Dell Inc: Not So Fast Mr. Dell

There is a good live case study at csinvesting on the Dell Inc. (NASDAQ:DELL) private buyout being led by the founder Michael Dell and private equity firm Silver Lake Partners.

The big question is whether the consortium’s bid of $24.4 billion or $13.65 per share for Dell is fair.  Using the Value Line information supplied by csinvesting, I will value Dell using the back of the envelope calculations of free cash flow yield.   I typically define free cash flow (FCF) as operating cash flow less capital expenditures. However, for this valuation I will use Value Line’s “cash flow” per share as a proxy for FCF.  Value Line defines cash flow as earnings per share plus depreciation and amortization per share.  Using this definition of cash flow is not my preferred method but it will work for a back of the envelope calculation.

About what is Dell worth?

I would require a 10% cash flow yield on my investment.  Using single point valuations, this would estimate the intrinsic value of Dell at $16.70 per share in 2008 and $25.10 per share in 2011.  This assumes no growth in the cash flow for the company.  If 3% annualized growth is assumed, then the 2008 value would be $23.90 per share and the 2011 value would be $35.90.  Using the average and median cash flow per share from 2007 to 2011 as normalized cash flow, the intrinsic value comes in at $17.30 to $17.90 per share.

I can get to a higher intrinsic value if I assume 3% cash flow growth into perpetuity but I have a hard time justifying that.  Dell’s cash flow has been pretty lumpy and stagnant since 2007 and the future of PC sales is looking overly mature for much growth so I would be reluctant to bake growth into my valuation without more investigation on the future of the company’s other business segments.

Are the valuations in the Barron’s article valid?

The Saturday, February 9, 2013 Barron’s article The Dell Deal May Die mentions that Southeastern Asset Management believes Dell is worth $24 a share while Pzena Investment Management believes the shares are worth $25 each.  Using the back of the envelope valuation, it appears that both managers are baking some growth into their valuations.  If I assume 3% cash flow growth I arrive at an intrinsic value estimate of $24.70 to $25.60 per share.  These valuations are valid if you believe the company can grow cash flow and you don’t need to apply a larger discount to the valuation due to poor stewardship by management.

Barron’s presents a chart for the Dell buyout showing the initial equity and new debt versus five years later.  The annualized return on the equity would be 29% assuming all the debt is extinguished in five years.  With $5.2 billion in cash on the books, assuming normalized earnings to be the median cash flow per share of $1.73 and there is no growth in the cash flow over the next five years, it looks like Dell will have generated enough cash flow to pretty much pay off all the debt in five years.

Barron’s expected annualized return might be pushing it a bit but if we assume only ¾ of the debt is paid off in five years, the annualized return only falls to 24%.  The valuations in the Barron’s article are much more valid than the consortium’s bid.

Does growth have value?

Absolutely, growth can have value.  Sustainable and predictable growth has more value than transitory and speculative growth.  Growth for growth’s sake or growth that doesn’t provide a return greater than the cost of capital can decrease the value of a company.

What aspects of Southeastern Asset Management’s letter put heat on Michael Dell?

Southeastern Asset Management, the advisor to the well-regarded Longleaf Partners Funds, responded to Dell’s proposed go-private transaction in a letter stating they would oppose the transaction.  As the largest outside holder of Dell’s shares with an 8.5% stake in the company, Southeastern has a lot at stake.  They clearly articulate a rational valuation to Dell shares.  Through a sum of parts valuation, they arrive at a value of $23.72 a share.  Southeastern puts the most heat on Michael Dell when they highlight that Dell has spent $13.7 billion or $7.58 per share on acquisitions since 2007.  The well phrased throw down is pretty damning after I think about it.

In addition, since Michael Dell resumed his role as CEO in 2007, the Company has spent $13.7 billion or $7.58 per share on acquisitions intended to transform the Company into a sustainable IT business and lessen its reliance on the PC business. During Dell’s June 2012 analyst day, Dell Chief Financial Officer Brian Gladden said that in aggregate the acquisitions to that point had delivered a 15% internal rate of return. The Company has neither taken nor discussed the need to take any write downs of these acquisitions. We therefore conservatively believe the acquisitions are worth a minimum of their cost. Taken together, these items total $12.94 per share before we even look at the other businesses.  The current bid therefore places a value of less than $1.00 per share on the remainder of the Company. By any objective measure, that is woefully inadequate.

So not only has Dell made capital allocation decisions since 2007 equal to over half the buyout offer, money that could be returned to shareholders, but the acquisitions are returning a 15% internal rate of return.  The acquisitions are doing well and it looks like Dell wants to buy the future profits for a song.

What in Michael Dell’s prior history makes you perhaps not surprised by his current actions?

As nicely illustrated in the recent New York Times article Dell’s Up and Downs with Options, Dell has a long history of buying back stock in order to prevent dilution from issuing stock options to executives.  Amazingly, over the life of Dell, the company has spent $39.7 billion buying back overpriced stock.  The current market cap is approximately $22 billion.  The amount of money spent buying back stock is nearly twice the current market cap!  This is astonishingly bad capital allocation.  Michael Dell has profited handsomely by fleecing his shareholders over the years with handsome stock option grants.  Now that stock options are more properly accounted for, he is using a different but more visible tactic, lowballing the price of the company to take it private and leave shareholders out in the cold.

