Thursday, 31 December 2015

More on Enbridge

Yesterday's post got me thinking, why not look further at Enbridge's 3.5% 6/10/2024 bonds?

Here was yesterday's quote table courtesy of TD:

I wanted to put the quoted yield into context, so I did the following quick and dirty analysis, comparing ENB to TRP and to the US BBB corporate yield curve:

Key takeaways:

  • Total expected yield is about 8% in USD's, comprised of 2.22% in capital gains yield (compounded annually) and 5.79% YTM (if held in a tax deferred account).  This conclusion is simplistic though, as it does not take credit risk into account.  It assumes that these bonds will mature at par...
  • The BBB US corporate yield curve is around 4.5%.  So, these bonds yield 357 bps above compare USD BBB corporates.  As noted yesterday, part of the spread must be due to duration, part must be due to credit risk
  • When I see this large of a yield in the context of today's piddly yields (especially in USD's), I wonder if it's too good to be true (put another way, why am I the only clown noticing this)?
  • Interest coverage relative to TRP appears to have deteriorated recently, TRP had 3.3x interest coverage in 2014, vs. ENB at 2.83x.  Without fully analyzing the components of EBIT in either case, or without examining fixed charges and go forward capx, it's hard to draw meaningful conclusions regarding liquidity.  These steps are left to the discerning investor.
  • There really is no end to capx in both cases.  An investor interested in either the bonds or the shares should take an objective look at both capital structure and projected capx (see slides below).
  • BNN featured "professional" money managers will, for the most part, not clue into the danger here (until it's too late). Instead, they will talk about how "great" and "safe" a name Enbridge is. Don't believe me, see below?  

Here is the current capital structure, courtesy of Morningstar.  I've highlighted the two bigger bond issues coming due in 2023 and 2024 below, about $2B+ USD.

Here are a few excerpts from the company's 5 year strategic plan:

Here's what Enbridge has done recently in order to lower their overall cost of capital:

Key takeaways and concluding thoughts:

I have more questions than answers unfortunately.  The drop down appears to be a piece of financial engineering aimed at moving leverage away from ENB to ENF so that ENB can go out and raise $38B to spend more on capx.  Current EV is around $80B per yahoo finance (not sure if this includes the debt before the entire drop down transaction is completed).  Even so, ENB is proposing to spend $38B (as budgeted) equivalent to 50% of current pre drop down EV.  So my questions (if I were a stakeholder):

  • How are they going to raise $38B?  Certainly, if they want to maintain the current 80/20 D:E capital structure, they would raise $30B in debt, and $8B in additional equity.
  • Where does the old debt supporting the drop down program reside?  In ENF? Is ENB guaranteeing the ENF debt?  
  • Where will existing bondholders stand next to new bondholders in terms of seniority?
  • How are they going to finance payment of dividends of $1.86/sh on the additional equity to be raised if the new assets being built aren't going to throw off meanigful cash flows until they are put into service?  
  • What happens if the $38B capx budget is wrong?  What happens if it ends up being $45B?  Who makes up the difference?

Wednesday, 30 December 2015

Q: Why are Enbridge Corporate Bonds Trading Like Junk? A: Because they are

An observational post.

I was scrolling through the offerings in 5-10 year bonds at TD.  I happened across Enbridge's US$ pay 3.5% bonds, maturing in 2024. These are 8.5 year bonds.

I note a few things:

  1. These are bid to yield 6.29%, offered to yield 5.83%
  2. Closest comparable duration are Husky Energy 4% bonds, maturing in 2024, bid to yield/offer about 50 bps below Enbridge, due to higher coupon.  
  3. BofA M/L BBB effective yield has been creeping up all of 2015 (equity markets seem to be ignoring this).  Current BBB effective yield is about 4.44%, so these Enbridge corporates yield about 185 bps higher at bid, 139 bps at offer.  The difference has to be a function of both duration and credit quality.
  4. Equity has priced in deterioration as per below.  I've compared ENB's price performance to Kinder Morgan over the last 5 year's on a weekly basis.
  5. Enbridge is an absolute favourite to hold in long term / DGI portfolio's, and I ask myself, why? For equivalent to lower risk, investors can buy the bonds if (and only if) they do a sufficient analysis of credit worthiness and determine that the bonds are covered.  ENB looks like it has the makings of a Canadian Kinder Morgan situation, as does Transcanada in my opinion. What's going to get cut first equity, think about it...

