Highlights from Monarch’s 3/14/12 Lunch
For those of you weren’t able to make it to our Roundtable Lunch on March 14, we’ll hit you with a few highlights. Normally for our “winter lunch” series, we’d assume that many of those who were unable to join us were in warmer climes. Not so in the past 2 weeks as we pushed up to 87 degrees in the Fort!
Anyway, for those of you in cooler climes, after the usual pleasantries, Dave started the lunch by congratulating everyone for making it through 3 years since the bottom of the bear market in March, 2009. The reward has been immense, as most indices have broken out to new post-recessionary highs, and only have the 2007 all-time highs to yet attain.
John surgically dissected 2 of Monarch’s core stocks: Abbott and Wal-Mart. These 2 are about as “core” as the core list gets. Both stocks actually rose in 2008, when the market fell 40%. This is a testament to their durability, quality, and defensive appeal. And yet, there are some stark differences in the way each operates its business, manages its balance sheet, and uses its cash flow.
One obvious difference is that Wal-Mart is, by necessity, a capital-intensive company. Its prized asset is its vast network of stores, which are designed to maximize scale and efficiency, and bring value and selection to customers. It takes a lot of capital to build, maintain, and refresh its store base ($13,510,000,000 last year). Yet Wal-Mart still has $10-$14 billion of free cash flow annually to invest, after all of its capital spending on stores. You can see Free Cash Flow on the following chart, under “Investments”:
We highlighted that Wal-Mart’s free cash flow was higher in its fiscal year 2010 than in fiscal 2012 (which just ended in January), $10.745B, down from $14.065B. One huge reason is the shift of inventory investment, which was a generator of cash in fiscal 2010 of $2.265B, but was a consumer of $3.727B cash last year. In calendar 2009, Wal-Mart, like most companies, pulled in cash by reducing inventories. This was partly in order to pump up cash, but also part of an ill-fated attempt to clean up its aisles by reducing SKUs (the number of products it sells). This effort burned Wal-Mart, which has since retreated and brought back SKUs, which has required an investment back into inventories. Stripping out inventory adjustments, Wal-Mart’s free cash flow has improved by $2.672B in those two years. That’s just one example of what we look at in order to gauge the fundamentals of our investments, and in the course of assessing new ones.
Another way of looking at cash usage can be found in the last section. As a shareholder, your payback every year can be counted up in the dividend yield (paid directly to you), share reduction (directly increases your ownership), and square footage growth, meaning the % growth in the size of Wal-Mart’s store footprint. Those 3 figures totaled 12.8% last year. If Wal-Mart sells more stuff per store, or increases margins, or pays less interest expense as a percent of sales, that’s all extra return above 12.8% for you.
We also looked at Wal-Mart’s balance sheet. The effect of the company’s share buybacks has been a 4% annual reduction in shares outstanding in the last 5 years. That means you own 4% more of the company every year just by not selling! The Walton family, after settling founder Sam’s estate in the wake of his passing, ended up with 40% of the company’s stock. Rather than divesting, they’ve basically held on, and their ownership was about to rise to 50% earlier this year! Rather than become majority shareholders again, they finally sold some shares.
Finally, we looked at the company’s income statement. Some people might be surprised to see that Wal-Mart is actually still growing, given negative U.S. same-store sales growth in the last 2+ years, and a sharp reduction in U.S. new store build. Thanks to strong international sales growth, and (to a lesser extent) Sam’s Club, sales have grown at a 5% annual rate in the last 5 years, a period which encompasses the Great Recession. Despite the chaos of the period, and the company’s shifting strategy, return on equity has hardly budged, still at an incredibly high 22-23% rate. Despite the stock price moving up 17% in the last year, shares can be had for a near-record-low P/E.
There is a lot to love about Abbott, but chief among them is its virtual immunity to the economy. While we often extol other companies with that virtue, Abbott rises above even most health care and consumer staples companies in terms of safety. Think Similac, Ensure, treatment of chronic diseases like rheumatoid arthritis, and antibiotics, among others. And yet, Abbott has numerous avenues to growth, especially as Abbott pushes deeper into emerging markets, which now represent 27% of sales.
Abbott continually brings to market new products, many of which it has developed in-house. Many of its new products, however, started out in the labs of companies which Abbott has acquired. As the cash flow statement below shows, Abbott has invested over $12 billion in the last 3 years in acquisitions. Normally, Abbott will make a big acquisition every 5-7 years. In 2009 and 2010, however, the company was able to pick up plenty of assets at discounted prices, thanks to low stock prices. With Abbott’s high credit rating (AA), those acquisitions can be financed at very cheap borrowing rates. These acquisitions serve to create future growth for Abbott. Case in point: in 2001, in the depths of the 2000-02 bear market, Abbott bought Knoll Pharmaceuticals from BASF for $7.4 billion, mainly for its drug Humira. Humira now is the largest-selling drug in the world, with worldwide sales over $8 billion annually, and annual profit that likely comes close to matching the price tag Abbott paid for the whole company. 100% return on investment? Even Madoff would blush at that!
One more aspect of Abbott’s cash flow statement to notice is that, like all research-driven companies, it is not capital intensive. With $8.97 billion of operating cash flow in 2011, only $1.492 billion was needed for capital spending, on the company’s facilities. That gives the company a lot of latitude to invest via acquisitions, pay down debt, and fund a good dividend. Abbott doesn’t spend much on share repurchases.
Abbott has racked up some debt over the years, as it pays for acquisitions with cash (which we applaud), then pays down debt in subsequent years. Its total debt outstanding has grown at only a 4% rate, much slower than its shareholders equity has grown (a 12% annual rate). So, its debt/equity ratio has actually fallen since 2007, despite the $12 billion acquisition binge.
Abbott’s growth is very impressive, with 12% annual sales growth and 13% annual earnings per share (EPS) growth. Research and Development (R&D) spending has increased 13% annually. Return on equity has risen to a very high 31% rate.
As the last line indicates, all this goodness could be had for 11.8 times 2012 estimated earnings, which is less than the market’s P/E. Note: Abbott is planning to split the company into two–the branded pharma business (which includes Humira), and the rest of the company–by the end of 2012. While we’ve always appreciated Abbott’s diversification, we understand the company’s contention, that the faster growth potential of its “other” (non-pharma) business is underappreciated by the market. Splitting it off will hopefully encourage a revaluation of the stock.
Finally, George elaborated on a chart produced by Exxon, the oil giant, in its annual “Outlook for Energy” report. The chart shows how the world’s mix of fuel consumption has changed since 1800: from biomass (wood) to coal to oil to natural gas to….everything else. You can find it on Exxon’s website, at: http://ir.exxonmobil.com/phoenix.zhtml?c=115024&p=irol-reportsenergy. Once there, click on the text in the middle of the page which says “2012 Outlook for Energy: a View to 2040.” An Adobe .pdf file will open; the chart is found on page 37.
You might find this especially relevant with the increasing discussion about U.S. energy independence, and how America’s shale natural gas boom has begun to transform our economy. Low natural gas prices and plentiful supplies gives confidence to energy-sensitive manufacturers of chemicals, plastics, fertilizers, and other basic materials to build new plants in the U.S. How low are natural gas prices? The ratio of the price of Brent crude oil to U.S. spot natural gas is usually 7-1; it is now 61-1 ($127 vs. $2.08). Will CNG-powered cars make more of an impact than electric cars? It also shows that, for all the promise of solar and wind, we’ll still be dependent upon fossil fuels for a long time.