Should Dell offer to do a tender offer?

If Dell stock is undervalued at $13.65 as it certainly appears to be based on my back of the envelope calculation and Southeastern and Pzena’s valuations, a tender offer that allows for stub stock to trade so remaining holders can participate in the future cash flows of the company would be one of the best courses of action.  Company buybacks below the intrinsic value of the stock adds value to the intrinsic value of the remaining outstanding shares.  This would be a good capital allocation decision, something Dell has little history with.

Dell looks like a classic value trap.  By the numbers, Dell looks cheap.  How can you avoid a value trap like this?  One way is to use qualitative factors in addition to quantitative factors such as low P/E, P/B ratios and valuation.  While cash flow trends look robust enough for the company to comfortably transition its product mix from the PC business to more sustainable IT products and services, management motivations and incentives have to be brought into the equation.  An analysis of the capital allocation history of management would provide good insight.

If the price collapsed to $9 or $10 based on the deal being pulled what would you do?

While a $9 or $10  purchase price looks very attractive to my rough $17.30 to $17.90 intrinsic value estimate and extremely attractive to Southeastern’s $24, I would be reluctant to buy the stock without identifying a catalyst for closing the price to value gap.  If more activist investors got involved, I would be more interested if it meant I’d have to wait for the activists and buy the stock at $11 or $12.

Disclosure:  No position in DELL

Posted in Analysis, Case Study | Tagged | 2 Comments

Heartland Payment Systems, Inc: The Pipes in the Fight Against Cash

The Value Guys are two veteran Wall Street analysts that produce a podcast of their candid stock picks every week.  Using screens to cull through a list of stocks, The Value Guys narrow the list to three or four stock ideas and highlight their favorite.

After my McKesson Corporation case study where I used DuPont analysis, I was excited to listen to The Value Guys DuPont Formula Edition.  They screened for companies generating a high return on assets as a function of margin and asset turnover.  They presented some interesting companies including Heartland Payment Systems, Inc.

Business Overview

Heartland Payment Systems, Inc. (NYSE: HPY) provides bankcard payment processing services to merchants in the United States and Canada.  The company specializes in end-to-end electronic payment processing including merchant set-up and training.  Over 70% of their business is with small and mid-sized enterprises which is recurring in nature as their clients use Heartland to process Visa, MasterCard, Discover and American Express credit and debit cards.  Bankcard revenues consist primarily of a combination of percentage of dollar amount of each transaction and a flat fee per transaction.   The company also provides electronic transaction services for secondary and college education markets and runs a payroll processing division.

Co-founded in 1997 by Robert Carr, Heartland employs 2,667 people and is based in Princeton, NJ.  The company has a $1.2 billion market cap with Carr serving as the Chairman and CEO while owning 1.3% of shares outstanding.

As pointed out by fund manager Chuck Akre during a Value Investing Congress, there is an international war on cash.  This is the underlying secular trend supporting his thesis for a long position in MasterCard Inc (NYSE:MA).  While MasterCard provides the network in the war on cash, Heartland provides the pipes.

A typical $100 bankcard transaction cost the merchant $2.50.  The $2.50 is split among the card issuer, the network and the payment processor as seen in the graphic below from the company’s most recent annual report.

What Happened in 2009?

Taking a look at a summary of the financials for Heartland, 2009 stands out like a sore thumb.  What the heck happened there?  Clearly it’s the only year in the past six years that the company has lost money.

 The $51.7 million loss in 2009 looked like it came out of nowhere.  Assets weren’t written down from an impairment and operating cash flow was positive.  With free cash flow of $19.9 million, it was some type of non-cash charge.

For Heartland, the loss did come out of nowhere.  On January 20, 2009 Heartland announced the company was a victim of a security breach of their processing system sometime in 2008.  According to the Federal indictment of Albert Gonzalez, Mr. Gonzalez was the ring-leader of a hacking scheme allegedly called “Operation Get Rich or Die Tryin” that stole 130 million card numbers beginning on December 26, 2007.  It seems that Heartland’s systems were compromised for nearly a year.  The sentries guarding Heartland’s moat were compromised and the enemy was living in the castle.  How could the castle be saved?

It appears that Heartland management took swift action.  In April 2009, within months of their announcement, Heartland was returned as complaint service providers with Visa and MasterCard.  In December 2009, they settled with American Express.  For the 2009 fiscal year, they expensed $132.9 million and slashed their dividend to free up cash.  In January 2010, Heartland settled with Visa and their sponsor banks.  In May 2010 they settled with MasterCard.   In August 2010 they settled with Discover.   By the end of 2010, 98% of the financial liability was behind Heartland and they posted recoveries for the processing system intrusion expense from 2009.  This shows that management conservatively estimated the liability.

Competitive Analysis and Return on Equity

Even more interestingly, the company exhibited evidence of having a competitive advantage as return on equity immediately recovered along with net margins.

 The loss in 2009 looks like a blip.  Heartland immediately went back to 20% returns on equity and it looks like they may even improve on it.  However, the security breach certainly took at least two years of profitability away from the company if you count not only the loss but also the opportunity cost of not earning normal profits for the year.  Equity took an even harder hit with a loss of three years of returns.  Security breaches are a very real risk to Heartland.