Finally, the long term monthly chart:

Tuesday, 29 December 2015

The "FANG" economy vs. the real economy, and why I bought Hyster-Yale today

A quick post on "FANG" vs. a real nuts and bolts out of favour business.  This is a rant, so I'm going to apologize in advance.

First off, let me say that I think FANG" is a joke.  I think it's a joke that "FANG" is an acronym that actually exists.  I think the various components comprising "FANG" are a joke, and I think that it's an ever bigger joke that Wall Street pushes that buying a "FANG" basket is emblematic of investing.  In my opinion, it isn't, and it will never be. Buying "FANG" is no different than buying any of the Nifty-Fifty stocks back in the 1970's.  It will be an interesting exercise to check back on "FANG" at the end of 2016 to see whether Amazon added another +50% (+$160B in market cap) by next year's end.

Were it not for the performance of "FANG" in 2015, SPY's YTD performance would be materially worse than it currently is.  But this is the game we play, and our job as (hopefully) intelligent investors, is to ignore fluff.  And "FANG" is the epitome of fluff.

Here's "FANG" today, on the second last trading day of the year.  Although I don't particularly like to comment on day to day moves (I'm certainly not qualified to do so), I believe what we're seeing today is the stampede effect of performance based managers chasing all of the "FANG" names up to all time historical highs in a concerted effort to show either on-par performance with SPY or out-performance relative to SPY for the year on their books.  Compounding this effect on the lowest volume days of the year? Everyone in market looney-land who's a trend follower / breakout chaser jumps on the "perceived" movement and a breakout becomes a self-fulfilling prophecy.

Now, onto Hyster-Yale (HY):

I stumbled across HY as it hit my new 52 week low list a # of times in the past couple of months. The company makes forklifts / lift-trucks.  It was a spin-off from Nacco Industries in 2012.

Here's the chart (it ain't pretty).  I've superimposed the price performance of FDN (First Trust Dow Jones Internet ETF, proxy for "FANG") vs. Hyster-Yale over the last two years.  While "FANG" is up close to 30%, Hyster-Yale is down close to 50% over the same period.  "FANG" is the new economy.  Hyster is the old economy.  The old economy is industrial equipment.  The new economy are the disruptors in the "FANG" basket, worth whatever the next greater fool will pay today for borrowed future growth.

So what are the problems with Hyster-Yale?  You name it:

  • Industrial equipment manufacturing
  • Highly cyclical
  • Significant exposure to currency swings
  • Limited market for lift trucks
  • Longevity of lift-trucks in service (these things last a loooong time)
  • Limited to low growth
  • Low overall margins (both gross & op margins)
  • Nothing to do with the internet, so not "FANG", therefore pretty much ignored or sold in favour of "FANG"
  • Recent spin-off from Nacco Industries (2012)
  • Piddly market-cap (just under $1B), so too small to matter

Here's what appealed to me:

  • The company trades at 10x ttm, and 11x fwd earnings, although they recently warned about softness in the lift truck market going forward.
  • Minimal debt vs. cash on hand of $115M, equivalent to about $9.30 per share
  • Current assets less "total" liabilities were $205M, equivalent to about $16.55 per share.  If the stock got down to $17 from here, you'd be buying the business for free.  Let's say liquidation value is $16.55.  Current price less liquidation value for going concern business is $36.45.
  • Buried in the most recent investor presentation (link here) was a summary of an interesting sounding business development.  The company purchased and has been further developing a Hydrogen Fuel Cell business aimed at powering lift trucks (among other applications).  The development costs have been eating into operating income, so my job is to attempt to stratify what each business piece is worth.  
  • As per 2014 10K, the company expected to spend between $40M & $50M developing and commercializing the fuel cell business over the next 2-3 yrs.  This is a use of free cash flow that would otherwise be retained &/or distributed to shareholders.

For me, this becomes a question of attempting to value what I know, not what I do not know.

First, I know that ttm op cash flows were $90M.  $90M includes the spend on Nuvera.  I'm going to add back the total 2015 as-guided loss on Nuvera of $17M (after tax), to get estimated op cash flows of $107M.  Less capx of $46M gives me estimated free cash flows of $61M.  Over the last few years, free cash flow has dropped from $116M down to $50M.  I'd hazard a guess that a good chunk of the use of free cash flow relates to Nuvera.  The company has also upgraded it's IT systems over the same period.  Let's say average free cash flow over the last 3 years is $92M.

