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Aside from fears of reputational damage, one of the big concerns surrounding Cochlear’s recall earlier this year, was how long it would take to return to market.  As you know we purchased shares after the announcement that it had recalled its Nucleus CI500 cochlear implant much to the chagrin of some investors who follow our musings here at the Insights blog.

In NSW every child receives a hearing test within two days of birth.  Those identified as having profound hearing loss are often assisted by Cochlear.  And thats just NSW.  Cochlear sells its devices in 100 countries.  Once implanted changing devices is not easy.  Changing brands may be even harder.  Audiologists and speech pathologists are involved and the devices are finetuned to ensure the device suits the individual.

As Matthew pointed out here on the blog a few days ago:  “A family member [of Matthews’s] is a key member of a large Australian charity that does a lot of work with children that are deaf and many get the implants. All the equipment they use to “map” or finetune the device after implanting is specific to that company. For example the only brand they have is Cochlear. Recently they had a child from the US that they began to support that had a different brand implanted – they had to change many things to be able to help them. When thinking about market share with these devices I think it is important to know that the decision isn’t solely with the surgeon or specialist, because all of the support people have to change too. I don’t think market share will change quickly or by very much because of these barriers.”

Analysts at Macquarie recently surveyed 389 US-based Audiologists. Despite the product recall, Cochlear is still the world leader in CI devices and retains 60% market share selling into 100 countries.  The broker also believes the market is growing at 12 per cent per year.

Many of you know we purchased shares in Cochlear after the September recall (see below), confident this was a temporary issue being treated as permanent by a perennially short-term-focused market.

That now appears to be the case as today’s announcement, posted on the ASX platform by the company reveals; 20122011_COH CI500 impant update

The company previously covered the subject in its AGM presentation here: http://www.cochlear.com/files/assets/corporate/pdf/agm_presentation_18102011.pdf

Analysts were subsequently concerned that 1500 units are going to have to be removed through surgery and another 2800 units have been pulled from shelves. They also worry that an inventory shortfall across the entire market will lead to market share losses from insufficient inventory as well as damage to reputation.

Today’s announcement reveals any small market share loss (we estimate five percent and some analysts suggest between five and ten per cent overall) will be now stemmed by the timely identification of the manufacturing issue that resulted in the failure of 1.9% of devices and their subsequent recall.

Cochlear has ramped up production and its early intervention has enhanced its reputation rather than damaged it as evidenced by several surveys with clinicians.  In fact, 93% of doctors surveyed by Macquarie felt that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.

Ultimately the company’s intrinsic value is determined by its profit and we expect there will be an impact on profit of some import.  Cochlear has already created a provision of $130-$150 million and an after tax cash cost of $20 to $30 million.  Given the news flow that will now transpire, one expects these costs may be treated by analysts as a ‘one-off’ and investors may have to wait for another temporary setback before being able to buy shares cheaply again…

For those of you interested in following our thoughts back in September 14 (COH $51.30), I wrote the following :

“Imagine spending years waiting patiently for the opportunity to buy that rare coin, vintage bottle of wine or celebrated painting, only to be outbid when it finally comes up for auction.

Sometime later the opportunity presents itself again and you are outbid once more, this time by much more. Successive auctions only take the price further out of your reach – if only you acted sooner!

Then one day you stumble across that very thing you desire being offered for sale by someone who appears to have no interest in its long-term value, for a price you regard as a fraction of its real worth.

Would you buy it?

That is the situation I find myself in today as the Cochlear share price plunges another 14% to $51.30, or about 40% since its April 2011 high of $85.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Overnight one of those rivals received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news this week came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors are spooked.

The financial impacts of these events (and there will be an impact) have yet to be quantified so until they are why don’t we look at how the company has performed in the past and see if we can’t learn something about it in the interim.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and last week the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base.

Growth has always been viewed as is limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock yesterday for the Montgomery [Private] Fund. It is likely that I will to add to this position over the coming days and weeks when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall – and there will be one – remains unclear; when that changes it will impact my intrinsic value estimate (UBS has revised its forecast net profit for 2012 by 10.5% to $179.5 million).

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not.”

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

by Roger Montgomery Posted in Companies, Health Care, Investing Education, Value.able.