Market Share Dynamics

Over the past twenty years, the processing industry has been consolidating as the larger players take more market share on a dollar volume basis.  The top ten merchant acquirers captured 79.7% of the market in 2008 versus 39.0% of the market in 1988.   Founded in 1997, Heartland has been able to go from zero market share to 3.1% in 2008 and a top ten competitor.  Heartland’s entry into the bankcard processing industry was prescient.  They were able to gain a foothold in the industry prior to significant consolidation that has created some barriers of entry for new entrants to take large market share.  Heartland’s niche market of restaurants and small acquisitions has allowed the company to gain market share since 2003.  There is evidence that barriers of entry exist in the industry with the purchase transactions market share for the top ten acquirers ranging from a high of 89.2% in 2006 to a low of 85.1% in 2011.  Additionally, the position of the companies in the top ten and their market share has remained relatively stable indicating the ability of these companies to defend their turf.

The question of concern is the market shift downturn from 87.0% in 2010 to 85.1% in 2011 for the top ten U.S. acquirers.  Is this the beginning of substitute payment methods like PayPal, Square and mobile payments encroaching on the traditional players or just typical variability in the industry?  These data points will be important to watch as 2012 information comes in.

In 2011, 34.8% or $1.9 billion of Heartland’s processing volume was for restaurants.   According to the National Restaurant Association, restaurant sales are expected to grow 3.5% to $631.8 billion in 2012.  Thus, 2011 restaurant sales were approximately $609.7 billion and Heartland’s $1.9 billion in processing volume gives them a 0.32% restaurant market share.  However, Heartland states in their 10-K that they provide services to 45,219 independent restaurants.  In 2010, The NPD Group puts U.S. restaurant locations at 578,353.  On a location basis, Heartland has a 7.8% market share.  It appears they have some niche market advantages with a long runway of growth ahead of them.  A feature of this niche is it provides lower risk business since restaurants have a low chargeback rates as service is typically provided prior to card use.

Bargaining Power

In 2011, top 25 merchants represented only 3.2% of Heartland’s processing volume.  This gives their customers little bargaining power as a group.  On the other hand, Heartland is unaffiliated with a Visa or MasterCard issuer and must be sponsored by an issuing bank in order to be a merchant acquirer.  Heartland has three sponsor banks they work with.  There is some risk in having such concentrated vendor relationships.  A good litmus test regarding this risk is Heartland’s journey through its 2009 security breach.  Heartland maintained all it’s relationships with its sponsor banks.  The value of sponsoring a merchant acquirer as a customer to the sponsor banks could be seen as Heartland secured lending from one of their sponsor banks in the aftermath of the security breach.

Substitution Risk

The largest risk to Heartland is its services being substituted by new competitors like PayPal and Square that lie just outside of the traditional payment processing industry.  This is a risk to monitor closely for investors in the bankcard processing industry.  Even with these risks, Heartland’s positioning gives the company some competitive advantages.  I like the Heartland at the right price.

Disclosure:  No position in HPY

Posted in Analysis, Case Study | Tagged | 2 Comments

Models are Only as Good as Their Formulas

While I was brushing my teeth last night I thought about the discounted cash flow model that I used to value the high-tech HVAC company discussed in the last post.  I had the feeling something was wrong.  I asked myself, was each year of the present value of free cash flow the same?  If they were the same, then I had a problem.

Models are only as good as their inputs and their formulas.  I went back and checked my spreadsheet and found my formula for PV of FCF (Present Value of Free Cash Flow) was incorrect for years two through five.  I was going too fast when I was putting my analysis together.  After pulling the worksheet from another model, I made changes and some how changed the formula.  Each year was only discounted once.  This changes the valuation so it falls in the $3.9 million to $7.2 million range instead of the $5.2 million to $9.6 million.  This is critical and embarrassing to have to admit to the three readers of this blog.

However, when something like this happens, it is best to find the error, make the correction and disclose it.

This mistake is critical because the cornerstone of valuing financial assets is the time value of money.

The correct table for my discounted cash flow using the company’s disclosed free cash flow at zero future growth and a 25% discount rate:

The correct table for my discounted cash flow using my net income estimates as a proxy for free cash flow at zero growth and a 25% discount rate:

I feel much more comfortable with this range of valuations than I did with the first.  So luckily, my instincts were somewhat correct.  More importantly, it shows how the investment process of estimating intrinsic value and buying at a discount to that estimate has validity.  There are so many things that can go wrong in an investment so you need to build a margin of safety.

It is less likely that this business is worth more than $6.2 million based on these calculations.

This problem is an example of why I prefer to use a modified dividend discount model like I have in previous case studies.  Keeping things simple helps to eliminate these type  of mistakes.   There are a lot of moving parts in a discounted cash flow model.

Val Hughes commented on the original HVAC case study post.   He basically used a form of the Gordon growth model.  I really like his approach.  He assumed a dividend or owners earnings of $1,500,000 with zero growth and a 30% discount rate.  This is a simple and clean model where you can actually do the calculations in your head if you wanted to.  The model and calculation would look like this:

Intrinsic\:Value = \frac{D}{(r-g)}

Intrinsic\:Value = \frac{1,500,000}{0.30-0.0} = 5,000,000

D = Dividend in next year
r = required return or discount rate
g = growth in dividend

While I will continue to use a discounted cash flow model as one of my valuation tools, I certainly will make sure I reach into the tool box for those robust basic models that have stood the test of time because they have survived the errors that occur with additional complexity.

