Showing posts with label guest post. Show all posts
Showing posts with label guest post. Show all posts

Thursday, January 31, 2013

Costco Dividend Stock Analysis for 2013

Costco Wholesale (COST) is a large membership warehouse retailer that sells a variety of bulk goods in several countries.


-Seven Year Revenue Growth Rate: 9.4% Dividend Stock Report
-Seven Year EPS Growth Rate: 8.6%
-Seven Year Dividend Growth Rate: 13.3%
-Current Dividend Yield: 1.08%
-Balance Sheet Strength: Strong
Costco is one of the lowest yielding stocks that I publish analysis articles on when not taking into account their recent huge one-time special dividend.
Overall, much like last year, I think Costco is a fantastic company and a respectable stock for long-term capital appreciation, but at the current time, I view it as fully valued with little or no margin of safety, and it doesn’t offer a very appealing regular dividend yield.

Overview

Founded in 1983, Costco Wholesale (NASDAQ: COST) is a large warehouse-based retailer, primarily located throughout North America but with a presence in Europe and Asia as well.
With over 170,000 employees, Costco operates 622 warehouses. Of these, 448 are in the US and Puerto Rico, 85 are in Canada, 32 are in Mexico, 23 are in the UK, 13 are in Japan, 9 are in Taiwan, 9 are in Korea, and 3 are in Australia. In addition, Costco operates its large online retail site.

Category Sales

Costco warehouses offer various items, clothes, food, electronics, glasses, pharmacy drugs, gasoline, car-washes, and more. There are bulk items for cheap shopping, but there are select higher-end items.
Sundries (cleaning supplies, tobacco, alcohol, candy, snacks, etc.) accounted for 22% of 2011 sales.
Hardlines (electronics, hardware, office supplies, beauty supplies, furniture, garden, etc.) accounted for 16% of sales.
Food accounted for 21% of sales.
Softlines (clothing, housewares, small appliances, jewelry, etc.) accounted for 10% of sales.
Fresh food accounted for 13% of sales.
Ancillary and other (gas, pharmacy, food court, optical, etc.) accounted for 18% of sales. (This is their fastest growing segment, as they put more of these areas in newer Costcos.)

Ratios

Price to Earnings: 25
Price to Free Cash Flow: 24
Price to Book: 3.5
Return on Equity: 15%

Revenue

Costco Revenue
(Chart Source: DividendMonk.com)
Revenue growth over this period has been particularly strong at 9.4% per year, which is quite substantial for a large and consistent company. Every year except 2009 had strong revenue growth

Earnings and Dividends

Costco Dividend
(Chart Source: DividendMonk.com)
EPS has grown by an average of 8.6% per year over this period. The growth has been fairly smooth with the exception of 2009.
Costco has a low dividend yield of only 1.08% as of this writing, and a dividend growth rate averaging 13.3% per year over the last seven years. I rarely cover companies with a yield that low, but Costco is an exception because the company quantitatively has all the characteristics of a dividend growth stock despite the fact that it will fall significantly below many income investors’ yield minimums. The payout ratio is on the low side at only around 25%, but as a comparison, that’s higher than Exxon Mobil and Aflac, and only a bit below Chevron, which are all classic dividend growth stocks that I publish reports on.
The low yield is the result of a combination of this fairly modest dividend yield and a fairly high valuation (PE of 25) rather than due purely to an extremely low payout ratio.
How Does Costco Spend Its Cash?
For the fiscal years 2010, 2011, and 2012, Costco brought in a total of approximately $5.2 billion in free cash flow. Over the same period, the company spent under $1.2 billion on dividends, $1.8 on net share buybacks, and under $1 billion on acquisitions. The company has reduced its share count by a bit over 10% over the last seven years, which isn’t a very large amount due the consistently robust valuation of the stock.
Unfortunately, in my Dividends vs. Share Repurchases article which I often reference, I use Costco as a prime example of a well-run company that makes suboptimal share repurchase decisions. Few would argue that Costco has not been exceptionally well-managed since it’s founding overall, and yet it is quantitatively demonstrable that the company is not making the best possible use of its cash when it comes to these buybacks. Costco is not alone in this; it’s the corporate norm.
For example, the Costco stock price has been on a smooth upward trajectory over the last 10 years, with the one big exception being during the financial crisis between late 2008 and throughout 2009 and into early 2010. The year of 2009 was a particularly low year for the stock. And yet, when one looks through their history of share repurchases, it turns out management spent a considerable amount of money on share repurchases every year since 2005, with the exception of 2009. When the stock price was at its lowest, Costco was hording cash and not buying, but when times are better, cash is flowing, and the stock valuation is higher, Costco liberally buys back more shares.
This is a consistent theme with American blue chip stocks. A Credit Suisse research study showed that broadly speaking across the market, share buyback amounts are positively correlated with stock price. In other words, the higher the stock value, the more companies are buying their shares back.
While Costco management has done a tremendous job in terms of total shareholder returns, wise shareholders would likely be slightly better off if the payout ratio was increased to a more moderate figure; perhaps in the 40-55% payout ratio range, at the cost of reduced share buybacks. Shareholders can decide to reinvest that money or not.
The recent $7 special dividend was in my opinion a good use of cash for shareholders. This won’t be a common thing, since it was based on the political environment and was worth a couple years worth of free cash flow generation by the company.

Balance Sheet

Before the special dividend, Costco had a very strong balance sheet with a total debt/equity ratio of under 11%. The total amount of debt was lower than the annual income and the interest coverage ratio was well over 30. Due to Costco’s low acquisition activity, goodwill hasn’t accumulated on the balance sheet.
The company tapped into this battery of capital to pay a huge $7 special dividend at the end of 2012 that is not yet reflected in a quarterly report. That was before there was a ‘Fiscal Cliff’ deal and changes in dividend tax rates were uncertain. It was prudent to pay a larger dividend while tax rates were known to be low. The company offered over $3 billion in debt to fund this dividend which cost over $3 billion to pay all shareholders. Based on the addition of debt and the subtraction from shareholder equity, Costco’s balance sheet will be a bit more leveraged but still fairly conservative.
A dividend of this magnitude shows specifically why a strong or weak balance sheet should be taken into account when valuing a stock. A strong balance sheet can act as a battery for shareholder returns should the opportunity arise, either in the form of dividends, buybacks, acquisitions, or core growth. When analyzing a stock with the Dividend Discount Model or Discounted Cash Flow Analysis, I generally take the strength of the balance sheet into account by allowing for a smaller margin of safety or by allowing for a slightly reduced discount rate.

Investment Thesis

Costco’s business model is meant to maximize efficiency. The warehouse format keeps costs low, as they buy and sell items in bulk. Shoppers (both consumers and small business owners) pay membership fees, and in return receive exceptionally low prices. The warehouse model also generally operates moderately reduced hours compared to typical retailers. Although Costco offers a large range of products, they limit their selections in each category to only the best-selling ones, so the number of individual products is actually lower than many other retailers (as in, less than 10% as many items as in a Walmart store) and they can maximize their purchasing power for these items. This further streamlines their business.
Costco’s memberships keep customers loyal, and they have a high renewal rate. Costco can keep its prices reasonably competitive with Wal-Mart by maintaining such a low profit margin. The company gets most of its profit from membership fees while its goods are sold at very low markups or even at losses.