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You will have noticed that since November 16 every post here at the Blog has been a cautionary one.  You have not seen me post a ‘here’s possible good value’ story.  There is a little method in that, even though we might be unduly conservative.  But here goes again…

Many of you have heard me discuss JB Hi-Fi and its preferred status among retailers – I believe if JBH is doing it tough everyone else is doing it even tougher.  But we sold JBH from our holdings at $15.50 recently and I thought the story of why (ahead of a downgrade as it turns out) would be a good insight into the way we think.  Hopefully other investors can gain some insight into the process and fill in the 1) ‘bright prospects’ part of the equation that also requires 2) extraordinary businesses and 3) discounts to intrinsic value.

Starting way back in February 2010 we commented on the impending retirement of JBH’s Richard Uechtritz (now looking as well-timed as other prominent CEO departures, such as the Moss departure from Macquarie and I am sure you can list a few more – go right ahead) and the maturing outlook for the business itself.

“If JB Hi-Fi could re-employ all of its profits at the returns of about 45% it is generating now, its value would be over $38. That’s a pipe dream. The company is generating cash faster than it can ask its employees and contractors and landlords to employ the funds to open new stores. And because the profits also produce taxes and associated franking credits that have no value for the company, shareholders are being handed back the funds, which is a disappointment. However, as chairman Patrick Elliott implied when I spoke with him on radio this week, this is a function of growth and the limited size of the Australian population.

It happens eventually to all retailers and it will happen to JB Hi-Fi in the next five to seven years. The best you can hope for is that once the stores have saturated the market, directors stick to their knitting, and the company continues to generate high returns but pays out all of those earnings out as a dividend (becoming like a bond) rather than make some grand attempt to buy something offshore or diversify too far away from their core expertise (often at the behest of some institutional shareholder) and blow up the returns.

The result of not employing as much retained earnings at 45% is that the intrinsic value declines. It is still going up but not as much.”

In August here at the blog we wrote:

“The big story however is that Terry Smart will need to start looking beyond this organic growth to other strategies if JB Hi-Fi is to avoid developing the profile of another mature Australian retail business like Harvey Norman.”

and

“JB Hi-Fi needs to establish new and emerging business models to try and counter the shift away from physical music unit sales.”

and

“Having said that, the current sales environment is probably not representative of the future. Share market investors generally use the rear view mirror when assessing the future. I have previously discussed the “economics of enough”, which David Bussau from Opportunity International introduced me to many years ago. As it applies to consumers generally, they will get sick of trying to keep up with the latest technology, be happy with their TVs and replace everything less often – opting instead to ‘experience’ travel, food, adventure and other cultures. That of course doesn’t mean JB can’t grow its share-of-wallet. In the face of declining retail sales volume growth over the last five to ten years and deflation, JB is proving it is already the market leader.”

and

“JB Hi-Fi’s quality score dropped from A1 to A3 and interestingly, this was only partly due to the increase in debt. (We really need to know whether it was just timing issues and new stores that contributed to the jump in inventory).”

In addition to these comments I wrote more recently:

“The release of the iPhone 4S seemed to underwhelm technology reviewers when launched and a portion of the population do take their purchasing cues from such quarters.

The 4S is apparently an evolution in the iPhone series, rather than a revolution, and as such, fewer users of the most recent release – the iPhone 4 – will upgrade. Instead, it is likely that they will wait until the iPhone 5 is released next year (owners of the previous model the iPhone 3GS, however, should be coming off their two-year contracts about now and are expected to upgrade). We’ll come back to that shortly.

The iPhone doesn’t contribute anything like a majority profit to JB Hi-Fi’s bottom line. This is because margins on Apple products are slim. But the iPhone does generate foot traffic and phone upgraders also buy protective covers and other accessories on which JB Hi-Fi makes much more significant margins.

So why do we care so much about the iPhone?

It’s because when JB Hi-Fi announced its full-year results the company forecast more than $3 billion in sales and management cited growth from computing, telco, and accessories. They said:

“While we anticipate the market to remain challenging, our diversified product portfolio, particularly the categories of computers, telco and accessories, from which we expect strong growth, will assist JB Hi-Fi in delivering another year of solid sales and earnings in FY12. Assuming trading conditions are comparable with FY11, we expect sales in FY12 to be circa $3.2b, an 8% increase on prior year.”

It’s the lower “telco and accessories” sales that are expected to stem from the iPhone 4S underwhelming so-called early adopters and its most ardent fans that may put pressure on that sales forecast.”

