Hedge Funds
This week, the Managed Funds Association (MFA) is holding its conference in Palm Springs, FL.
Recently, the SEC and CFTC issued a new form stating that hedge funds should disclose their holdings quarterly to determine which ones are "too big to fail." Richard Baker, president of the MFA, believes no oversight is needed. Believers of more regulation over hedge funds often point to the failure of Long-Term Capital Management. In this instance, the Federal Reserve instituted a "Wall Street-style" bailout of the hedge fund. To counter this, Mr. Baker stated there are no hedge funds that are systemically important as Long-Term Capital was. In addition, hedge funds use less leverage today and investors are often pension funds and endowments. The industry is more transparent as a result of these pension fund and endowment investments as investors often perform more due diligence.
Is No Hedge Fund Too Big to Fail? (click here)
At this conference, much time appears to be spent to tell managers how to "woo" future investors. The jist of the story out of the conference is managers of large pension funds or endowments often have a strategy of their own. In addition, because of their large investment, they want concessions on pricing individual investors often cannot get. To help bag the "whale," an investment from a substantial client, hedge fund managers simply need to be patient and do their homework. This includes initiating the relationship with the pension fund, knowing the size of the fund and understanding the fund's investment strategy.
For Fund Managers, a Class in Raising Money (click here)
How a Hedge Fund Can Land a Whale (click here)
Massey Energy
Massey Energy, which has faced safety problems, will sell itself to Alpha Resources. When the deal is completed, the two companies will create the largest American coal producer. Also, Massey has a strong presence in metallurgical coal, which is used in steel.
Massey Energy Is to Be Sold to Alpha Natural Resources (click here)
Monday, January 31, 2011
Sunday, January 30, 2011
Reading List - Davos 2011
The World Economic Forum in Davos has been going on. I have not had any articles about the forum, so I thought I would touch on some of the more interesting articles for the readers of this blog.
The themes of the conference should come as of no shock to anybody. Key issues have been financial reform, saving the Euro, and how to increase growth in the West.
The Euro
As a currency, the Euro appears to be struggling politically and fighting for its "survival." At Davos, German Chancellor Angela Merkel went as far as to say, "...if the Euro fails, Europe fails." These are pretty strong statements as global leaders and investors are clearly looking to a strategy from Europe regarding the sovereign debt crisis that seems to overtaking Europe right now.
Essentially, the Euro issue boils down to this: there is a group of strong countries in Europe and weak countries at the periphery. In the strong countries, it is politcally unacceptable to continue to just give money to the peripheral countries to bail them out. As most leaders say, this isn't a strategy. To help the cris, the European Central Bank has continued to buy the bonds of Greece, Spain, and Ireland to keep yields low. The bank cannot continue to do this without losing credibility.
There appears to be no easy way out!
At Davos, No Clear Strategy to Save the Euro (click here)
Jamie Dimon
Jamie Dimon, CEO of JPMorgan Chase, had positive words coming from Davos regarding the global economy. For full disclosure, I own shares of JPMorgan, but highly regard Jamie Dimon as a CEO. During the financial crisis, JPMorgan did not take all of the "dumb" risk other banks did (i.e. Citi, Bank of America, etc.) and has become a stronger bank as a result.
In an interview on CNBC, Mr. Dimon stated there are plenty of positives and that everybody is looking for "black swan" events (an unforeseen event):
Overpriced equity markets
Robert Schiller, economics professor at Yale, stated he believes markets are overpriced. In addition, he believes we are operating in the "dual economy" dynamic, where emerging markets and the developed markets are growing at two different and diverging growth rates.
Stock Markets Are Overpriced: Robert Schiller (click here)
Company size and IPO's
Below is a clip from Barry Silbert, CEO of SecondMarket, which is an exchange for trading shares of private companies. In this short clip, Silbert highlights the short death the IPO market over the past few years. Key reasons for this is the minimum size for companies to go public, having to deal with onerous regulations like Sarbanes-Oxley, and having to focus on quarterly earnings versus the long-term profitability of the business.
Voices from Davos - video clip (click here)
So, I went back and tried to do a little more research on SecondMarket. I believe it is a very interesting service and will provide another outlet for qualified investors seeking "private equity-type" (my phrase) exposure. In addition to the reasons above, SecondMarket also provides investors a market for their shares when the financial crisis caused liquidity for micro-cap and small-cap names to dry up:
In some ways, the financial crisis drew interest in these types of funds. During the crisis, the market for initial public offerings dried up, denying company founders and venture capital firms one of their main ways to cash out. Many employees of start-ups have substantial parts of their net worth tied up in company stock, and some want or need to cash out.