Growth

YearWarehousesGold Star MembersBusiness Members
201262226.736 million6.442 million
201159225.028 million6.352 million
201054022.539 million5.789 million
200952721.445 million5.719 million
200851220.181 million5.594 million
200748818.619 million5.401 million

Each year in this snapshot, as well as in many previous years, Costco increased their number of warehouses, and saw an increase in both gold star members and business members. As of the most recent report, Coscto has 622 warehouses as of the end of their fiscal year 2012.
Despite Costco’s mild setback in 2009 due to the recession, Costco became the 3rd largest retailer in the US compared to its spot at 5th in 2008, and is one of the largest retailers in the world as well.

Two Points for Bullishness

There are a couple key things I want to highlight that, in my view, make Costco not (quite) as overvalued as it seems.
1. Revenue growth is outstanding. Most large businesses aren’t growing revenue at nearly the pace of Costco. Costco’s number of stores is growing, their number of members is growing, and they have repeatedly demonstrated the ability to raise their membership prices without substantial drop-off rates.
2. Low profit margins can mean eventual upside. Costco is currently sacrificing profitability for solid ethics and market share growth. Costco is a viable competitor to even Walmart, and yet has only existed since the 1980′s. The larger the revenue becomes, the more pricing power they have, and the denser their store locations get, the more efficient they become. The net margin is currently under 2% compared to Walmart that has a profit margin of over 3%. The retail industry competes on price and has low profit margins across the board, so an increase of 25-50 basis points has a huge impact on the bottom line. Costco’s business of model of high employee pay and selling a larger amount of fewer products has resulted in extremely strong sales per square foot of retail space.

Risks

As a retailer, Costco is a middle-man, with limited pricing power, and the retail industry is incredibly competitive. Costco faces competition from warehouses like BJ’s and Sam’s Club (owned by Wal-Mart), general retailers like Wal-Mart, Target, and Kohls, as well as from online competitors like Amazon.
In addition, since the stock has a fairly high valuation, there is considerable risk of poor stock performance if Costco doesn’t continue to outperform as a company.

Conclusion and Valuation

Based on DCF analysis with a 10% discount rate, the current market cap of around $44 billion is justified if the company can grow free cash flow by 8% per year over the next 10 years followed by 4% per year perpetually thereafter, which is a rather aggressive estimate.
Alternatively, if those estimates are toned down to 7% growth for 10 years followed by 3% perpetual growth with a discount rate reduced to 9%, the current market cap is fair.
These estimates demonstrate that while the current valuation may not represent an overvalued stock, it likely doesn’t offer any significant margin of safety either.
With such a low yield, the stock is obviously not an ideal selection for investors that desire current income as part of their financial freedom. For investors that appreciate the qualities of Costco that make it a similar quantitative and qualitative investment to other dividend growth stocks but with a reduced yield, it may be a decent selection for long term capital appreciation.
I believe Costco stock will continue to increase in price over the long-term, but at the current time with the stock a bit over $102/share, I observe that there are likely better (and significantly higher yielding) dividend growth investments out there.
Full Disclosure: As of this writing, I have no position in COST.
You can see my dividend portfolio here.
This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]

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Thursday, September 10, 2009

Why now might be a good time to buy Manulife (MFC)

This post is presented by Intelligent Speculator, a blog that discusses the markets, makes some picks, mainly in the ETF asset classes as well as technology stocks.

Making stock picks is never easy, but we are now ready to make another one. Manulife has been in the news for the past few weeks, mainly for negative reasons. On August 6th, it took markets by surprise by announcing a 50% cut to its quarterly dividend, from .26$ to .13$, starting with this year’s September 21st dividend. It is a surprise in the sense that few had expected such a drastic measure. Most investors are aware that Manulife, like many other insurance companies, has been hit very hard by the recent financial crisis. This move will save the company $800 million, in order to recover its historical stability from what has now become a vulnerable financial situation. Naturally, investors did not appreciate the move and the stock price dropped very quickly. This might be an opportunity to get a solid stock at a decent price, for many investors. While in the past we have warned about investing in financials, we believe they are now back on the right track.

Manulife's CEO said: "While we recognize the importance of a cash dividend to many of our common shareholders, we believe that retaining more of our earnings is the most effective means of building capital while still providing an attractive yield for our shareholders who will benefit as we deploy our capital for growth." Most companies would deliver a similar message when dropping their dividend but I do believe that the more positive news is that Manulife did not wait too long to make this move. The company's stock is down 42% over 2 years because of bad hedging decisions that have been very costly.

Big buys, like Jarislowsky Fraser (who holds 49.5 million shares), have already confirmed they would be buying more shares as they deem the drop as exaggerated. "I don't like dividend cuts, but it was the prudent thing". One question, of course, is if you'd prefer investing in an insurance company like Manulife that has already dropped its dividend yield or perhaps take a chance on the banks. They continue to do their best to keep up their dividend yields yet it is still unclear if they will be able to do so.

Personally, I'd go ahead and buy Manulife, the stock seems poised to recover, eventually. Even now, its dividend yield of about 2,4% is not bad considering the current market. For the next 12 months, the estimated earnings per share are 1.244 (according to Bloomberg) so even its current valuation should warrant a purchase of the stock.

What do you think? Agree with the purchase of MFC with a medium to long term time objective?

Full Disclosure: None

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Tuesday, August 18, 2009

Buffett's Newest Stock Pick

Jae Jun is the author of Old School Value, a value investing blog focused on fundamental analysis, stock valuation and stock ideas that offer high returns with low risk.

With the release of Berkshire Hathaway's 13-F filing, you can see that a new addition has been made to the holdings of Berkshire Hathaway.

1.2million shares of Becton Dickinson & Co (BDX) were added which totals $86.6 mil but compared to his total portfolio and other holdings, it is a very small position. This initial position is half the size of when Berkshire first added Eaton Corp (ETN) which again leads me to think that it was a subsidiary making the purchase as Buffett is known to go big first time around.

I previously went over BDX briefly while going through the 40 Best Stocks to Retire on and noted that the company...

...has consistently produced plenty of FCF but FCF growth has been minimal, very good CROIC of 15%, steady growth in shareholders equity/book value, stable rising margins, debt to equity is consistently dropping, sales has been increasing. - Best Stocks for Retirement

Whoever made the purchase, BDX looks to be a typical Buffett type company. Long history or consistent performance with results to match.

Quick Look


[caption id="attachment_2136" align="alignnone" width="433" caption="BDX Spider Graph"]BDX Spider Graph[/caption]

Business Summary


Becton, Dickinson and Company (BDX) is a medical technology company that operates through three business segments: BD Medical, BD Diagnostics, and BD Biosciences.

