Companies

Many of us grew up with a diet of the brilliant work of Walt Disney. As children we laughed and cried along with the characters of Donald Duck and Mickey Mouse, Cinderella and Bambi.  More recently, boosted by the purchase of Steve’s Job’s Pixar business, Disney continues to build its library and draw many more generations into the fold with the characters of Finding Nemo, Toy Story, Monsters Inc and Cars.  The company dominates with its ‘share-of-mind’ competitive advantage. In this Guest Post Andrew takes the scalpel to the company and dissects its major components.

What does your company REALLY do?
A nuts and bolts look inside the happiest company on earth

The ability to make assumptions about the future prospects of a business is fundamentally linked to how we understand that business. Without a good understanding you will be more than likely flying blind and your perceptions and reality could be in very different places and therefore throwing a great deal of uncertainty into any estimate of intrinsic value (which is linked more to the future prospects than anything).

A company that I am very fond of and one that I am sure almost everyone here has heard of is the Walt Disney Company (NYSE:DIS). I thought this would make a great case study in understanding the business.

So what does Walt Disney do? The first thing that comes to mind is the feature cartoons that it made its name on and its theme parks. These are the most iconic images that are attached to this famous company and more than likely where we were first knowingly exposed to the brand whether it be entering Disneyland for the first time and looking up Main Street towards the castle or watching movies like Snow White, Dumbo, Pinocchio.

What may surprise some people however is that most of the revenue and net income for the company comes from television.

Take a look at the below table:

Figure 1-Yearly breakdown of DIS segment revenue and net income (net income is before non-controlling interests taken out and are reported in US$ Millions)
As you can see in Fig.1, every year from 2001 to 2011, the largest contributor to revenue and profit (except 2002) was the Media Networks segment of the business. Over this period the company has on average brought in around 41.5% of the groups revenue and 55% of the net income as shown by fig 2.

Figure 2- Average % of total group figures
This technique of looking at the individual segment results and comparing them to the overall group is a technique I like to use to really understand the nuts and bolts of the business. Looking at these figures I can see that even though DIS made its name by animating feature cartoons and opening gigantic theme parks, it is the TV channels they own that make up the most crucial element of the business as it is today. There for if you were interested in investing in DIS you would be very wise to focus particular attention on understanding how the media Networks business derives its revenue and what risks are associated with this segment. Luckily the DIS annual report defines this in quite good detail but back to this later. One thing to realise though is that this type of analysis is greatly influenced by scale of operations. The biggest divisions will or at least should, bring in the bulk of the revenue and profits. It may be helpful to see on a relative basis at where the magic happens.

To do this, you might like to use profit margins of each segment. It is not uncommon for a diversified businesses smallest division to have the highest profit margin as in Qantas with their frequent flyer division. Disney is no different. It can change from year to year as shown in figure 3 however. Once again as you can see, lately it has been about the media networks. Looking at this however, you can gain a clearer picture of the profitability of each division in a relative manner. Despite being one of the smallest divisions, the consumer products segment is right up there in regards to profitability.

Figure 3- Net margins by division and overall group
So now, simply by looking at the financials we can get a clearer picture as to what DIS is really all about. We can see that the media networks business is arguably the most important. I can also see that the parks and resorts division is a pretty predictable segment with revenue and profit growth pretty consistent throughout the years and whose margins remain quite stable.

So where to next? Well you want to understand the risks associated with each segment so that you can be better placed to understand them and be able to make informed decisions and assumptions on the future. As mentioned earlier, the DIS annual Report actually goes into detail about the specific risks of each segment as well as detail as to how they derive their revenue. All annual reports will have a description of what the principal activities of the business are as well and if the management is shareholder orientated than it may include some very handy bits of information about the companies past, present and future. This is the next step, read all the information you can about that company whether it be through annual reports or newspaper articles, also read about the industry and read industry specific media to see what the insiders are doing and saying about the future. Knowledge is indeed power.

These are the simple steps to understanding a business and is aimed at the beginning investor although I think everyone can benefit from thinking more about how to understand a business they want to invest in.

Have you got any examples of businesses where the core operation may differ from what people may perceive? What gems can be found in the nuts and bolts of existing businesses? What techniques do you use to understand a new business? Feel free to post any thoughts below.