Indeed the only thing that was going for JB Hi-Fi was its discount to intrinsic value.  Many investors believe that a stock I mention is below intrinsic value is a “darling’ of mine.  It isn’t.   A company must meet all of our criteria and it will only be held for as long as it does.  Those of you using Skaffold will however have seen JBH was trading only at a discount to one of the intrinsic value estimates – the intrinsic value based on analyst forecasts – but not the more conservative Skaffold Line valuation estimate of $13.16. See Figure 1.

Figure 1.

Both valuations are now likely to decline further in coming days -even the more conservative $13.16 valuation SKaffold has been displaying – and the downgrade may also be reflected in pressure on the company’s cash flow which Skaffold members would have already seen in the 2011 results and which prompted some of the above comments.  (See Figure 2. and note the negative funding gap line (international patents pending))

Figure 2. Showing declining operation cash flow and a growing Funding Gap (patents pending).

JB Hi-Fi was 5 per cent of our portfolio however we sold all of our position at $15.50 recently.  Our reasoning was simple;  Given present circumstances and expectations for retailing (having spoken to many retailers recently) many retailers JB Hi-Fi would have to revise their earlier outlook statements and this would produce lower future valuations.  At the same time analyst forecasts are typically optimistic in the first half of the financial year (this year being no exception to that rule) and we should therefore be demanding much larger discounts and JBH was not offering that margin of safety.  We also commented to our peers in conversations over the phone and in person that the delfation story – as explained by Gerry Harvey who noted selling plasma TVs for $399 this year means he has to sell three times the volume as last year to make the same money – would put pressure on profits because people already had enough plasma TVs.  Finally we also believed that ANZ’s profit growth being dominated by bad debt provisioning writedowns meant that credit growth was non-existant.  When you take away growth in credit card purchases – thats got to hurt discretionary retailers.

On November 7 we wrote to our Montgomery [Private] Fund investors thus:

A prominent media commentator and broker however wrote on December 6

“Our No.1 discretionary retail recommendation remains JB Hi-Fi (JBH). We all know 21% of JBH’s register is currently shorted, a massive short position usually reserved for financial impaired or structurally stuffed stocks. JBH is neither, and that is why we continue to be aggressively recommending buying the stock which generates 25% of its annual profit in December. JBH is trading on 11.2x bottom of the cycle earnings. Nowadays, the P/E’s of cyclical stocks compress with their earnings, meaning that both P/E and E bottom concurrently.”

So, JBH still has long term prospects that surpass many of its peers and I believe it still has a competitive advantage.  And if all those short sellers cover their position, the stock could rally.  That however would be speculating.  On the flip side, changes to accounting reporting standards will give it a lot more liabilities – contingent liabilities such as operating leases will need to come onto the balance sheet.  Also, the medium outlook, which includes deflation continuing, will put pressure on JB to sell more volume at precisely the time everyone may just have enough stuff.  Finally, the market may now finally catch up to the maturity story we described way back in 2010.  Of course consumers will return at some point and spending and credit growth will recover, but given the current weakness and fear among consumers the idea of requiring very, very large discounts to the more conservative estimates of intrinsic value dominates our thinking.

As always be sure to do your own research and seek and take personal professional advice.

Posted by Roger Montgomery, Value.able author and Fund Manager, 16 December 2011.

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

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Roger Montgomery discusses why Embelton (EMB) is one of his stocks to watch in 2012 in this article published in the December 2011 issue of Money Magazine.  Read here.

by Roger Montgomery Posted in Intrinsic Value, Investing Education, On the Internet.

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On Wednesday November 2 Woolworths held a strategy briefing for professional investors. Woolworth’s effectively asked us to adopt a longer time frame before judging its performance and revealed four strategic priorities that I will describe in a moment.

Prior to the strategy day, the company updated the stock market with a growth outlook that was the lowest in a decade. The market responded negatively to the change and it entrenched previous sentiment by professional investors to switch from Woolworths to Coles.

But Woolworths remains a superior business from a business economics perspective, with high return on equity and it also remains cheaper than its competitor as measured by the larger discount to an estimate of its intrinsic value.

The wider sentiment towards Woolworths Supermarkets is that the period of strong growth is over, and the other businesses, such as Big W, the New Zealand supermarkets, the Masters hardware venture and a possible acquisition of The Warehouse group could be the focus of earnings growth for the company. Gambling pre-committments would not be.

Meanwhile, the Woolworths-owned Dick Smith electronics business appears to have failed to excite consumers and has certainly failed to excite investment professionals. Dick Smith is a relatively weak offering in a market that has been hit particularly hard by the empowerment of the consumer through high Australian dollar.