  • BD Medical: offers syringes, needles, monitoring systems, drug delivery systems, blades, scalpels and thermometers



  • BD Diagnostics: microbiology products, specimen collection products, specimen management systems, diagnostic instruments and consulting services



  • BD Biosciences: flow cytometry systems for cell analysis, monoclonal antibodies for biomedical research, molecular biology products for the study of genes and their functions, cell growth and screening products and labware products


The company generates more than half of its revenues from international operations which will help to diversify income but swings in foreign currency can impact top line results. But remember, it's the bottom line that is most important.

Financial Statement Analysis


Running through the numbers I see the following:

  • Gross, operating and net margins have been steadily increasing even in a recessionary environment

  • A dividend aristocrat which has increased dividends for 36 years

  • FCF positive for more than 10 years

  • Inventory turnover consistent but since margins have increased, leads to higher efficiency and profit

  • ROA and ROE increasing steadily

  • Reduced debt

  • Very low capitalization ratio which shows how leveraged the company is with debt

  • Has plenty of FCF to pay down debt rather than issue stock or seek loans

  • CROIC is very steady at 17% which means that the company makes 17c off every $1 of cash invested

  • Converts 12c of every dollar in sales to FCF. BDX is a FCF machine.

  • Excellent management


DCF Intrinsic Value Estimate


The assumptions are as following for the DCF model:

  • With the level of consistency and outstanding numbers a 9% discount rate is used

  • 10% growth rate which is just a little under the FCF growth but looks to be the rate of growth the company has displayed according to the graph below. After all price follows value which means I can reverse engineer the DCF to find the growth rate.

  • 50% margin of safety but don't feel it has to be so big for BDX


With a couple of assumptions you can see from the graph below that BDX has been trading close to its intrinsic value until September 2008 when the markets crashed. It's probably the biggest drop and difference its had so far.

Intrinsic value comes out to $87.

[caption id="attachment_2139" align="alignnone" width="500" caption="BDX Price vs Value Graph"]BDX Price vs Value Graph[/caption]

(Click on the image to view the PDF version of the stock analysis and graphs.)

Benjamin Graham Formula Valuation


BDX top line growth is just as good as its bottom line. By looking at multiple years and comparing them in a staggered fashion and then looking at the mean to smooth out cycles and one time bad years still shows a historical EPS growth rate of 17%. My calculated 17% is actually fairly close with Yahoo or Reuters past 5 yr growth rate of 16%.

This is a little too high by my standards for future growth in a mature company which is why I lowered it down to 10%.

This gives a fair value of $111.

Competitor and Peer Analysis


Probably the simplest way to value a company.

If you look at the 7th page of the stock analysis report that I posted, you will see that BDX side by side with 5 competitors and the numbers show that BDX is slightly cheaper than its competitors.

BDX current PE of 13.86 is lower than peers with less revenue and lower metrics. Seems like 15 or 16 is what BDX would be trading at if priced correctly.

  • PE 15 = $72

  • PE 16 = $76


Summary


From the valuations we looked at, BDX looks to be worth somewhere between $72 - $111 but I believe the range would be more towards $76-$90.

Becton Dickinson looks to be a very typical Buffett type company selling at a discount to its intrinsic value.

This article was featured on Carnival of Personal Finance - History of College Football Edition

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Saturday, June 6, 2009

Risk Tolerance and Smart Investing: When Fear shouldn't be a Factor

This is a guest post by Carson Brackney, writer for Personal Finance Analyst. Personal Finance Analyst is an online community of bloggers dedicated to taking the mystery out of money and helping you to live a happier, more successful life with the money you have.


New Jersey's Cooperative Extension Services (operated out of Rutgers University) offer a great online quiz that will calculate your level of investment risk tolerance. If you don't like that one, you can take a look at Yahoo's free calculator. Still not happy? Merrill Lynch has their own. And there are others. Many others.

And all of the calculators attempt to do the same thing--they want to tell you how much risk you're comfortable taking in your financial planning. Obviously, that's a tough nut to crack. We don't really have a standard unit of measurement for risk, after all. So, what you end up with is a numerical score that corresponds with a few sentences describing the way the calculator believes you feel about risk and money.

Is that valuable information? For some people, it might be. There are undoubtedly a few folks out there who aren't big fans of introspection who've never considered whether they're devil-may-care or risk aversive. Those horoscope-like explanations of what the results mean might give people a slightly better sense of what their feeling really mean in some senses.

In those ways, you could consider the risk assessment tools valuable. They also have some potential value if you find that your attitudes about risk are in direct conflict with your optimal personal finance objectives (more on that later).

Even though there is some value in calculating your risk tolerance, you shouldn't fool yourself into believing this information is truly mighty. Don't make the common mistake of assuming that your comfort level should dictate your resource management.

That's right, the argument that you should only invest at a risk level compatible with your own comfort level is wrong, wrong, wrong. If you're tolerance for risk is out of whack (in either direction), you don't necessarily need to change your investment pattern. You need to adjust your attitude instead.

That argument assumes an optimized investment plan, of course. The argument is quite simple. You should be following the best possible system to reach your financial objectives. If you are using that system and your personal sense of risk tolerance runs contrary to it, you need to change your attitude, not your plan.

Not everyone agrees with that. Statements like, "Your risk tolerance should determine a suitable asset allocation that is right for you" are common. There's a belief out there that you shouldn't invest if the move makes you uncomfortable.

That's a backwards perspective, though. You should be focused on developing a plan of action that will meet your needs and objectives. If you can do that while staying in your psychological "comfort zone", that's great. If, however, it moves you into uncomfortable territory, you need to change the dimensions of that "comfort zone".

Otherwise, you're setting yourself up for a long-term failure. If you need to undertake a certain level of risk to reach your goals, anything short of that is going result in you falling short of those goals. If the plan is sound and the strategy is workable, you should be at least somewhat comfortable in knowing you're doing the right thing. If you don't feel that way, it's time to either (a) persuade yourself to start or (b) prepare to be nervous for a while.

InvestorGuide.com lays out the argument:

We need to remember that it is not only our personal risk tolerance that we want to consider, but we also want to ask ourselves, "What is the appropriate risk to take?"

Asking how you feel about something is wonderful. Letting the answer dictate your personal finance strategy, however, isn't. Instead, you should be making decisions based on your own financial interests.

If you don't have a good plan and you're living on a personal finance roller coaster, it's fine to take stock of your comfort level and to act accordingly. If you're following the kind of smart plan you need to get ahead, however, your comfort level needs to take a backseat.

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Tuesday, May 26, 2009

The Sweet Spot of Dividend Investing

The following is a guest post from Dave Van Knapp, the author of The Top 40 Dividend Stocks for 2009. Make sure to check his site from this link.

In long-term dividend investing, one needs to control risk in many areas. Risk comes in many forms: selecting unsound companies; purchasing companies whose dividends are in peril; creating a portfolio that is insufficiently diversified; and so on.