What do I think of Disney? Their return on equity has been increasing but is still below my required return so my valuation would still be at around or lower than their reported book value but I would love to own them personally. They are one of the biggest brands in the world and when they get it right, they create products that will last generations.

Guest Author: Andrew Leggett. Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 18 April 2012.

by Roger Montgomery Posted in Companies, Investing Education.

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PORTFOLIO POINT: Given the outlook for Chinese growth and iron ore prices, is it time to cast a critical eye over your BHP holding?

The 2001 merger of BHP Limited and Billiton Plc created the world’s largest diversified resource company. The company is also one of the largest in the world by market capitalisation and I would guess one of the longest-held stocks in many investors’ portfolios, as well as one of the most likely to have been inherited by superannuants from their parents.

Operationally, the company is nothing like it once was. Seriously underperforming assets and overpriced acquisitions had to be written off in the late 1990s, and since then external candidates including Paul Anderson, Brian Gilbertson, Chip Goodyear and, most recently, Marius Kloppers have taken the top job at the Big Australian. Under their sound stewardship – and the biggest mining boom in history – BHP’s share price has risen from less than $10 when the merger was consummated to almost $50 prior to the GFC, and again a year ago. But since then, BHP’s share price has crashed 30%.

A year ago, with the share price at its zenith, many analysts were extolling the virtues of BHP. I note one company said their positive view on BHP was due to low-cost and long-life mines, growing production and cost discipline. With demand from China strong, the common refrain of course was – and still is – that the outlook for BHP’s products was (and is) bright. Many also went on to add that copper had a strong bullish case over the next two years, and with global consumption outpacing supply and a lack of new high-grade deposits coming into production imminently, the marginal cost of copper was set to rise, which could only be positive for the price. And back in November 2010, some analysts were applying a notional price/earnings multiple of 12 to the EBIT numbers of UBS and Goldman Sachs of $US12.4 billion to $US12.8 billion, to arrive at an independent iron ore business valuation of $US144 billion – roughly the same as the market of the entire conglomerate at that time.

So what has happened?

Well, the copper price is indeed up 13% since March 2010, but BHP’s share price languishes. And I wonder whether the talk of new in-the-ground metrics to value iron ore assets is akin to the bubble-talk price/sales and price-per-click ratios being proffered as a new way to value internet companies back in 1999 and early 2000.

BHP’s principle revenue drivers are the price of iron ore (for the manufacture of steel), the price of oil and base metal prices (predominantly copper). Emerging economies and their insatiable demand for construction and manufacturing materials has thus far ensured BHP grows its revenues and earnings.

Talk to BHP employees and they’ll tell you it’s all really quite simple: ‘Dig it (iron ore) out of the ground for $33 and sell as much of it as you can (currently the price is $US140/mt)’.

But how much of it can they sell? And at what margin?

China’s economic data shows its economy is growing at the slowest pace in recent memory. China’s economy expanded at its weakest pace in 2.5 years in the fourth quarter of 2011. Sagging real estate (something I have warned investors here to watch) and export sectors have heralded a sharper slowdown, while triggering pro-growth responses from the government.

Most recently, gross domestic output rose just 2% from the previous quarter, suggesting to some economists that underlying momentum is slowing more rapidly than expected.

Interestingly, the fourth-quarter growth rate was the slowest pace since the second quarter of 2009. And this was when the global economy was emerging from a deep recession. It also marked the fourth straight quarter in which growth had slowed down.

Importantly, recent data shows net exports and property investment subtracting from growth. This latter development is a serious concern for investors in BHP, because the property sector is worth some 13% of total economic output and steel is the primary input for building construction.

Back in March 2010, I wrote: “The key concern for investors is to examine the valuations of companies that sell the bulk of their output to China. Any company that is trading at a substantial premium to its valuation on the hope that it will be sustained by Chinese demand, without a speed hump, may be more risk than you care for your portfolio to endure.

“The biggest risks are any companies that are selling more than 70% of their output to China, but anything over 20% on the revenue line could have major consequences.

“BHP generates about 20%, or $11 billion, of its $56 billion revenue from China; and Rio 24%, or $11 billion, from its $46 billion revenue. BHP’s adjusted net profit before tax was $19.8 billion last year and Rio’s was $8.7 billion.