Moreover, in many ways these businesses are peripheral since the Australian Food & Liquor division accounts for 80% of earnings before interest and tax.

The impact of the company’s lower growth profile on intrinsic value, particularly intrinsic values over the next two years, has been negative and intrinsic value does not appear to be going anywhere in a great hurry (see Skaffold chart below).

This combination of circumstances, in my experience, set Woolworths shares up to be vulnerable to any negative shocks.

Estimating intrinsic value is not the same as predicting price direction, however the above circumstances are not unique historically in putting a lead on price appreciation.

On top of the above combination of factors, there is also the continuing debate in Parliament about the introduction of preset loss limits for poker machines, which, if introduced, would negatively impact Woolworths’ gaming business. Though it is most closely associated with supermarkets, Woolworths is actually the largest poker machine owner in the country, with more than 10,700 pokies.

And a few weeks ago, The Economic Times of India also reported that Woolworths appears to have been dumped by its Indian partner, Tata Group. Woolworths enjoyed a five-year partnership with Tata, introducing Dick Smith-style electronics stores to India under the Infiniti Retail brand. Even though foreign retailers are not permitted to have a direct presence in India, Woolworths partnership offered the hope of growth – albeit with a partner – if the rules were ever relaxed.

Nonetheless, despite these accumulative negative factors, Woolworths is regarded by conventional analysts and investors as a defensive’ company. Its strong cash flows and its status as a major retailer of food makes it an ideal investment in a recessionary or slow or low growth environment. The company also enjoys entrenched competitive advantages over smaller rivals that, until now, the ACCC has done little about. One example of this are the new EFTPOS charges.

From the first of this month, the new Eftpos Payments Australia Limited (EPAL) fees mean retailers incur a 5¢ fee for every transaction over $15 (75% of all EFTPOS transactions). Previously there was no fee and that will still be the case for transactions under $15, which means 25% of transactions.

The retailer’s bank will charge the retailers, some of whom are describing the charges as an “EFTPOS tax”, and they will have no choice but to pass on to the consumer.

Unsurprisingly, EPAL’s members include the major banks, Coles and Woolworths and, because they manage their own terminals, they can opt out of the new charges.

But despite these entrenched advantages, Woolworths has been hit – or so it says – by the state of the economy, noting in its annual report: “Consumer confidence remained historically low as customers reacted adversely to rising utility costs, interest rate hikes in the first half of the year and general global uncertainty, and opted to save rather than spend their money”.

From an investment perspective it is worth noting that retail investors now have a choice of supermarkets, with Coles improving its offering to consumers and taking market share from the incumbent Woolworths.

The investment community is not convinced that further changes to private-label offerings or more innovation around the supply chain will make a dramatic difference to the growth prospects for Woolworths, which set below forecast growth in household income, population and the economy.

One other source of earnings growth is cost-cutting, but the reality is that gains from such strategies are one-offs and again unlikely to excite investors.

Having presented the negatives – which have caused the share price to fall 12% since July, one positive was the strategy briefing’s opportunity to showcase new CEO Grant O’Brien, who replaces Michael Luscombe. The company announced that it planned to extend and defend its leadership in food and liquor, act on the “portfolio” to maximise shareholder value, maintain its track record of building new growth businesses (we’ll ignore Dick Smith) and finally, put in place the enablers for a new era of growth.

In the supermarkets business WOW hopes to grow fresh produce from 28% market share to 36% market share. If achieved this would be an additional $2.5b in sales. Woolies also wants to target a doubling of home brand sales and this aim flies in the face of the ACCC’s stated concerns.

The company will also open 35 new BIG W stores in next 5 years reaching 200 by 2016.

In a reflection of the massive structural shift online, BIG W’s 85,000 in-store SKUs will be expanded and all put online.

And the topic on the tip of everyone’s tongue; Masters. There are now five stores open, another two are due to open in December/January, there are 16 under construction another 100 in the pipeline and the company reported the venture is well ahead of budget.

I also note the advertised sale of $900 million of property ($380 million of which was sold last financial year); and, most recently, the oversubscribed $500 million hybrid note raising that substantially extend the balance sheet strength of the company.

Below we examine the intrinsic value track record and prospects for Woolworths based on current expectations for earnings growth and returns on equity using Skaffold.com

Woolworths (MQR: B2) is currently trading at the same price it was in December 2006 and February 2007, despite the fact profits have risen 11.1% pa, from $1.3 billion to a forecast $2.2 billion in 2012. This growth in profit however is offset by having 16 million more shares on issue; by increased borrowings – up $1.8 billion to $4.8 billion; and by retained earnings, which have risen by $2 billion. The increase in shares on issue and retained earnings have offset the positive impact on return on equity rising profit would normally have.

