing new lending based cards. So AMEX is looking for other avenues of growth rather than just relying on increasing spending on existing cards which is not easy in "new normal" environment. My views are conflicted in this. Additional earnings from non credit risk sources are good. But they also mean less growth in core areas where management has better experience. It may be positive since AMEX is not a bad allocator of capital.

6. To summarize: AMEX will become better underwriter due to issuing lesser number of lending based new cards, closing some poor performing cards and improved underwriting model to take real estate into account. These actions will reduce earnings growth but increase p/e.
AMEX will Focus back on driving up spending. Considering new normal and this is difficult.
Higher capital standards will be in force in future resulting in lower ROE. Hence lower earnings growth to be expected and possibly lower payout ratio (unlike 65% in the past for dividends and share buyback).
Internatinal expansion will be positive.
AMEX in general is a better steward of capital than some other companies. It provides good dividends and not focusses only on share buyback to give back capital. I give a B+ (and not A) because some of their buy back does not add much value especially at the peak but helps stock options become valuable.

7. Valuation: ROE of 25% and payout ratio of 50% seems appropriate. This results in earnings growth of 12%. I will settle for 70% of revenues (discount fees + other fees) without big credit risk and 30% of reveunue based on lending model. A p/E of 18 seems appropriate (.7*22 + .3*10).
Settling on normal earnings number is difficult. It should be possible to get to at least 2005 earnings of $2.38. lets say $2.4. This results in valuation of $44. So AMEX is fully valued current market price of $45.23 (4/19/2010).

8. I own shares in AMEX now. My average cost basis is $36. I should have bought more at around $10 in Mar 09. Warren Buffet advised as much in CNBC. I did not have enough cash in hand. So one lesson is to have cash in hand. Other question always is, do you double down or buy another stock that has fallen but is not directly impacted(like Infosys). I guess some of both is not a bad idea if this were to ever happen (I hope it does not!).

Please leave your comments. I will update next year again.

Sunday, February 14, 2010

Book about Jammie Dimon

I recently read a book titled 'The last man standing'. It's a good read to gain insight into Jammie Dimon's (CEO and chairman of JP Morgan chase) work. Few items of interest are listed below from the book.

1. Jammie Dimon likes fortress like balance sheet. Considering banks are leveraged businesses, it is surprising why more such bankers are not around.

2. Likes to be counter cyclical in terms of acquisition. No doubt Wa Mu acquisition is a good example. In contrast, Wachovia bought Golden West at the height of housing bubble. This essentially provides a margin of safety.

3. Jammie's crtierion to buy is as follows. Buy when it makes business sense, price is right and the acquiring company is operationally ready to integrate new business.

3. Cut costs and have lean operations. It somehow always seems that penny pinchers are better stewards of shareholder money. More on this in a later article.

4. Straight forward and no nonsense reporting to share holder. Buffett has appreciated Jammie on his share holder letters. Thats as good as it gets!

5. Jammie is the chief risk officer and has an intutive sense of identifying and acting on risk.

In short, banking is commodity business. In a commodity business, management makes all the difference. Further, the leverage in banking business adds inherant risk. So it is important to have a CEO who understands risk. If you find a small bank with an excellant CEO, it is worth considering for further research. Typically, it is difficult to identify a good manager in banking unless an entire cycle passes.

On the whole, this book helps understand why JP Morgan chase stands tall in this crisis. Simple answer is Jammie Dimon.

Friday, January 22, 2010

Moody's intrinsic value

This piece attempts to value Moody's (MCO) share price.

My original purchase assumption was that Moody's will earn at least $2.00 eps once credit bubble pops and normal environment returns. This was when the company earned $2.58 in 2007. I did figure that regulatory environment will be tough and their moat may weaken. I figured that even if they turn out to be one of many players, they still have a good chance to get a decent size of the pie. I also thought that Moody's is exporting capital markets to world (think of Coke's world wide expansion!) and is in early stages of global capital expansion. Needless to say, credit market world has changed.

