The advantages of Western Union (Ticker: WU) business model is fairly well known. It is scalable and generates lot of cash. We are now in a new reality and it is worth checking back if it is worth continuing to be invested. Here are some thoughts...
1. General ongoing environment: It looks like we are in for a period of prolonged downturn and possibly a reset to new level of economic activity rather than return to pre-bubble economic activity. Lets say, two years of painful revenue drops (15% drop) and followed by growth based on inflationary levels from that point. No one knows for sure but evaluating companies with this in mind is always a good start. If it survives this scenario, other scenarios (except great depression II) will be good outcomes.
2. Debt: In this environment, any debt is a bad debt. Western Union had around $2 Billion of debt. First the good news. Much of this debt is due to paying a dividend to First Data and not due to business needs. Western Union generates more than $1 Billion dollar of free cash flow per year. Still that assumes future will be like the past. Plus operating leverage works both ways. Since the network of money transfer is already established, incremental revenue falls to bottom line. The reverse (current situation) is also true. That is, drop in revenue could cause much steeper loss of earnings. I think management must act conservatively first and pay back debt as soon as possible.
3. The general lack of growth in economy means less activity in construction and employment levels. So in general, Western Union customers have less money to transfer. So revenue can drop off. This is negative like it is for many other companies.
4. Western Union's competitor (Money Gram) is weaker because of issues in their check cashing business. Since money transfer is not capital intensive business, Money gram can still find ways to grow. But not with as much strength to compete against Western Union. If it comes down to it, Western Union can sustain lower prices for longer than Money Gram. So weaker competitor does not hurt but does not help as much as it would in a capital intensive business. Plus perception of strong player is always a plus in anything to do with money.
5. While growth due to economic activity will be reduced, we can expect some acquisitions of smaller players. Plus smaller players may find it hard to withstand prolonged recession. This is positive.
6. Since multinational Banks are weaker, they may now start to focus on their core areas and not focus on money transfer. This is positive.
7. Western Union does not carry credit risk and can withstand prolonged recession if it manages it's expenses and debt carefully.
8. The current political climate in Washington may result in meaningful immigration reform which will be positive for Western Union.
In summary, if economy falls into few years of weakness, Western Union will take few hits to it's earnings but will survive. The pain until then is definite. But will remain as one of the last standing players. When economy eventually returns to more normal level, their rise will be remarkable! Or so I hope!
Wednesday, February 25, 2009
Monday, February 2, 2009
Why stock options misalign incentives
It is a common cliche that stock options align management and shareholder interests. The story goes something like this. If stock price goes up, both option holder and share holder benefit. If it goes down, stock option holder does not reap any benefit. I think this is a very superficial analysis and needs a little digging. The following discussion will provide reasons why this is not necessarily the case. In a nutshell, I think shareholders are usually better off without stock options and providing high cash bonus.
Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.
Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.
So what's to worry about! Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.
Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?
Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!
Stock options are granted at market price and not at it's intrinsic value. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?
Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).
Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.
Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.
Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.
The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.
Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.
o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.
Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.
1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.
2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.
3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.
4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.
4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.
I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.
If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.
Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!
"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."
5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.
Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.
Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.
So what's to worry about! Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.
Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?
Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!
Stock options are granted at market price and not at it's intrinsic value. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?
Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).
Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.
Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.
Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.
The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.
Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.
o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.
Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.
1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.
2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.
3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.
4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.
4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.
I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.
If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.
Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!
"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."
5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.
Thursday, January 29, 2009
How to benefit from Retail companies
Retail is very competitive business and usually has very few competitive advantages. Many retail businesses have low operating margins and make their money by having high turnover of inventory. I view low operating margin for a business as low margin of safety for business errors. If that's the case, why bother playing this segment? The answer lies in some impressive gains if right retail business is acquired. Think buying Walmart even in late 80's! We will look at some factors that can maximize our success in finding good investments in this field.
First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.
1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.
2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!
Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.
1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.
2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.
3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.
4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.