Assuming zero growth in lift trucks, and a 12% required return, FCF's = $92 / .12 = $766M, compared to current EV of $797M.

So, at a high enough discount rate, I'm basically buying perpetual free lift truck cash flows at current EV pricing in zero growth, and I get any future Nuvera growth for free.  Put another way, the market is pricing zero growth for Nuvera, and I'm willing to allocate capital into this situation.

Concluding Thoughts

It's funny how the business of selling the "sex-appeal" of investing differs entirely from the act of investing.  The market really is a looney-bin.  On the one hand, you have performance chasing short term group-think piling into "FANG" at ridiculously unsustainable valuations.  Does anyone with half a brain actually think that paying 43x EV/EBITDA for Facebook, 45x EV/EBITDA for Amazon, 20x EV/EBITDA for Google, and 134x EV/EBITDA for Netflix will actually result in sustainable alpha beyond the short term?

The entire approach to capital allocation is backwards.  The market bids anything and everything in favour up to unsustainable valuations, while dumping anything out of favour with no regard for attempting to uncover value.  There is a theoretical valuation limit to the pendulum of insanity and it's swung to the extreme upper limit in terms of favouring "FANG".  In the case of Hyster-Yale, I believe the pendulum of pessimism has swung the other way, although this is not to say it won't get cheaper in the short term.

Saturday, 26 December 2015

Revisiting Model Assumptions Using Procter & Gamble (Again)

When I first started blogging this summer, I was pretty gung-ho about having discovered Bruce Greenwald's writings.  I quickly built my own EPV valuation model based on his teachings, without thinking too carefully about the model inputs or outputs.  Well, Greenwald would probably be the first person to say, garbage-in, garbage out, and my model valuations were no exception.  As I enter 2016, I have more questions about the models I've strung together than answers (which is a good thing, I think).

I chose PG to analyze back in the summer because the company is a useful barometer of blue-"chipness" in general.  It's a dividend aristocrat (whatever that means), a key Dow component, and is most likely a key component in any serious dividend investor's portfolios.

Here's a snapshot of PG's current stats courtesty of gurufocus:

I've highlighted a few areas of concern right off the bat, on the summary above, which require further investigation / clarification:

  1. The reported ttm P/E is 31x.  This seems high for a steady, slow growth consumer products company.  The curious investor needs to ask him/herself why the ttm P/E is 31x.
  2. Similarly, the NRI P/E (non-recurring items) is pretty high as well, at 26x.  Same comments apply, why so high?
  3. Similarly, P/S seems high at 3.1x.  Same comments apply, why so high?
  4. Similarly, price to FCF as reported seems high at 20.77x (on the subject of P/FCF, another criticism, why use P/FCF?  Shouldn't we use EV / FCF? After all, price is just market cap, EV is enterprise value, which belongs to both bondholders and  shareholders.  The fact that P/anything is so widely used and accepted off the cuff is actually somewhat of a joke)
  5. Finally, EV / EBIT seems high at 19x.  Same comments apply, why so high.

The recurring theme in 1-5 above may not be all that straightforward:  Either PG is currently overvalued causing all cursory (and widely accepted) valuation ratios to seem high, or all measures of value (EBIT, earnings, sales, FCF) as published (scraped) are wrong, or if not outright wrong, non-representative of actual earnings power on a go forward basis.  While there may be some truth to the numbers, the job of the curious investor is to uncover the truth.  

But wait a second, gurufocus, yahoo finance, google finance, marketwatch, morningstar, etc., all show the same (or similar) valuation ratios and the same (or similar) published numbers.  If all of these unbiased sources of information have the same or similar published numbers, how can they be wrong?  Well, the longer I actively research, the longer I realize that it's my job to ignore published numbers from all sources except for the company itself.  Why?  Because an algorithmic scrape is a just a scrape, and it doesn't read the 10K or 10Q or MD&A for explanations regarding the published numbers.

Case in point, here's PG's summary and brief discussion of 2015 reported results:

I've highlighted some key areas of focus above:

Net sales were indeed down by $4.1B in 2015 vs. 2014, in USD terms.  This was due to foreign exchange.  Whether the weakness in all other currencies vs. the USD persists in the short term vs. medium term vs. long term is anyone's guess, but I ask this: if PG continues operating as is for the forseeable future, with 37% of revenue derived from the United States, and 63% of revenue derived from outside the United States, and PG does not repatriate its international cash or dispose of its international operations and repatriate the proceeds, has PG really experienced loss?  Yes and no.  On paper, yes, the value of international sales has dropped relative to USD's, so on FX translation of foreign subsidiary sales, GAAP requires that sales get translated at avg FX vs. USD for the period, which in the case of 63% of International sales,  dropped vs. the USD.  No, for the simple reason that I don't believe PG as currently structured is about to readily dispose of a significant portion of its International Operations. Here's PG's statement of OCI for the year.  You can see how large the FX translation adjustment was for 2015 relative to net income:

FX translation losses were $7.2B, almost 100% of reported net income!

