Reading List - May 14, 2011

YUM! bids for Little Sheep

YUM! (ticker: YUM) bids for Little Sheep.  Little Sheep is a "hot pot" concept restaurant based in China.  Customers essentially dip vegetables in boiling broth.  YUM has been betting on growth in the China market since the 1980's when introducing the Kentucky Fried Chicken brand to China.  The company has changed the image of its US brands to fit Chinese preferences and has been successful.  Simply, going to a KFC or Pizza Hut in the United States is completely different than going to one in China.

From a business standpoint, this makes sense.  Acquiring the brand completely gives the company increasing exposure to the Chinese consumer.  It can also bring the brand to the United States.  Asian style food is definitely on the rise of consumer preferences in the United States, as evidenced by brands like Panda Express or Flat Top Grills expanding.

U.S. Fast-Food Giant Yum Bids for Chinese Chain (click here)

Stocks vs. commodities

From CNBC:

Commodities have lost their luster for leading investment strategists on fears that global economic growth, particularly Chinese demand, may be lower than previously expected.

"While we would wait for a better entry point, we believe the cyclical bull market in equities is not over and would buy any summer weakness in stocks, Michael Hartnett, Merrill Lynch's chief global equity strategist, wrote in a report, in which he favors U.S. and emerging markets over Europe and Japan.

Defensive stocks are preferred to cyclical ones, JP Morgan said, arguing that the economic indicators show the global manufacturing sector is experiencing an inventory correction similar to the one seen around the middle of last year.

Defensive stocks are not the only ones that should perform well this year, according to Merrill Lynch. Companies with strong and stable profit growth are also expected to thrive as corporate earnings decelerate in general and the Federal Reserve prepares to reduce monetary stimulus, it said.

Time to Move Some Money from Stocks to Commodities (click here)

Reading List - May 3, 2010

"Negative Outlook" is not even close...

Martin Weiss, Weiss Ratings, appeared on CNBC.  According to Weiss Ratings methodology, the US sovereign rating should be 'C' or similar to a BBB rating given by either Moody's or S&P.  The 'C' rating is based purely on statistics and there are no qualitative factors considered.  The only way to get ourselves out of this mess it appears is to cut government spending (i.e. reform entitlements) and enact pro-growth policies.  No nation is history has taxed its way to prosperity.  According to Weiss on CNBC:

A 'C' is equivalent to approximately a triple-B on the S&P, Moody's and Fitch scales. It's two notches above junk and one notch above the equivalent of a single A," Martin Weiss, President of Weiss Ratings, told CNBC Tuesday.

Weiss was quick to add that while the rating seems weak, the debt situation is not in a danger zone that would trigger panic, noting that there was still broad market acceptance for Treasurys.

The grade reflects the U.S. massive debt burden, low international reserves and the volatility in the American economy, he said.

David Einhorn: The Fed's Policy is Backfiring

To quote CNBC:

A recent letter from Einhorn's Greenlight Capitol argues that fear of inflation is causing investors to sell bonds and avoid housing, leading both to slump.

Inflation fears are also driving up commodities prices, the letter argues.

From the letter:

Here in the United States, our fears that quantitative easing would be a net harm to economic activity appear to be playing out. The prices of things people actually pay for including food, energy and healthcare continue to go up at an accelerated pace ...

While Chairman Bernanke claims that quantitative easing has succeeded in raising stock prices, it seems that equities have gone up for the opposite reason he proposed. According to Mr. Bernanke, Federal Reserve purchases of government bonds were supposed to raise their price so that they would be less attractive than other investments, including housing and equities. Investors would note the disparity and “rebalance” their portfolio to buy more houses and stocks, which would appear cheap compared to higher bond prices. This would support the housing recovery and make the equity market rise.

Instead, it appears that in response to quantitative easing, investors now fear inflation and have sold bonds. Interest rates have risen and housing prices have declined further. The housing recovery has faltered, creating another negative wealth effect and putting additional strain on the banking system. The money that the private sector would have lent to the government, had the Federal Reserve not printed the money instead, has gone to other goods, notably commodities and stocks to the extent investors see them as a better inflation hedge than bonds. Though the Federal Reserve has produced “research” that purports to show that quantitative easing has not caused commodity prices to rise, many observers disagree. As the Bank of Japan put it in March, “[I]t is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand for commodities and investment flows into commodity markets.”

David Einhorn: The Fed's Policy is Backfiring (click here)
Full letter (click here)

Higher rates mean severe recession

According to this strategist, it may be time to end the ultra-low interest rate policy central banks around the world have pursued.  Recently, the economy has underperformed what should be expected out of the economy.  This strategist believes a slowdown will occur in the fall.  The difference between this slowdown and the last slowdown is central banks will be raising rates going into it which may make the recession that much deeper.