[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]
5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.
So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!
6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.
7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.
Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.
Please leave your thougths....
First, I think there are broadly two types of retail businesses. One is pure play like Walmart or Target. Other is like Starbucks who manufacture a product and sell themselves. This analysis applies broadly to both. Lets first look at some good reasons as to why not to ignore this sector and then move to what to look for.
1. Judging growth potential: If a retail concept works in one city, it is likely to work out in other towns and cities in US. So growth potential can be evaluated with some level of certainity.
2. Easy to understand: It is fairly easy to understand how a retail business makes money. It is also possible to check out the retail locations and shop to get a feel for service, merchandise selection and whether you love or hate it!
Lets look now at what to watch out for. Usually, if you like a retail concept, you will need to evaluate if it has some intangible that cannot be easily copied like benefits of scale, first mover advantage, brand, low cost and excellant management. Assuming there is some barrier to entry and competitor's have not mushroomed, here are items to watch out for.
1. Look for companies in early stages of growth. This cannot be over stated in retail companies. The following will explain some of the reasons.
2. Same store sales: Market is usually fixated on same store sales growth of stores open at least 12 months. However, many retail locations take few years (5 years for Car Max) to mature and get to full potential. So for initial few years the same store sales growth of new stores ( older than 12 months but less than maturity age) will provide tail wind for this number. Once a store matures, it is difficult to maintain the same level of same store sales growth.
3. During initial growth years, earnings benefit from double-dip, delivered partly by new stores as well as same store sales growth (aided by stores approaching maturity but older than 12 months). The earnings growth will be a treat to watch and stock price will move accordingly. If you like the retail concept and are convinced that there is enough room to grow and like the management, buy when the company or market hits a snag and stock is on sale.
4. Management in early years: Management will have huge effect on the outcome in retail especially in early years. In early years, you want management who have business savvy in retail plus big stake in the company (a founder with big holdings in the business) is ideal. Think Sam Walton. In particular you need to be careful about compensation based managements who focus exclusively on earnings growth. Quick growth with leverage benefits management more than share holder. Leverage can come back to bite very quickly when economy goes through a cyclical downturn. Needless to say, you want Walmart or Star bucks rather than krispy Kreme. Look for managements who treat their business as their baby(if you are lucky to find one!) and who plan to grow steadily and with as less leverage as possible.
[As an aside, I find that CEO who are thrifty turn out to be good stewards of share holder money. I do not know why this is but seems to be a good attribute to watch for. Examples include Warren Buffet, Sam Walton, charlie Munger etc. In fact Warren Buffet likes this in a manager. He has mentioned about a manager looking for free parking spots when coming to sell his business. Needless to say, he was thrilled !]
5. Saturation: Bad word in retail! At some point the game runs out on new stores. At this time, usually management used to promising the sky need to think of soft landing. They need to think of slowing growth expectations and also focus more on dividends. Usually though managements do not do this. Blame it on Management compensation. Management compensation usually does not reward shareholder dividends as much as per share earnings growth.
So the story goes like this. They put up additional stores cannibalizing the sales of neighboring stores and provide a variety of good justifications. Management finds out that inevitable happens. New stores placed close to existing stores do not turn out to be that productive. In addition, at this point the same store sales growth slows because the newer stores (> 1 year but less than maturity age) are much smaller part compared to fully matured stores. A combination of these factors cause the earnings growth to slow. Market punishes crushingly. Management focusses on cost cutting next or try new lines of business!
6. Selling is not a bad thing! To avoid this fate, one needs to have an understanding what level of stores cause saturation. Look at similar retail outlets. When it is close, be satisfied with the profits and get out.
7. Value trap: In the final phase of a company, it is important to watch out for value traps. The retail company may look cheap based on past growth expectations. It is best avoided at this time unless the price is so cheap even assuming no future growth. In that case, you will benefit if any additional growth does turn out. If not, you may still get the one time benefit of market reevaluating the price. But usually it is better to avoid this cigar butt scenario.
