Tuesday, August 12, 2014

Value Stocks In Market Corrections

So with all of this talk of a market correction coming and people wondering what to do in this toppy market, Pzena put out an interesting newsletter back in June.  It looks at value stocks and how they performed in market corrections in the past.

They define value stocks as the lowest quintile of stocks based on price-to-book.   We can argue all day what a value stock is, but since many value studies seem to show similar results whether you use p/b, p/e or whatever, let's just say p/b is a decent proxy for value.

Another question is whether there is survivorship bias in the data.  Companies that go bust often get kicked out of a database so when you go back and do a p/b ratio study, it excludes all the cheap stocks that went to zero (and therefore improves the performance of the low p/b group).  I think Greenblatt, in his studies, used a Compustat database that showed actual data that was available at the time (so eliminates this bias), and since Greenblatt and Pzena both spent time together researching these things, I assume that he is using a similar database for this study.

Anyway, read the whole thing here:

Pzena Second Quarter Newsletter

Here's an excerpt:
Recessions alone or corrections driven by excessive valuations absent a financial crisis appear to favor value stocks, which outperformed in nine out of ten of these periods by an average of 6.8%. One of the most dramatic of these periods was the bursting of the internet bubble which started in March, 2000. During the subsequent thirty-five months, value stocks went on to outperform the S&P 500 index by 14.1%, as the massive overvaluation of “new economy” stocks unwound. Although the magnitude of value’s outperformance was smaller during the stock market crash of 1987, this sudden adjustment in valuations saw value stocks outperform by 7.9%. Four other periods associated with economic recessions but no financial crises also saw value stocks outperform.

Of the five periods of underperformance, four were associated with financial crises. This included the Global Financial Crisis of 2008/09, European “echo” crisis of 2011, the Asian currency crisis of 1998, and the U.S. Savings & Loan crisis of 1990/91. Although the 1968-70 correction, where value stocks underperformed, included the Penn Central bankruptcy (the largest such event in U.S. history to that date), we have not included it in the financial crisis category.

The history of value in periods following market corrections is one predominantly of outperformance, in many cases by a significant margin. During our study period, value outperformed in thirteen of fourteen periods post-correction (Figure 1), leading to value stocks adding almost 2.5% per annum of excess return over the S&P 500 for the entire fifty-four year period. 

Figure 1:  Value Stocks In Market Corrections

Source:  Sanford C. Bernstein & Co., Pzena Analysis

Pzena points out that we can't really know what is going to drive the next bear market (recession, financial crisis or just valuation correction without either).

But if you don't think a financial crisis in the near term is likely, then value stocks is the place to be.

Buffett has said that he thinks it is highly unlikely that the next crisis will come from the banks.  I tend to agree with that as there is some institutional memory and people tend not to make the same mistakes twice in a row.  Of course, there will be crises in banking/finance.  But I don't think the next one will be anything like the last one.

More Fear Now?
I don't really follow sentiment figures or anything like that, but it does feel like there is a lot more fear in the market than earlier this year.  A lot of that is due to the situation in Iraq, Israel, and of course Ukraine.   I think there have been more calls of a market crash or severe market correction.

So people seem to have a different vibe when asking about what to do in the stock market.  I still point people to Buffett's annual letter and the market hasn't moved all that much since he wrote it earlier this year.

This is what he wrote:

It's interesting to ponder what Buffett might have written if the S&P 500 index was trading at a p/e ratio of 150x, but he suggests a 90% S&P 500 index fund and 10% cash (to pay expenses/bills etc).

Buffett says the S&P 500 index is fine now, regardless of all the things the pundits worry about.  But let's take a look at some of the things that people worry about.

Profit Margins Unsustainable
I've sort of looked at this in the past in various posts.  This is an interesting topic.  There is an argument that some of the higher profit margins is due to increasing globalization of U.S. corporations (especially when looking at profit to GDP), that some of it is due to more value-added businesses in the stock market now compared to in the past (more Googles and Apples rather than Bethlehem Steels; low margin businesses moving out of the U.S. to low labor cost countries etc...).  Pzena made a case that return on capital was consistent and that is what matters.

All of these arguments are interesting.

But for me, I just look at what I own and see if they have unsustainably high profit margins. And for most of the businesses that I talk about here on this blog, that is not the case.  For a lot of the larger big caps, I don't see anything like that either; margins seem stable over time.  Look at BRK's businesses, for example.  Which businesses are over-earning?  Housing?  Nope. Insurance?  Nope. Retail?  Nope.

Unsustainably Low Interest Rates
This too is a concern as it impacts the stock market in various ways.  It affects the discount rate, of course, and also the cost of capital for corporations with debt.  It can also affect final demand (sales) as low debt encourages consumption/investment.

As for the discount rate aspect of it, I don't worry too much about it as earnings yields stopped going down long before interest rates kept declining.  If the market kept going up with the decline in interest rates, the stock market would be trading at 40x p/e (using the Greenspan model of earnings yield = 10 year treasury rate).   The S&P 500 didn't go up to 70x p/e when interest rates went down to 1.5%.  This is why the market hasn't collapsed as interest rates came back up to 2.5%.

And this is why I don't believe the market has to collapse if interest rates goes back up to 5.0%.

As for financing costs, higher interest rates would reduce earnings of companies with a lot of debt for sure.  But many firms actually have a lot of cash and would benefit from higher interest rates.  Banks and insurance companies come to mind (and we like financials).

Companies with a lot of debt also anticipate higher interest rates in the future so are locking in rates at  current low levels, and future capital allocation decisions can be made with higher interest rates built into the model.  If anyone is expecting low rates forever, we should just stay away from that business!

Market Crash is Coming!
And of course, one major argument is that the market is just overvalued, plain and simple.  For that too, I just take a look at my holdings and see what might be overvalued.  If I don't see anything overvalued, I don't worry.

As Pzena has shown above, when the market is overvalued and there is a valuation correction, the overvalued stocks tend to get hit and value stocks tend to do way better.  This is a major reason why I am usually not worried too much about crashes/corrections.

Anyway, nothing new here, but I just thought the Pzena study was interesting.  And I thought I'd recap my thoughts about the market and why I am so at peace despite people calling for a market crash.

Of course, I am not saying that the market won't crash or go into a bear market.  I just have no idea about that.  I do have no doubt that something like that will happen at some point.    But I don't worry too much about it (for the above reasons).

TETAA: Teton Advisors, Inc.

Speaking of nanoo, nanoo, how about a nano-cap?  

There is some interest in small cap stocks as they tend to outperform over time, but small caps are now looking really expensive.  So I was kind of surprised to take a look at this thing and notice that it's not that expensive.

Teton Advisors (TETAA) is a 2009 spinoff from Gamco (and spinoffs outperform over time so check that box! You can also check the owner-operator box too and then maybe the tiny-cap/below-the- radar box too).  They have been doing really well since the spin, but that's because they were spun off at the bottom of the bear market.  I don't think what they did from 2009 through 2013 can be considered 'normal'.

Tiny Cap with No Float!
But first, let's get this out of the way.  This is a highly illiquid stock on the pink sheets so doesn't even have decent filings (well, OK, not so bad.  But the proxy is a little thin).  Plus you can forget about any shareholder rights as Gabelli basically controls this entity and it is still intertwined with Gamco.  How this gets untangled over time is something I have no clue about.  But I do like and respect Mario Gabelli and think he wouldn't do anything to hurt minority shareholders.  He is sometimes criticized for his 10% pretax profit bonus he gets at GBL but that sort of thing doesn't bother me at all either.