We can make an eduated guess that the FX translation loss getting added to OCI and included as part of equity is a result of foreign self-sustaining subsidiaries reporting in their own functional currency.

So, in the above case, the constant un-translated dollar amount of revenue would likely be about $4.1B higher if not for the extreme FX moves which occurred during the twelve months ended June 30, 2015 (and which have continued thereafter).

The next key area of focus is also FX related.  Per note 1 on the slide above, the company explains that net earnings were negatively impacted by $1.4B due to FX, $2.1B due to non-cash impairment charges incurred on disposal of the Duracell batteries business, and a $2.1B charge due to deconsolidation of the company's Venezuelan operations.  In total, about $5.6B of charges not expected to recur, and not typically tied to the ongoing business of selling diapers, or laundry detergent (not accounting for restructuring charges).

Recasting the ratios above:

Sales of $76B + $4B FX = $80B
Net earnings of $7B + $5.6B (assuming after tax) = $12.6B 
EBIT of $11.8 + $2B + $1.4B /( 1-.25) = $15.67B

Adj P/E = $217B/$12.6B = 17.2x ttm
Adj P/S = 2.71x
Adj EV/EBIT = 15.1x

Not nearly as bad as originally thought.  Certainly, 17.2x ttm earnings is a lot more palatable than 31x ttm earnings!

What about overall valuation?

For this piece of the exercise, I had to revisit my model.  As I was grabbing the reported numbers from the last 10 years of annual reports, I ran into a problem.  Namely, the reported results don't stay constant! Don't believe me?  Compare the 10 year summary of selected financial info from the 2015 annual report to the 10 year summary of selected financial from the 2013 annual report, reproduced here:

The difference in reported results is due to retroactive restatement of historical results in 2015 attributable to disposition of operating segments which were historically consolidated in previous years (no one said this was easy).

So how does one analyze a company  in which the reported revenue base is constantly changing? The answer, very carefully!

The more I think about this, the more I think that PG is in two businesses.  One: consumer products, and Two: acquisition and sale of consumer product businesses.

The second piece is evident from a review of the cash flows from investing activities each year, as so:

I'd hazard a layperson's guess that purchase and sale of consumer products businesses is likely going to continue as a key part of PG's ongoing strategy going forward, so I don't think I can ignore the net cash flow impact in evaluating the overall business, however, I don't want to understate the impact of PG having to invest in additional capx (more on this later).

Here's the company's P/L as stated, and adjusted by me for the last 10 years:

A few observations:

  • Gross margins have remained at or close to 50% over the last decade, indicative of sustainable pricing power.  This isn't surprising given the defensive nature of PG's products
  • EBIT margins have remained at or close to 20% over the last decade, but have trailed off over the last few years.  On further investigation though, the reason for the diminished EBIT margins recently seems to be a function of PG's restructuring program, initiated in 2012.  A cursory review of diminishing EBIT margins without asking why could potentially lead to incorrect conclusions regarding the sustainability of EBIT margins.
  • Between 2012 and 2015, the company has incurred both restructuring charges and taken non-cash charges of close to $9B.  As a mature company, my guess is that in order to drive growth in the face of intense competition for consumer budgets, the company has had to resort to internal cost savings programs.
  • SG&A as a % of sales has remained fairly constant over the last decade.  This isn't surprising given that PG is a marketing machine.
  • For now, I haven't arbitrarily added back a % of SG&A / Advertising expense in attempting to determine EPV.  I will come back to this shortly though

Here's the remainder of the recast P/L:

My biggest issue with the recast P/L is what to do with capx.  If I include capx - cash proceeds on sales + acquisition of businesses, I can get into a situaton whereby I overstate current year's normalized after tax EBIT.  If I ignore - cash proceeds on sales + acquisition of businesses, I may end up understating the current year's normalized after tax EBIT.  So, I took the average net capx over the last 10 years.  