Bottom line, focus on buying retail concepts with growth left in them. Do not forget to focus on price and excellant management. Also, avoid value traps towards the end. Watch how management compensation is set and if they have skin in the game (real money not funny money like options) so much the better.
Please leave your thougths....
Thursday, December 4, 2008
Concentration vs diversification
The argument between whether to concentrate investments or diversify is sometimes taken to extreme as if one or the other is the correct way and that it is always true.
Lets look at what Mr. Buffet has said. Warren has outlined two different strategies based on the type of investor. Warren has said that in cases where an investor can bring intensity to the game("know something investor"), concentration would be beneficial. In cases where the investor wants to participate in stock market returns but is either not interested or not trained ("know nothing investor"), it is best to buy an index fund that broadly gets market return. Do not automatically assume that smart money will outsmart dumb money. Warren adds that when dumb money acknowledges it's limitation (and invests in index fund), it will in many instances outsmart the "smart" investor. Beating the market is no easy task over long periods of time in any significant margin.
To me, both these make sense. So what do I do. For my retirement accounts(401K, IRA), I pick mutual funds. On my personal account, I pick stocks and this is usually focussed on 10 to 15 companies bought over a period of 2 to 3 years. These are well run businesses that produce cash and have decent growth prospects and are not highly priced. I do my own investing because I like to study, learn and understand investing in good businesses. I will not consider studying a business waste of time even if I decide to not invest in it. So as long as I enjoy investing, this dual strategy works well for me. This mixed strategy gives me the best compromise. If I mess up my personal accounts, the retirement accounts will at least be safe. If I do well, it will produce a meaningful return.
I think there is another piece of treasure I heard from Bill Miller interview that is meaningful for this downturn. This advice adds another dimension which is market pricing. When the market is selectively cheap (one company or a group of companies), it is meaningful to concentrate on those few investments. However, if the market is cheap across the board, then excessive concentration is not necessarily a smart strategy. When market recovers, most stocks will have decent upside. So in this case, some diversification is called for because this will produce returns similar to concentration but at the same time limiting certain stock specific risk.
During this downturn, I feel Bill Miller's strategy is applicable. I have purchased companies that are new to portfolio. In addition, I have also reshuffled some within my portfolio for tax reasons.
Bottom line play the game only if you are both interested to spend time as well as have the necessary aptitude. Even then, do not feel compelled that you need to do choose one or the other. Do what works best for you. Note Berkshire Hathaway itself is highly diversifed and it has moved in that direction from day one though not necessarily for this reason alone.
Lets look at what Mr. Buffet has said. Warren has outlined two different strategies based on the type of investor. Warren has said that in cases where an investor can bring intensity to the game("know something investor"), concentration would be beneficial. In cases where the investor wants to participate in stock market returns but is either not interested or not trained ("know nothing investor"), it is best to buy an index fund that broadly gets market return. Do not automatically assume that smart money will outsmart dumb money. Warren adds that when dumb money acknowledges it's limitation (and invests in index fund), it will in many instances outsmart the "smart" investor. Beating the market is no easy task over long periods of time in any significant margin.
To me, both these make sense. So what do I do. For my retirement accounts(401K, IRA), I pick mutual funds. On my personal account, I pick stocks and this is usually focussed on 10 to 15 companies bought over a period of 2 to 3 years. These are well run businesses that produce cash and have decent growth prospects and are not highly priced. I do my own investing because I like to study, learn and understand investing in good businesses. I will not consider studying a business waste of time even if I decide to not invest in it. So as long as I enjoy investing, this dual strategy works well for me. This mixed strategy gives me the best compromise. If I mess up my personal accounts, the retirement accounts will at least be safe. If I do well, it will produce a meaningful return.