According to the last 10-K they filed in 2009, Gabelli owned 600,000 shares and the CEO Nicholas Galluccio owned 260,000.    Westwood Management owned 200,000 shares but TETAA has since repurchased those shares.  Assuming there has been no big change in ownership since then, Gabelli would currently own 55% and Galluccio owns 26%.    Between them they own 81% of TETAA.   So float would be less than $10 million.   So let's not all go out and buy some at once!

Historical Performance
So let's look at how TETAA has done in the recent past.  Below are some figures I pulled out of the financial reports.  Some of the 2013 AUM figures are rounded to the nearest $100 million because reference to the AUM in the earnings release and 10-Q only gave a figure like $1.8 billion instead of a more precise number.  It may be posted somewhere else, but I just grabbed what was convenient for me.  And besides, it shouldn't make much of a difference.

Quarterly Results for TETAA
(figures are in $thousands except EPS and AUM)

As you can see, AUM has been growing nicely and they are making decent money with pretax margins up into the 30's.  In the last twelve months, they earned $3.34/share and pretax earnings of $5,883 million or $5.35/share.    At the current $49/share, that's 14.7x p/e and 9.2x pretax earnings.  I remember money management companies being valued at 10x pretax earnings in a post a while back, and TETAA is trading at below that.  At the risk of annualizing and capitalizing peak earnings, if you annualized the $0.95 2Q2014 EPS, you get $3.80/share in run-rate EPS; TETAA is trading at 12.9x that (or 8.0x pretax earnings).

Given this growth (and potential), it does look cheap.

Of course, the counterargument is that we are at the top of the stock market so equity managers should trade cheap, just as old, industrial cyclicals trade at a low p/e at the top of the economic cycle.  This is true to some extent, but if you look through-the-cycle, I don't think that is necessarily the case for asset managers (unless their AUM is bloated and unsustainably high due to a bubble; AUM here at $2 billion doesn't seem like that).

But How Are Their Funds?!
The important thing for me, though, is the funds.  Do they perform?  If they don't outperform, they can still be great businesses (as mutual fund/retail assets tend to be sticky), but for me, I would get more excited about an asset manager if I think they have a reason to exist.  And the only reason they should exist is if they can outperform.

Unfortunately, most of their funds aren't that interesting at all.  They started a new mid-cap fund, but it is too new to evaluate.

But the one big fund is actually really good.

Teton Westwood Mighty Mites Fund
This fund name makes me itchy, but let's take a look at it.   I pasted the table from their annual report since it includes a benchmark (and their semi-annual report doesn't).

Average Annual Returns Through September 30, 2013 (a) (Unaudited)  1 Year  5 Year  10 Year  Since
Mighty Mites Fund Class AAA
  36.18%    14.57%    12.20%    12.48%  
Russell MicrocapTM Index
  32.12       11.12       7.55       N/A(b)  
Russell 2000 Index
  30.06       11.15       9.64       6.81      
Lipper Small Cap Value Fund Average
  28.19       11.17       9.90       8.26(c


*Past performance is not predictive of future results. The performance tables and graph do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
**The Russell Microcap™ Index inception date is June 30, 2000 and the value of the Index prior to July 1, 2000 is that of the Mighty Mites Fund (Class AAA). 

It does look pretty impressive, no?

The Teton website lists Mario Gabelli as the lead portfolio manager for this fund.   Here's a cut and paste from the website:


Fund Characteristics

  • The TETON Westwood Mighty MitesSM Fund seeks long-term capital appreciation.
  • The Fund focuses on securities of companies which appear underpriced relative to their Private Market Value (PMV) with Catalysts to unlock that value. PMV is the price the Fund's Adviser believes a strategic buyer would be willing to pay for the entire company.
  • The Fund primarily invests in micro-cap equity securities that have market capitalizations of $500 million or less at time of investment.

Investment Strategy

  • Diversified portfolio of micro-capitalization equities
  • Invests in companies with above average revenue and earnings growth
  • Focus on underpriced companies relative to their private market value
  • Seeks to exploit market inefficiencies associated with micro cap companies

Portfolio Management

Mario J. Gabelli, CFA
Chief Executive Officer
GAMCO Investors, Inc
  • M.B.A. Columbia Graduate School of Business
  • B.S. Fordham University
  • Founded GAMCO Investors, Inc. in 1977
  • Fund manager since inception
  • Co-Portfolio Manager with Laura S. Linehan, CFA, Elizabeth M. Lilly, CFA and Paul Sonkin.

So that would sort of be a problem if Gabelli's contribution is not perpetual.  Gabelli and some other employees work for both TETAA and GBL, and this will not last forever.  I think there is an agreement for two more years of GBL employees working for both GBL and TETAA.  After that, who knows what will happen. 

The question obviously is how much does Gabelli do for the Mighty Mite fund?  There is a team of co-managers, but can they perform as well without Super Mario?  Or will he stick around long enough for others to be able to step in as lead manager?  Or is he not doing much these days anyway?  I have no idea. 

The other interesting thing about TETAA is that Paul Sonkin of Hummingbird value has joined the company.  Sonkin is the co-author of the highly regarded book, Value Investing: From Graham to Buffett and Beyond.  His presentation(s) from value investing conferences were very interesting.  

I wonder what happened to Hummingbird Value fund?  Why would he join another asset manager?  Maybe his business didn't scale well?  I don't know.  I do remember him digging deep and alone into below $15 million market caps.  Maybe that sort of business model was unsustainable? 

But whatever the reason, it looks like Sonkin will be looking at stubs, spin-offs and other special situations.  He is currently listed as a co-manager of the Itchy Bites fund  Mighty Mites fund, but there might be a special situations fund offering in the future.

Hmmm...  Interesting... 

This is a tiny idea with only $10 million (or less) in float so not an idea for most.   And there is a lot I don't know.  If you buy TETAA, you will be a super-minority so you will just be along for the ride.  And whatever deal happens between TETAA and GBL (and Gabelli personally), too bad.  There is nothing you can do about it.

But I do have faith in the character of Gabelli and his team.  I don't think they would do anything funky.

This is a tiny spinoff with $50 million in market cap, so just a few ideas can really create value here.  Compared to running an asset management conglomerate with $100 billion in assets, you don't need a whole lot of ideas to work to get the market cap up.  And the fact that the highly regarded (as far as I know) Paul Sonkin of Hummingbird has joined is a very interesting development.  It's almost like getting in on the ground floor of whatever they do going forward.

Some would argue for a liquidity discount, but sometimes maybe there should be an easy-to-move-the-needle premium.

Oh, and at the very least, looking at the fund holdings (Mighty Mites) might be a great place to find some ideas. 

Friday, August 8, 2014

Y So Cheap?

Alleghany (Y) announced earnings earlier this week; BPS is up +9.4% in the first six months to $451.65/share.  The stock is trading at $417.70/share so is trading at around 0.92x BPS.  The stock market is down 1.5% since then, so maybe less of a discount now.   But it does look cheap. 

Interestingly, book value was up 6.9% but thanks to share repurchases (2%+ of outstanding), BPS went up +9.4%.  

I guess in this market that seems expensive, why not repurchase shares at below book value?  That makes a lot of sense.  
Is 0.9x BPS Really Cheap? 
OK, so the question is, should Y trade at or above BPS?  I always liked Y; their annual reports, how they think, how they operate etc.  But they have always been a little bit on the conservative side for my taste.  The annual reports read like gloom and doom reports, and I always wondered if that would get in the way of good performance.  Warren Buffett is conservative too, but he'll back up the truck when he sees something he likes regardless of the outlook.   