The latest estimate of its intrinsic value, of $23.23, is forecast to rise modestly over the next two years. For investors looking at opportunities to investigate only when a meaningful discount to intrinsic value is presented, a price of $19 or less for Woolworths would represent at least 20 per cent.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

by Roger Montgomery Posted in Companies, Consumer discretionary, Insightful Insights, Investing Education, Skaffold.

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You don’t normally expect to get investment tips from a mothers’ group get-together, but that’s what happened to me recently when the conversation turned to retail operations.

Relaxing with a glass of pinot gris the women, who have met regularly for a decade, were explaining why they spend less time in Harvey Norman stores than they used to. Why? Tired stores, tired layouts and uncompetitive prices have served the retailer only with the need to revamp its entire offering. And that, it hasn’t done.

Retailing in Australia has been in the eye of a perfect storm for some time. As I’ve written previously, the strong Australian dollar has encouraged overseas travel and online purchases from overseas businesses; and the two-speed economy has ensured that credit growth (the borrowing of more money to buy stuff) is muted.

I’ve always been suspicious of a company that issues a report to the market after the close of trade. On Monday 31 October, a major retail business in Australia did just that. After closing time, Harvey Norman released its sales and earnings for the first quarter of the 2012 financial year. Given its timing, the announcement was almost certain to be negative. Indeed, the stock fell 4% the next day.

Instead of focusing on the retailing offer, refreshing store designs and improving range, company representatives focus on property, horse racing (Gerry Harvey is one of the country’s biggest bloodstock owners), goading the Reserve Bank of Australia to cut rates in “the national interest” and campaigning to have Australians pay GST on items they buy overseas for less than $1000.

Harvey Norman’s first-quarter sales were down 3.8%, as were like-for-like sales. In Australia, like-for-like sales were down 2.8%, in New Zealand down 10.6%, down 8.9% in Slovenia and down 11.1% in Northern Ireland. A stronger currency against the New Zealand dollar, the Euro and the pound has exacerbated the results. Profit before tax – a very important measure to us when estimating intrinsic value – was down by … wait for it, 19.3%!

Harvey Norman claims the strong Australian dollar and the closure of 34 Clive Peeters stores contributed to the poor result. I would argue that a failure to reinvent the offering also contributed. More worryingly, this latter factor is unlikely to go away any time soon.

Compounding this problem is the very likely scenario that the declining iron ore price – recently at about $115 a tonne – will seriously crimp margins for the only sector that has been running at full capacity in this country. Australia’s stock market has become the tail that wags the dog. Its wealth-effect on Australians and the impact on sentiment are important determinants of activity and in particular, retail activity.

With the All Ordinaries index dominated by resource companies and financial services companies it is possible, if not probable, that a declining iron ore price leads to lower stock prices and lower economic activity. I am no economist, but I can understand some experts’ calls for further rate cuts.

Back to Harvey Norman, and like-for-like sales declines of 2.8% compares favourably with JB Hi-Fi’s decline of 3.5%. Indeed, if it became a trend, one would argue Harvey Norman is winning back market share from JB Hi-Fi.

But before you get too excited about this comparison, you have to realise JB Hi-Fi’s profits are higher than they were last year and last year’s profits were higher than the year before that. In Harvey Norman’s case, profits before tax are down 19.3% compared to the same time last year, and last year first-half profits were down 16.5% from the year before that! One retail analyst I know and respect made the point that at this rate Harvey Norman will produce an average profit slightly ahead of the first-half profit made back in 2004, when it generated sales revenue of 62% of today’s sales.

My intrinsic value estimate for Harvey Norman is about $2.00 a share against today’s share price of $2.17. However this is based on earnings per share of 23¢ for 2012 and that is, quite possibly, optimistic. Over the next few weeks, analysts will bring their earnings after tax estimates down for 2012 materially. This will have a negative impact on intrinsic values and I suspect we will discover a price above $2 is a premium to intrinsic value. Most interestingly, for followers of any rational approach to calculating intrinsic value, Harvey Norman’s updated intrinsic value is no higher today than it was nine years ago, in 2003.

This can be seen in the following chart, which plots the share price of Harvey Norman against its estimated intrinsic value. Generally, we look for companies that have a demonstrated track record of rising intrinsic values and are available at a large discount to the current year’s intrinsic value (see 2006 in the graph).