Posted in Analysis, Case Study | 2 Comments

This Business Might be Worth More than $6.2 Million but I Wouldn’t Pay Up

John Chew over at csinvesting, a fun blog focused on Intensive investing education through case studies, posted a link to The New York Times You’re the Boss blog that makes for an interesting valuation case study.   The blog post, Would You Pay $6.2 Million for This Business?, presents information on a small HVAC company in the southeastern United States with $4.67 million in revenues and $1.69 million in free cash flow in 2011.  My interest was immediately peaked.  There is a reason why I titled my blog Enterprising Investor.  While I like being a desk jockey, I have always had a slight entrepreneurial streak and have admiration for small business owners, especially the ones that find financial success.

The owner is asking $6.25 million for the business and real estate.  It is interesting that the asking price is 3.2x free cash flow which is about a third higher than most companies in the industry ask.  This business is making a cash flow yield that is hard to believe.

Is It Possible?

The first concern is whether or not the numbers presented are possible.  We are starting with limited information in the blog post but with a little research, we can find some interesting information.  The broker for the business is Jim Dunmie at Murphy Business and Financial Corporation in Clearwater, Florida.  The listing for the business can be found on their website with more detail regarding the business:

This is a High Tech Residential Retail HVAC Sales and Service business. They have 7,800 Extended Warranties, 37,400 Annual Tune-Ups and 1,008 Service Agreements for their 40,000 customer base. Techs carry laptops and printers in their service vehicles (powered by inverters). The techs have the ability to print a system replacement quote from the truck and usually offer same day installation. Technicians are highly trained. They replaced 800 full systems in 2011. They also sell, service, and install pool heat pumps, generators, and insulation. Stable employees with most on board 8 years plus. Very efficient POS dispatching software. Exceptionally clean books and records with no pending litigation. Revenue through September 2012 is up 3.8% and net income is up 7.9%.

The location is disclosed as east central Florida in the business listing and we know that with a list of 40,000 customers and 37,400 annual tune-ups, the business is likely to be in a large metropolitian area.  The central Florida region has population of 3.3 million and incompasses a large area of Florida.  However, I think I may have identified a business that fits the profile.  There is an HVAC business in a suburb of Orlando that fits the profile.   A bedroom community of Orlando with above median income levels would be great demographics for a service oriented HVAC company.

Depending on the actual location, the company may have a market share that indicates some competitive advantage.  Actually only being located in a small geographical region lends to the company achieving economies of scale that make it difficult for competitors to encroach.  The fact that the service area is within a 20 minute drive decreases the cost of transportation and more importantly the opportunity cost of travel time.  With less driving time, the company can have higher transaction turnover, something that is very valuable in a low markup industry but exceptionally valuable in a high markup industry like construction.  Operational effectiveness alone doesn’t create a durable competitive advantage but certainly helps to garner market share on the way to achieving economies of scale.  This company utilizes point-of-sale technology in the service trucks used by their technicians.  A point-of-sale system connected to a robust cost estimating system at the home office leverages technology in a way I have seldom seen in the construction business.

It Looks Possible

While the numbers are rough, we can get an idea of what the revenue and cost structure for this company might look like.

The extended warranties and service agreements revenue estimates are particularly rough around the edges as we don’t have enough information for an accurate estimate for accrual accounting since we would need to know the timing of when services were provided before booking the warranties and service agreements to revenues.  This would be critical in analyzing the free cash flow numbers presented by the business broker since much of the warranty and service agreement cash payments would flow through the cash flow statement prior to hitting the income statement.  There is no sense in halting the analysis at this stage due to a lack of data because I’m having too much fun.  Let’s soldier one.

To estimate the extended warranties and service agreements revenues, I assumed that 20% of the warranties and service agreements in force would have $100 on average in revenues booked in 2011.  First, I assumed that 65% of the revenues were labor costs for the extended warranties, annual tune-ups and service agreements business and 40% for the full system replacements.  If we mark-up the lower cost items that would likely be used in warranty work, annual tune-ups and service agreements at 100% and the higher cost items like air conditioning condensers and furnaces at 50% we can arrive at an reasonable estimate of the costs associated with the 2011 revenue break down.  I think the labor costs are in-line on average.  I’m sure some details are missing but the data is not available to us.  I don’t think that 100% mark-up on the lower cost items is unreasonable for this company assuming my thesis that this company is leveraging IT for the cost estimating and marketing systems.  If the operational effectiveness is robust, this company is properly marking up each item whether it’s freon, a small switch, copper piping or any of another hundred or more items used in their business.

From this, we can get an idea of what the income statement of the company could look like.  To estimate the labor cost associated with cost of revenues, I assumed 20 of the 26 employees average salaries 10% higher than the average $42,530 for HVAC technicians as reported by the Bureau of Labor Statistics.  Employer costs were also included in the estimate.