Two important areas of risk to a long-term dividend strategy are the initial yield and expected growth rate of the dividend itself.
If you start out with too low a yield, it will take many years for the dividend to grow to where it provides a worthwhile return on your original investment. On the other hand, if you start out with too high a yield, it may well be that the dividend is unsustainable and in peril.
If the company typically increases its dividend at too slow a rate, again the dividend will take too long to grow into a desirable return. On the other hand, if you anticipate too fast a growth rate, the company may not achieve it.Plotting these two characteristics against each other--initial yield and anticipated dividend growth rate--gives us a diagram of the "sweet spot" in dividend investing.

On this diagram, the left (vertical) axis represents the dividend’s likely growth rate. It ranges from very slow (say less than 3 percent per year) to very high (say 20 percent per year or more). The bottom (horizontal axis) represents the initial dividend yield, from very low (less than one percent) to very high (greater than 10 percent).

The red area represents four places you don’t normally want to be. Here’s why:

The left edge of the chart is where the stock’s yield is simply too low to be attractive. I seek initial yields of 3 percent or more. Fortunately, because of the long bear market, a lot of quality stocks that formerly would not have cleared this hurdle now offer yields over 3%.
The lower edge is where dividend growth is too slow. Generally seek a growth rate of at least 4 to 5 percent per year. Even in this slow economy, many quality dividend companies have increased their dividends in 2009 by attractive amounts. Examples would be Abbott Labs (ABT, 11%); Coca-Cola (KO, 8%); Chubb (CB, 6%), Procter & Gamble (PG, 10%), Colgate-Palmolive (CL, 10%), and PepsiCo (PEP, 6%).
The top edge is labeled “Growth Traps.” This is where the dividend’s growth rate is probably unsustainable because it is too high. It’s a “trap,” because a high dividend growth rate is usually an attractive quality in a dividend stock. But when the growth rate is too fast, it usually cannot be continued. The very high growth rate may be a red flag that the company is over-extended in its dividend policy and will need to pull back. The risk in stocks with a high dividend growth history is that continuation of a very high rate of dividend growth is unlikely. Many value investors (including Warren Buffett) consider annual earnings growth of 15 percent to be about the maximum sustainable for long time periods.
The right edge is labeled “Yield Traps.” Again, a high yield is a good thing, up to a point. But extremely high yields often point to a problem. The reason the yield is very high is probably because the stock’s price cratered. While that could simply be the byproduct of the bear market of 2007-2009, it could also be a reflection that the company is in serious difficulty and will need to cut its dividend soon. In 2008 and early 2009, we have seen this time and again, especially among financial firms. It should go without saying that the very finest dividend stocks suitable for a long-term dividend strategy are not in danger of cutting their dividends.

The green area in the middle is the sweet spot: Initial dividend yields of between about 3% and 9%, combined with dividend growth rates of about 4% to 17%. Those are generally sustainable numbers, and it is where we will find most of the best dividend stocks for long-term investing.

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Tuesday, May 12, 2009

LCA Vision - A profitable Value Idea

The following post was written by Saj Karsan. Saj regularly writes for Barel Karsan, a site dedicated to finding and discussing value investments, and applying logic to investment decisions (as opposed to falling prey to psychological biases).

LCA Vision (LCAV) is a provider of laser vision corrective surgeries. Demand for these non-essential, expensive surgeries is strongly correlated to levels of consumer confidence. As one can imagine, this correlation has resulted in the number of surgeries performed this year to be slashed in half as compared to last year. Combined with the fact that the company's cost structure is fairly rigid (medical/laser equipment, service locations and staff still have to be present even if not used to capacity!), and the prospects for this company look grim.
This business model would make most investors head for the exits at economic times like these. For investors who look to buy businesses rather than stocks, however, this company still hassome value. And it is precisely because most investors headed for the exits that value investors were able to buy into this company for far less than it is worth.

When we last looked at LCAV, it traded with a market cap of $64 million, despite the fact that it had $56 million in cash alone! When looked at from the point of view of a buyer of an entire business (as value investors like to do), one was essentially paying $8 million to purchase a business that had earned an average of $15 million in net income the last four years. Yes, it had lost $7 million in the last quarter, but management was closing unprofitable locations, reducing capital expenditures, and believed to have cut expenses such that the company's cash flow would break even in 2009.

Since the stock's low just two months ago, the stock is up some 250%! Investors who avoided the herd mentality, and instead focused on buying businesses selling for below their worth were handsomely rewarded.

At Barel Karsan , we try to find and discuss businesses that are undervalued. If this topic interests you, consider subscribing to the Barel Karsan feed .

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Thursday, April 23, 2009

Best Big Companies for the Long Term

This is a guest post from Jae Jun from Old School Value. His blog is focused on value investing.

In the current market, small caps are not the only companies that are undervalued or mispriced. Although the markets have risen substantially from its lows there are still bargains to be had, especially if your focus is on buying for the long run. Late last year, Forbes released their platinum 400 best big companies and 200 best small companies which is a fantastic source of finding undervalued bargains. Take for example the following companies which were reviewed and estimated on Dec 11, 2008.

Blue Nile (NILE)


  • Price on Dec 11: $27.84

  • Estimate price: $32

  • Current price: $36.88


Jos. A. Bank Clothiers (JOSB)

  • Price on Dec 11: $26.15

  • Estimate price: $44

  • Current price: $36.61


Diodes (DIOD)

  • Price on Dec 11: $4.39

  • Estimate price: $15

  • Current price: $12.24


FactSet Research Systems (FDS)

  • Price on Dec 11: $38.36

  • Estimate price: $44

  • Current price: $48.22


These are small to mid cap size companies so the price difference is to be expected, but todays market also has created many of the same opportunities within the large cap universe.

Forbes Best Big 400 Companies Screen



  1. Immediately exclude financials (don’t understand or know how to value them)

  2. Run the companies through the investing spreadsheet with the PE as the growth rate, but capped at 15% except for some special cases. The selected companies shall exhibit;

    • Positive, consistent and growing cash flows.



    • Consistent margins. Fluctuating/decreasing margins over several years will not be accepted unless the other criterias are outstanding.



    • Above average returns from capital investments (CROIC, ROE, ROA)



    • Strong balance sheet



  3. Companies should have at least 5 years of operating history

  4. The companies that make the cut will have to be reviewed individually


As I was going through each of the first 25 companies, I noticed there were many capital intensive companies with high debt loads. This is because Forbes ranked the companies based on ROE where having a high debt load can play a significant role.

Also, the spreads between the current price and estimated price were much smaller as a percentage as these companies are heavily followed and more likely to trade closer to its fair value.

Going through the first 25 businesses has produced 7 candidates for further analysis. They are:

  • Apple (AAPL)

    • Great company. Need I say more?

    • Estimated fair value: $160



  • Hug Group Inc (HUBG)

    • Consistent margins, reduced debt, increased FCF/debt. Bottom line margins have not dropped too much.