The lack of any real change in intrinsic value and prices (which follow intrinsic value in the long run) reflects the maturation of the business. You can see that in the short run (in 2007 and again in 2009-2011) prices can get ahead of themselves thanks to many factors including irrational exuberance.

In the long run, however, the market’s weighing machine will do its thing and prices generally revert to intrinsic value. That’s why having a rational method for estimating intrinsic value is so important!

The forecast change in intrinsic value may also decline now that Harvey Norman has provided lower guidance. And it’s not unusual for analyst forecasts to be “hockey-stick” optimistic at the commencement of the financial year.

But long-term, Harvey Norman is a mature business in a small country and it continues to swim upstream against the online retailing avalanche. This is a structural shift rather than a short-term trend and Harvey Norman will need to respond by convincing Australian women in mothers’ groups all round the country that it is fresh, new and competitive.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

by Roger Montgomery Posted in Consumer discretionary, Insightful Insights, Investing Education, Skaffold.

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I have not discovered a method for predicting the short term direction of share prices.  Once we purchase an A1 company’s shares at a discount to intrinsic value, we cannot know what the share price will do in the short term.  We do know that provided the prospects for intrinsic value growth remain bright, the weighing machine that is the market will eventually cause share price and intrinsic value to converge.

Thats why it is so valuable to have an current and future intrinsic value estimate for every company updated daily.  Having a long term demonstrated track record of intrinsic value growth can also provide us with insights into management’s capital allocation decisions.  Knowing what the cash flow profile of a company looks like and whether the company has profitably employed capital entrusted to it by shareholders can further ensure you aren’t overstaying the party.

Soon you too will able to simply and confidently navigate the noisy distraction of the stock market to be shown those securities that deserve your time and avoid those that have a higher probability of permanently impairing your returns.  Skaffold is launching now (so keep an eye on your inbox today!)

Last week I spoke on CNBC with my old friend and peer Matthew Kidman.

You can watch the interview here: http://video.cnbc.com/gallery/?video=3000054986

Our view about the market is influenced by how many companies we can find that are both high quality and cheap.  I remember back in April this year, we had just started investing on behalf of investors in our fund but we could only find a small group of suitable companies.  That was enough to suggest that the other 2050 listed companies were either expensive and or of unsuitable quality.  A similar thing appears to be happening now.  The lower credit growth and declining iron ore prices have impacted the growth rates of future intrinsic values for banks and resource companies and these dominate our stock market index.

If you are following the Value.able-style approach to value investing, you would only be interested in high quality companies with bright prospects at substantial discounts to IV. If that fact changes as a result of the constant process of re-evaluating the prospects for the businesses in which we are interested, then one must act accordingly.

I cannot tell you whether the market is going to rise or fall in the weeks and months ahead but it does seem that value is a precious and rare commodity.  With that in mind, what are the companies that may be most at risk?

We will update this post with a table shortly but here is the short list (keep in mind the issues that have caused the companies to be in this predicament may be temporary):  Tap Oil, Neptune Marine, AACo, Somnomed, Elders, Centro and Gunns.  I will update soon with a more comprehensive list of expensive C4s and C5s soon.

The current list is not exhaustive, what I have done is taken C4 and C5 companies and sorted them by those that most recently reported cash flows that were unable to cover interest.  There are many more but these are the names that piqued my interest and I thought they might pique yours.

Posted by Roger Montgomery, Value.able author and Fund Manager, 09 November 2011.

by Roger Montgomery Posted in Investing Education.

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Value.able investors can be forgiven for giving up.  You wait so long for value to be presented and then when it appears it just hangs around, remaining ‘good value’ for what seems an age.  Value can sometimes nag and nag and by the time action becomes urgent, the newest and least patient value investors are no longer listening.  I can see it in the statistics of my friend’s financial services businesses and no doubt it’ also being felt by tip sheets purveyors and CFD merchants.  For all the talk of value investing, few really have the patience to succeed.

Value.able-style investors can be forgiven for giving up.  You wait so long for value to appear and then when it does, its just hangs around.  STocks that were expensive, become cheap and then, simply, boringly, stay cheap.  Value can sometime nag and nag and by the time action becomes urgent, the newest and least patient investors are no longer listening.  I have no doubt this is impacting the revenues of the tip sheet purveyors and the CFD merchants, indeed any business in financial services whose revenue is dependent on investors maintaining the faith.