It is very difficult to determine how much is spent on advertising but a high-quality HVAC service company is going to take advertising and marketing seriously so I estimated $100,000.  Office labor and owner salary was estimated by assuming the six other employees averaged $40,000 per year in salary and the owner took home $100,000 per year.   Employer costs were included in the estimate.  Depreciation was estimated by taking a 29-1/2 years straight-line depreciation for $850,000 in real estate. While that is the market value claimed by the broker and not the cost, it’s the only data we have to work on.  There are surely lease or depreciation expenses for the fleet of trucks the company is going to be operating that we have no data on.

We arrive at net income of $981,632 for the company.  While this is 42% lower than the $1.69 million in free cash flow advertised, it appears to me that there is some possibility that this HVAC company is throwing off some serious cash.  It would be a blast to crack open their books and have a conversation with management to verify the results and see what they are doing to achieve them.

We can even construct a skeleton balance sheet of the company.  This begs even more questions like what is the working capital position of the company?  What is the cash position, are there any receivables and what are the terms for accounts payable with their vendors?  On the little information we have, book value of the company is approximately $1.1 million.


The owner is asking 3.2x free cash flow, 6.4x my estimate of earnings and 5.9x book value.   Using a discounted cash flow method and assuming that the free cash flow numbers presented are correct results in an impressive valuation $9.6 million for the company.

Even with zero growth and a 25% discount rate, the valuation seems excessive, especially since the owner is asking $6.25 million!  Surely the owner knows what the business is worth.

Clearly, you would want a margin of safety if you are purchasing a small business.  That is why I would only buy this business at a discount to the intrinsic value.  In this case, I’d probably be starting at a 50% discount which arrives at a $4.8 million bid.  In negotiating a business purchase, it’s probably not a good idea to go in saying I think it’s worth $9.6 million in theory but I’m willing to buy it if you put it on sale with a 50% discount.  A proud business owner is unlikely to want to run a blue light special.

I come up with a more reasonable valuation of $5.2 million if I use my net income estimate as a proxy for cash flow.

Based on the information I have and if a due diligence proved it to be accurate, I wouldn’t bid any higher than $5.2 million for this quality HVAC service business.

Posted in Analysis, Case Study | 2 Comments

Investigative Journalism and Investing

Basically news people and I are in same business.   I mean I go out and I try to report essentially on a company.  I try to evaluate, I try to evaluate its management, I try to evaluate its competition, its product, its service, its prices, its costs.  Everything.  I’m trying to do a reportorial job on a business.  I may have never heard of it before and that is my job.  I assign myself a story and every morning when I come to work,  it may be triggered by some event, but I assign myself a story.  The story always happens to be, what is X worth?  But that’s a story.

-Warren Buffett speaking at the Omaha Press Club, September 2, 1992

After reading a lot of books about Warren Buffett, I always thought that he likely took a journalistic approach to investing.  Buffett obviously loves the newspaper business, however this is the first quote I have seen from Buffett indicating he directly thinks of his investment process in terms of journalism.

Instead of Buffett merely reporting the sales and earnings of a company in a way you might see in a business publication, he investigates every aspect of the company that he can.  Like an investigative journalist, he may study a company for years before he submits his final report in the form of a bid to buy the company’s stock or even the entire company.  Indeed, he studied IBM for over fifty years before buying stock in the company.

I will be submitting my reports in the form of case studies.  It is not a lack of conviction when I post a case study that results in a decision to do nothing but rather a strong conviction that inaction is a valuable decision.  The value in studying company after company that results in taking no action is not measurable but the value counts extensively as they become building blocks that form a strong foundation for future action.

I attempt to write as a reporter for my audience, no matter how small, out of respect for the time they take to read my work.  Good writing not only communicates succinctly and clearly to the audience but also helps the author to better understand the subject.

This blog is a serious project but I try not to take myself too seriously.  I’m serious about taking the time to study, investigate and value a company.  I’m serious about writing well about a company as if I’m reporting on it.  Why be serious about it?  I am fulfilled by doing something well and in the case of investing, doing it well can make a lot of money.

Posted in Manifesto | 4 Comments

One Hour a Day for Yourself, The Other Eight for Bradlee

Its assigning yourself the right story and I said this to Woodward, why don’t you just assign yourself a story to work on between six and seven in the morning, they always want me to tell them what stocks to buy, I always say, well I’ll let you assign yourself a story and work on it from six to seven in the morning. One hour a day on your own assignment, the other eight or ten hours you can work for Bradlee.

-Warren Buffett speaking at the Omaha Press Club, September 2, 1992

This quote was in reference to Bob Woodward and his editor Ben Bradlee during the 1973 Watergate investigation and how coincidentally, Buffett was buying stock in the Washington Post when the market was valuing the company at $80 million while Buffett estimated the value to be $400 million.  Buffett gives the thought experiment of Bradlee assigning Woodward to spend the next week to come up with a story explaining what the Washington Post is worth.  Buffett says he would have come in with a pretty damn good story, he would have made a ton of money and it would be a lot easier than the stories he is trying to get.  Finding out what the Washington Post is worth is not a tough story.

This is what the blog is about right now.  Assigning myself the right story and spending one hour a day on my own assignment.  I report my one hour a day assignment here.

