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.