“…BHP’s profitability would be substantially impacted by any speed bumps that emerge from China…”

Annual growth in China’s property investment of 12.3% as at December marked a sharp slowdown from November’s 20.2% pace. Housing investment dropped precipitously in December, while many property developers are warning 2012 looks worse.

The booming housing market helped drive China’s parabolic growth, but the government’s attempts to engineer a ‘deflation’ of the property bubble appear to have had a sharper effect.

This compounds the adverse impacts on the country’s manufacturers and exporters from weakening European export markets, rising labour costs and inflation, as well as the widely reported leadership handover.

If you inherited BHP Billiton (BHP) and/or own it in your superannuation fund, you have to do more than simply keep a close eye on China. If indeed the writing is already on the wall, you need to decide whether you are going to respond.

Skaffold’s valuation for BHP has, as I previously predicted, been falling. The 2012 valuation of $36.85 has indeed been leading the share price lower, as Ben Graham might have suggested it would when he explained that in the long run the market is a weighing machine. (BHP is currently trading at about $34.51) For those who are interested, my Rio valuation is $70.62 (Rio is currently trading at about $66.12).

However, my BHP valuation currently rises to $44 for 2014, but I say “currently” because I suspect by 2014 an iron ore supply response will have forced the iron ore price lower, and triggered a raft of earnings revisions that will reduce BHP’s valuation.

China may continue to drive GDP with capital and fixed investment spending on fast trains, highways, cities and airports, but irrespective of whether the GDP is 9% or 6%, the proportion of fixed-asset investment cannot be sustained at 60% of GDP. More importantly, the iron ore China does require may be purchased at much lower prices and like the declining margins Apple faces on its new generation iPads, and Gerry Harvey endures on sales of widescreen TVs, BHP may also have to endure lower margins on iron ore while also selling less.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 18 April 2012.

by Roger Montgomery Posted in Companies, Energy / Resources.

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For many, beating the market indices is the hold grail of share market investing.  In this Australian article published 14 April 2012 Roger Montgomery discusses how you too can beat the market using his Value.able investing strategy.  Read here.

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Do New Hope Corporation (NHC), Northern Star Resources (NST), Mt Gibson Iron (MGX), Navarre Minerals (NMC), Allmine Group (AZG), Credit Corp Group (CCP), Matrix composites (MCE), Coffey International (COF), Data #3 (DTL), Breville Group (BRG), UGL (UGL), QR National (QRN) and Seymour Whyte (SWL) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 14 April 2012 to find out, and also learn Roger’s current insights into the Mining Services sector. Watch here.

by Roger Montgomery Posted in Companies, Energy / Resources, Intrinsic Value, Investing Education, TV Appearances, Value.able.

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Do Lonrho Mining (LOM), Integrated Research (IRI), Hawkley Oil and Gas (HOG), Boart Longyear (BLY), Forge (FGE) and Environmental CleanTechnologies (ESI) achieve Roger and coveted A1 grade? Watch Part 2 of Sky Business’ Your Money Your Call 10 April 2012 program now to find out. Watch here.

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Do Thorn Group (TGA), Maverick Drilling (MAD), Campbell Brothers (CPB) and Galaxy Resources (GXY) achieve Roger’s coveted A1 grade? Watch Part 1 of Sky Business’ Your Money Your Call 10 April 2012 program now to find.  Watch here.

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Roger Montgomery expounds upon his Value.able investing approach to illustrate how Big does not mean Best when choosing companies in this Australian article published on 31 March 2012. Read here.

by Roger Montgomery Posted in Airlines, Companies, In the Press, Investing Education.

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I enjoyed the process of writing Value.able immensely and its best seller status suggests there’s a growing band of individuals in Australia who’d like to be successful value investors.  If you want to become a successful investor or simply invest successfully, I believe it’s best to learn from those that have a demonstrated track record. As Buffett once observed, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” One bloke who I count as a mate, a successful investor and who doesn’t need to take the subway, has written a book on investing that I think will prove to be a classic. Matthew Kidman and I were on CNBC together recently and knowing we were going to be on air together we happened to bring in our respective books, which of course we swapped. I have finished reading Matthew’s Bulls Bears & a Croupier, enjoyed it immensley and I commend it to you. If you were wondering what you were going to read over Easter, well now you have a very profitable suggestion.  I am sure Matthew would love to hear what you think so be sure to return here and post your thoughts and questions.