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Book Review: Moonwalking with Einstein

Moonwalking with Einstein inspired Whopper at the Whopper Investments blog to develop a process of deliberate practice after he read the book.  This in turn, inspired me to develop a more deliberate practice regime for myself.  The passage that inspired Whopper concluded that it’s not the number of hours that one practices that makes you an expert but it’s the kind of practice you engage in that makes you an expert.  While the passage that inspired Whopper to begin a deliberate practice process resonates with me, journalist Joshua Foer’s journey and reporting of the world of memory enlightened me.  For someone like myself that hates rote memorization, Moonwalking with Einstein shows that there is another and better way to consciously remember.

Foer neatly ties the history of memory techniques, academic research on memory and his imbedded reporting as a participant in the U.S. Memory Championship into an easy to read story.   Foer begins with the ancient Greek story of the origins of the Memory Palace, a memory technique where you visualize each item you want to remember by placing them in a specific location in a building that you are very familiar with.  After nearly two decades of formal education, this alone was news to me especially as I have discovered that the ancient Greeks considered the art of memory as one of the building blocks of the art of rhetoric, a subject sorely missing from our educational system.

Foer meets with K. Anders Ericsson, the Florida State University professor now famous for showing that it takes ten thousand hours of practice to become an expert.   Foer volunteers to be studied by Erickson’s Human Performance Lab as he starts to prepare as a complete novice for the U.S. Memory Championships.   The book takes us on an entertaining journey as we learn about historical studies on memory and we meet current case studies like EP, a well-studied case of memory loss and Kim Peek, the inspiration for Dustin Hoffman’s character in the movie Rainman.

While anecdotal, the author’s first hand account of his journey from being of average memory to being able to perform savant like skills is inspiring.  If it is to be believed that Foer has average memory, than it is possible for most of us to develop the skills necessary to remember the order of deck of cards in less than a minute or remember one hundred names and faces in fifteen minutes.   In a world where massive amounts of information is available to us with a push of a computer button, these skills seem ancient.  Surprisingly they are.

The ancient Greeks and the civilizations that followed them used memory techniques on a daily basis up until the time the printing press was invented.   Once the expense of archiving information declined through the use of the printing press and now through the computer, our memory is less and less necessary for storing data or stories internally in our minds like our ancestors did.   While there are clear advantages to this, there are disadvantages also.  How do we experience our own lives and how do we learn if our memories are stored outside our brain?  After all, is it really your life story if you can’t remember it but have to read it from a book?  How can you learn words if you have to reference a book to remember the alphabet?  Memory is vitally necessary for learning.

Experts see the world differently according to the research by Professor Ericsson.  It is not because the experts have better memories.  While their memories in their fields are exceptional, their memories else where are merely average.  That is because they are remembering things in context, not isolated facts.  This is why the memory techniques are so useful.   You can remember things in context.  If I think of the number two as a swan because of its shape, I can then visualize a swan floating in the water along the shore in Key West to help me remember the number two.  If I’m trying to remember the number 28, then I can also think of a street performer juggling an hourglass since the number eight looks like an hourglass.   This helps me remember the number because the images are in context of a trip to Key West I made years ago where my wife and I sat along the shoreline at sunset watching street performers.

To be a good investor, there are some things we need to know cold.  These cornerstone building blocks are where these memory techniques can be beneficial.  By having the key concepts memorized, it frees us up to think more about important concepts rather than struggling to recall the fundamentals.  Surprisingly, creativity is bolstered by the memory techniques because we learn from the techniques that the more creative an image we use to remember an item, the easier it is to remember.  Having the key concepts memorized frees up your mind to work on how those concepts interplay with each other.  At the same time, as seen by the research on experts, remembering patterns is a key characteristic of experts.  It’s one thing to have experience and another to remember those experiences.  Those that remember the experiences have an advantage.

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The Enterprising Investor

The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor.

- Benjamin Graham in The Intelligent Investor

I think of an enterprising investor as entrepreneurial.  A good entrepreneur is a value investor.  He sees value where others do not.

A small business consultant once told me that the job of the entrepreneur is to take risk out of the business.   Entrepreneurs are often thought of as visionary risk takers.  However, that is not necessarily the case if you think about the great entrepreneurs.

Like great entrepreneurs that saw an opportunity where others did not, the enterprising investors sees value where others don’t.

Like the good entrepreneur that reduces risk in his business by being fiscally conservative and focusing on the core business, the enterprising investor can reduce his risk by being fiscally conservative and focusing on deep research.  The entrepreneur is contrarian and the enterprising investor is contrarian.

Like the good entrepreneur that doesn’t limit himself to a desk job at a large corporation, the enterprising investor doesn’t limit himself to a dogmatic investment process.   He adapts.

This doesn’t mean that the enterprising investor neglects his principles.  On the contrary, the enterprising investor conducts his business in a disciplined manner around his principles.  The principle that the value of an investment is determined by its cash flows doesn’t change.  How you determine and arrive at that value can change depending on the circumstances that surround the investment.  Whether the investment is a bond, stock, real estate or a farm, the enterprising investor remains focused on the value principle.  The extra work he puts into determining how to value the investment is worthwhile over time.

Due to the power of compounding, this extra work rewards the enterprising investor that approaches his investments with a disciplined research and valuation framework.