Higher Rates Mean Severe Depression (click here)

Jack Welch on "free money"

Jack Welch essentially believes the easy money policy of the Federal Reserve will cause problems, as "free money" in the hands of smart people causes problems.  To quote Welch on CNBC:

"Free money in the hands of very smart people for too long is going to create something that's not very pleasant," Welch said. "I don't know what it exactly is. But every time we get free money to lots of people who are very, very smart and know how to use it you end up with a bubble or a problem that we don't quite see in front of us."

'Free Money' About to Cause Big Problem: Welch (click here)

Stocks signaling inflation

Typically, stocks underperform when inflationary expectations increase.  This time around it is different.  As commodities prices keep rising, stocks are rising as well.  So, is economic theory actually playing out?

What Are Stocks Saying About Inflation? (click here)

Reading List - May 1, 2010

Besides, I cannot believe it is already May, I have added some new articles of interest...


The Woodstock of Capitalism


Warren Buffett, annual shareholder meeting has been going on.  Highlights include:

1. Buffett is taking a hard line against the David Sokol/Lubrizol incident.  He has said that he should have been more vigilant in knowing about Sokol's trades.
2. His successor, although not named, is "straight as an arrow."
3. Due to Japanese earthquake, Berkshire may have to incur the first underwriting loss in years
4. The "elephant gun" is still loaded.  The Sokol/Lubrizol incident will not slow Buffett down and look forward to future deals.  Most likely, the deals will be overseas (i.e. India)
5. Berkshire's value would go down if Berkshire paid a dividend.  It would signal to the market Mr. Buffett could not re-invest capital at a high enough hurdle rate.

Buffett Still Stands To Build Wealth for Shareholders: Gabelli (click here)
Berkshire Gets Tough With Sokol As Meeting Nears (click here)
Berkshire May Have Underwriting Loss on Disasters (click here)
Guessing Game Builds Over Buffett's Next Deal (click here)
Berkshire Stock Would Drop If Company Began Paying Dividend (click here)

Bernanke & inflation

I couldn't agree with this analysis anymore! From CNBC:

...But quantitative easing does seem to be doing a good job of creating inflation expectations. As Larry Kudlow pointed out yesterday, “inflation-sensitive market-price indicators — like rising gold, oil, and commodity indexes, and the falling dollar exchange rate — are trying to signal higher future inflation.”

I suspect that the cause of this breach between inflation expectations and reality is that we have so little experience with these unconventional policies. Markets understand pretty well how to anticipate the future consequences of the ordinary Fed policies like targeting interest rates. But the very newness of quantitative easing means that the outcome is difficult to predict...

The irony is that nearly everyone is misreading what has happened.

What Bernanke is worried about is not that we’ll get too much inflation—he knows he can just put a stop to inflation by hiking rates—but that anticipation of inflation will get out of hand. And that is something he cannot directly control.

Inflation Expectations and New Monetary Policy (click here)

Is the silver rally sustainable?

From marketwatch.com:

We have now entered just the beginning of the third [and final] phase of the bull market in precious metals” — the phase in which everyone has become aware of the bull market but aren’t yet engaged and involved in it, he said. The third phase is far from over but when it ends, “precious metals will become a bubble with heavy public participation...

...Karnani never expected, however, that silver would be near $50 by the end of April.
“I am not bearish on silver. I am only concerned over the pace of the rise of silver,” he said. “For long-term sustainability, silver prices must fall for a week and then rise. If silver prices continue to rise, then a bubble will be formed and silver prices can crash to $25 next year.”

$50 Silver Price Screams Caution (click here)

Weak dollar, strong stocks

Kudlow & Co. clip feat. Rick Santelli (click here)

Thoughts on the Fed's first press conference

The Federal Reserve made history yesterday by having its first press conference.  Key takeaways include:

• Economy is weaker than planned.  As a result, the Fed has reduced its full-year forecast for economic growth slightly.
• Fed intends to intend QE2, but will maintain the size of the balance sheet.  There is little possibility of QE3.
• The end of the "extended period" is a couple of Fed meetings away
• Ending reinvesting is tightening of monetary policy
• The value of the USD is the problem of the U.S. Treasury, not the Federal Reserve.