Before I go, here’s an extract from Bulls Bears & a Croupier (pp173-176). It’s one of the many real life stories in the book and this one ties in nicely with our value investing and ROE methodology…

With Permission.

Extracted From Bulls Bears & a croupier, John Wiley & Sons, 2012

by Roger Montgomery Posted in Companies.

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Portfolio Point: BHP Billiton is well known to every Australian investor, but what you may not be aware of is the unique opportunity the corporate structure offers the trader and investor.

BHP Billiton was formed when BHP and Billiton merged in June 2001; following the merger the companies maintained their separate stock exchange listings. Australian investor know BHP Billiton Limited (ASX:BHP) traded on the Australian Stock Exchange, the other major listing is on the London Stock Exchange (LSE:BLT) BHP Billiton Plc. A share bought on either exchange has equal economic and voting rights, meaning you receive the same dividend payment and have equal claim to the company’s assets.

A logical person would assume that adjusted for the exchange rate a share of BHP Billiton Limited would trade very closely to BHP Billiton Plc, surprisingly this assumption is not correct. BHP Billiton Plc has traded at a discount every day for the last five years compared to the Australian listed BHP. If the shares were interchangeable between the exchanges the law of one price would remove the price difference, but in this case it is not possible to transfer a London listed BHP share to the Australian Stock Exchange, so there is not an arbitrage trade opportunity.

On the other hand, as the discount does not remain constant under all market conditions there is an opportunity to profit in the movement of the spread. To trade the spread a person buys one BHP and sells the other listed BHP, the trader is in a hedged position and is not concerned by the price movement of BHP they are just concerned by the movement of the discount/premium between the two shares.

As the shares are traded on different stock exchanges in different currencies, the exchange rate and the movement of the exchange rate needs to be considered if a trader is going to take a spread position. Fortunately in this case both are also traded on the New York Stock Exchange (NYSE) in US dollars through the use of American Deposit Receipts (ADR) an ADR traded on the NYSE represents shares in a foreign company. The ADR shares are interchangeable with the company it represents, so the law of one price keeps the price of the ADR adjusted for the exchange rate in line with the share it represents.
During the last five years the London listed BHP ADR (NYSE:BBL) has traded between 78% and 96% of the price of an Australian listed BHP ADR (NYSE:BHP), with an average of 86%.

An excellent risk/return ratio is obtained if the trader can buy the spread near it historic low and sell when the spread moves up to its average and the timing to perform this trade is when the price of BHP is collapsing. In November 2008 when ASX:BHP hit the low of $20.10 the above spread moved 8% in 9 days, 8% might not sound like a great return but as the trade is a hedged position leverage is safely utilised to increase the return on invested capital.

On the other hand, if you are an Australian value investor who wants to buy BHP shares at a discount to their intrinsic value there is a greater margin of safety in buying the London listed BHP for a 15% discount compared to buying the Australian listed BHP. If you follow Roger’s advice and only invest in the highly rated companies on Skaffold then BHP is not going to be a buy for you today at any price, but as the financial situation of every company is constantly changing one day in the future BHP may be rated A1 on Skaffold and at that time it might be worth you considering the London listed BHP.

Author: David Smith 13 March 2012

by Roger Montgomery Posted in Companies, Energy / Resources, Insightful Insights.

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PORTFOLIO POINT: Despite the headwinds facing retailers in Australia, Domino’s Pizza is growing and expanding its margins. But is that growth already be priced in?

Retailers in Australia are facing a perfect storm of weak consumer spending, online competition and a rising Australian dollar. But despite these headwinds, there’s one company that is not only expanding its physical footprint, but is becoming a serious force online. It’s also notching up double-digit growth in Europe, in spite of the economic climate, and breaking records to boot. You may be surprised to learn that this success story is in fact Domino’s Pizza Enterprises (ASX: DMP).

Domino’s Pizza listed on the Australian stock exchange in May 2005, and opened its 400th store in the same year. The company is the largest pizza chain in Australia and enjoys a growing presence in France – a country that, with the exception of the United States, consumes more pizza per head than anywhere else in the world – Belgium and the Netherlands, having bought existing operations in those countries in 2006 and becoming the largest Domino’s franchisee in the world. Domino’s Pizza now operates more than 889 stores, employs more than 16,500 people and, according to one report, makes more than 60 million pizzas per year. And all of this is run by a Lamborghini-driving CEO, who is as obsessed about Domino’s today as he was when he merged his 17-store franchise company into what is now Domino’s Pizza Enterprises.