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McKesson Corporation: Good Company, Fair Investment


In my previous analysis, I determined McKesson Corporation (NYSE:MCK) to be a solid and well run company with some competitive advantage.  That is not enough to make an investment.  As a value investor, I have to see a discount to a conservative estimate of a company’s intrinsic value in order to warrant an investment.

The future demographics look good for MCK.  The U.S. Census Bureau forecasts growth of 2.1% annually in the 65-84 year old age group and 2.8% annually in the 85 and over age group with total growth for both age groups coming in at 2.2% for the 2000 to 2010 period.

Obviously, a growing older population bodes well for a drug distributor since older people take more medication.

The U.S. Bureau of Labor forecasts real GDP at 3.0% annually for the 2010-2020 period and the investment firm GMO forecasts normalized inflation over the next 15 years to be 2.2%.  It seems reasonable to me to forecast MCK’s revenue growth at 5% annually for the next five years.  Basically, I’m looking at 3% real growth in distribution revenue and 2% for inflation.  I believe this to be conservative since I’m in the higher inflation camp.  However, I have to defer to GMO’s 15-year normalized forecast since they have one of the most robust forecasting methodologies around and a hell of a historical track record.

Additionally, all of my 5-year forecasts are viewed more as conservative normalized figures.

I’m forecasting Costs Of Goods Sold (COGS) to expand 20 bps to 94.8% and Sales, General & Administrative (SG&A) to remain flat at 2.9%.  Both are conservative and less optimistic since there is a possibility that COGS could decline as more generic drugs are distributed by MCK since they have higher margins.  There is also the possibility that SG&A should compress over time as MCK continues to improve operational efficiency and gain more scale.

Assuming continued share buybacks and the payout ratio remaining at 15%, I arrive at diluted EPS of $10.34 in year five.  With the industry average P/E of 14.3, MCK’s 5-year average P/E of 16.2 and the S&P 500’s current average P/E of 14.9, I am using a market multiple of 15.  This assumes some compression in MCK’s P/E while it remains above the industry average.

Using a modified Dividend Discount Model (DDM), I arrive at an intrinsic value of $100.20 per share.  With the stock trading at $98.00, there is very little discount to intrinsic value.   I would prefer to buy these shares at a 20% to 25% discount to intrinsic value.  That would put the current entry point at the $75 to $80 range.

While I am skeptical of using EBITDA since it excludes the real costs that are interest and taxes along with depreciation and amortization which are accrual estimates of real costs, I have included it in my analysis since The Value Guys use EBITDA as a proxy for cash flow in their discussions.  I suspect that Val Hughes does more extensive modeling in the value shop he runs and uses EBITDA as a quick view into a business.

I would not value a business using EBITDA alone.  However, I do find some value in deconstructing the income statement into EBITDA, EBIT and EBT and finally NI to see where the costs are.  There is also some value in EBITDA in that others use it to value companies, especially private equity companies.  A lot of Mergers & Acquisitions (M&A) are transacted with EV/EBITDA multiples in mind.  So EBITDA gives some view of the potential of a company if it is a possible M&A target.  It shows what the upside potential is.  Some might describe me as more pessimistic.  I like to think of it as being realistic.  I like to look at the downside and base line scenarios.  However, it also helps to look at the upside for a frame of reference.  In this case, I don’t think MCK is a potential take over target, so I wouldn’t even bother to look at EV/EBITDA as a proxy for the company’s upside potential.

Interestingly, in the podcast, Val Hughes said that at the time of their podcast that MCK was trading at around 8.5x EBITDA.   Val said that the all time high for MCK is trading at 11x EBITDA and that he would look to sell at the high-end of the range.   Putting my valuation into that frame of reference, I would look to be buying at 8x EBITDA and selling at 10x EBITDA.  So currently, that would be buying at $82 and selling at around $102.  This works for MCK because the company doesn’t have any excessive cap-ex requirements or leverage.

I’m sticking to my official answer though.  My intrinsic value estimate is $100.20 and it’s a potential buy at the $75 to $80 range.  Otherwise, I’d sit on the sidelines.

Disclosure:  No position in MCK

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McKesson Corporation: There is Money in being a Drug Dealer, I mean Drug Distributor

For the first time in their history, The Value Guys used momentum as part of their screen for their Good Fundamentals/Good Momentum Edition.  They started with the fundamental factors of sales growth greater than the industry, operating margin greater than the industry median and an expected EPS growth greater than 10%.  The additional momentum screen of 52-week stock performance better than the S&P 500 was then added.  Five hundred stocks passed each filter but only 71 passed all four filters.   The Value Guys then picked ResMed Inc (NYSE: RMD), Union Pacific Corporation (NYSE:UNP) and McKesson Corporation (NYSE:MCK) for review in their podcast.  Val Hughes’ picked MCK as his favorite of the three.

Business Overview

McKesson Corporation (NYSE:MCK) primarily provides pharmaceutical distribution to pharmacies and hospitals.  They operate in two business segments, Distribution Services and Technology Services.  Distribution Services makes up over 95% of the $123 billion of revenues the company posted in 2012.