I think there is another piece of treasure I heard from Bill Miller interview that is meaningful for this downturn. This advice adds another dimension which is market pricing. When the market is selectively cheap (one company or a group of companies), it is meaningful to concentrate on those few investments. However, if the market is cheap across the board, then excessive concentration is not necessarily a smart strategy. When market recovers, most stocks will have decent upside. So in this case, some diversification is called for because this will produce returns similar to concentration but at the same time limiting certain stock specific risk.
During this downturn, I feel Bill Miller's strategy is applicable. I have purchased companies that are new to portfolio. In addition, I have also reshuffled some within my portfolio for tax reasons.
Bottom line play the game only if you are both interested to spend time as well as have the necessary aptitude. Even then, do not feel compelled that you need to do choose one or the other. Do what works best for you. Note Berkshire Hathaway itself is highly diversifed and it has moved in that direction from day one though not necessarily for this reason alone.
Tuesday, September 2, 2008
How to intelligently buy Financial firms
I have attended the past two Berkshire Hathaway annual meeting in Omaha. They are great lessons for anyone interested to learn about investing. The 2008 meeting had a question about investing in financial firms. Warren Buffet's reply was classic.
Warren said that he would invest in financial sector only if he has confidence about the management. He added that in a sector where the earnings are nothing more than guesstimates, management character is the most important attribute.
This is a profound statement that merits closer attention. Many full time analysts have gone through balance sheets of big banks but did not forsee such big write offs. In some cases, the sheer complexity of some of the loan products made it difficult to make meaningful judgement of asset quality. This is further compounded by off balance sheet nature of loans plus relying on financial models that assumed housing price will not decline did not help either. Irrespective of reasons, end result is huge write offs resulting in dilutive capital raisings or firms going bankrupt.
An example of complex product is CDO (Colaterized debt obligation). A CDO is made up of so many different combinations of Mortgage backed security that it is almost impossible to figure out credit quality intelligently. If it is difficult for a full time analyst, think how difficult it is for part time investor!
So what does an average investor do to invest intelligently in financial firms. Here are few things that an investor can do that were derived from Warren's advice.
1. Culture of an organization: This is difficult to evaluate for an outsider. But getting a handle on this is priceless. CEO sets the culture from top. One way to evaluate is by reading up as much about CEO as possible. The annual letters are a good start to verify if the CEO provides a thoughtful evaluation of future or just presents only rosy scenario.
2. CEO must be the chief risk officer: Warren stated that CEO must be the chief risk officer. An organization with CEO who is risk conscious will invariably respond by being risk conscious. Risk metrics in that case are no longer abstract tool output but management task.
3. Keep it simple. Complexity is enemy of a good investor and a good manager. Complex dervatives, CDO's, off balance sheet SIV's and so on are not easy to follow for a reason. They cannot be judged easily. Less complex assets ensures that management as well as the investor will have better handle. My thinking in this line is also to be careful before investing in huge financial entities that are difficult to manage even for a CEO much less for an investor to get an handle. Exceptions always exist like Berkshire Hathaway.
3. Leverage: Financial companies by definition have leverage. But it is best to stay away from those with huge leverage or at least understand what you are doing when you buy a company with huge leverage.
4. Management has skin the game: This does not make the company immune from disasters. But atleast you know that management has incentive to take only those risks that are prudent.
5. Cost conscious CEO/organization: I add this based on reading Warren Buffet's biography as well as his preference for organizations with low over head (including his own). Warren likes entrepreneurs who are very conscious of cost. There is a story of an entrepreneur coming late to a meeting with Warren in order to find unexpired parking meter. This cost conscious nature permeates other aspects of decision making and results in a prudent risk taking. I do not have solid evidence but this attribute seems to be more important than the obivios cost savings it produces. It highlights a culture.
5. Bottom line, Do not buy if you do not have very high confidence on the management. With out that, it is difficult to get a handle on risks. Except CEO, no one else can resist the urge to make huge profits in a division even if they will result in future losses. So CEO is your best margin of safety.