Anyway, here's a look at Y's BPS performance over the years and the P/B ratio of the stock:

Y Long Term Performance and P/B Ratio

So it looks like Y has always traded at around BPS since 1987.   It traded above book in 1997 and 2000 (bubble times?) and most recently between 2004 and 2007 (peak of the credit bubble).  So judging from that, we can't really expect Y to trade very much above book in a normal environment.  The business model sort of evolves and has changed over time so we can't really say for sure.  But a prudent expectation is for Y to trade at around BPS over time.   Their big transformational merger with Transatlantic also increases the size of a business that comes with low multiples (many reinsurers, even with much higher ROE than Y trade at or below BPS). 

Long Term Relative Performance
Now let's take a closer look at the long term performance of Y.  Getting long term BPS change for Y is sort of a pain because of their 2% stock dividends they used to pay (so you can't just compare BPS values in different years to each other like you can with BRK or MKL.  Someone should ban these stock dividends that make comparisons a pain!) 

This is really not that surprising given the extremely conservative nature of the folks at Y.  Check this out: 

For the 26 years since 1987, Y has actually underperformed the S&P 500 index total return.  Y's BPS grew +9.6%/year versus a total return of +10.7% for the S&P 500 index (and +17.4%/year for BRK; I put BRK's BPS growth there just for fun). 

Y also underperformed in the 20 year time period. The five year time period is sort of irrelevant because that is off of the financial crisis low and is more a function of how far down something went during the crisis.

So that's really disappointing. 

But Wait! 
Weston Hicks became CEO in December 2004, so the important performance metric here might be to see how he has done.  In the above table, I put the returns for Y, S&P 500 and BRK since the end of 2004.  By this measure, despite Y's (to me) overly conservative and gloomy-doomy world view, Y has outperformed the index by +1.2%.  

Other interesting metrics are returns since previous market peaks.  This can also be pretty telling.  Since the peak (on a year-end basis) in 2000, Y has outperformed the S&P 500 index by +5.5%/year, and since the 2007 peak by +0.4%.

Here's a nice chart from a June investor presentation: 

Y also talks about risk adjusted return in their annual report.  It's not the most important thing for me, but it may be of interest to others who are more worried about the stock market.  

If you are going to invest in a stock but are worried about the stock market, you may want to invest in a business that is almost overly conservative and has a world view that is very gloomy.  This way, you can rest assured that they won't overreach for performance and get hit in a bear market (or I should say, get hit too hard in a bear market). 

Y has proven itself over time through various insurance cycles (huge events in the past decade+), some bear markets and a 100-year event financial crisis.  So in that sense, I would view Y as on the safe side of things. 

Of course, with insurance, you can never really know.  All surprises tend to be on the downside.

Why Not Other Insurers? 
OK, so why bother with Y when we have BRK and MKL?  Well, BRK and MKL are really good investments. It's amazing how well BRK has done even in recent years given it's size.  So I won't argue there.  I won't say Y is better than BRK/MKL.  But I still like it, even though I may not give it a big allocation (again, just due to their seeming over-conservatisim). 

There are plenty of other insurance companies with higher ROE's trading at book or less.  So why not look at the others? 

Well, I am more interested here in Y as an investment conglomerate than as an insurance company.  I look at them more as value investors.  I think a lot of us who follow Y, MKL, FRFHF and others think of it the same way.   So yes, there are other insurance companies that are very good businesses. 

I think Y is a solid investment.  It may not trade much above BPS in the near term; their stated goal is to increase BPS 7-10%/year over time, and I think it's great if they can achieve that and worth BPS if that is the case. 

With BRK now trading at 1.4x book and intrinsic value expected to grow at 10% (on the high side, I think), Y is not so bad at 0.9x if it can achieve 7-10%/year growth in EPS.  (How many mutual funds can you name that have long term records comparable to Y?  And even if you find some that do, fund returns are pretax (you would have had to pay taxes on dividends and capital gains along the way). 

Either way, this is an interesting situation to watch as there have been changes since the Transatlantic merger which I tend to view as positive (more disclosure etc.).  Check out the financial supplement they put out on their website, for example.   Also, their interest income is increasing due to their investments with Ares.  I know there is added risk in reaching for yield here with risk spreads as low as they are, but the folks at Y, given their conservative nature, would no doubt keep overall exposure in check. 

Wednesday, July 9, 2014

Catmull's Mental Models

OK, so I mentioned this book in my last post:

      Creativity, Inc: Overcoming the Unseen Forces That Stand in the Way of True Inspiration.

This is written by Ed Catmull, one of the founders of Pixar.  It's always great to read something written by such an amazing person about an incredible business they built.  Just as I like to read investment books written by people who have actually done it well, business books tend to be better when they are written by the actual people who have done it.  Yes, there is self-serving drivel sometimes too, but this is definitely not such a book.

I think it should be required reading for just about anyone involved in business and investing.  There is something for just about everyone to learn from it, even if they are not in necessarily creative industries.  It's about human nature and organizational dynamics too, so there are lessons to be learned from anyone who deals with people.

But what prompted this post was some mental models, as Catmull calls them, that he says has helped the people at Pixar get through the tough times.  And without getting through the tough times, there would have been no great movies (just as there would be no Berkshire Hathaway today without having gone through tough times.  If Buffett wanted to avoid nasty bear markets, nobody would know who he is today!)  None of their blockbuster movies came easily.  I think there is a perception, that Catmull meticulously dismantles, that Pixar is such a wonderful, talent-full business that they can crank out these amazing movies like Model T's on an assembly line.

These mental models, by the way, aren't the sort of mental models that Munger talks about.  They are more like metaphors that help people get through the inevitable rough periods that they go through when making movies.  He says that all of their movies suck at first (OK, maybe he didn't put it that way), and they have to keep working on it to make them better.   Sometimes it doesn't work out.

Tangent (already?)
OK, so as I was looking through the book to find the quotes, I found this quote and it immediately reminded me of a recent event so I can't help mentioning it:  Catmull quotes Apple's chief scientist, "The best way to predict the future is to invent it."  Of course, the first thought that came to mind when I read this was Bill Ackman's purchase and activism in Allergan  (or any activist investment for that matter, actually).   I actually like and respect Ackman, so this is just for fun (I know this is not the unanimous view of him in the value investing world).

Back to Mental Models
Before getting into Catmull's mental models (which, by the way, aren't really Catmull's mental models, but models he has observed and were articulated to him by his directors etc.), there is a similar model that I found in Chris Davis' letter to fund holders back in 2008:
Shelby M. C. Davis offers a sailing metaphor to describe this fundamental challenge of investing: "To sail across the ocean, you must balance making progress in fair weather with the ability to withstand the inevitable storms. Those who think only of the storms will never leave the shore. Those who think only of fair weather will never reach the other side."
So this is very similar to Andrew Stanton's model, and what's interesting is that Shelby Davis is talking about investing and Stanton is talking about directing a movie. 

I think Shelby Davis also said something about guiding the ship by the lights of the lighthouses in the distance and not by the waves tossing the ship around.  This metaphor was really helpful to me in getting through big down days/weeks/months in the market or my portfolio.

Anyway, here are some of the models that made me go, "wow, that's exactly the same as in investing!".

Brad Bird (directed Ratatouille, The Incredibles at Pixar) 
The themes Catmull recognizes in Bird's dreams (read the book to get the whole story) are blindness, fear of the unknown, helplessness and lack of control.  All us traders and investors experience this too.  Bird's mental model is skiing.  He relates:

This is where directing is a lot like skiing, "I like to go fast," Brad says, before launching into a story about a trip he took to Vail when, "in the course of a week, I cracked the lens of my goggles four times.  Four times I had to go to the ski store and say, 'I need a new piece of plastic,' because I had shattered it crashing into something.  And at some point, I realized that I was crashing because I was trying so hard not to crash.  So I relaxed and told myself, 'It's going to be scary when I make the turns really fast, but I'm going to push that mountain away and enjoy it.'  When I adopted this positive attitude, I stopped crashing.  In some ways, it's probably like an Olympic athlete who's spent years training for one moment when they can't make a mistake.  If they start thinking too much about that, they'll be unable to do what they know how to do."
This reminds me of those people who get in and out of the market all the time due to all sorts of fears.   Many of them understand that value investing works over time, but they just can't stand losing money, so they sell out every time the market looks scary to avoid a drawdown.  This sort of thing just totally destroys their performance.