I've also included an as-stated Dupont Analysis of ROE in my model, but I don't think it's useful as is, because it uses reported NPM as one of its inputs.  What I should be doing in order to properly analyze ROE is recast NPM using the after tax-impact of non-recurring charges I've identified. Here's my recast Dupont Analysis:

As can be seen, out of all of the component parts comprising ROE, Asset Turnover and Financial Leverage have been fairly constant over the last decade (with the exception of 2005/06 during which PG added Gillette, signifincantly increasing the asset and equity base as a result).  Interestingly, recast NPM has remained fairly stable between 14.5% and 15.5% since 2011.  This leads me to believe that the company is targeting ROE of around 18%.

Here's my first crack at valuation using my EPV model:

And, not surprisingly, my first comment regarding the valuation is that it's wrong, because it doesn't take brand value into account.  Unlike my previous attempt at valuing AXP, there is no published brand value for PG as a whole using Brand Finance.  However, Brand Finance does list values by individual brand, see attached:

Per above, Gillette and Pampers alone have estimated brand values approaching $15B. Unfortunately, Brand Finance doesn't list every single brand offered by PG, but I don't think I really need to know what every single brand is supposedly worth in order to come up with a reasonable valuation estimate.  I just need to know that a value exists, and it's likely greater than the $15B attributable to just these two brands.

I further thought that a reasonable proxy for fair value of brand worth might be reported goodwill. After all, it represents the excess paid for fair value of identifiable net assets on acquisition by PG, and as PG is fairly acquisitive, Goodwill might be a relevant benchmark to use for brand value.

Here's a quick table showing Goodwill as reported, and as adjusted by me:

Goodwill carried:44,61233,45916,730
o/s shares2,8682,8682,868
g/w / share15.5611.675.83

I'm going to rule out a 50% reduction in reported Goodwill on the basis that just two of the brands per Brand Finance were estimated to have brand value of $15B, which would suggest that across close to 40 brands, PG's remaining brand across the remaining brands is about $1.7B (which is absolute rubbish).

If I take 100% of goodwill as indicative of total brand value, I have to estimate the correct %ge of SG&A & R&D to capitalize in order to bump EPV / share by around $16.

Here are the results:

I determined that brand value of $44B is equivalent to capitalizing approximately 30% of SG&A and 25% of R&D, which is consistent with Greenwald's teachings.

Final Thoughts

I'm hoping that I've demonstrated how important it is to not take reported numbers as per mainstream financial reporting sources as given.  I'm also hoping that I've demonstrated how thinking critically and recasting operations is essential in developing an investment thesis.  Caveat, none of the above suggests that PG is currently cheap.  If actual WACC is somewhere between 8% and 10%, then PG is at best, fairly valued, and at worst, about 20% overvalued.

Interestingly enough, here's where PG got during the July/August 2015 lows:

And here's the valuation table at $65...all I can say is that it's not surprising that PG found support here...

Friday, 25 December 2015

Review of Portfolio Performance 2015

I finally got around to adding a link to my combined registered savings accounts to the blog.  I have some unregistered savings as well, spread between Shareowner and Interactive Brokers, but am not including these accounts in this analysis as the amounts are relatively small, &/or not really conducive to discussion in a blog on long term value oriented investing.  The Interactive Brokers account is my play account, and I mostly trade options in this account.

2015 was a strange/transitional year for me in terms of approach.  I began my journey into the world of attempting to understand more about value investing in the summer of 2014, and 2015 was a continuation of this process.  My expectation regarding 2016 is that I will continue on my path to developing a more robust framework for analyzing and evaluating businesses, while hoping to avoid dumb mistakes (which I am sure I will have my fair share of).  I have no expectations for the market, or for individual stocks, and I do not have any current stocks on watch for addition to my portfolios.  I will continue to scour the new 52 week lows for ideas, and for the index portion of the registered savings accounts, I will only add new units if the monthly price change is lower than the previous month's close.

From an investing standpoint, had the USD $ not appreciated the way it did vs. the CDN $, my overall performance likely would have been flat.  As it happened, the combined accounts returned around 2%, not including dividends and interest.  Including dividends and interest, the combined accounts likely returned 3%.