    • Estimated fair value: $25-$43



  • Monsanto (MON)

    • Strong profits in recession, increased margins significantly, metrics are up.

    • Estimated fair value: $100



  • Cliffs Natural Resources (CLF)

    • Mining and natural resources is cyclical. FCF +ve past several years and margins increased. Good margin of safety but unpredictable. Cheap price could factor in the unpredictability.

    • Estimated fair value: $53-$60



  • Google (GOOG)

    • Great company. Need I say more? Incredible numbers.

    • Estimated fair value: $390-600 (Difficult to tell with GOOG)



  • Occidental Petroleum Corp (OXY)

    • Oil company but FCF +ve for past 10 years, numbers and margins are excellent for this company.

    • Estimated fair value: $87



  • Nucor (NUE)

    • Excellent company and numbers but big drop in last year margins.

    • Estimated fair value: $60


Full List of 25 Companies


Forbes 400 best big companies undervalued and cheap stocks

Disclosure


No positions in any stocks mentioned

Thursday, April 16, 2009

Value Investing is all about finding market inefficiencies

The following post was written by Saj Karsan. Saj regularly writes for Barel Karsan, a site dedicated to finding and discussing value investments, and applying logic to investment decisions (as opposed to falling prey to psychological biases).


In an "efficient market", all stocks are fairly priced by the market. If the US stock markets are efficient, and many finance industry professionals believe this to be the case, one cannot generate index-beating returns except through luck. However, if we were in an efficient market, it seems hard to believe that stock prices for even the most stable of companies should fluctuate so drastically from year to year and even from week to week. Yet that is exactly what happens.
Consider Best Buy (BBY), a US-based multi-national electronics retailer. It has generated consistent returns year after year, and has a low debt to equity ratio resulting in minimal financial risk. Yet it's stock price has fluctuated dramatically, offering astute investors the opportunity to achieve enormous returns.

Below is a chart depicting Best Buy's annual return on invested capital (ROIC) contrasted with its stock price:


While ROIC has been predictable and consistently range bound for the last several years, the stock price has been anything but. It seems hard to believe that the market is efficiently pricing this security when its price can fluctuate wildly in relatively short periods of time while the company itself generates predictable earnings on capital. For example, if the company is worth X amount in early 2000, how does it become worth just one quarter of this amount 3 months later, and then three times this amount six months after that?

More recently, three months ago the market valued Best Buy at $7 billion, but now values it at $16 billion! Investors who recognized the mispricing have seen returns of over 100% in a 3 month period!
We've also seen other examples of this phenomenon: we've looked at graphs illustrating wild fluctuations in the historical P/E ratios of Coke and Walgreen, for example, which have allowed value investors to buy in at tremendous discounts.
Value investors willing to put psychological bias aside and instead invest at the height of the market's fear can indeed achieve above average returns. If this topic interests you, consider subscribing to the Barel Karsan feed.


Disclosure: Author owns a long position in BBY

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Thursday, March 26, 2009

Variable Annuities: The Fee Factor

By Laurence Greenberg, CEO, Jefferson National

In today's environment, "fee transparency" is the mantra for all kinds of financial products. Unfortunately, it’s been slow in coming to variable annuities.

Some real progress has been made with simple, transparent, low-cost products. But until greater consumer value is widespread, here's a primer on how to peel away the layers of an annuity's fees so you can weigh the benefits of what you’re getting against what you’re paying.

Generally, variable annuity owners are subject to two levels of fees: insurance-related fees from the issuing insurance company, and fees charged for the underlying investment options inside the VA. Most of these fees are asset-based—so the more you invest and the more your account value grows, the more you pay in fees. Other fees are driven by a transaction or time period, like annual service charges or additional trading fees.

PEELING BACK INSURANCE CHARGES
Most variable annuities get criticized for the insurance-related fees that drive costs up and performance down. On the typical VA, these combined insurance charges average 1.35% per year according to Morningstar.1 Here's what to look for:

Mortality and Expense (M&E): Most, but not all, annuity issuers assess M&E charges. According to Morningstar, this asset-based charge averages roughly 1.2%.1 For most annuities, this fee covers the basic death benefit guarantee, the promise that annual insurance charges won't increase, and the ability to annuitize at a guaranteed lifetime payout option down the road at the rates specified in the contract.

Because this is an asset-based fee, these costs increase as your investment grows. For a $100,000 annuity, the owner may pay around $1,200 in M&E fees; for a $250,000 annuity, the owner pays around $3,000.

With the growing popularity of ETFs in recent years, and with capital gains taxes at an all time low, to some investors this kind of M&E may seem like a high price to pay for a tax-deferred VA. So if tax-deferral is one of your objectives, it may benefit you to look for low-cost, or flat-insurance fee VAs.

Death Benefit Riders: All variable annuities have basic death benefit protection: a guaranteed return of the current account value or some portion of the initial premium if the annuity owner dies before payments begin. Now, though, more than 90% of all annuities offer an optional enhanced death benefit through the purchase of a death benefit rider.2

So if you added this rider for an extra 50 basis points a year on a $500,000 annuity, it would cost an extra $2,500 a year on top of the $6,000 M&E. Now both of those annual fees are chipping away at the returns of the underlying funds. If you’re insurable, a term life policy may be more cost-effective.

Living Benefit Riders: Many annuities also offer options that guarantee an enriched income stream in the future—but at a price. Annual fees for these riders typically cost an additional 1% to 3% per year or more.2

Here's another thing to consider. While annuities grow tax-deferred, annuity income benefits are taxable. So that enhanced benefit has a bigger tax bite. If you are looking to lock in additional future income, tax-free bonds may be a better alternative—providing more tax-advantaged income in the future, without annual fees.

Surrender Charges: Most typical VAs will pay a sales rep a commission of 5% to 7%, or more. Then to ensure that the issuing company can recoup their commission, these VAs impose a surrender charge. The surrender charge is an asset-based fee that may start as high as 7%, but will decrease to 0% over the course of the surrender period, which is typically the first 5 to 7 years of your contract. The surrender charge helps the issuing company to defray the commissions paid to its salesperson if the annuity does not stay on the books—and it can keep you locked in for years, unless you are willing to pay this penalty. Be sure to check your contract to find out whether surrender charges apply.

“No-Load” VAs do not pay a commission to a salesperson, so they do not have a surrender period or a surrender charge.

Annual Policy Fees. Many VAs charge a nominal policy fee, such as $25 a year. One more item that adds to your costs.

EVALUATING INVESTMENT FEES
Inside your variable annuity, you will find a selection of underlying funds, also known as sub-accounts or investment options. These underlying funds will charge annual asset-based fees which may vary widely—averaging from 0.6% for basic money market funds to 2.3% for bear market domestic stock funds.2

The annual fees charged for your underlying funds cover the cost of professional third-party money management—such as fundamental research, ongoing monitoring and allocation rebalancing. These annual fees may also include 12b-1 fees, which may pay for marketing and distribution.