On a personal note, I stayed away from AIG because I did not know enough about management. I read that Chris Davis (Selected fund manager) called for new management to be hired from outside the board. I could sense a lack of satisfaction with management selection. So I stayed away. Short of this, there is no other reason to stay away from bargain priced AIG at that time. It is possibly luck and limited of funds too! But a visit to Berkshire always pays for itself!
Welcome your thoughts....
Warren said that he would invest in financial sector only if he has confidence about the management. He added that in a sector where the earnings are nothing more than guesstimates, management character is the most important attribute.
This is a profound statement that merits closer attention. Many full time analysts have gone through balance sheets of big banks but did not forsee such big write offs. In some cases, the sheer complexity of some of the loan products made it difficult to make meaningful judgement of asset quality. This is further compounded by off balance sheet nature of loans plus relying on financial models that assumed housing price will not decline did not help either. Irrespective of reasons, end result is huge write offs resulting in dilutive capital raisings or firms going bankrupt.
An example of complex product is CDO (Colaterized debt obligation). A CDO is made up of so many different combinations of Mortgage backed security that it is almost impossible to figure out credit quality intelligently. If it is difficult for a full time analyst, think how difficult it is for part time investor!
So what does an average investor do to invest intelligently in financial firms. Here are few things that an investor can do that were derived from Warren's advice.
1. Culture of an organization: This is difficult to evaluate for an outsider. But getting a handle on this is priceless. CEO sets the culture from top. One way to evaluate is by reading up as much about CEO as possible. The annual letters are a good start to verify if the CEO provides a thoughtful evaluation of future or just presents only rosy scenario.
2. CEO must be the chief risk officer: Warren stated that CEO must be the chief risk officer. An organization with CEO who is risk conscious will invariably respond by being risk conscious. Risk metrics in that case are no longer abstract tool output but management task.
3. Keep it simple. Complexity is enemy of a good investor and a good manager. Complex dervatives, CDO's, off balance sheet SIV's and so on are not easy to follow for a reason. They cannot be judged easily. Less complex assets ensures that management as well as the investor will have better handle. My thinking in this line is also to be careful before investing in huge financial entities that are difficult to manage even for a CEO much less for an investor to get an handle. Exceptions always exist like Berkshire Hathaway.
3. Leverage: Financial companies by definition have leverage. But it is best to stay away from those with huge leverage or at least understand what you are doing when you buy a company with huge leverage.
4. Management has skin the game: This does not make the company immune from disasters. But atleast you know that management has incentive to take only those risks that are prudent.
5. Cost conscious CEO/organization: I add this based on reading Warren Buffet's biography as well as his preference for organizations with low over head (including his own). Warren likes entrepreneurs who are very conscious of cost. There is a story of an entrepreneur coming late to a meeting with Warren in order to find unexpired parking meter. This cost conscious nature permeates other aspects of decision making and results in a prudent risk taking. I do not have solid evidence but this attribute seems to be more important than the obivios cost savings it produces. It highlights a culture.
5. Bottom line, Do not buy if you do not have very high confidence on the management. With out that, it is difficult to get a handle on risks. Except CEO, no one else can resist the urge to make huge profits in a division even if they will result in future losses. So CEO is your best margin of safety.
On a personal note, I stayed away from AIG because I did not know enough about management. I read that Chris Davis (Selected fund manager) called for new management to be hired from outside the board. I could sense a lack of satisfaction with management selection. So I stayed away. Short of this, there is no other reason to stay away from bargain priced AIG at that time. It is possibly luck and limited of funds too! But a visit to Berkshire always pays for itself!
Welcome your thoughts....
Tuesday, June 10, 2008
RV - Winnebago and Tho industries
It is no secret that high gas prices, high food prices and slow economy results in reduced discretionary spending. Recreational vehicles are purchases that can definitely be delayed or even avoided during a slow economy. So why am I interested? One word, prices. Lets look at other aspects of this business.
Business or competitive advantages:
WGO produces motorized homes.