I go into 2016 with approximately $125.5K CDN in assets under management, allocated as follows:

  • $72K in GIC's and short term savings, or 57% of the combined accounts.  I expect to draw down on this portion of savings if I find new investment candidates in CDN $'s.  I'm pretty much locked out of buying additional USD $'s units as the price is prohibitively expensive, around 1.4x after factoring in brokerage spread on FX conversion.  The cash savings should produce around $886 in interest income for the year.
  • $26.4K in fixed income or equivalent, or 21% of the combined accounts.  I'm likely not going to add much more in terms of fixed income, except for the TD CDN Bond Index.  The fixed income component should produce around $665 in interest income for the year.
  • $2,790 in index funds, or 2.22% of the combined accounts.  As noted above, I will add new units if I get a lower monthly closing price vs. the previous month's close.  The index fund component should produce around $56 in dividends for the year.
  • $20.9K in equities and preferreds, or 17% of the combined accounts.  I'm really looking to add Canadian exposure to the equities portion of the accounts, but I'm not finding much in terms of new candidates in terms of compelling valuations.  The equities and preferreds component should produce around $450 in dividends for the year.
So, overall, my expected combined yield is around 1.6% as the holdings are currently structured.

Here's hoping 2016 is a productive and successful year.

Thursday, 24 December 2015

2015 Dogs of the Dow: Revisiting American Express, Paccar, and More on Mike Burry

More on Mike Burry.  Last post, I attached a link to Burry's writings from 2000/2001.  Here's the link again, and an excerpt on his analysis of Paccar, circa 2000.

(I'll attempt to tie the concepts back to American Express shortly)

I think the key takeaways here are as follows:

  • Don't take reported mainstream financial ratios/metrics at face value, especially when screening for ideas.  In Paccar's case at the time, Yahoo Finance reported a debt:equity ratio which was misleading in the context of understanding the entire business.  Paccar's overall business was (and still is) two seperate businesses rolled into one.  A trucking and parts business, and a finance business.  In Paccar's case, the debt was (and still is) allocable to the finance business.  The trucking and parts business actually didn't (and still doesn't) have any allocable debt at the time.  Currently, Paccar has about $3.5B in cash and securities allocable to the trucking and parts business, but minimal debt
  • This mode of analytical thinking can certainly be extended to examining a wide range of businesses today.  At first thought, I think of companies with integrated finance businesses. GE comes to mind first and foremost, as does Caterpillar.
  • The investor's job is to stratify the distinct businesses if possible.  This is not an easy task, but I think it's necessary in order to do a proper valuation.  If the sum of the parts, conservatively valued, exceed the whole (being current enterprise value), there may be a margin of safety.
  • I find it fascinating that Burry concluded that he was ignoring the finance company debt in evaluating Paccar at the time, but it sort of makes sense.  The debt was tied to and supported the loan book (ignoring the debt worked up until, oh, about 2007/2008).  To be honest, I don't think an investor can ever fully ignore debt, but because the loan book showed an equity/assets ratio of 20% vs. comparable commerical bank ratios of between 5% - 8%, Burry concluded that the loan book was relatively safe
  • The ratio of Equity / Assets is extremely important in analyzing financial entities (or financial operations within an entity)

What does any of this have to do with American Express?

American Express comes to mind for a number of reasons.
  • AXP (the stock) has performed terribly in 2015 relative to the broader market.  On a YTD price performance basis, it's right up there with Walmart and Caterpillar.  See pic below:

  • The company is facing numerous challenges:  Merchant fees are getting squeezed, Costco severed ties this year (impact yet to be felt), the EU and DOJ could potentially impose restrictions on merchant exclusivity, Visa and Mastercard are taking market share in terms of charge business, customer charge habits are constantly changing, foreign exchange headwinds are adversely impacting international charge business, etc. (the more bad news I read, the more bullish I get).  Here's the outlook provided by the company for the remainder of 2015 through 2017:

  • In response to these challenges the company has attempted to ramp up spending on marketing and has engaged in restructuring efforts.  The company has also attempted to sign additional co-branding agreements, most recently, Sam's Club.
  • The company certainly seems to fit into the analytical company within a company Burry evaluation framework.  Here are the most recent statistics, courtesy of gurufocus:

Notice the huge discrepancy between market cap and enterprise value, about $30B, largely attributable to the company's debt in excess of cash and securities.  But hold on a second, what if we attempted to stratify the charge business from the loan/credit business?  (Incidentally, this exercise is purely hypothetical on my part).

Charge Business

From my understanding, the charge business is driven mostly by merchant fees and services, customer credit card fees, and travel related services. 