This fear of failure also reminds me of what I talked about in the previous post about non-founder CEO's; they so fear destroying the wonderful business that a super-genius created that they become timid, avoid taking risks and make the easy decisions.  Catmull talks about how avoiding risk, going for the sure thing and making safe decisions in movie-making will most definitely create a mediocre, derivative movie.  Think about what happens to a company after a superstar, founding CEO retires.  Hmmm....

Andrew Stanton (WALL-E, Finding Nemo, A Bug's Life etc.)
If you're sailing across the ocean and your goal is to avoid weather and waves, then why the hell are you sailing?  You have to embrace that sailing means that you can't control the elements and that there will be good days and bad days and that, whatever comes, you will deal with it because your goal is to eventually get to the other side.  You will not be able to control exactly how you get across.  That's the game you've decided to be in.  If your goal is to make it easier and simpler, then don't get in the boat." 
As Buffett says, if it will upset you if a stock you buy goes down by 50%, then don't buy stocks because stocks will inevitably go down.  And we usually can't know when it will go down so we won't be able to enjoy the upside and then get out just in time to avoid a downturn.  Stanton's view is exactly the same idea.

Pete Docter (Up, Monsters Inc. etc.)
Peter Docter compares directing to running through a long tunnel having no idea how long it will last but trusting that he will eventually come out, intact, at the other end.  "There's a really scary point in the middle where it's just dark," he says.  "There's no light from where you came in and there's no light at the other end; all you can do is keep going.  And then you start to see a little light and then a little more light and then, suddenly, you're out in the bright sun."  For Pete, this metaphor is a way of making that moment - the one in which you can't see your own hand in front of your face and you aren't sure you'll ever find your way out - a bit less frightening.  Because your rational mind knows that tunnels have two ends, your emotional mind can be kept in check when pitch blackness descends in the confusing middle.  Instead of collapsing into a nervous mess, the director who has a clear internal model of what creativity is - and the discomfort it requires - finds it easier to trust that light will shine again.  The key is to never stop moving forward. 
This reminded me of 2008/2009.  I had no doubt that we would come out the other end, eventually.  I just didn't know when.  But I was 100% confident that we would come out of it.  After all, the banking crisis was just about money and liquidity.  We weren't facing nuclear annihilation.  Some entities were insolvent and/or had no liquidity, but there was a lot of cash/liquidity lying around.  It was just a matter of some traffic cop moving things around to avoid a total collapse.

If you own a business at a valuation you are comfortable with, and the business is sound and is run by good, competent people, then they should be able to get through the tunnel just fine and we as shareholders should hold on without too much fear.  If you have high confidence in their survival, there is nothing to worry about.

And it's amazing how he says "...and the discomfort it requires" about creativity.  We all know that value investing and even trading requires a lot of discomfort.  In my trading days, we used to say that the hard trade is the right trade, and that if a trade is easy, then it's probably wrong and you are probably about to get crushed.   Greenblatt says that most people don't do value investing because it's too hard.  Most can't take the ups and downs that is a must in this business.  Like my friend that was a temporary value investor; it was great during the bull market but once the market turned, he was no longer a value investor.

Michael Arndt
Michael Arndt, who wrote Toy Story 3,  and I have had an ongoing dialectic about the way he envisions his job.  He compares writing a screenplay to climbing a mountain blindfolded.  "The first trick," he likes to say, "is to find the mountain.".  In other words, you must feel your way, letting the mountain reveal itself to you.  And notably, he says, climbing a mountain doesn't necessarily mean ascending.  Sometimes you hike up for a while, feeling good, only to be forced back down into a crevasse before clawing your way out again.  And there is no way of knowing where the crevasses will be. 
Catmull, of course, has his own mental model and he describes it in the book.  It's basically about the concept of "mindfulness".  It resonated with many of the issues that he was thinking about at Pixar; control, change, randomness, trust, consequences.

All of this stuff is from Chapter 11, "The Unmade Future", pages 223 - 239 in the current hard cover book.  (Don't make me figure out what percentage that corresponds to on your Kindle. OK, the last numbered page is page 340 so figure it out yourself)

I am always fascinated when I read something and note the similarities to investing and in so many diverse endeavors. I don't think I would ever have imagined any connection between making films at Pixar and investing (that's not why I read the book!).

But I suppose we shouldn't be surprised that when going for excellence, there is a lot in common in just about every area.  One can learn to be a better investor by learning how others achieve what they do in other areas, and the Pixar book was very inspiring in that sense.

There is much, much more in this book than this sort of thing.  This is just what really struck me at the time and I just had to make a note of it.  I was actually going to write this out in my private notebook, but I thought other investors might get something out of it so decided to post it publicly.

Cost Cutting, R&D etc.

This is going to be a wandering post, just thinking out loud about a few things that have been on my mind.  I've been posting about "outsider" CEO's and now about 3G Capital.  They of course have a lot in common, but one thing is that these acquisitive CEO's cut costs, and sometimes a lot.  And this obviously raises questions about the sustainability of the business model.

This also ties in with the current Valeant / Allergan drama which I haven't posted about yet.  The bearish view is that Valeant's business model is unsustainable.

Many say the same thing about other cost cutters.  Popular examples would be Sears Holdings and Hewlett Packard.  The consensus seems to be that Lampert cut investments so deeply that it has destroyed Sears Holdings, and Mark Hurd cut R&D so deeply at Hewlett Packard that he destroyed the business.

I'm sure there is some truth in both.  When I used to go to K-mart at Astor Place in NYC, the elevator would make a scary, grinding sound.  I only rode it when I had to and it only went from the first floor to the basement; I would not have ridden an elevator that sounded like that to a high floor.  (I actually love that K-mart.  Since we don't have a Walmart or Target in Manhattan, it's great for cheap things you might need.)

And every time I walk into a Sears it was really a sad sight.  I actually really liked the kid's clothes at Sears.  I thought it was good stuff for the really low prices.  But I could get the same sort of thing at Target, Old Navy, Children's Place and many other places (so why would I go all the way to Sears just for that?).

But on the other hand, I'm not too sure more capex to make the stores look nicer would have made much of a difference.  Sears seems to have clearly lost business in their respective categories to Home Depot / Lowes, Best Buy etc.  And K-mart is just losing out to Walmart, Target and now the dollar stores.  Capex doesn't seem to me (and never did) to be the answer, really.   A nicer look wouldn't make me want to go to Sears versus Lowes.  They are just suffering from a much deeper existential problem.

Hewlett Packard too may be undergoing similar pressures; they could have pumped more money into R&D, but to achieve what?

This got me curious about what many consider the most innovative company on the planet:

Apple (AAPL)
So, let's take a look at AAPL.  Just out of curiosity, I looked at AAPL's sales and R&D since 1992.   Steve Jobs came back to AAPL in 1997, the iPod was launched in 2001, the iPhone hit the market in 2007 and the iPad came out in 2010.

Surely, Jobs must have come back to AAPL and boosted R&D and spent billions (like other tech companies) to create such great products.

Let's take a look:

Apple R&D History

What is stunning here is that AAPL spent an average $610 million per year in R&D between 1992 - 1996.  Jobs came back in 1997, and between 1997 through 2001 when the iPod was launched, R&D averaged only $382 million, 40% less than previous management!  OK, so the iPhone is really what shook the world.  Between 1997 and 2007 when the iPhone came out, R&D averaged $486 million per year, still 20% less than the previous management.  In terms of percentage of sales, previous management spent 6.9% of sales on R&D, and Jobs spent 5.6% over the following ten years until the iPhone came out.