1. WGO owns leading market share in Class A and Class C combined (18.8%). Second higherst market share in Class A (21.6%) and next only to Fleetwood which is 23%. Highest markets share in Class C (24.5%).
2. Has good brand equity and name recognition in the industry. WGO has received Quality Circle awards for past 11 years. Quality is achieved by state of art technology and manpower.
3. The leading market share, brand name, high product price and quality points closer to franchise type business rather than commodity type business. Since many of WGO customers are well to do and since the product prices range higher than $60,000 price is not the only consideration during purchase. It is a luxury item and does not lend to competition on price alone.
4. RV Business will have a need as long as people take vacations. While fuel prices and slow economy can be a damper in the short run, people will continue to take vacation 5 or 10 years from now. If fuel prices increase, it will increase transportation cost for all means of transport and RV will likely be comparable to others. Plus the high end customers that WGO targets are less affected by gas prices than the average Joe.
5. Company is not unionized and hence can shutdown plants to remain profitable during soft markets.
Growth drivers:
1. The demographics is in WGO's favor. The 50 year and older market is increasing and every year and this segment is the one most likely to choose RV. The current baby boomer population is between ages 44 to 62 years.
2. Fragmented market: The current market is weak and WGO is profitable even in soft 2007 market. 2008 will also likely be soft. Many other competitors are weak. This can lead to their going out of business or being acquired resulting in lesser competition when economy turns around.
3. Company has leading market share in Class C which is smaller and more likely attractive under higher gas prices.
Business or competitive advantages:
WGO produces motorized homes.
1. WGO owns leading market share in Class A and Class C combined (18.8%). Second higherst market share in Class A (21.6%) and next only to Fleetwood which is 23%. Highest markets share in Class C (24.5%).
2. Has good brand equity and name recognition in the industry. WGO has received Quality Circle awards for past 11 years. Quality is achieved by state of art technology and manpower.
3. The leading market share, brand name, high product price and quality points closer to franchise type business rather than commodity type business. Since many of WGO customers are well to do and since the product prices range higher than $60,000 price is not the only consideration during purchase. It is a luxury item and does not lend to competition on price alone.
4. RV Business will have a need as long as people take vacations. While fuel prices and slow economy can be a damper in the short run, people will continue to take vacation 5 or 10 years from now. If fuel prices increase, it will increase transportation cost for all means of transport and RV will likely be comparable to others. Plus the high end customers that WGO targets are less affected by gas prices than the average Joe.
5. Company is not unionized and hence can shutdown plants to remain profitable during soft markets.
Growth drivers:
1. The demographics is in WGO's favor. The 50 year and older market is increasing and every year and this segment is the one most likely to choose RV. The current baby boomer population is between ages 44 to 62 years.
2. Fragmented market: The current market is weak and WGO is profitable even in soft 2007 market. 2008 will also likely be soft. Many other competitors are weak. This can lead to their going out of business or being acquired resulting in lesser competition when economy turns around.
3. Company has leading market share in Class C which is smaller and more likely attractive under higher gas prices.
Tuesday, May 27, 2008
Whats attractive about Carmax
Carmax:
I recently received Carmax annual report and in any investment, few important factors determine it's success. I have tried to distill few important items that may attract you towards further research.
Moat or whats special :
1. Carmax primarily sells automobiles that are 1 to 6 years old. It's main competitor is new car dealer franchise. Independent dealers usually sell cars with average of 100,000 miles or more and are not direct Carmax competitor. In fact Car max auctions off older cars to these independent car dealers.
2. A new car dealer on average sells around 110 new and old cars per month. A Car max location sells around 425 used cars per month. The higher per location sales results in leverage of fixed costs. This results in scale. In addition, customers can choose a car from a different location and transfer it to their site using their website. Overall both these attributes provides much better scale than new car dealers.
3. Carmax's another advantage is no haggle pricing for customer thereby providing a plesant customer experience while buying a car. (Think last time you were in new car dealer.)