That is the situation I was recently delighted to observe as the Cochlear share price plunged another 14% to $51.30, or about 40% since its April 2011 high of $85.

Recently I ascribed to Cochlear’s shares, a valuation of $59. Since 2004 the price has been persistently above my intrinsic value estimate, which means the combination of circumstances that have pushed the share price below value most recently are worth exploring.

Cochlear has the largest market share for cochlear hearing implants worldwide and, after announcing a voluntary recall of its flagship Nucleus CI500 implant range recently (the Nucleus accounts for more than 70% of sales), investors voted with their feet and the stock fell more than 20%.

The recall was voluntary and relates only to those devices that have not been implanted. The devices have a fail rate of about 1% and the fault – due to moisture on 1 of 4 diodes from loss of seal – is not believed to be harmful in any way, the device simply shuts down.

With about 25,000 of the units in use globally, that implies around 250 recipients of the implant will be affected and although that is significant, the proactive and patient-focused response of the company should ensure the reputational damage is contained.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Med-El is gaining market share in the US generally but patients waiting for implant surgery have switched to the Cochlear Freedom product and apparently with no delays.

At the same time as Cochlear’s recall, Advanced Bionics received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors became spooked.

And in that reaction a potential opportunity may be presented.

The financial impacts of these events won’t be fully known until later in the year but is expected currently to be $130 – $150 mln, translating to an after tax impact of about $20 mln.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and most recently the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote in the Eureka Report: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base. Growth has always been viewed as being limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock for the Montgomery [Private] Fund. It is expected that I will to add to this position over the coming weeks and months (provided value remains) when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall remains uncertain; when that changes it will impact my intrinsic value estimate.

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not. I wonder whether you are listening for value?

Posted by Roger Montgomery, Value.able author and Fund Manager, 19 October 2011.

by Roger Montgomery Posted in Companies, Health Care, Investing Education.

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by Roger Montgomery Posted in Companies, Investing Education, Technology & Telecommunications, Value.able.

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This journey began with the simple question Will David beat Goliath?

Value.able Graduate Scott T resolved to take up a fight with conventional investing, by tracking the performance of a typical and published ‘institutional-style’ portfolio against a portfolio of companies that receive my highest Montgomery Quality Ratings.

By 30 June 2011 the A1 portfolio was up 1.8 per cent compared to the XJO, which was down 2.9 per cent. As for the conventional ‘institutional’ portfolio, the bankers were down 6.2 per cent.

Over to Scott T for his third quarter update…

“For new readers to Roger Montgomery’s Insights Blog, welcome. Here at Roger’s blog we are conducting a 12-month exercise measuring the performance of a basket of 10 stocks recommended by Goldman Sachs, against a basket of 10 A1 or A2 businesses that were selling for as big a discount to Intrinsic Value as we could find.

“Nine months have now passed since our twin brothers each invested their $100 000 inheritance, and it has been a very turbulent time in the market.

“Our Queensland regional accountant has had his head down at the office for the entire quarter. The end of the financial year had come and gone and hundreds of clients where sending in their tax documentation, calling with questions and chasing their refunds. Time flew by in the office, and he hardly had time to try to attract new clients, let alone watch the daily gyrations of the global equities markets. By the end of September when he was finally able to take a breath and look at the performance of his portfolio.

“He was surprised at how poorly his portfolio of A1 and A2 companies, acquired at prices less than they were worth, had faired. But he quickly realised the overall market had done even worse. Loosing 12 per cent, or $12 000, YTD was bad. But it could have been worse, much worse.

“His twin brother was in a world of pain. The federal department he worked for felt like it was under attack. The mood in the department was that the media seemed hell bent on criticising everything the government did. No initiative was well received and every announcement was instantly compared to last months failure. To top it all off, every night he would check his portfolio, to see how much more of his inheritance had vanished. The red negative number on his spreadsheet just seemed to steadily increase. With little information to go on, and a feeling of helplessness washing over him, he thought seriously about visiting his financial advisors, desperately seeking reassurance, and perhaps changing the mix of the stocks held. He resounded, “Buying what they advised would be good for 2012”.

“As per the first half of the year, dividends will be picked up in the fourth quarter, when shares have finished going ex-dividend and the dividends have actually been received.