If you only looked at the numbers, you might have been horrified.  My gosh, you would say.  AAPL is so "has been" that they should be boosting R&D, not cutting it!  This is a disaster in the making!

At the time, one of the most innovative companies was Nokia, so let's just look at what their figures looked like around the peak.  In 2013, they sold the phone business to Microsoft so I left out 2013.

Nokia R&D History

So these guys, the most innovative company in the world at the time, were spending between four to six billion euros per year on R&D, and double digits as a percentage of sales.   Nokia was spending more than ten times as much on R&D as AAPL.

OK, so this is an exception you say.  These disruptive innovations are always like this and they are unpredictable.  Jobs is also a special case; a super-genius, so we can't use this as a standard for anything.

This is also true.   But this would reinforce my doubts about AAPL's long term future (I have no position, but my view hasn't changed since the series of posts I made about AAPL in the past). If Jobs was able to create so much and change the world with less than $500 million per year in R&D, what are they coming up with now spending ten times that amount every year?!  Does AAPL now have the big company disease?

Other Companies
Being curious, I took a look at a bunch of other companies considered innovative (and not), and some others that are known for spending a lot on R&D:

                             Sales         R&D      R&D%
MSFT                   $77.8        $10.4       13.4%
AAPL                 $170.9        $ 4.5         2.6%
Samsung             $201.1       $11.5          5.7%   (converted at 1000 KRS/$, 2012)
GOOG                  $55.5         $8.0        14.4%
IBM                      $99.8         $6.2          6.2%
HPQ                    $112.3        $3.1           2.8%
INTC                     $52.7      $10.6         20.1%
Sony                      $45.2        $4.7         10.3% (converted at 100 yen/$, sales exclude financials, film                                                                              and music)
Nintendo                 $5.7        $0.7         12.5%

BA                        $86.6        $3.1           3.6%
GM                     $155.4        $7.2           4.6%
Toyota                $256.9        $9.1           3.6%  (converted at 100 yen/$)
Honda                 $118.4        $6.3          5.4%  (converted at 100 yen/$)

So there are some surprises here.  MSFT is spending $10 billion per year on R&D, or 13.4% of sales.  You wonder where that money is going given their lack of innovation.  Sure, there is some stuff going on; incremental improvements etc.  But nothing really exciting.  And that's after spending $10 billion per year?  Again, maybe it's not fair but it's stunning what AAPL was able to achieve with less than $500 million per year.

Sony too spends $5 billion per year, and the iPod should have been their product.  GoPro too came out of nowhere and that's exactly the sort of product Sony would have come up with back in the 1970's and 1980's when Akio Morita was still running the place.

GOOG spends a lot, and who knows where that goes.  We know they are working on all sorts of things; Google Glass, driverless cars etc.

Owner-Operator Tangent
This AAPL and Sony talk gets me off on a tangent.  What's really interesting is that AAPL created the products that Morita would have no doubt created.  Why was Sony not able to?  There have been a bunch of books on the topic, but at the end of the day, I just think that true innovation is hard with non-founder-owners  (I use the term owner-operator, but I actually mean founder-owner).  Sony, like MSFT, had certain businesses to protect too; AV business that would have become obsolete due to digitization (which happened anyway!) etc...

(Which makes me wonder, how much of MSFT's $10 billion is actually spent on creating new things versus trying to protect the Windows business?  Imagine buggy manufacturers, upon seeing the automobile on the horizon,  investing massively in R&D for horse feed that might increase the speed of horses.  Is that what MSFT is doing?)

I read a few books written by Tadashi Yanai, the amazing CEO of Fast Retailing (which runs the Uniqlo stores).  At one point in 2002, he retired and handed off the CEO-ship to someone he thought was perfect for the part; he understood the culture and what drove Uniqlo's success, was smart, ambitious and hard-working.

But it didn't work out.  Why?  Yanai said that the new CEO set a modest growth target and got too comfortable.  He didn't want to take risk and make drastic actions to further the success of Uniqlo; he wanted to protect what was there and grow modestly with low risk.  This turned out to be a disaster for Uniqlo and Yanai had to come back.

Maybe it was a similar story with Howard Schultz and Starbucks.  He also retired once and had to come back.

This is what worries me about the generation directly after the founder/owner.  A founder/owner will take big risk and take bold actions because he can.  Employees can't complain.  He is the star.  Shareholders can't complain.  Suppliers, vendors and customers can't complain.   They are all there thanks to this one individual (well, OK, it's all teamwork.  But there is usually that one person that attracts the team).

But when a non-founder / non-owner takes over, they can't afford to upset people.  They can't take bold actions and take big risks because if they fail, it can be catastrophic.  They tend to work to maintain the status quo, or work for modest growth and improvement.

(This is something to think about too with Berkshire Hathaway, by the way.  Buffett can afford to take bold actions and goof up since he has so much goodwill (and cumulative performance) built up over the years that even a humongous blunder (unless it destroys BRK completely) will probably be forgiven.  Not so the next CEO.)

This, by the way, is why I think Samsung was able to give AAPL a run for it's money while Sony is nowhere on the map:  Samsung is still (or was until recently) founder-run and Sony is not.

A really great book written by a founder is:  Creativity, Inc: Overcoming the Unseen Forces That Stand in the Way of True Inspiration.   Catmull is really honest and discloses a surprising amount of stuff about Pixar in the book.  I guess only Catmull or one of the other co-founders would be allowed to disclose so much.  But reading this book, it makes you realize how hard it is to create and maintain a culture even when the founders are still there.  This makes it feel like it will be very hard to keep up the winning streak without Catmull, Lasseter, Stanton etc.

Other Innovative Companies
We can look at Facebook, Twitter, GoPro and many others; they were created with very little capital. But it's not fair to say that the cost of creating Facebook was a laptop, an internet connection and a college student.  For every Facebook, there are many others who try to follow in the footsteps of Michael Dell, Bill Gates, Steve Jobs, and most fail.  So the actual cost of creating a Facebook is much higher than that.

I suppose we can argue that that is the case with the recent AAPL too, that Steve Jobs is a special case.  Very few people change the world multiple times.   So Jobs can work wonders with $500 million and most others can't.  But does that mean they can with $5 billion?   If they can't do something with $500 million, why should we think they can do it with $5 billion?

Valeant, Allergan, Yahoo
So it makes me wonder, maybe Michael Pearson is right.  He has been in the business a long time and has seen a broad view of the pharmaceutical industry as a consultant so probably really understands the waste that goes on in R&D.   And his idea is to just spend R&D where it matters; go for the high probability bets like line extensions or alternative uses and forget about the shotgun approach that seems to be common in the industry (not sure if that's still the case but I think it used to be; just do everything and see what sticks).

And perhaps purchasing products via M&A is more efficient than spending a ton on R&D.

Which reminds me that Yahoo's best investments have been Yahoo Japan and Alibaba.  I suppose they could have spent the same money in R&D or marketing.

Masayoshi Son of Softbank is like that too; he has made some great bets over the years.  I've never owned Softbank or any of his entities only because he is just too far out for me.  He told Charlie Rose not too long ago that his stock price went down 99% but bounced back quite a bit.

Well, I tell people don't worry about stock price volatility and who cares what happens to the stock price as long as intrinsic value is growing.  But a 99% decline, however temporary, even for me, is too much.  We all have our limits, I suppose.