4. Car max sales associate's incentives are structured based on volume. They receive the same commision irrespective of whether they sell an expensive car or a economy model. So they do not gain by pushing one car over other or more expensive ones that the customer does not want. In addition, sales associates do not make any money from financing and hence help customer with the plan that suits them best. Overall a pleasant consumer experience.
5. Carmax prides in selling only high quality cars in it's retail outlet. Anyone shopping for used car knows the importance of buying quality cars (think peace of mind!).
6. Carmax has a wide selection of cars of all makes and model. This will easily beat the selection at a new car dealer.
7. One of the competitor that Carmax cannot beat on price is private party transactions. In this case, the customer has to do due diligence (check the vehicle with mechanic), negotiate price and wait for the right vehicle to appear in market. This requires lots of time and patience for both buyer and seller. Other than price, Carmax can compete favorably on other factors (like wide selection, no haggle pricing, high quality vehicles and one stop financing) with private transactions. Having said that, private party transactions will still be a viable competition that will co-exist and the market place is big enough to provide enough opportunities for Carmax.
Management
8. Carmax has won many awards for ethical behavior towards customers, employees and shareholders. This throws light on culture of the place and is less prone to poor management.
9. Management has said that growth will be slowed if performance at stores are reduced. They have done this in the past and is a positive indication of management quality. That is, growth only when it makes sense. (Think what fast growth did to Krispy Kreme.)
Growth Drivers:
10. Carmax currently has 89 superstores. They cover roughly 43% of population now. So at the minimum, they can become slightly more than 2 times their current size. My guess is it can be more than that.
11. Carmax plans to expand 15% per year. So it will be at least 5 years before their growth slows down.
12. New stores mature in 5 years. So same store sales should be robust as stores mature. Management expects 4 to 8% same store sales though it wont be even in all years.
13. In mature markets, Carmax owns 8% market share. It is possible to grow this too!
So growth drivers are new store opening, maturing of recently opened stores and increase market share.
Numbers
14. Return on invested capital is around 10 to 12%. I think this figure understates real return because newer stores mature over 5 years. So after maturity, this figure will be higher.
15. ROE is decent and between 14 to 18% depending on year.
16. Their debt is not much of a concern. Their long term debt to equity is less than 25%. Long term Debt (including other long term debt) to earnings is less than 2 times earnings . Much of the growth is equity financed. They retain all the earnings.
Valuation:
17. Assuming, Carmax rolls out as planned and doubles it's store count in 5 years (likely scenario), then it's earnings will double. Likely it will be more than double due to same store sales growth of newer stores.
Currently for 2009, Carmax is forcasting $.78 eps to $.92 eps. Note that 2009 Fiscal is a slow economy year and hence normal year eps should be higher than this. Lets assume eps in normal year will be $.90. So it is not unreasonable to think that in 5 years it will double it's eps (conservative estimate) due to store count doubling plus same store sales growth of 4% will result in eps of $2.
Lets assume P/E after 5 years will be 18 (which as per DCF would mean free cash flow increases by 3% per year from that point and 10% discount rate). This is reasonable assumption considering newer stores will still be maturing over 5 year period. So valuation after 5 years will be $36. So if Carmax is purchased at around $18, it will result in nice 14% per year return. Note that we have made conservative estimates.
Other
18. Davis advisors own 15%, Berkshire owns 10% and Dodge and cox holds 7%. Never buy because others buy but when all value investors aggregate, it is atleast worth looking further!
Let me know your feedback and if you will be interested in more such writing.
I recently received Carmax annual report and in any investment, few important factors determine it's success. I have tried to distill few important items that may attract you towards further research.
Moat or whats special :
1. Carmax primarily sells automobiles that are 1 to 6 years old. It's main competitor is new car dealer franchise. Independent dealers usually sell cars with average of 100,000 miles or more and are not direct Carmax competitor. In fact Car max auctions off older cars to these independent car dealers.