Some companies allow free, unlimited trading of funds. Some will limit the number of free trades in a year by assessing a transaction-based fee. While a transaction fee may not be an issue if you are practicing a buy and hold strategy, it may be very costly if your variable annuity assets are actively managed. So be sure to know the trading policies of your annuity carrier.

WHAT YOUR STATEMENT DOESN’T STATE
Here's a little-known fact: Fees are not explicitly reported on variable annuity statements. All you will see is performance after fees have been deducted. So there's no annual reminder of what you are paying for, or what it costs you in terms of performance.

The best way to deconstruct the fees for any variable annuity is to read the prospectus. Then, ask yourself or your financial advisor these three key questions:

1) Does the annuity's long-term tax deferral match your financial objective?
2) Do death benefit and living benefit riders offer worthwhile guarantees--at a good value?
3) If a change is warranted, have your surrender charges expired?

The Bottom Line: The right variable annuity can still offer an attractive value for many investors, and can maximize the power of tax-deferral to help you accumulate more and reach your retirement goals faster—but only if it's not bogged down with excessive fees.

Laurence P. Greenberg is President and CEO of Jefferson National, which developed Monument Advisor, the first flat insurance fee variable annuity. See the impact fees and charges may actually have on your savings by taking the challenge at http://www.annuityrescuecenter.com/. For more information or to receive a prospectus, visit http://www.jeffnat.com/ or call 1-866-WHY-FLAT (866-949-3528).

1 Morningstar® data as of 12/31/07.

2 2007 Annuity Fact Book, National Association of Variable Annuities.

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Thursday, March 5, 2009

Telling the truth or being positive?

Intelligent Speculator is a blog about investing, news and comments about the markets and the relevant news. It also supplies users with free stock picks that will hopefully help you get ahead. You can visit the blog at IntelligentSpeculator.net and subscribe to the RSS feed here.

It is always quite a dilemma isn’t it? No matter if you are a politician or a company executive, you are faced with this crucial decision once things start to go wrong. Which one? Telling the truth or painting a more interesting picture of the situation. So you think this is an obvious choice? Not so I would say.

I always find it interesting that citizens think it is always in our best interest to tell the truth about the financial situation. Of course in theory it sounds so obvious. But there are so many examples. Take General Motors (GM). I think every single planet in North America (and many other parts of the world) know they are in a major danger of going bankrupt and that they need a massive intervention by the US Federal Government. Will it happen? Who knows really? But if you are buying a car, don’t you think that could come into play when deciding about buying one brand as opposed to another? Wouldn’t you think for a second that you might have more problems with your warranty for example? And so it does become self-fulfilling in a way. GM is in trouble, it announced to everyone that it could face bankruptcy without help. Because of that, the few that are buying cars right now are mostly staying away from GM creating an even bigger problem for the executives and the government. How long can it go? Probably not very long unless the government takes out the uncertainty about what will happen in GM’s future. Want numbers? Toyota has suffered a 32% decrease in sales this January in the US market. Terrible isn’t it? But GM has suffered an even bigger loss with a number about 50% lower than in 2008!!! Let’s not remember that in the US, GM and Toyota (TM) have a similar market share.

I think the same applies to financial markets in general. We all know that we rely on a system based on trust. Trust that the US dollar and other currencies is worth something. Trust that the government will provide services but also trust that our banks, despite having very little liquid assets, will be able to provide liquidity when needed. But with the banking crisis that has been ongoing for over a year now, it is that exact confidence that is under attack. What would happen if consumers started doubting that their banks could give them back their money? Sure, the FDIC insures deposits in the US, but we all know it is in theory possible for the FDIC and the entire system to collapse.

And so the US government had a tough challenge in my opinion. On one hand, you do not want to worry the citizens or generate any panic that could become self-fulfilling, but on the other hand, how do you convince citizens that Wall Street requires a $800 billions bail-out if you do not explain how dire and serious the situation is? Probably the best way is the one that has just happened. Bring in a president that inspires so much confidence that citizens will trust him when he tells them it is necessary and that it must pass. That is probably the best thing that could have happened and probably the way it should be.

Ask for answers and explanations, but always know that it is potentially better to have Americans not waking up to news about a possible system collapse. We’ll never know for sure what happened but when Lehman Brothers and a few others collapsed, a major part of it was rumors about their liquidity problems generating margin calls that in turn created more liquidity issues, and so on… do we really want to risk that happening with an entire system?

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Monday, January 12, 2009

Taking Stock in Coca-Cola (KO):

This is a guest post from Brad, who maintains http://www.nurseb911.com/ and http://www.dividendsanonymous.com/. I have always enjoyed Brad's thorough stock analyses. Luckily, he is starting out a quality stock analysis subscription service which will definitely benefit your investment performance.

When you first examine Coca-Cola (KO) there is an immediate emotional response many individuals have to their product(s). Love it or hate it; the products of this company are consumed on a daily basis globally to the tune of nearly 1.5 billion times. To put this in some perspective that's the equivalent of 25% of the global population consuming a minimum of one product sold by the Coca-Cola Company each and every day.

This is the brand power on a massive scale with a strong domestic history in North America dating back to 1886. Globally Coca-Cola products are sold in over 200 countries and the company is the "largest manufacturer, distributor and marketer of non-alcoholic beverage concentrates and syrups in the world." The company sells four of the top five carbonated brands around the world (Coca-Cola, Diet Coke, Sprite & Fanta), owns or licenses an additional 450 brands and possesses the largest beverage distribution system on the planet.

Coca-Cola operates in distinct global structures currently organized in the following regions:

  • Africa
  • Eurasia
  • EU
  • Latin America
  • North America
  • Pacific
  • Bottling Investments
  • Corporate
Global sales (non-North American) accounted for 76% of total revenues for the company in 2007 and provided 10% of total worldwide sales of all non-alcoholic beverages. 10% may seem small upon initial examination, but when you consider competition from PepsiCo, Nestle, Cadbury Schweppes, Groupe DANONE, Kraft Foods, Unilever and non-alcoholic products sold by global breweries the truly dominant presence of this company can be easily grasped.

The company in the face of such global competition has done an excellent job of concentrating on my Value Rule of doing what you do best. The company has not expanded operations into food or alternative products instead deciding to focus nearly exclusively on sparking and still beverages. This concentration on beverages and syrups for drink consumption allows the company to operate from a much lower cost structure which I will touch on later in depth.

From a quality control perspective the company holds ownership in 75% of all production, bottling and distribution operations in their global supply chain representing equity positions in 46 of its unconsolidated bottling operators. This is a significant strength for the company as it enables management to maintain tight control of operations, quality control, efficiencies in production & distribution and prevents operating risks from various disruptive elements. When you manage so many brands globally worth billions of dollars your focus on control should always be very high and sustained. It would cost too much for KO to operate independently in so many global markets and partners (majority or minority owned) allow the company to maintain oversight on important aspects of their business while not absorbing the entirety of costs. Specifically any equity investment in production and distribution operations ensures the company maintains control and protects its intellectual property such as product recipes or product development research.