Now it is time to reevaluate what the security is worth. First, Warren Buffet is selling Moody's for the past few quarters. One obvious reason is that he thinks security is fairly valued considering future prospects of the company. It is also possibe that his decision is precipitated by a moral responsibility of being a part owner of the company (up to 20% owner at peak) and not able to influence it's role in credit crisis. If I have to bet, it is not in Mr. Buffet's genie to sell undervalued security. So it is likely a combination of all of the above.

Moody's moat at it's core comes from trust it's customer's place on it's ratings. The credit crisis has shaken that. Moody's is addressing some of the issues but changes are not as drastic as the problem requires. The regulatory environment will be changed and it's shape unknown.

Now lets look at numbers. In 2008, Moody's earned around $1.8 eps. Estimating future growth is tough. World will likely not get back to high levels of leverage any time soon. In particular structured finance business will likely dry up and not return to any where it was in 2006 and 2007 (as stated by CEO in 2008 annual report). Further, 2008 is a baseline year as stated by CEO in 2008 annual report. Company will likely have more competitor's in future in it's regular plain vanila bond rating business. For example, Morningstar has come out with ratings on bonds. Regulation is likely to tighten. If you add all up, Moody's will likely grow few points ahead of inflation because of it's Analytics business and some rating business growth with world economy growth. I will pull up some numbers here. Lets say 5 to 7% revenue growth with 10% eps growth (because of share repurchase).

These figures are not bad. Moody's throws out lots of cash. But the big rub is that shareholders do not benefit from high free cash flow. Moody's repurchases shares regularly instead of giving high dividends. Further, this occurs even when stock price is high. For example, from Oct to Dec 2006, company repurchased 2.2 million shares at around $65 per share. It is not difficult to figure out even in boom period that this price is not a screaming bargain. Share repurchase benefits option holder more than regular share holder. So not much can be expected in terms of value creation due to capital allocation of excess cash. So a lower valuation is warranted.

Over the next few years, Moody's non rating business will grow faster than ratings business due to consumption of risk analysis products. This segment has lower operating margins than the ratings business. As of Q3 2009, op margin of Moody's Analytics business is 34% (still healthy) compared to 40% for ratings business. So op margin expansion is not likely.

Another piece of interest is that 2009 has had good growth in Corporate Finance segment of the Moody's ratings business. This is the ratings on investment grade and speculative grade bonds due to company's refinancing. Likely, this level of activity may not not occur every year since company's have refinanced to avoid any near term maturities.

I think it is not unreasonable to give 15 to 20 as P/E without doing DCF. So this translates to valuation between $27 to $36 based on 2008 eps. Mr. Buffet is selling in lower end of this valuation indicating future prospects are not that great. It is best to take note of when Buffet sells based on past experience.

Please leave your thoughts...

Tuesday, January 12, 2010

Warren Buffet's role in Kraft

A lot is written about why Mr. Buffet pays part of Burlington North Fe transaction in equity. Check this link if interested (http://www.rationalwalk.com/?p=4035). But the more interesting question is why Mr. Buffet is opposing Kraft's offer of issuing more equity to buy Cadbury's.

Buffet in the past two decades has chosen to be passive investor. His key was to associate with good managements rather than to direct or influence management actions. This has worked well for him in general. His rationale was that managements usually do not listen even if such advice is provided from within the board room. Usually CEO ego takes precedence over advice from elders!

However, investment in Moody's may have changed his opinion. Mr. Buffet was criticized for not taking more active role in Moody's operations during the boom years even though Berkshire owned 20% of the company. In effect, Berkshire was a silent partner in company's role in the credit crisis. In the annual meeting, Mr. Buffet was questioned about this and he gave the same standard answer that managements will not listen.

I think that Mr. Buffet has had second thoughts on this issue. While being a passive investor is still his first choice and correct choice most of the time, he has a responsibility to exercise his responsibility as an owner in circumstances when value is destroyed or when the direction of company is wrong. Ben Graham in intelligent investor asks all investors to take an active role in the companies in which you invest. I think Mr. Buffet may be taking more such active role in future and that is good for all investors who invest along side him or with him.

Please leave your thoughts....