Buying Shares in Private Start-Ups (click here)
Start-Ups Could Sell Their Shares Privately (click here)
This whole segment of the market is extremely interesting to me. Expect a post just about these private exchanges soon!
Davos Mistresses
On a lighter note, the wife of Joseph Stiglitz, wife of the Nobel Prize winning economist, had an interesting blog post about wives and mistresses at Davos.
Jealous Davos Mistresses (click here)
The themes of the conference should come as of no shock to anybody. Key issues have been financial reform, saving the Euro, and how to increase growth in the West.
The Euro
As a currency, the Euro appears to be struggling politically and fighting for its "survival." At Davos, German Chancellor Angela Merkel went as far as to say, "...if the Euro fails, Europe fails." These are pretty strong statements as global leaders and investors are clearly looking to a strategy from Europe regarding the sovereign debt crisis that seems to overtaking Europe right now.
Essentially, the Euro issue boils down to this: there is a group of strong countries in Europe and weak countries at the periphery. In the strong countries, it is politcally unacceptable to continue to just give money to the peripheral countries to bail them out. As most leaders say, this isn't a strategy. To help the cris, the European Central Bank has continued to buy the bonds of Greece, Spain, and Ireland to keep yields low. The bank cannot continue to do this without losing credibility.
There appears to be no easy way out!
At Davos, No Clear Strategy to Save the Euro (click here)
Jamie Dimon
Jamie Dimon, CEO of JPMorgan Chase, had positive words coming from Davos regarding the global economy. For full disclosure, I own shares of JPMorgan, but highly regard Jamie Dimon as a CEO. During the financial crisis, JPMorgan did not take all of the "dumb" risk other banks did (i.e. Citi, Bank of America, etc.) and has become a stronger bank as a result.
In an interview on CNBC, Mr. Dimon stated there are plenty of positives and that everybody is looking for "black swan" events (an unforeseen event):
Now people see black swans behind every rock...The fact is loans are up, financial conditions are terrific, companies are growing again...we think there's a lot of cash. You're talking about trillions on balance sheets earning zero. Eventually people are going to say, 'Zero isn't an adequate return, I want to do something different than that.'
Cash Is Flowing Again, Will Fuel Global Recovery: Dimon (click here)
Another thing I like about Jamie Dimon is he is not afraid to stand up for the banking industry. At Davos, Mr. Dimon said, "...he was sick of “this constant refrain — bankers, bankers, bankers.” Mr. Dimon said he is not against regulation, just against irrational regulation. In addition, I highly applaud Mr. Dimon for breaking with other banking heads and state that there should be an orderly process for banks that fail to be dissolved.
Stop Picking on Bankers, JPMorgan Chief Says (click here)
Robert Schiller, economics professor at Yale, stated he believes markets are overpriced. In addition, he believes we are operating in the "dual economy" dynamic, where emerging markets and the developed markets are growing at two different and diverging growth rates.
Stock Markets Are Overpriced: Robert Schiller (click here)
Company size and IPO's
Below is a clip from Barry Silbert, CEO of SecondMarket, which is an exchange for trading shares of private companies. In this short clip, Silbert highlights the short death the IPO market over the past few years. Key reasons for this is the minimum size for companies to go public, having to deal with onerous regulations like Sarbanes-Oxley, and having to focus on quarterly earnings versus the long-term profitability of the business.
Voices from Davos - video clip (click here)
So, I went back and tried to do a little more research on SecondMarket. I believe it is a very interesting service and will provide another outlet for qualified investors seeking "private equity-type" (my phrase) exposure. In addition to the reasons above, SecondMarket also provides investors a market for their shares when the financial crisis caused liquidity for micro-cap and small-cap names to dry up:
In some ways, the financial crisis drew interest in these types of funds. During the crisis, the market for initial public offerings dried up, denying company founders and venture capital firms one of their main ways to cash out. Many employees of start-ups have substantial parts of their net worth tied up in company stock, and some want or need to cash out.
Buying Shares in Private Start-Ups (click here)
Start-Ups Could Sell Their Shares Privately (click here)
This whole segment of the market is extremely interesting to me. Expect a post just about these private exchanges soon!