2. A new car dealer on average sells around 110 new and old cars per month. A Car max location sells around 425 used cars per month. The higher per location sales results in leverage of fixed costs. This results in scale. In addition, customers can choose a car from a different location and transfer it to their site using their website. Overall both these attributes provides much better scale than new car dealers.
3. Carmax's another advantage is no haggle pricing for customer thereby providing a plesant customer experience while buying a car. (Think last time you were in new car dealer.)
4. Car max sales associate's incentives are structured based on volume. They receive the same commision irrespective of whether they sell an expensive car or a economy model. So they do not gain by pushing one car over other or more expensive ones that the customer does not want. In addition, sales associates do not make any money from financing and hence help customer with the plan that suits them best. Overall a pleasant consumer experience.
5. Carmax prides in selling only high quality cars in it's retail outlet. Anyone shopping for used car knows the importance of buying quality cars (think peace of mind!).
6. Carmax has a wide selection of cars of all makes and model. This will easily beat the selection at a new car dealer.
7. One of the competitor that Carmax cannot beat on price is private party transactions. In this case, the customer has to do due diligence (check the vehicle with mechanic), negotiate price and wait for the right vehicle to appear in market. This requires lots of time and patience for both buyer and seller. Other than price, Carmax can compete favorably on other factors (like wide selection, no haggle pricing, high quality vehicles and one stop financing) with private transactions. Having said that, private party transactions will still be a viable competition that will co-exist and the market place is big enough to provide enough opportunities for Carmax.
Management
8. Carmax has won many awards for ethical behavior towards customers, employees and shareholders. This throws light on culture of the place and is less prone to poor management.
9. Management has said that growth will be slowed if performance at stores are reduced. They have done this in the past and is a positive indication of management quality. That is, growth only when it makes sense. (Think what fast growth did to Krispy Kreme.)
Growth Drivers:
10. Carmax currently has 89 superstores. They cover roughly 43% of population now. So at the minimum, they can become slightly more than 2 times their current size. My guess is it can be more than that.
11. Carmax plans to expand 15% per year. So it will be at least 5 years before their growth slows down.
12. New stores mature in 5 years. So same store sales should be robust as stores mature. Management expects 4 to 8% same store sales though it wont be even in all years.
13. In mature markets, Carmax owns 8% market share. It is possible to grow this too!
So growth drivers are new store opening, maturing of recently opened stores and increase market share.
Numbers
14. Return on invested capital is around 10 to 12%. I think this figure understates real return because newer stores mature over 5 years. So after maturity, this figure will be higher.
15. ROE is decent and between 14 to 18% depending on year.
16. Their debt is not much of a concern. Their long term debt to equity is less than 25%. Long term Debt (including other long term debt) to earnings is less than 2 times earnings . Much of the growth is equity financed. They retain all the earnings.
Valuation:
17. Assuming, Carmax rolls out as planned and doubles it's store count in 5 years (likely scenario), then it's earnings will double. Likely it will be more than double due to same store sales growth of newer stores.
Currently for 2009, Carmax is forcasting $.78 eps to $.92 eps. Note that 2009 Fiscal is a slow economy year and hence normal year eps should be higher than this. Lets assume eps in normal year will be $.90. So it is not unreasonable to think that in 5 years it will double it's eps (conservative estimate) due to store count doubling plus same store sales growth of 4% will result in eps of $2.
Lets assume P/E after 5 years will be 18 (which as per DCF would mean free cash flow increases by 3% per year from that point and 10% discount rate). This is reasonable assumption considering newer stores will still be maturing over 5 year period. So valuation after 5 years will be $36. So if Carmax is purchased at around $18, it will result in nice 14% per year return. Note that we have made conservative estimates.
Other
18. Davis advisors own 15%, Berkshire owns 10% and Dodge and cox holds 7%. Never buy because others buy but when all value investors aggregate, it is atleast worth looking further!
Let me know your feedback and if you will be interested in more such writing.
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