“In summary for the nine months to 30 September 2011:

The XJO ​​is DOWN 15.5 per cent
The Goldman Sachs Portfolio​​​is DOWN 19.7 per cent
The A1 and A2 Portfolio ​​is DOWN 12.0 per cent
The A1 and A2 Portfolio has achieved an OUTPERFORMANCE of 3.5 per cent over the XJO and 7.7 per cent over the Goldman Sachs portfolio.

“Here are the portfolios in detail, including cash dividends received in the first half (click the image to enlarge)

“We will visit the brothers again at the end of December for a final wrap up of their first year, and discuss their strategies for 2012

“All the Best
Scott T”

Thank you Scott.

How is your A1 portfolio performing?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 6 October 2011.

by Roger Montgomery Posted in Companies, Insightful Insights, Investing Education, Value.able.

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With school holidays well and truly underway, plenty of my peers are also taking a few days off here and there to take their kids to the football finals, duck up to the beach or entertain. That offers plenty of time to review your portfolio with recurring profits in mind.

Stability and predictability are two key words that many investors are unlikely to have heard in recent times and two important components of the ‘toolkit’ that may have gone astray. But at all junctures of the business cycle, stability and predictability are helpful investment partners.

Irrespective of whether you are building a portfolio from the ground up or are reviewing your current holdings, it is vital that you ensure your portfolio is always pointed in the right direction. Few, if any are able to reliably and predictability predict short-term share prices so there is relevance, if not necessity, in ensuring the very best opportunity is given to your portfolio. When a recovery transpires and investors are willing to accept risk again, the portfolio constructed from businesses with some stability and predictability to their revenues and earnings streams will have an excellent chance of outperformance.

While there are many definitions of what constitutes ‘stable’ and ‘predictable’, in terms of business analysis, recurring revenue would be the one I would use. And if you built a portfolio of such businesses, would it matter if this week a country defaulted on its debt or another had its credit rating downgraded? These issues are both temporary in nature and only likely to impact share prices, not the economics of the business.

Long-term contracts are the best form of recurring revenues and these contracts take many forms; There are of course the obvious long-term contracts, such as a mobile phone plan, internet or TV subscription, a car lease or a property tenancy, but less obvious are the long-term contracts we have with our own bodies to feed them, clean them and take out the waste. We have a long-term contract with our teeth, our cutlery and our toilets and these contracts ensure Coles and Woolworths, Kelloggs, Procter & Gamble and Kimberley Clark have millions of customers buying their consumables frequently and with monotonous regularity. In other words – recurring revenue.

Knowing that a percentage of revenue can be relied upon to come in the door each year allows a business to budget, rewarded staff consistently and plan expansions with fewer surprises.

And if you are buying a small piece of such a business, you can sleep more comfortably at night ‘knowing’ that your share will always have value even if the share price halves or worse.

The following two businesses are examples of companies we hold in The Montgomery [Private] Fund, and that we believe display the characteristic discussed.

M2 Telecommunications is a reseller of telecommunications equipment and services into the $6 billion SMB Telecommunications market. While dominated by Telstra (ASX:TLS) with 80 per cent market share, M2 is the seventh largest Telco in Australia with a 4.5 per cent share.

Two thirds of the business’s revenue is recurring via traditional fixed voice services, mobile (phone and broadband) and wholesaling services. Typically, contracted revenue is on 2-4 year terms giving management a significant amount of predictability.

It is due to this predictability that management have forecast 15 per cent earnings growth for FY12 and have the ability to self-fund a couple of large acquisitions, which Vaughn Bowen has moved aside from day-to-day duties to focus on.

Credit Corp – With new management installed and a demonstrated focus on transparency and sustainable growth, 70 per cent of collections are now on recurring payment arrangements.

This frees up collection staff to focus on those clients that are finding it harder to repay their liabilities and drives efficiencies across the group. Not only this, but the degree of certainty has allowed management to invest in even more self-funded ledger purchases and forecast earnings of $21m-$23m in FY12.

Additionally, the businesses offer the following financial metrics:

High Montgomery Quality Ratings (MQR), high forecast ROE’s, low debt levels, a Safety margin and high, recurring revenues have attracted us. After conducting your own research and seeking and taking personal professional advice, I’d be interested to know whether these companies or any others meet your recurring revenue test.

Go ahead and use this blog post as the beginning of a thread listing companies with solid recurring revenue and earnings.

Given the time to be interested in stocks is when no one else is, now is the time to go through your portfolio and determine those holdings that have a component of revenues that are recurring.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 30 September 2011.

by Roger Montgomery Posted in Insightful Insights, Investing Education, Value.able.

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