Davos Mistresses
On a lighter note, the wife of Joseph Stiglitz, wife of the Nobel Prize winning economist, had an interesting blog post about wives and mistresses at Davos.
Jealous Davos Mistresses (click here)
Thursday, January 27, 2011
Reading List - January 27, 2010
Deal Book was just awesome today! Maybe what made it a good day is all the IPO's.
Congressional report on financial crisis
Ask any two people and you'll get a whole list of responses as to whom was responsible for the financial crisis. The moral is a lot of people were involved. Today, the Financial Crisis Inquiry Commission finally released its report. Deal Book summed it up the best:
"The blow-by-blow chronicle of the Wall Street recklessness that led to the financial crisis is reminiscent of a legendary house party. The booze was flowing. Nobody wanted to leave. And the police didn’t bother to shut it down. While the bash is often great in the moment, the morning after usually isn’t pretty."
Everyone was to blame, Crisis Commission Finds (click here)
Full report (click here)
Ally IPO
It looks like the government is going to take another step from ridding itself of commitments made during the financial crisis and ensuing bailouts. The latest move is Ally Finanical (the former GMAC) starting the stages for an initial public offering. By being valued at over $20 billion, it appears the government is poised again to make a profit.
Banks Prepare to Compete for Ally Financial Stock Sale (click here)
Valuing Ally Financial (click here)
BankUnited IPO
In a coup for private equity investors, one of the banks private equity helped turnaround is going public shortly. Bank United was one of the more costly bank failures in U.S. history.
BankUnited Prices I.P.O at $27 a share (click here)
Prada IPO
Prada appears to be completing an IPO. As the article states, luxury retailers are at or near all-time high valuations. Looking at earnings from retailers like Tiffany & Co. or Nordstrom's, it appears the high end retailer is back. As a value investor, these are all great companies to invest in (although not at these valuations). Whether it be Tiffany's, Hermes, or now Prada, each has a distinguishing characteristic about its brand consumers are willing to pay a premium for creating an economic moat, pricing power, and thus high returns on equity. This is a perfect industry to be fearful when others are greedy and greedy when others are fearful, as Buffett says.
The interesting side note to the deal is Prada is listing in Hong Kong versus Europe or the U.S., as it is an European company. This deal is significant as it continues to point to Asia as the places for Western retailers to expand.
Prada Plans I.P.O in Hong Kong (click here)
Colonel Sanders Goes to China
Ok, this article is not from Deal Book, but rather Bloomberg. Either way, the article is about how YUM and McDonald's are going after the hearts and minds of the Chinese consumer.
McDonald's No Match for KFC in China as Colonel Rules Fast Food (click here)
Demi Moore
On a lighter note, Demi Moore is starring in a new film about Wall Street. She is going to play a female risk officer at a Wall Street bank.
Chief Risk Officer, Hollywood's New Sex Symbol (click here)
Congressional report on financial crisis
Ask any two people and you'll get a whole list of responses as to whom was responsible for the financial crisis. The moral is a lot of people were involved. Today, the Financial Crisis Inquiry Commission finally released its report. Deal Book summed it up the best:
"The blow-by-blow chronicle of the Wall Street recklessness that led to the financial crisis is reminiscent of a legendary house party. The booze was flowing. Nobody wanted to leave. And the police didn’t bother to shut it down. While the bash is often great in the moment, the morning after usually isn’t pretty."
Everyone was to blame, Crisis Commission Finds (click here)
Full report (click here)
Ally IPO
It looks like the government is going to take another step from ridding itself of commitments made during the financial crisis and ensuing bailouts. The latest move is Ally Finanical (the former GMAC) starting the stages for an initial public offering. By being valued at over $20 billion, it appears the government is poised again to make a profit.
Banks Prepare to Compete for Ally Financial Stock Sale (click here)
Valuing Ally Financial (click here)
BankUnited IPO
In a coup for private equity investors, one of the banks private equity helped turnaround is going public shortly. Bank United was one of the more costly bank failures in U.S. history.
BankUnited Prices I.P.O at $27 a share (click here)
Prada IPO
Prada appears to be completing an IPO. As the article states, luxury retailers are at or near all-time high valuations. Looking at earnings from retailers like Tiffany & Co. or Nordstrom's, it appears the high end retailer is back. As a value investor, these are all great companies to invest in (although not at these valuations). Whether it be Tiffany's, Hermes, or now Prada, each has a distinguishing characteristic about its brand consumers are willing to pay a premium for creating an economic moat, pricing power, and thus high returns on equity. This is a perfect industry to be fearful when others are greedy and greedy when others are fearful, as Buffett says.