Does R&D Have to be Constant? 
Back to the subject of R&D.  I wonder if R&D has to be constant.  Ackman pointed out that Allergan actually pays the CEO to spend money on R&D. I think that is to deter a CEO from slashing R&D dramatically to boost profits to collect a bonus.  So it makes sense at some level.  But it also reduces the incentive to make R&D more efficient.  It's sort of the opposite of zero-based budgeting; they know R&D will not be cut regardless, because it can't be cut by contract.  Is that really the way to run a business?

What would happen if all of the R&D in every company was subject to zero-based budgeting?  Every year, you would have to justify every dollar of expense in R&D; why it is needed, the probability of success and potential return etc.

Unfortunately, for competitive reasons we shareholders really can't demand details on R&D spending.  But I guess we can demand more disclosure as to how efficient or useful the R&D actually is.  What the heck is MSFT spending $10 billion on?!  NASA (actually, a panel that includes NASA) says that they can get people to Mars with $80-100 billion in 20 years.  That's $4-5 billion per year to get a manned mission to Mars!   What's MSFT gonna do with twice that?!

In a lot of companies, particularly high margin companies, it may be that they spend on R&D because they can.  Their margins are high enough that even if they spend a ton on R&D, their margins would still be higher than anyone else, so why not spend and see what will come out of it?

Other Costs
So I looked at R&D and innovation (well, not really;  I just looked at some raw numbers), but the same argument applies to all other costs.  Just because you cut cost doesn't mean you are hurting the business, and just because you spend more doesn't mean you are improving the business.  It all depends on what the costs are for.  Is the cost really essential, or is it there because the business can afford it?  In companies, people constantly need to be promoted so organizations tend to get bigger and bigger.

The guys at 3G Capital have been doing this sort of thing for years (as have, for example, the folks at Danaher) so they understand this very well and obviously have a good grasp of what sort of costs can be cut and which can't.

Even though I have no proof, I tend to believe that more businesses go out of business or suffer due to lack of cost controls (complacency) rather than too much cost cutting (which no doubt occurs too).

Well, there's really no conclusion in this post.  Just more questions.  I've worked in a big company and understand the resistance to change.  Whenever we are asked to cut costs, all hell breaks loose and people fear that all sorts of bad things will happen.

Well, I did experience one bad cost-cutting drive.  A company I worked for hired an efficiency expert and all hell did break loose.  Suddenly there were no more paper towels, toilet paper or soap in the bathrooms and the hallways went dark as there were no more light bulbs.  A bunch of other problems popped up, and it turns out that this efficiency expert was paid a percentage of total costs saved.  Duh.   So this guy basically just cut everything he had an authority to cut and I think walked away with a nice bonus (or he may have gotten fired before collecting for cause, but I don't even know;either way he wasn't around for too long).

As it says in the Fifer book, the trick is to cut costs that don't add to business and increase spending on what does.  It's not about cutting cost across the board.

The problem with middle management is that when someone is in charge of a section or division, it's a rare manager that will work hard to shrink it.  Most people want to expand their divisions regardless of whether it's a profit center or cost center.   When you go to a budget meeting, who the heck goes, "I want my budget cut 10% next year!".

Sorry for the long, meandering post.  Eventually this will turn into an idea and a more cohesive post.

Thursday, July 3, 2014

Heinz Update: Who's Next?

So it's been about a year since BRK and 3G Capital acquired Heinz (HNZ).  This is old news to most of you as the 10-Q for the first quarter was posted more than a month ago.  It is pretty amazing to read and you will see how incredible the 3G folks really are.  To find it you have to search Hawk Acquisition Intermediate II at the SEC website.

The thing about the 3G book, even though it 's a great read, is that there aren't that many figures in there.  This is true with a lot of books and even newspaper/magazine articles in general, but I guess it's too much of a hassle for most non-financial people to talk numbers.  In journalism, there is some standard about "who what when where why and how".  Someone should come up with a similar standard for financial/business news.  I'm always baffled at how little information there is in articles in the U.S.  They never seem to ask, "at what valuation?".   They seem only to focus on notional size; like, "$28 billion, wow, that's like, huge!!".   But never mind.

Anyway, first of all, let's take a look at HNZ before the acquisition:

Heinz Margins 2008-2013

It looked pretty decent.  15% margins in the highly competitive food segment seemed reasonable.  SGA expenses in the 20%-ish range also looked pretty normal.   Most would wonder how you could possibly increase margins from here in this segment as we all know that with big customers like Walmart, Target and Costco, there isn't a whole lot of pricing power.

But of course, we all know what 3G Capital is capable of.   Let's see what these guys did with HNZ:

If you look at the headline figures, there is not much progress:

                          2013 1Q                        2014 1Q
Sales :                 $2,856                            $2,800
Gross profit:       $1,040                               $955
Gross mgn:          36.4%                             34.1%
SGA:                     $629                                $521
SGA%:                   22%                             18.6%
Op income:           $410                                $433
Op mgn:              14.4%                              15.5%

But of course this is not the whole story.  In these figures are a bunch of one time expenses to cut cost.

The one time charges and expenses from the 10-Q were:

Restructuring and Productivity Initiatives 

During the second half of 2013 and the first quarter of 2014, the Company invested in restructuring and productivity initiatives as part of its ongoing cost reduction efforts with the goal of driving efficiencies and creating fiscal resources that will be reinvested into the Company's business as well as to accelerate overall productivity on a global scale. As of March 30, 2014, these initiatives have resulted in the reduction of approximately 3,500 corporate and field positions across the Company's global business segments (excluding the factory closures noted below). Including charges incurred as of March 30, 2014, the Company currently estimates it will incur total charges of approximately $300.0 million related to severance benefits and other severance-related expenses related to the reduction in corporate and field positions, of which $279.6 million has been incurred from project inception through March 30, 2014.

In addition, the Company has announced the planned closure and consolidation of 5 factories across the U.S., Canada and Europe during 2014.  The number of employees expected to be impacted by these 5 plant closures and consolidation is approximately 1,650, of which 175 had left the Company as of March 30, 2014. The Company currently estimates it will incur charges of approximately $93.0 million related to severance benefits and other severance-related expenses related to these factory closures, of which $48.6 million has been incurred from project inception through March 30, 2014.  In addition the Company will recognize accelerated depreciation on assets it plans to dispose of but which are currently in use. The charges that the Company expects to incur in connection with these factory workforce reductions and factory closures are subject to a number of assumptions and may differ from actual results.  The Company may also incur other charges not currently contemplated due to events that may occur as a result of, or related to, these cost reductions.


The Company recorded pre-tax costs related to these initiatives of $140.8 million in the three months ended March 30, 2014, which were comprised of the following:

$53.7 million for severance and employee benefit costs relating to the reduction of corporate and field positions across the Company.
$13.7 million associated with other implementation costs, primarily for professional fees, and contract and lease termination costs.
$73.4 million relating to non-cash asset write-downs and accelerated depreciation for the planned closure and consolidation of 5 factories across the U.S., Canada and Europe.

Of the $140.8 million total pre-tax charges for the three months ended March 30, 2014$118.8 million was recorded in Cost of products sold and $22.0 million in Selling, general and administrative expenses ("SG&A"). 

So adjusting for these one timers, the actual results are:

Results Excluding Special Items
Management believes that this measure provides useful information to investors because it is the profitability measure used to evaluate earnings performance on a comparable year-over-year basis.

2014 Results Excluding Charges for Productivity Initiatives and Other Special Items

The adjustments were charges for productivity initiatives, amortization of deferred debt issuance costs related to new borrowings under our current Senior Credit Facilities and the Notes, incremental depreciation and amortization as a result of preliminary purchase accounting adjustments and stock based compensation expense that, in management's judgment, significantly affect the assessment of operating results. See “Restructuring and Productivity Initiatives” sections for further explanation of certain of these charges and the following reconciliation of the Company's first quarter of 2014 results excluding charges for productivity initiatives and other special items to the relevant GAAP measure.