My thoughts on the press conference:

• Yes, the USD is more of the problem that should  be dealt by the U.S. Treasury.  But, the issue is that Chairman Bernanke is not taking blame for the policies that he's pursuing is one of the primary causes of the fall in value of the USD
• Chairman Bernanke did not take blame for the rise in commodity prices as calling them "transitory" or temporary.  A few moot points.  First, around 80% of the world's commodities are traded in USD.  Second, when there are negative real interest rates, the inflation trade (i.e. commodities) is going to be on steroids.  Thus, Bernanke (as with the USD) not taking at least partial blame for the rise in commodities was troubling.
• The overall tone of his messages were not hawk-ish, but at least less dove-ish.
• In a previous post, I posted an article that likened Fed policy to house party gone mad.  I still stick with that assessment.  As before, the market was usure whether there would be a QE3, this means the party could go onto in the morning.  Now, at least with implicit no to QE3, the party is going to keep going, but end at 6 am and could end badly.
• I'm bearish on the market following QE2 because of the reaction to the news of the press conference.  During the conference, the USD hit a new three-year low.  In addition, there is extreme complacency in the market when one looks at how gold trades, stocks continuing to go up, and little volatility as measured by the VIX.

How should investors play the market:

A CNBC article highlighting last night's Fast Money show hits the nail on the head, in my opinion.

Trader Brian Kelly also found Ben Bernanke’s comments bullish for stocks. “If there's going to be even a minor uptick in inflation investors will put money to work in assets that will beat inflation and that makes the stock market the place to be. The outcome is a much higher stock market.”

Company Analysis - National Presto Industries (NPK)

I do not want to appear as a genius or sly investor.  I was reading an article on thestreet.com that highlighted National Presto Industries (ticker:NPK) and felt it was a company that I would be interested in analyzing and potentially adding to my portfolio one day.  Investing in these names offers huge upside as they may continue to grow (higher price and higher dividends) and may be undervalued leading to be a potential buyout target.  NPK did not appear on those screeners since the regular dividend it pays is low and yields less than 1%.

Note: I have changed the DCF model I have used to value NPK slightly.  I do not believe it would have a material impact on other companies I have highlighted on this blog.  I feel this new methodology is cleaner and more transparent.  As always, if you feel an investment idea is worth pursuing, please do additional research and/or contact a financial advisor.

Firm overview

National Presto Industries (ticker: NPK) is a diversified manufacturing company.  The company operates in three key segments: housewares/small applianes, defense products, and absorbent products.  Housewares/small appliances include the wide variety of Presto products, which can be found at Wal-Mart; Wal-Mart is a major customer.  Defense products sell products to the U.S. Department of Defense.  Absorbent products include the sale and manufacture of adult diapers.

Investment rationale

Key reasons to initially look at this company include the low valuation and high dividend yield (after factoring in the annual special dividend).  Once an investor digs deeper in the company, an investor finds a company that has solid management who generates cash effectively and effective re-invests cash in the business.  This is proven by increasing returns on common equity.

But, like most manufacturers, NPK is highly tied to the recovery of the U.S. economy.  Most of its products are sold through Wal-Mart and most of household items they sell are discretionary.  As consumers become more confident, they will begin to purchase discretionary items like small appliances.  If Wal-Mart’s sales increase, so should NPK’s.  One interesting sidenote is although NPK’s household appliances are primarily sold through Wal-Mart, the firm has found a way to increase margins over the past ten years.  As a potential investor, this indicates to me the firm has effective costs controls and/or can pass on higher costs to consumers (both are pluses).

Key risks NPK include the concentration of customers.  Like the Wal-Mart scenario stated above, NPK also heavily relies on the U.S. Department of Defense.  If U.S. defense spending is materially reduced or NPK loses any contracts for whatever reason, this may have a material impact on the earnings power in the future.

Sales & profitability

Total sales have grown from $119.1 million to $479.0 million in the years 2001 to 2010.  When compounded, this is 16.7% per year.  The firm only had one year of negative profitability; the year was 2001. 

In addition, the firm has increased gross margins, operating margins, and net margins during this time.  Gross margins increased from 21.0% to 23.7%.  Operating margins have increased from -1.9% to 20.3%.  Net profit margins increased from 5.3% to 13.3%.  Net profit increased from $6.3 million to $63.5 million.  When compounded, this is 29.3% per year.

	Sales	Net profit
2001	$119.1	$6.3
2002	$124.8	$8.7
2003	$125.7	$15.5
2004	$159.0	$15.4
2005	$184.6	$16.4
2006	$304.7	$28.0
2007	$420.7	$38.6
2008	$448.3	$44.2
2009	$478.5	$62.6
2010	$479.0	$63.5

Do these trends indicate NPK has a durable competitive advantage?  Sales are increasing; which is positive.  A firm with a d.c.a. typically has a gross margin of 40% or greater.  At year-end 2010, NPK had a gross margin of 23.7%; over the ten years analyzed, this ratio was consistent, which is a plus.

Capital structure

The firm does not have any outstanding debt.  In addition, the firm typically holds plenty of cash on balance sheet, in addition to investments in marketable securities.  Per the Form 10-K, municipal bonds make up a majority of the investments in “marketable securities.”  Per the Form 10-K, marketable securities are sold in order to meet short-term liquidity needs.