The interesting side note to the deal is Prada is listing in Hong Kong versus Europe or the U.S., as it is an European company. This deal is significant as it continues to point to Asia as the places for Western retailers to expand.
Prada Plans I.P.O in Hong Kong (click here)
Colonel Sanders Goes to China
Ok, this article is not from Deal Book, but rather Bloomberg. Either way, the article is about how YUM and McDonald's are going after the hearts and minds of the Chinese consumer.
McDonald's No Match for KFC in China as Colonel Rules Fast Food (click here)
Demi Moore
On a lighter note, Demi Moore is starring in a new film about Wall Street. She is going to play a female risk officer at a Wall Street bank.
Chief Risk Officer, Hollywood's New Sex Symbol (click here)
Monday, January 24, 2011
Reading List - January 24, 2010
JCPenney & activist investors
JCPenney just announced two new members of its board - Bill Ackman of Pershing Square Capital Management and Steven Roth of Vornado Realty Trust - after disclosing large stakes in the retailer. The move by JCPenney is probably the boldest move recently of the reaction shareholder activism, as shareholder activism has recently been on the rise. For long-term investors, one positive move appears that neither man wants to financial engineer JCPenney to prosperity. Instead, they want to focus on JCPenney's core businesses.
2 Big Investors Get Their Say at J.C. Penney (click here)
Penney Shares Rise As Ackman and Roth Join Board (click here)
Below is a link to an article from late last year. In it, it highlights the difference between the increase in longer-term activist hedge funds that focus on improving the firm's core businesses versus increasing the value through financial engineering. These hedge funds typically have long lock-up periods where investors cannot receive the initial investment back for a 3-5 year period. Investors should demand a higher return for their investment. For 2010, some of these firms did extremely well being up over 30%.
For Activist Funds, Long-Term Approach to Investing (click here)
John Paulson
John Paulson, whose firm is Paulson & Co, just released his annual letter to investors regarding 2010. Essentially, Paulson has made some bets on a broad range of assets over his career including mortgages and gold. What I found extremely interesting is his breakdown of implementation and monetization. An example from Paulson's own experience, as the article states, is the implementation of shorting credit and monetizing it when the credit bubble burst in 2008.
At root, this is fundamentally the key to value investing or all of investing in general. When practicing value investing with stocks, the implementation is analyzing a company, calculating its intrinsic value, determining whether or not the intrinsic value is higher than the current market value, and purchasing the company. The monetization part is selling the company when the company meets its intrinsic value.
John Paulson Recaps Big Bets in Year-End Letter (click here)
JCPenney just announced two new members of its board - Bill Ackman of Pershing Square Capital Management and Steven Roth of Vornado Realty Trust - after disclosing large stakes in the retailer. The move by JCPenney is probably the boldest move recently of the reaction shareholder activism, as shareholder activism has recently been on the rise. For long-term investors, one positive move appears that neither man wants to financial engineer JCPenney to prosperity. Instead, they want to focus on JCPenney's core businesses.
2 Big Investors Get Their Say at J.C. Penney (click here)
Penney Shares Rise As Ackman and Roth Join Board (click here)
Below is a link to an article from late last year. In it, it highlights the difference between the increase in longer-term activist hedge funds that focus on improving the firm's core businesses versus increasing the value through financial engineering. These hedge funds typically have long lock-up periods where investors cannot receive the initial investment back for a 3-5 year period. Investors should demand a higher return for their investment. For 2010, some of these firms did extremely well being up over 30%.
For Activist Funds, Long-Term Approach to Investing (click here)
John Paulson
John Paulson, whose firm is Paulson & Co, just released his annual letter to investors regarding 2010. Essentially, Paulson has made some bets on a broad range of assets over his career including mortgages and gold. What I found extremely interesting is his breakdown of implementation and monetization. An example from Paulson's own experience, as the article states, is the implementation of shorting credit and monetizing it when the credit bubble burst in 2008.
At root, this is fundamentally the key to value investing or all of investing in general. When practicing value investing with stocks, the implementation is analyzing a company, calculating its intrinsic value, determining whether or not the intrinsic value is higher than the current market value, and purchasing the company. The monetization part is selling the company when the company meets its intrinsic value.