The global economy has shown clear evidence of contraction coming out of 2008 and any global business can anticipate a slowing of growth in a number of markets. Concerns for KO exist currently in North America, Great Britain, Germany, India, Japan and Philippines for various economic or logistical reasons. Competitive factors always need to be accurately addressed when analyzing a company and there certainly is no shortage of global or domestic competition for the market share of Coca-Cola products. Competitive factors play a very important role in how the company executes pricing, advertising, sales, promotional programs, product innovation, production efficiencies, packaging technology, vending equipment, brand development and trademark protection.

KO has direct exposure to bottling and distribution operations of its products because of equity stakes in these businesses that are responsible for bringing their products to market. One major concern of late has been the increasing material costs and energy in the production and bottling process. The largest core cost for the company is nutritive & non-nutritive sweeteners such as high fructose corn syrup, sucrose, aspartame, acesulfame potassium, saccharin and sucrolose. These products are found in high concentrations in Coca-Cola products and recent high corn prices, while down in recent months, and have led to increased costs in raw materials required for production. Energy is needed not only to ship product to market but a large amount of heat is needed in the production process to appropriately dissolve the large amounts of sweeteners placed into the company's syrup products.

A significant threat to the company is the extent to which Coca-Cola operates globally in over 200 countries. In each country the company operates within there are abundant government regulations or restrictions on product safety, product composition and competition. Governments, regardless of their composition, tend to be unpredictable in making rational decisions at times and this can adversely affect a business that has plans for expansion but is met by political resistance. It would not be uncommon for any government (local or regional) to adjust current laws or regulations to better protect national interests or competitive issues relating to their own domestic brands. The recent issue taken by The Food & Drug Administration (FDA) on Coca-Cola's new Diet Coke Plus demonstrates the oversight and resistance that the company can encounter when attempting to develop and market new products.Availability of key infrastructure is a current concern of mine, most specifically in India, where production, distribution and energy requirements are providing barriers to growth of the company's operations. In order for the company to meet food and safety, operating standards and distribution schedules in various markets the company requires the proper infrastructure in order to deliver market demand. Building domestic infrastructure is beyond the financial capacity of Coca-Cola in these markets so product either needs to be shipped farther distances into new markets or not offered due to complications of such limited logistics. With such a concentrated focus on the Chinese market I feel many investors have missed the clear barriers to entry that KO faces in many other emerging economies.

Coca-Cola battles this lack of available infrastructure with a focus on brand development in emerging consumer markets and establishing a very strong emotional response to their products. They sponsor large sports events, become integrated in communities through charitable events and spend large amounts of money on effective advertising. Once the brand has been successfully entrenched into a market domestic competition and governments have found it very difficult to place restrictions on their growth or to motivate change in consumer perceptions.

In recent years public initiatives have been created to restrict the sale and distribution of Coca-Cola and PepsiCo products within schools citing the concern for the recent and significant increases in obesity of young children. Some municipalities, school boards or governments have successfully implemented bans on dispensing machines in schools, but others have found strong resistance from school boards who receive lucrative donations to their sports teams, social programs or for new equipment as part of a negotiated partnership with one of the large corporations. The focus here, ethics aside, for the companies is their clear interest in funding social programs for brand development with the initiative to create lifelong loyalty to their brands and products by impressionable youth and create habit forming behaviours.

There are also a high number of serious economic, technological and social threats to the growth and profitability of KO. Each of the following items I've cited as a major concern for the company and are being handled adequately using a variety of methods by management:
  • The increasing trends in health awareness are here to stay and KO has been proactive with increased product development and advertising of brands such as Diet Coke and Fanta as well as the recent successful launch of their Zero products (Coke Zero, Sprite Zero).
  • Fresh water continues to be a concern as availability; prices and resources come under increased pressure in developing economies and markets. The health of consumers is a top concern of the company when they examine a market and spend considerable expense securing and treating water used in their products either directly or indirectly in the manufacturing process.
  • With the global economy likely to contract into 2009 growth and expansion into emerging markets may be more difficult than the company had previously targeted. This may put pressure on marketing budgets, but will likely lead to consolidation in the industry as smaller companies with high quality brands don't have access to credit/financing or aren't able to service high levels of internal debt.
  • Foreign currency and interest rates are major factors in the profitability of the company. Management balances the risk of operating in so many countries by hedging their exposure with derivatives. KO hedges operations up to 36 months in advance with most derivative instruments expiring within 24 months or less of their creation. While financial derivatives have been a toxic element to many businesses in the recent credit environment hedges held by the company help buffer cashflow from international operations from the significant volatility in the valuation of foreign currencies.
  • Unions and collective bargaining agreements (CBA) will always be a concern in any unionized environment. With 75% of sales outside of North America the company is well positioned to balance disruptions to operations in domestic markets. One part of owning equity stakes in bottling operations is to ensure that KO has a vested interest in how employees are treated to avoid such conflicts.
In May of 2007 Coca-Cola successfully acquired Energy Brands (Glaceau) for $4.1B in cash to increase its product portfolio of enhanced water drinks adding vitamin water to its list of health conscious brands. On September 3rd of 2008 Coca-Cola announced another strategic offer to purchase China Huiyuan Juice Group Limited for $2.4B in cash. KO has operated in China since 1979 and was a major sponsor of the recent summer Olympic Games held in Beijing. Still beverages have been a focus in the Chinese market in recent years and the acquisition of the Huiyuan Juice brands diversifies the product portfolio of KO in China. One strategic element that comes from this acquisition is the proposed expansion of their distribution network within the country. Costs and operations can be now streamlined with sales, distribution, manufacturing, product development and marketing benefiting from the merger of the two companies.

While we think of juice in North America as a product not associated with large-scale sales; juice products in China are an established and fast growing segment of the beverage market. Juice is actually a more profitable product from a margin perspective and the Minute Maid brand is a key complimentary product to the established Huiyuan brands in the Chinese market. KO has been looking for growth vehicles to support stronger domestic growth in China and local bottling partners between the two companies make a strategic fit. The deal is anticipated to close in early 2009 and be accretive to earnings within three years. The obvious threat to this deal is that it is conditional of Chinese regulatory approval but currently no problems with that process have been publicized or speculated upon.

While conducting additional research on the company I found a Virtual Vending Machine that was fun to gain a sense of the Coca-Cola brands offered globally by the company. With a supply chain valued at over $50B US it's easy to gain a sense of just how global this company is in all aspects of their businesses.

One key concern I always maintain with any company is a keen evaluation of their management. Executives are not only responsible for the daily operations of a company, but also establishing the corporate culture and expectations of how an organization expects to do business. No company grows to the size and scale of operations that Coca-Cola has without an extraordinary vision of where the company is going, how it will get there and a group of effective leaders to pave the way. In my evaluation of management, which I encourage all investors to do on their own, I've found very clear objectives and strategic priorities from management on where they expect the business to grow, operate and execute. The core competencies of the company are defined as consumer marketing, commercial leadership and franchise leadership which is clearly evident when you evaluate the company from a number of perspectives.