First Quarter Ending March 30, 2014
(Continuing Operations)
Gross Profit
Operating Income
Pre-Tax Income
Net Income attributable to Hawk Acquisition Intermediate Corporation II
(In thousands)
Reported results






Charges for productivity initiatives






2014 special items(a)






Amortization of deferred debt issuance costs



Incremental depreciation and amortization from preliminary purchase accounting adjustments





Stock based compensation





Results excluding charges for productivity initiatives and 2014 special items






Includes incremental costs primarily for additional warehousing and other logistics costs incurred related to the acceleration of sales ahead of the U.S. SAP go-live, which was launched in the second quarter of 2014, along with equipment relocation charges and consulting and advisory charges not specifically related to restructuring activities.

Redoing my above table, we get these figures:

                          2013 1Q                        2014 1Q                  2014 1Q
Sales :                 $2,856                            $2,800                    $2,800
Gross profit:       $1,040                               $955                    $1,096
Gross mgn:          36.4%                             34.1%                    39.1%
SGA:                     $629                                $521                       $493
SGA%:                   22%                             18.6%                    17.6%
Op income:           $410                                $433                       $603
Op mgn:              14.4%                              15.5%                    21.5%

HNZ averaged an operating margin of 14.9% for six years.  And then comes 3G and boosts that to 21.5% in less than a year.  In a single year, they took out 7.1% of revenues in costs;  4.4% out of SGA and 2.7% from COGS.

They increased operating earnings +47% in less than a year.

At BUD, I think they also took out around 6% of combined sales from expenses.  Since there wasn't a lot of overlap, this was probably mostly costs taken out of the old BUD, so as a percent of old BUD revenues, the cost savings were probably much higher than that.

It is still a little early so we have to see how things go going forward, of course.  But things look pretty good so far.

Heinz as a Platform
OK, so you may be rolling your eyes.  First, this guy (me) trips over himself seeing "outsider" CEO's everywhere; every acquisitive company is an outsider CEO company.  And then when a great CEO takes over a company, it suddenly becomes a "platform" for more acquisitions.

So yes, maybe I get a little caught up in these things and maybe it's the fad of the moment.  But as long as what I am looking at makes sense and are operated by competent people with track records of success (and we don't go out and overpay), I suppose there is nothing wrong with that.

I thought I'd just mention that since I too sometimes wonder if I take things too far.

Anyway, having said all of that, I do actually think that HNZ is a platform for further acquisitions.   Why not?  This has been the M.O. of 3G from the beginning.  The current BUD is a perfect example.

Think about it.  They got 6% of revenues worth of costs out of BUD and that was probably with very little synergies as operations didn't overlap too much.  At HNZ, they took out 7% of revenues in cost and this wasn't even a merger so there were no synergies or scale advantages.  It was just pure cost cutting and increased efficiency.

Can you imagine what they can do if they did a merger?  If HNZ bought another food company, they can probably take out 6-7% or more in cost savings, but then they can probably get more value from scale advantage and cost synergies (one human resources department instead of two, one legal department instead of two, consolidating manufacturing/distrubution/sales organizations etc...).

Now that would be incredibly value-creating.

HNZ Buying Power
Obviously, since HNZ is loaded up on debt, the question is whether HNZ can do anything in the near term.  They have $14.6 billion in long term debt on the balance sheet as of March 2014.  Annualizing the 1Q EBITDA, we get $2.8 billion.  So HNZ has leverage of 5.2x, but excluding cash and using net debt we get a leverage ratio of 4.2x.  4.2x is lower than the typical 5.0x or so in LBO's, but on it's own it doesn't look like HNZ has a lot of room to take on too much debt to do any huge deals right away.  With free cash to increase substantially going forward, maybe the gun gets loaded more quickly than we think.

But then again, there is Buffett sitting there with a lot of cash he wants to put to work.  Maybe he buys HNZ stock to help fund a deal (and more bonds/preferreds as needed); he would no doubt love to buy more HNZ and see a big value creating deal.

Recap of HNZ Deal
Before we look at who might be next, here are some figures from the HNZ deal last year (valuation).
The deal was a 20% premium at $72.50/share and a total deal value of $28 billion.

The EPS and EBITDA estimates for the year ending April 2013 and 2014 and respective valuations at the time (at $72.50/share) were:

                             EPS       P/E        EBITDA                 EV/EBITDA
April 2013e          $3.58     20.3x     $2,057 million         13.6x
April 2014e          $3.78     19.2x     $2,195 million         12.8x

Not cheap, right?

Shopping List? 
Here's a list of some of the big food companies. K and CPB are often mentioned as potential BRK/3G candidates and that does sort of make sense.  The companies with an asterisk on them have one time things that impact the figures.  For example, K is not trading at a 12.7x p/e and 8.1x EV/EBITDA, and KRFT is not as cheap as it looks there either.  They had one times gains and CPB is not as expensive as it looks in the table.

Anyway, GM is gross margin, SGA% is sales, general and administrative expense as percent of revenues, OM is operating margin, MC is market capitalization, EV is enterprise value, and p/e cye is current year estimate p/e.  I put that there due to some of the abnormal figures in the ttm p/e; I think the current year estimate reflects a more normalized p/e.

For K, it looks cheap on a ttm basis, but it is trading at 17.6x 2013 EPS and 11.8x 2013 EV/EBITDA (actually, current EV to 2013 EBITDA).

For CPB, it is trading at 17.3x July 2013 year end EPS and 18.0x July 2014 estimate EPS.  It is also trading at 12x 2013 EV/EBITDA.

KRFT is trading at 13.8x 2013 EV/EBITDA.

Precedent Transcactions for Food Companies
And just for reference, here are some valuation analyses from past deals.  This is from the HNZ merger proxy.  A valuation analysis was done by Centerview, BOFA Merrill Lynch and Moelis.

Centerview Analysis
Selected Precedent Transactions Analysis
Centerview analyzed certain information relating to selected transactions since 2000 in the food industry with transaction values over $3.5 billion that Centerview, based on its experience and judgment as a financial advisor, deemed relevant to consider in relation to Heinz and the merger. These transactions were:

Date of Transaction
  Target  Acquiror  Transaction
Value /
Value /
November 2012
  Ralcorp Holdings Inc.  ConAgra Foods, Inc.

  $6.8    1.5x    11.9x  
November 2010
  Del Monte Foods Co.  Funds affiliated with Kohlberg Kravis Roberts & Co. L.P.,
Vestar Capital Partners and Centerview Partners
  $5.3    1.4x    8.8x  
January 2010
  Kraft Foods’ North America frozen pizza business  Nestlé S.A.  $3.7    1.8x    12.5x  
July 2007
  Group Danone S.A.’s biscuits division  Kraft Foods Group, Inc.  $7.2    2.6x    13.2x  
December 2000
  Quaker Oats Co.  PepsiCo, Inc.  $14.0    2.8x    15.6x  
October 2000
  The Keebler Company  The Kellogg Company  $4.4    1.6x    11.1x  
July 2000
  Pillsbury  General Mills, Inc.  $10.5    1.7x    11.0x  
June 2000
  Nabisco Holdings Corp.  Philip Morris Companies Inc.  $18.9    2.1x    13.2x  
June 2000
  Bestfoods  Unilever PLC  $24.3    2.6x    13.9x  
No company or transaction used in this analysis is identical or directly comparable to Heinz or the merger. The companies included in the selected transactions are companies with certain characteristics that, for the purposes of this analysis, may be considered similar to certain of Heinz’s results, business mix or product profile. Accordingly, an evaluation of the results of this analysis is not entirely mathematical. Rather, this analysis involves complex considerations and judgments concerning differences in financial and operating characteristics and other factors that could affect the public trading or other values of the companies to which Heinz was compared.
For each of the selected transactions, based on information it obtained from SEC filings, FactSet, Wall Street research and Capital IQ, Centerview calculated and compared transaction value as a multiple of LTM sales and LTM EBITDA, with LTM EBITDA excluding one-time expenses and non-recurring charges. This analysis indicated the following multiples:

Implied Enterprise Value
as a Multiple of:
  2.0x    12.4x  
  1.8x    12.5x  

Centerview then drew from this analysis and other considerations that Centerview deemed relevant in its judgment and experience an illustrative range of multiples of implied enterprise value / LTM EBITDA of 11x-14x. Centerview then applied the illustrative ranges of multiples to Heinz’s LTM EBITDA for the period ended October 28, 2012. The results of this analysis implied a value per share range for shares of Heinz common stock of approximately $55.75 to $74.00, based on the outstanding number of shares of Heinz common stock on a diluted basis. This range of $55.75 to $74.00 per share was compared to the $72.50 per share merger consideration to be paid pursuant to the merger agreement. 