John Paulson Recaps Big Bets in Year-End Letter (click here)
YUM! Brands (YUM) Stock Analysis
OVERVIEW
About YUM!
YUM is the largest quick service restaurant company (QSR) based on the number of locations. YUM! has over 37,000 locations in 110 countries and territories. These locations are split through five primary brands: Kentucky Fried Chicken (KFC), Pizza Hut, Taco Bell, Long John Silver’s (LJS), and A&W.
KFC, Pizza Hut, Taco Bell, and Long John Silver’s have the highest market share in their respective categories. KFC has the largest relative portion of market share with slightly over 40%, which is 3x larger than the next nearest competitor. Pizza Hut is the market leader in ready-to-eat pizzas with 14% market share. Taco Bell operates in 20 countries and has 52% market share in its respective category.
In the mid-2000’s, YUM tried to adopt a dual branded approach with many of its stores. This approach meant combining brands like Taco Bell and Long John Silver’s together in one location. Since then, the company has abandoned this strategy due to operational issues and a negative response from consumers.
Of YUM’s five brands, the two lowest performing brands are Long John Silver’s and A&W. Of total locations, these two brands account for slightly more than 4% of the total locations combined. It was just recently announced that YUM intends to sell these two brands to focus on the other three brands to increase brand perception in the United States and grow these franchises abroad.
Growth strategy
In its reports to shareholders, YUM management highlights four key strategy objectives:
1. Build leading brands in China in every signifcant category
2. Drive aggressive international expansion and build strong brands everywhere
3. Dramatically improve U.S. brand positions, consistency, and returns
4. Drive industry leading long-term shareholder and franchisee value
Each of these key tenets relates well to YUM’s future, as YUM sees the key growth opportunities not in the United States, but in emerging market economies like China, India, and Africa. In my opinion, this is how YUM views itself at the current time. YUM accepts that the McDonald’s brand is too powerful of a brand in the United States and will accept being number two. But, China, India, and Africa all have economies with rising incomes, but low per capita QSR’s. Management intends to challenge McDonald’s in these countries by becoming the McDonald’s of emerging economies, with emphasis on the KFC, Pizza Hut, and Taco Bell brands.
Over the past few years, the perception of the YUM brands in the United States has slipped. Management has realized this and is working to rebuild the images of these brands. By shedding lower margin and performing LJS and A&W, management should be able to put more emphasis on these brands in the United States.
Increasing emphasis on these emerging economies is good for shareholders. These economies will grow at a faster rate than the United States. In addition, the currencies of these economies should strengthen against the USD making those earnings and cash flow worth more in USD. This will allow YUM to distribute more to shareholders through either dividends or share buybacks.
Risks to the growth strategy
I identify the following as risks to the growth strategy:
1. Commodity inflation
2. Local preferences for core products
3. Repatriation of cash for “U.S. cash needs”
First, commodity prices have a major impact on gross margins for YUM. In 2009, YUM saw slight margin expansion as food inflation was down from 2008. In 2010, there was a general increase in agricultural commodities. To maintain margins if there is inflation, YUM will need to increase prices and it will be interesting to see how consumers react.
Second, local preferences will be key as the company will face competition from strong U.S. brands like McDonald’s and Starbucks. The firm will need to continue to build quality franchises overseas that attract local consumers to continue building the brand.
Third, over 60% of cash is generated in internationally for YUM. YUM will need to pay dividends and fund stock buybacks with USD. It will be important to see if YUM can continue repatriating cash at local tax rates to fund these programs. If not, YUM will be forced to either reduce these programs or increase USD borrowings.
Refranchising
Although not explicitly part of the four key strategy objectives, YUM management seems focused on reducing the number of company owned franchises in the United States. In its 2009 annual report, the firm intends to reduce company owned franchises in the United States from 16% in 2009 to less than 10% by 2011. Doing this has both advantages and disadvantages for shareholders.
Advantages include more cash for the firm. First, by refranchising, the firm will receive cash from the sale. Second, because the firm is no longer responsible for the upkeep of these stores, it will require less cash for capital improvements. This will have a positive impact on free cash flow.
Disadvantages include franchisees obtaining the proper capital to effectively run the franchises and running the franchises in a matter that YUM would like for them to run them. Currently, YUM brands have a negative perception in the United States as being dirty stores. Part of the firm’s strategy is to rebuild brand image in the United States. Selecting the appropriate franchise owners will be critical.