There was a recent transition in leadership at the company when Neville Isdell stepped down as CEO and Muhtar Kent assumed the role as new CEO. Muhtar Kent has been with the company since 1978, comes from a strong background in marketing and has a strong history of participating in the global operations of the company in many capacities. The transition between the two managers was smooth and without incidence which is something I always carry as a litmus test for preserving corporate culture and maintaining a pulse on the business.

In the spreadsheets provided I've listed the past five years of critical data for the company


(Data since 1988 made available via SAML or with full analysis purchase below).


Whenever I look through the operating numbers of a company I'm looking to evaluate three main items:
  • A consistent theme of performance
  • Conservative fiscal management
  • Emerging trends that hold the potential to influence the company either positively or negatively in the future
A portion of my analysis always focuses on vital criteria such as EPS, dividends, cashflows, debt/equity ratios, book value growth and other important metrics but running a successful business is more than just keeping those numbers in check. Your business has to be sustainable, flexible to meet global challenges and adaptive to changes in the consumer environment

I've accumulated various data on Coca-Cola and organized it in a spreadsheet very similar to my presentation of Taking Stock in COST. While each companies spreadsheet in my SA data will differ slightly based on their unique industry my focus will often concentrate on margins, return on equity, debt levels, book value growth, increases in costs and dividends. Remember that as a prospective owner in the business I want to investigate information that directly impacts my returns, my financial stake in the business and potential for future returns.

First on the list for examination are revenues and cost of goods sold (COGS). Revenue is income that the company receives from the sale of a good or service and COGS is the direct cost of producing that product or service.

Coca-Cola has successfully reported a profit over the past twenty years, but I want to evaluate the relationship and trend between revenues and COGS. This is important because I want to identify if one side of the equation is changing in any drastic manner relative to the other. The 20-year average for increases in revenues has been 7.12% and the increase in COGS has been 6.45%. This is positive in my view because I can see an established trend where overall revenues are increasing at a faster rate than overall costs. If these numbers were reversed (6.45% for revenues & 7.12% for COGS) I would be very concerned because it demonstrates that costs are increasing at a faster rate than revenues and that is not sustainable for any business. These trends affect the profit growth of a company and as a shareholder I may be concerned that management isn't doing a good enough job of managing their cost structure. Taking the past five years (a smaller snapshot) I get an average increase in revenues of 8.42% and average increase in costs of 8.36%. The margin between the two is smaller, but the trend remains intact.

Margins are one of the first calculations I ever determine when I've decided to look at a company in greater depth. There are two types of margins I want to identify and examine: gross margins and profit margins.

When we examine gross margins for KO we see a very healthy average of 63.85% on a historical basis. This means for every $1.00 the company receives in revenue they retain nearly $0.64 after direct production costs. Profit margins for KO are 17.46% and for every dollar the company receives in revenue they retain a profit of over $0.17.

This is a much higher gross & profit margin than many other businesses and is a direct effect of the type of business Coca-Cola conducts. They sell higher margin products around the world and do so because their costs are relatively low and brand loyalty is very high. We can clearly see variations in each margin category through different time periods where profit and gross margins fluctuated in relation to different economic periods. One thing to notice is whenever they dropped relative to the historical average they subsequently rebounded shortly after with increases in the margins.

SGAE as % of net sales is another category I always focus on that provides insights into how management is managing their own spending and not just that of the corporation. SGAE stands for "Selling, General and Administrative Expenses" and tracks the spending of non-core expenses that aren't linked to the production or operating process. Management may be great at minimizing costs and boasting a fat gross margin, but I want to focus on the question: Can they control the spending that directly impacts the profit margins their company achieves?

Readers will notice a stark contrast in SGAE versus my previous stock analyses with KO reporting its average SGAE as % of net sales of over 40%. This means that non-core production costs are 40% of total revenues! Normally this should be an alarm bell going off for any prospective investor, but we first need to put this number into the proper context. We can see that the historical trend has fallen over the past few years, but 38% is still a relatively high number in 2007.

We first need to identify that Coca-Cola's business is much different than other businesses. Although they have low production costs and significant gross margins, they spend a lot of money on advertising promoting their products around the world. KO didn't become the biggest and wealthiest brand in the world by restricting spending on promotion of their products and this commitment to effective advertising has led to sales increasing globally for the past twenty years. KO also operates in a variety of challenging markets where they may be focusing on conservation of market share for mature products and heavy spending for promoting new innovative products that are fuelling future sales growth.

To really put this into the proper perspective we need to compare margins to a company in the same industry: PepsiCo (PEP)


(Margin Analysis, Valuation Model & Dividend Discount Cashflow Calculator available via SAML or with full analysis purchase below).


Coca-Cola has a simple business model to understand and this benefits an individual investor who wants to focus on fundamentals. They sell carbonated & still beverages and syrups for consumption around the world, have a dominant brand image in hundreds of products, own stakes in nearly all their bottling operations, possess strong brand loyalty, are expanding into new markets with conservative acquisitions and focus on doing what they do best.

The company is profitable and by a large margin because they keep costs low and focus on maintaining very high margins. Despite slower sales growth than their main competitor (PEP) their growth of expenses has been lower resulting in revenue growth outpacing expense growth and this too is by a wider margin than PEP.

The company has made accretive acquisitions by not overpaying and continues to focus on growth of products domestically (Coke Zero) and abroad (Huiyuan Juice Group Limited). Although they've had a change of management the new CEO steps into a role that the company has adequately prepared him for as seen by his past leadership roles.

I've found that there are times when focusing on the simplest facts of a business result in some of the best businesses to invest in over the long-term. An individual who drinks one Coca-Cola product today is likely to drink another one tomorrow and again in the near future. A Coke tastes the same at 9am in the morning as it does at 5pm in the evening regardless of if those two drinks are consumed in opposite parts of the world and this creates the perpetual demand that the company has enjoyed for so many decades.

One of the most distinct and sustainable competitive advantages held in the world today is possessed by Coca-Cola. It's not a patent, a manufacturing process or real estate; it's the products, brands and operating structure that allow Coca-Cola to operate at a much more cost effective position than their global competition.

I don't want to discount that there are significant long-term threats due to an increase in health awareness and the short-term global economic dynamics. Management has done an admirable job diversifying their product portfolio to more health conscious brands and the one wonderful thing about a lower cost structure and significantly higher margins is that as a company you are well protected to weather any significant storm. While I never advocate that a company compete on price higher margins provide Coca-Cola with an adequate buffer to cushion any economic volatility so that the bottom line of the business is minimally affected.

(Disclosure: I own shares of Coca-Cola (KO), Kraft Food (KFT) and IGM Financial (IGM) at the time of this post).

If you are interested in receiving comprehensive stock investment reports like this one in the future, consider signing up for the SAML Service.

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