For this piece of the analysis, I took the last 10 years of reported "non-interest" revenues and stratified the P/L as follows. I had to make number of assumptions here in terms of matching up the appropriate non-interest related categories in the P/L.  Here are the results:

A few observations:

  • This is a low growth business in terms of revenues.  Charge revenues have really only grown 2.8% over the last decade.  I don't realistically expect this to change, although revenues could likely grow at a slower pace going forward given the challenges noted above
  • Notice the drop-off in charge revenues between 2008 and 2009.  Charge business, travel business, etc., are highly cylical and sensitive to economic disruptions.
  • Notice that EBIT as a % of revenues has been steadily dropping since a decade ago.  This could be symptomatic of diminishing discount rates.  I've taken the average EBIT %ge of 16.18% to recast the P/L over the 10 years studied
  • SG&A as a %ge of revenue is significant.  This isn't surprising given the company's recently implemented initiatives to drive brand recognition.  
  • For this initial analysis, I haven't added any %ge of SG&A spend back in order to hypothetically capitalize SG&A spend, although an argument can certainly be made that some portion of SG&A / marketing efforts should be capitalized in an attempt to determine sustainable earnings power value (more on this later)
Here's my initial attempt at determining a valuation range for the Charge Business

A few more observations:
  • This is only part of the picture.  I'm not putting much credence into the premium/discount to EPV calculation, as the valuation only reflects charge, and not loan
  • I've assumed that the majority of the debt is allocable to the loan business, and that the net cash excess cash on hand is a function of Basel capital tier ratios required 
  • The cost of capital rates are estimated ranges 

Loan Business

The second business which accounts for most of the carried debt, is the loan business.  For this business, I analyzed both the last decade of reported results allocable to the loan business, and I analyzed the ratio of equity to assets in each year.  Here are the results:

A few observations:
  • Loan is also a low growth business in terms of top line, just under 4% CAGR over the last decade
  • EBT as a %ge of Interest Income is significant at between 45% and 53%.  This may be more a function of my not allocating any amount of overhead or SG&A to Loan, but what I haven't allocated to Loan, I've allocated to Charge, so the end result will be a combined valuation of the two pieces which reflects the overall correct SG&A (again, this is purely hypothetical, and I haven't looked into each year's segmented results to see if the company breaks the actual amounts out)
  • 2007 through 2009 really took the company by surprise.  Observe the sheer scale of the loan losses in 2008!  Perhaps the company fell victim to similar delinquencies in its loan book as every other money centre bank experienced?  I can't recall if Amex had a mortgage business in 2008, but if it didn't, perhaps it held subprime paper and had to write it off?
  • If I call 2007-2009 an anomaly, maybe the current loan loss provisions are more precise?  I've reduced EBT down from current of $3.9B for the annualized ttm ending 12/31/15, to $3.38B, however, this doesn't mean that the loan loss provisions relative to the scale of the loan book are correct
  • The company doesn't give net income by segment, so I've estimated net income using the overall tax rate
  • The equity / asset ratio has improved signficantly from the depths of 2008/2009, but is still well below 2005 at 14.9% vs. almost 28%
  • The company's loan book has grown from $41B in 2005 to $69B currently.  Card member A/R has grown from $36B in 2005 to $46B currently.  Both pieces have grown commensurate with growth in debt and deposits.  
  • The larger the overall debt grows relative to homogeneity in the loan book, the riskier the company potentially becomes

Here's my attempt at valuation:

Tying it all together 

So I now have to seperate valuation tables for the two businesses, one for Charge and one for Loan.  I combined the two businesses into a consolidated P/L, and came up with the following combined valuation:

Problems with the combined valuation

Right off the bat, I noticed one problem.  American Express as a whole, has a brand value which hasn't been reflected anywhere above.  When I initially read Bruce Greenwald's book, he suggested capitalizing 25% of SG&A  / marketing in determining normalized earnings power value.  I haven't done this, because I don't know if 25% is right (it seems too arbitrary).

What I do know is this:  If I'm ultra conservative and do not capitalize any SG&A, I'm likely undervaluing the company.  And if I make the mistake of undervaluing the company, I may not determine its viability as a candidate for purchase correctly.

So here's how I attacked the problem:

I found a ranking of the top 500 most valuable brands, see link here at Brand Finance.  No one would be surprised to find Apple at the top of the ranking.  American Express was ranked 38th (down from 33rd in 2014).

Despite the drop, the company still seems to have brand value of around $21B according to Brand Finance.  Ok, who the hell is Brand Finance, and why should I listen to them?