TOTAL SHAREHOLDER RETURN
From 2005 to 2009, management returned a total of $6.3 billion to shareholders with net income of $4.5 billion. The $1.8 billion shortfall was made up with increased borrowings. From 2005 to 2009, total debt increased from $1.9 billion to $3.3 billion.
From a dividend perspective, the management is currently committed to paying out between 35-40% of net income annually each year in dividends. Management appears committed to having a sustainable dividend policy that includes increases each year. From 2005 to 2009, the dividend payout ratio increased from 16.1% to 33.8%. From 2007 to 2009, the ratio has never quite hit the 35% minimum target of management.
From 2005 to 2009, the total yearly dividend increased from $0.22 per share to $0.88 per share. Compounded annually, this is a 38% increase each year.
From a stock repurchase perspective, management spent a total of $5.1 billion from 2005 to 2009. An area of concern is the leverage used to employ this program. From 2005 to 2008 (no stock repurchased in 2009), the stock buyback ratio exceeded 100% of net income each year ranging from 119% to 169% of net income. This program has reduced the number of basic shares outstanding from 572 million to 471 million.
Has the stock repurchase program increased shareholder value? Based on 2005 basic shares outstanding, the firm spent a total of $8.88 per share to repurchase stock increasing earnings per share by $0.40, thus a yield of 4.5%. Although this does not appear high, the market has rewarded YUM with a higher stock price. Based on the TTM earnings multiple of 15.1 in 2009, the stock repurchase program increased YUM’s per share price by $6.05 (15.1 x 0.40 = $6.05).
INCOME STATEMENT
Sales growth
From 2005 to 2009, YUM experienced top line sales growth from $9.3 billion to $10.8 billion. Compounded annually, this is a 3.8% increase each year.
Margins
Although not as high as initially expected, YUM has consistent margins. From 2004 to 2005, gross margin ranges from 24.4% to 26.8%. Of the five years, 2009 was the highest year as food costs went down from the previous year.
In addition, both operating and net margin has shown consistency. Operating margin had a range of 12.3% to 14.7%. Each year margins increased indicating management is effective in keeping fixed costs flat, so margins can expand on higher sales. Net margin ranged from 8.15% to 9.88%, with 9.88% margin in 2009. The increase in net margin is most likely due to more sales being generated overseas. Since each of these countries has a lower effective tax rate than the United States, each additional dollar earned is taxed at a lower rate. If YUM has issues repatriating cash and needs to, this number may go down as it will need to pay increased taxes to repatriate the cash.
Total net income vs. net income per share
From 2005 to 2009, net income per share (i.e. basic EPS) increased from $1.33 per share to $2.27 per share. Compounded annually, this is a 14.3% gain each year. Total net income increased from $0.8 billion to $1.1 billion. Compounded annually, this is a 8.9% gain each year. In other words, 8.9% growth each year is due to higher net income and 5.4% is due to stock repurchase. For shareholders, it is important to see if this driven by earnings growth or share repurchase.
BALANCE SHEET
As previously noted, YUM has increased leverage due to help finance stock repurchase. The $1.8 billion shortfall against net income was made up with increased borrowings. From 2005 to 2009, total debt increased from $1.9 billion to $3.3 billion.
In addition, the firm remains committed to maintaining its investment grade credit rating. Currently, YUM has a BBB- equivalent rating from both agencies. For example, in 2010, YUM issued the lowest “non-financial” bond ever by a BBB- issuer. Bond investors do not seem concerned by YUM high leverage or large stock repurchase program.
Equity base and return on common equity
Beginning in 2005, YUM began an aggressive stock repurchase program. Removing AOCI from common equity, the equity base for YUM fluctuated between $0.3 billion and $1.6 billion. In fact, if AOCI is included, YUM had negative equity in 2008 of (-$0.1) billion.
Because of this small equity base, return on common equity is higher than average for YUM. Excluding OCI, return on common equity averaged over 75% for YUM from 2005 to 2009. In other words, YUM management is extremely effective at allocating capital.
Traditional capital structure ratios
If one were to look at total debt to total assets, this number increased by almost half from 2005 to 2009. During that time period, total debt to total assets increased from 32.6% to 45.7%. In 2008, this number peaked at 55%.