Do these trends indicate NPK has a durable competitive advantage?  Yes.  Firms with a d.c.a. typically do not hold any debt, or little debt in general.  NPK does not hold any debt, in addition to being cash rich.  At year-end 2010, NPK had a current ratio of 5.2; in other words, NPK had 5.2x more current assets than current liabilities.

Capital efficiency

Since the firm does not have any debt, leverage should not play a huge role in capital efficiency.  The most common metric for capital efficiency is return on common equity (ROCE).  ROCE for NPK has increased since 2001; ROCE increased from 2.7% to 18.5%.  Long-term investors typically like to see high, consistent ROCE.  The fact ROCE has been increasing each year indicates NPK’s management is making productive use out of retained earnings; this should continue to increase in the future.

	Return on common equity
2001	2.7%
2002	3.6%
2003	6.3%
2004	6.0%
2005	6.2%
2006	10.0%
2007	13.1%
2008	14.2%
2009	18.6%
2010	18.5%

A favorite metric of Warren Buffett is return on unlevered net tangible assets.  Mr. Buffett has said a “great” company has a return of 25% or greater; this ratio can exceed 100%.  Return on unlevered net tangible assets has increased from -1.5% to 34.3%.

Dividends and share repurchase

NPK does pay a dividend, but does not engage in a share repurchase program.  Annually, the firm pays a regular dividend of $1 once a year.  Given the current closing price of around $111 per share, this equates to a dividend yield of less than 1%.  In addition, the firm pays a special dividend based on the previous year’s profitability once a year. 

NPK paid a total dividend of $8.25 per share earlier this year; this is a $0.10 increase from the previous year.  Since 2001, the dividend grew approximately at a rate of 16.9% per year.  The dividend growth rate is slower than rate in growth of net income; net income increased 26.9% during the same time.

	Dividend
2001	$2.00
2002	$0.92
2003	$0.92
2004	$1.17
2005	$1.67
2006	$2.12
2007	$3.80
2008	$4.25
2009	$5.55
2010	$8.15

Since the situation is different for NPK as most of the yield is from the special dividend, it is important to look at previous years to spot a trend.  The payout ratio, when using net income, has varied fro m 40.6% to 218.8%.  The payout ratio, when using free cash flow, has varied from being negative to 138.7%.  In 2010, when using net income, the dividend payout ratio was 88%.  This payout ratio is high, but should not be considered alarming; the firm elects to return cash to shareholders through this special dividend versus share repurchase.  When combined, both dividends and share repurchase frequently exceed either 100% of net income of free cash flow.

	Dividend payout ratio
2001	218.8%
2002	72.4%
2003	40.6%
2004	51.7%
2005	69.4%
2006	51.8%
2007	67.2%
2008	65.8%
2009	60.7%
2010	88.0%

If an investor is specifically looking at NPK as a dividend play, it is important to invest with a higher margin of safety.  When using the methodology I used to value this stock, I considered only the $1 regular dividend in my analysis (please see valuation section below).

In the valuation section below, I make some assumptions for the valuation.  If those assumptions hold true and the firm pays out 70% of earnings to shareholders, NPK should pay a dividend of approximately $7.00 in 2012.  The dividend yield would be 4.9% on the intrinsic value calculated or would have a yield-on-cost of 6.34% if the investor were to buy shares at the most recent closing price.  Given a payout ratio of 80%, the firm should pay a dividend of approximately $8.00 in 2012.   

Valuation

Using a DCF valuation model, I calculate the intrinsic value of NPK to be $144.20 per share.  This value is approximately $32.85 higher than the most recent closing price, giving an investor an actual margin of safety of 22.8%.

Key inputs into this model include 6% annual growth and a 19% EBITDA margin.  As for most investments, I like to use a 15% risk-adjusted discount rate.  In my opinion, since NPK has no short-term or long-term debt, the firm has approximately 80% the financial risk of the average company.  Due to broad product line, reliance on government contracts, and the impact of commodity prices, the firm has around 110% the risk of the average company.  When combined, this equates to a 13.2% discount rate.  Thus, given these inputs, the model produced an intrinsic value of $144.20 per share.

In addition, the price an investor should purchase NPK at given the level of risk is $112.21, or a 20.3% margin of safety to the intrinsic value.  The 20.3% margin of safety was calculated as I would like a 30% initial return for any stock.  After adjusting for 6% growth, the 0.9% dividend yield from the regular $1 dividend, and the business and financial risks mentioned above, the risk-adjusted margin of safety is 20.3%.

At current trading levels, the stock appears to be an attractive buy.

This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.