If anyone's interested in reading about their ranking methodology, you can find it here.

Let's assume I should, and the brand is worth $21B, or about $21 per share.  This changes my valuation.

Assuming a 12% stress test cost of capital, I get $59.47 capitalized no growth combined EPV +$21 in brand value, for an estimated all in valuation of $80.53, about $10 higher than current.

What if I don't trust Brand Finance and I want to cut their estimates in 1/2?  I'd get $10.5B in brand value, or about $10.5 per share.  Again, this changes my valuation.

In this case, assuming a 12% stress test cost of capital, I get $59.47 capitalized no growth combined EPV +$10.5 in brand value, for an estimated all in valuation of $70, just equal to current.

If I believe that actual real cost of capital should be lower than 12%, perhaps between 8% and 10%, my valuation changes again.

At 8%, and $21B in brand value, I get an overall valuation of $100 per share

At 10%, and $21B in brand value, I get an overall valuation of $88 per share

And so on, and so on, and so on...

Concluding Thoughts

As usual, this exercise is more art than science.  The above excercise is not a buy recommendation, rather, it's a sit up and take notice suggestion.  There is nothing saying that American Express won't continue lower on the heels of continued worry in the market over continued loss of market share, DOJ / EU restrictions, and the "inevitable" demise of the legacy merchant fee business in favour of competitors.  But I suspect that the more bearish the story gets, and the lower the stock goes, the better an opportunity it becomes.

Quick Update December 25th, 2015 (Merry xmas)

After I finished this post last night, I asked myself what capitalized %ge of SG&A is equivalent to $21 per share in brand value?

I can use my model as constructed in order to detrermine changes in EPV based on changes in add-backs in SG&A, and then make a determination as to whether the add-back %ge seems reasonable. To me, this seems more intuitively appealing than just using a straight 25%.

Interestingly, in order to create $21 in EPV due to brand value, I'd have to capitalize 35% of SG&A.

Here are the results:

The takeaway here is that capitalizing SG&A / marketing spend of about 35% results in recognition of brand value of around $21 vs. my previous attempt at valuation where I capitalized no SG&A / marketing.

Do I think 35% is reasonable?  Maybe?  The truth is, I don't know.  I do know that the company spends a substantial amount on marketing every year ($10.9B currently, up from $5.8B a decade ago), and I don't believe I'm arbitrarily capitalizing spend that shouldn't be capitalized.  The company tracks marketing spend as a seperate line on the P/L called: "Marketing, promotion, rewards and Card Member services".  I've only considered this line in my analysis.

If I want to be conservative, and want to chop $21B in brand value in 1/2 (perhaps reflective of eventual dimminution of the brand in favour of VISA  or Mastercard, etc), here is the resulting valuation using $10.5B in brand value:

In this case, marketing spend is only about 18% effective in terms of capitalization, and my margin of safety across a range of different cost of capital rates falls vs. 35% capitalization.

This brings me to more concluding thoughts / questions, in no particular order (and I apologize for this in case anyone is looking for a recommendation):

  • I'm using approximations of WACC here.  To be fair, I don't think WACC should be as high as 12% for an established company such as American Express (although one could make an argument that during 2007/2008, the guys from the Big Short would have argued to the contrary and they would have been right)
  • Maybe I need to use different WACC's for the different businesses.  Charge is inherently less risky than Loan.  Maybe the answer is, model Charge at a much lower WACC, given that the business is predicated on Cards if Force, merchant services, discount fees, etc, all of which don't typically involve lending activities, and model Loan at a higher WACC to account for the potential in a spike in loan losses
  • I'm not sure whether 18% or 35% capitalized marketing spend is correct in terms of recognizing brand value.  One thing I am certain is that there is some value and it's significantly higher than 0%.  If it weren't, we'd be into an impairment model in evaluating the business, and I don't think this is the case.
  • I'm more preferential to the 18% capitalized marketing spend scenario because it's conservative, but in doing so, and then by using a high discount rate, am I double dipping when I shouldn't be? i.e., if I've already modelled zero growth, conservatively adjusted EBIT / EBT, and used 1/2 the value of brand value, should I also be looking at the stress test case?  My thoughts here, are that if price moves significantly below my stress test valuation discounted at 12%, either I'm getting a very good price, or there is something fundamentally wrong with the business (or everyone else in marketland has lost their collective minds by bidding Amazon up to the moon in favour of binning AXP)