Coverage
Based on traditional accounting rules, most investors would fear the large increase in a ratio like total debt to total assets. The problem with solely looking at traditional metrics is it does not take into account better coverage of debt and interest by free cash flow. Free cash flow is defined as (operating cash – capital spending). In other words, it is the amount of cash management has to pay down debt or return to shareholders.
Like the traditional ratios, the coverage ratios have also worsened. From 2005 to 2009, debt payoff from free cash flow increased from 3.0 to 5.4. In other words, with the amount of cash flow generated in each of those years, it will take an additional 2.4 years to pay off outstanding debt based on that year’s free cash flow.
In addition, free cash flow interest coverage worsened from. From 2005 to 2009, free cash flow interest coverage decreased from 4.9 to 3.1. In other words, in 2005, YUM generated $4.90 in free cash flow for every $1 in interest expense. In 2009, YUM generated $3.10 in free cash flow for every $1 in interest expense.
Relatively, the coverage metric that worsened the least was the EBIT coverage ratio. This ratio decreased from 9.1 to 8.2. In other words, in 2005, YUM generated $9.1 in EBIT for every $1 in interest expense. In 2009, YUM generated $8.30 in EBIT for every $1 in interest expense.
RECOMMENDATION
In this analysis, I did not get into valuation of YUM. After looking at key income statement and balance sheet metrics, I do have some issues with YUM. First, I believe gross margins should be higher. I intend to perform further analysis when the 2010 10-K is release to obtain a full year number. With food inflation starting, I would like to see management’s comments regarding this and what impact, if any, food inflation has had on margins. Also, I would like to analyze gross margins of competitors like McDonald’s. Second, I believe the leveraged balance sheet could be an issue for growth. By issuing a large amount of debt for stock repurchase, YUM is limiting itself to borrow to finance for expansion. It further increases the need to YUM to have a successful refranchising program.
Expect further analysis and a recommendation at a later date.
I do not own YUM or plan on making an investment in the next 72 hours. This information is the best information I could obtain or analyze on YUM.
I do not own YUM or plan on making an investment in the next 72 hours. This information is the best information I could obtain or analyze on YUM.
Thursday, January 20, 2011
Reading List - January 20, 2011
In the past week, both YUM! Brands and the Wendy's Arby's Group both announced selling off less successful restaurants in their portfolios. Announcements by both of these companies represent just a small portion of the spin-offs by companies.
An article by NYT DealBook looks at the value and reason for corporate spin-offs. There are a few key points in the article worth noting:
- Wall Street's recent drive to break-up companies is nothing new.
- The parent company often uses the spin-off to divest itself of problems (i.e. debt). Although these problems are divested, spin-offs often mask the true problems that caused the business to have problems in the first place.
- Spin-offs create shareholder value, but only in the short-term. This value is created by the anticipation of the spin-off versus the actual spin-off
- Long John Silver's and A&W represent only a small percentage of total YUM! branded restaurants (little over 4%).
- In places like Africa and India, consumers cannot eat beef limiting the expansion of McDonald's. By focusing on the KFC brand, YUM! can develop KFC into a McDonald's of the emerging economies.
- Expansion overseas should lead to higher earnings growth, thus increase shareholder returns through either higher dividends or share buybacks
In my opinion, this will create a buying opportunity for either traditional lenders or investment bank/money center banks with strong franchises and prudent risk controls. Until there is an increase in interest rates and economic activity, these banks should remain at low valuations to historic levels creating the opportunity for a long-term investor. For traditional lenders, economic expansion needs to take foot so loan portfolios can expand, and higher interest rates can cause net interest margin to increase. For investment bank/money center banks, new revenue sources will need to found to replace profits from lost trading opportunities due to Dodd-Frank. An interesting not is comparing earnings for Morgan Stanley compared to either Goldman Sachs or JPMorgan Chase. Morgan Stanley experienced less of a decline than either of the other two banks from trading. This is in lieu of Morgan Stanley trying to de-risk by focusing on more traditional investment banking and brokerage activities.
Sunday, January 9, 2011
Dogs of the Dow 2011
A popular investment strategy for income-oriented investors is the "Dogs of the Dow" strategy. The strategy includes purchasing the ten highest yielding stocks of the Dow Jones Industrial Average and giving an equal weight to each stock at a point in time (usually the beginning of the year). After the one-year period, an investor sells the total value and allocates to the new Dogs of the Dow. The idea of the strategy is that each of the stocks produces a high yield because each stock is undervalued. Investors will see the high yield of these companies and will invest in these names, thus driving up the price of each stock.