Based in San Francisco, MCK employees 37,000 people and is the largest drug distributor amongst its competitors Cardinal Health, Inc. (NYSE:CAH) and AmerisourceBergen Corp (NYSE:ABC).

At first look, MCK’s margins and operating history are not very attractive.  In the past five years, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) has averaged 1.7% and EBIT (Earnings Before Interest and Taxes) have averaged 1.6%.  This is made up by ROE (Return On Equity) averaging 16.8% in the past five years.   These are low margins but on a small equity base.

Competitive Analysis

EBITDA margins of 1.7% don’t indicate a company with a competitive advantage.  GAAP accounting isn’t presenting the investor with the economic reality of this company as shown by the Income Statement below.

Most of the revenues can viewed as a pass through.  MCK receives product from the pharmaceutical companies and holds it for a short period of time prior to shipping it to the end customer.  The inventory turns are so high that looking at the revenue for the Distribution Services segment as a pass through would give us a picture of the economics of MCK’s competitive position.

The proforma income statement below presents MCK’s revenues as if the cost of goods portion of the drugs purchased is viewed as a pass through.  Instead of the sale price of the drugs being booked as revenue, the markup that MCK receives is booked as the revenue.  It’s as if MCK is running a logistics business.  If United Parcel Service, Inc. (NYSE:UPS) was running the logistics for drug distribution, they would charge for the shipping and storage of the drugs passing through their system.   Just think what UPS’s revenues would be if they were posting the underlying value of the packages they shipped as revenue!  If you step back from the number $122 billion in sales and think about it, that is a huge number.  That puts them behind the likes of Hewlett-Packard Co. (NYSE:HPQ) at $127 billion in sales and Ford Motor Co. (NYSE:F) with $136 billion in sales and both these companies make products that they sell to end customers.  MCK is a middleman, a wholesale drug dealer.

From the segment information presented in the 10-K, we know that the revenues for the Technology Solutions segment in 2012 was $3.3 billion of the $122.7 billion of total revenues for the company.  We know that practically all of the cost of sales was for the Distribution Solutions segment.  The segment information presents the operating income for Distributions Solutions and Technology Solutions.  Making adjustments so that gross income is the same as the original income statement, the revenues for Distribution Solutions was $3.3 billion in 2012 resulting in total adjusted revenues of $6.6 billion in 2012.

The company’s margins are dramatically different when looked at with adjusted revenue.   EBITDA margins now average 32.5% and EBIT average 30.1%.   These kind of margins indicate MCK may have a competitive advantage.

DuPont Analysis

To better look at this dynamic, it is good to look at the company with the DuPont Analysis.  Using the original income statement we can decompose to see where the return on equity is coming from.

MCK has solid ROE (Return On Equity) for the past five years averaging 16.7%.  This kind of ROE would indicate some competitive advantage.  While a higher ROE sustained over a long time frame would potentially indicate a stronger competitive advantage, the nice thing about this level of ROE is that it’s difficult to see a new competitor being able to enter MCK’s industry with $6.8 billion in equity and be able to compete effectively enough to garner a 15% return.  If the ROE for MCK was over 30%, that might attract upstarts to take the risk to enter their industry.

DuPont Analysis breaks ROE down into three components:  Profit Margin, Total Asset Turnover and the Equity Multiplier (Assets/Equity).  We can see from the DuPont Analysis, that while MCK posts very low profit margins, that averaged 1.02% in the past five years, the ROE is driven by Total Asset Turnover averaging 3.91 and Assets/Equity averaging 4.19.  ROE is driven by high asset turns with a dose of leverage.

The neat thing about DuPont Analysis is that you can continue to break down each component and get into the weeds to see what is going on. There is no need to do that here but it is interesting that while assets turn four times per year, average Inventory Turnover was 11.5x in the past year with 12.0x in 2012.  At 12x, MCK is basically emptying and restocking their warehouses every month.  That’s pretty impressive operating efficiency.   For perspective, that kind of Inventory Turnover is similar to Costco Wholesale Corp (NSDQ:COST) and The Kroger Co. (NYSE:KR) and higher than Wal-Mart Stores Inc. (NYSE:WMT).

Market Share and Customer Concentration

MCK has a large market share in the drug distribution business with approximately 32% of the market by revenues.  With only two other large competitors and the remaining being small fragmented players, MCK is the largest competitor in an oligopoly.  There are some customer-switching costs as the distribution contracts are typically multi-year contracts.  The downside is that MCK may lack bargaining power with its customers as they are highly concentrated with the top ten largest customers making up 52% of revenues.  Sales to their two largest customers make up 26% of total sales with CVS Caremark Corp (NYSE:CVS) at 16% of sales and Rite Aid Corp (NYSE:RAD) at 10% of sales.  Wal-Mart Stores (NYSE:WMT) maintains the second largest receivables balance at 10% of receivables indicating that WMT is likely 8%-9% of sales.  Luckily, it appears that the industry is fairly rational so the lack of bargaining power with customers is made up by the low competitive rivalry within the industry.

The potential of a lack of bargaining power with their customers is one of the few things that makes me nervous about MCK.  One upside to this weakness is that, as long as the industry remains rational, the loss of one of their top customers could be a great entry point into the stock if the market irrationally crushes the stock price.  I like MCK but the price has to be right.

Disclosure:  No position in MCK.

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