The company’s online strategy has been a raging success, not only for pizza ordering but also for recruitment. When the company launched its iPhone App in 2009, it became the number one free app on the iTunes site within five days. Today, 40% of orders are made online and the company expects this to be 50% in the next six months, with a third of these orders to come from mobile devices.

Domino’s recently reported its half-year results and saw an improvement on almost every KPI. Same-store sales growth was strong, exceeding expectations in both Australia and Europe; margins improved and stall rollouts continued; the balance sheet strengthened, as did free cash flow; and, despite even lower debt, returns on equity increased. Domino’s concluded by upgrading its full-year 2012 guidance.

My friends at American Express should be able to confirm that while fashion retailing is one of the hardest gigs to be in, restaurants and cafes are one of the best. This is something Domino’s Pizza CEO Don Meij would know only too well. Despite challenging economic conditions, particularly in Victoria and New South Wales, same-store sales grew by almost 9% and total sales were up 11.2%. In Europe, where conditions are arguably much worse and youth unemployment is in the high double-digits, Domino’s recorded 12.6% total sales growth and 7.5% same-store sales growth. By the end of financial year 2012, another 60 to 70 stores will have been opened, net profit is expected to grow by 20% (despite adverse currency movements), and same-store sales growth is expected to be in the order of 5 to 7%.

In the last three years, earnings per share have doubled (no doubt the company has also taken market share from its peers, such as KFC) and despite a substantial decline in borrowings, return on equity has increased from 17% to 23% (see Skaffold.com screenshot below)Rising returns on equity, with little or no debt, is an indication of powerful business economics. Generally, as a company gets larger, its returns on equity stabilise or decline. Domino’s, however, enjoys an ability to raise prices and, some say, reduce pizza sizes without a detrimental impact on volume sales. This is, in my estimation, the most valuable competitive advantage it has. Granted, it’s a surprising conclusion to put forward for a franchisee (for a look at how things can go wrong for a franchisee company, look no further than Collins Foods).

Dominos displays declining debt (red columns), rising equity (grey columns), rising return on equity (blue line) and rising profits (green line).  Source:  Skaffold.com

Since 2004, Domino’s profits have increased 40.11% p.a. from $1.954 million to $20.7 million.  To generate this $18.759m increase in profit, shareholders have tipped in an additional $64.37 million of equity and left in earnings of $34.82 million.  In other words every additional dollar contributed and retained has returned around 19%.  During the period under review the company has also reduced its borrowings by $9.11 million from $24.65 million it held in 2004 to $15.54 million at the end of FY2011.

Analysts worry about the risks associated with growing a business in Europe in the present climate. Rising commodity input prices, including oil for delivery vehicles and wheat for flour, and the stronger Australian dollar are also points of concern. In the face of these perceived challenges, the company continues to grow and expand its margins. It also expects greater than 25% profit growth from Australia within three years. Clearly, Domino’s competitive advantages are proving those analysts who said Australia was ‘ex-growth’ wrong. And the company is also moving to electric delivery scooters to hedge against higher fuel prices.

Domino is a high quality business – Source: Skaffold.com

I have not been able to buy Domino’s shares – as much as I would like to – because they have not been cheap enough for me. My valuation is based on the idea that I want to reduce my risks as much as possible by ensuring I obtain a bargain. DMP has simply never traded at a bargain price. But with a price close to $9.00 today, you could (admittedly with the benefit of hindsight) put forward the argument that the $2.65 the shares traded at in 2009 was every bit a bargain. The issue is simply the discount rate that I am willing to use to arrive at my valuation. If I use 8% to 9%, my valuation approximates the lower historical prices. But is 8-9% enough? I think not.

What would you pay for a business earning $25 million this year and $29 million next year, perhaps $35 million the year after that? If you said $300 million or $350 million, I’d label you a value investor, but today the market capitalisation is more than half a billion dollars. At that kind of multiple, I would guess the growth has been ‘priced in’. I would rather be certain of a modest return than hopeful of a great one, and at current prices – despite the obvious track record of the company and the very great skill of its management – I think buyers are being hopeful. Unless, of course, they know a takeover is imminent.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 March 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Investing Education, Value.able.

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