Over time, this investment strategy has been moderately successful for investors. For example, in 2010, the "Dogs" outperformed the Dow by about 4%, gaining 15.5% versus the Dow's 11% increase. Including dividends, the "Dogs" outperformed the Dow by 7%, gaining a total return of 21% versus 14%. On the other hand, investing in this strategy would have trailed the market between 2004 and 2009.
Two key themes make this strategy attractive to investors. First, the extension of the Bush-era tax cuts will keep taxes on dividends low relative to income making investing in dividend stocks attractive. Second, with Treasury yields at historical lows and uncertain inflation picture, investors will likely do better investing in stocks versus Treasuries.
While the political/economic landscape makes this strategy appealing, I have some problems with this strategy. First, the strategy does not give any weight to future earnings power of each of these companies. If earnings are to remain flat or decline, the dividend payout ratio will increase. This may force each company to cut the dividend. This is a concern as a longer-term investor. Second, its does not give any weight to the quality of the balance sheet or cash flow generation of each company.
In my opinion, as a value investor interested in income, these stocks (or this type of strategy) is very attractive. Instead, I would like to look at the general market to find stocks that generate cash, have strong balance sheets, and with consistent and increasing earnings. These three factors will only ensure higher future dividends. Furthermore, I would like to hold a name for more than one-year.
Are there other ways to play this strategy? As an income investor, I would have a 70/30 split between these names and U.S. Treasuries. Investing in Treasuries will provide a hedge against declining stock prices. Given the current interest rate environment, I would recommend investing in Treasuries with a maturity of five years or less. Since these securities are less affected by an increase in interest rates, an investor will be not see a decrease in the value of the Treasuries in the portfolio.
My goal is to analyze the Dogs of the Dow over the next few months and provide my insights to whether or not these are "great companies" to invest in. My opinion is that some of these companies are trading at low valuations for a reason because the current economics do not appeal to investors over the long-term, while others are just undervalued by the market.
The 2011 Dogs of the Dow (source - WSJ):
AT&T
Verizon
Pfizer
Merck
Kraft Foods
Johnson & Johnson
Intel
DuPont
McDonald's
Chevron
Over time, this investment strategy has been moderately successful for investors. For example, in 2010, the "Dogs" outperformed the Dow by about 4%, gaining 15.5% versus the Dow's 11% increase. Including dividends, the "Dogs" outperformed the Dow by 7%, gaining a total return of 21% versus 14%. On the other hand, investing in this strategy would have trailed the market between 2004 and 2009.
Two key themes make this strategy attractive to investors. First, the extension of the Bush-era tax cuts will keep taxes on dividends low relative to income making investing in dividend stocks attractive. Second, with Treasury yields at historical lows and uncertain inflation picture, investors will likely do better investing in stocks versus Treasuries.
While the political/economic landscape makes this strategy appealing, I have some problems with this strategy. First, the strategy does not give any weight to future earnings power of each of these companies. If earnings are to remain flat or decline, the dividend payout ratio will increase. This may force each company to cut the dividend. This is a concern as a longer-term investor. Second, its does not give any weight to the quality of the balance sheet or cash flow generation of each company.
In my opinion, as a value investor interested in income, these stocks (or this type of strategy) is very attractive. Instead, I would like to look at the general market to find stocks that generate cash, have strong balance sheets, and with consistent and increasing earnings. These three factors will only ensure higher future dividends. Furthermore, I would like to hold a name for more than one-year.
Are there other ways to play this strategy? As an income investor, I would have a 70/30 split between these names and U.S. Treasuries. Investing in Treasuries will provide a hedge against declining stock prices. Given the current interest rate environment, I would recommend investing in Treasuries with a maturity of five years or less. Since these securities are less affected by an increase in interest rates, an investor will be not see a decrease in the value of the Treasuries in the portfolio.
My goal is to analyze the Dogs of the Dow over the next few months and provide my insights to whether or not these are "great companies" to invest in. My opinion is that some of these companies are trading at low valuations for a reason because the current economics do not appeal to investors over the long-term, while others are just undervalued by the market.
The 2011 Dogs of the Dow (source - WSJ):
AT&T
Verizon
Pfizer
Merck
Kraft Foods
Johnson & Johnson
Intel
DuPont
McDonald's
Chevron
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