BofA Merrill Lynch Analysis

Selected Precedent Transactions Analysis. BofA Merrill Lynch reviewed, to the extent publicly available, financial information relating to the following nine selected transactions valued over $3.5 billion involving companies in food industry, which, based on its professional experience and judgment, BofA Merrill Lynch deemed relevant to consider in relation to Heinz and the merger:

Announcement Date
Value ($bn)
Multiple of LTM
November 2012
•    ConAgra Foods, Inc.
•    Ralcorp Holdings, Inc.
•    $6.8
•    1.5x
•    11.9x
November 2010
•    KKR & Co.
•    Del Monte Foods Co.
•    $5.3
•    1.4x
•    8.8x
January 2010
•    Nestlé S.A.
•    Kraft Foods’ Frozen Pizza Division
•    $3.7
•    1.8x
•    12.5x
July 2007
•    Kraft Foods Group, Inc.
•    Danone S.A.’s Biscuits Division
•    $7.2
•    2.6x
•    13.2x
December 2000
•    PepsiCo, Inc.
•    The Quaker Oats Company
•    $14.0
•    2.8x
•    15.6x
October 2000
•    Kellogg Company
•    Keebler Foods Company
•    $4.4
•    1.6x
•    11.1x
July 2000
•    General Mills, Inc.
•    Diageo PLC’s Pillsbury Division
•    $10.5
•    1.7x
•    11.0x
June 2000
•    Philip Morris Companies Inc.
•    Nabisco Holdings Corp.
•    $18.9
•    2.1x
•    13.2x
June 2000
•    Unilever plc
•    Bestfoods
•    $24.3
•    2.6x
•    13.9x
BofA Merrill Lynch reviewed transaction values, calculated as the enterprise value implied for the target company based on the consideration payable in the selected transaction, as a multiple of the target company’s latest 12 months EBITDA. The overall high to low latest 12 months EBITDA multiples observed for the selected transactions were 8.8x to 15.6x. Based on its professional judgment and after taking into consideration, among other things, the observed data for the selected transactions, BofA Merrill Lynch then applied a selected range of latest 12 months EBITDA multiples of 11.0x to 14.0x derived from the selected transactions to Heinz’s latest 12 months (as of October 28, 2012) EBITDA. Estimated financial data of the selected transactions were based on publicly available information at the time of announcement of the relevant transaction. Financial data of Heinz were based on Heinz’s public filings. This analysis indicated the following approximate implied per share equity value reference ranges for Heinz, as compared to the merger consideration:

Moelis Analysis
Selected Precedent Transactions Analysis. Moelis reviewed financial information of those transactions announced between 2000 and 2012 involving large target companies with significant food businesses that Moelis deemed generally comparable to Heinz in product mix and geographic scope. Moelis reviewed, among other things, transaction values of the selected transactions and the merger as a multiple of EBITDA for the most recently completed twelve-month period (“LTM”) for which financial information had been made public at the time of the announcement of each transaction, unless otherwise noted. Financial data for the selected transactions were based on publicly available information at the time of announcement of the relevant transaction. The list of selected transactions and the related multiples are set forth below:

  Target  Acquiror  EV
($ in thousands)
Dec. 2012
  Morningstar Foods, LLC  Saputo Inc.  $1,450    9.3x  
Nov. 2012
  Ralcorp Holdings, Inc.  ConAgra Foods, Inc.  6,775    12.1x  
Feb. 2012
  Pringles Business of Procter & Gamble Company  Kellogg Company  2,695    11.1x1 
June. 2010
  American Italian Pasta Co.  Ralcorp Holdings, Inc.  1,256    8.3x  
Jan. 2010
  North American Frozen Pizza Business of Kraft Food Global, Inc.  Nestlé S.A.  3,700    12.5x  
Nov. 2009
  Birds Eye Foods, Inc.  Pinnacle Foods Group, Inc.  1,371    9.5x  
Sept. 2009
  Cadbury plc  Kraft Foods Inc.  21,395    13.3x  
June 2008
  The Folgers Coffee Company  The J.M. Smucker Company  3,398    8.8x  
Apr. 2008
  Wm. Wrigley Jr. Company  Mars, Incorporated  23,017    18.4x  
Nov. 2007
  Post Foods  Ralcorp Holdings, Inc.  2,642    11.3x1 
July 2007
  Global Biscuit Business of Groupe Danone S.A.  Kraft Foods Global, Inc.  7,174    13.6x1 
Feb. 2007
  Pinnacle Foods Group, Inc.  The Blackstone Group, L.P.  2,142    8.9x  
Aug. 2006
  European Frozen Foods Division of Unilever plc  Permira Advisors Ltd.  2,199    9.9x1 
Aug. 2006
  Chef America, Inc.  Nestlé S.A.  2,600    14.5x  
Dec. 2002
  Adams Confectionary Business of Pfizer Inc.  Cadbury Schweppes plc  3,750    12.8x1 
Oct. 2001
  The Pillsbury Company  General Mills, Inc.  10,396    10.1x2 
Dec. 2000
  The Quaker Oats Company  PepsiCo, Inc.  14,010    15.6x  
Oct. 2000
  Keebler Foods Company  Kellogg Company  4,469    10.7x  
June 2000
  Nabisco Holdings Corp.  Philip Morris Companies Inc.  19,017    13.7x  
June 2000
  International Home Foods  ConAgra Foods, Inc.  2,909    8.5x  
May 2000
  Bestfoods  Unilever plc  23,503    14.5x  
1 Financial data were based on latest available fiscal year end information; not latest quarter-end information.
2 Financial data reflected revised deal terms pursuant to a second amended merger agreement.

This analysis indicated the following mean and median multiples for the selected transactions and the merger were as follows:

Selected Transactions

The Merger

      Mean  Median
    11.8x  11.3x13.7x
since 2009)
    10.9x  11.1x13.7x
Moelis then used its professional judgment and experience to apply a range of selected multiples derived from the selected transactions of 11.0x to 14.0x LTM EBITDA to Heinz’s LTM EBITDA as of the announcement date of the merger.

So, it seems like all three advisors came up with a fair value range of 11-14x LTM EBITDA.  They are all looking at similar past deals, so I suppose that's to be expected.

BRK/3G paid 20x p/e and 14x EV/EBITDA for HNZ which at the time didn't look cheap at all, but we see how much value they created already in one year.  And this was done in a deal as a 'financial' deal, meaning no operating synergies from a merger or anything like that.

This, to me, would suggest that they would have some room to pay more if there were going to be operating synergies / scale benefits from a real merger instead of pure LBO.

For KO and PEP, I am thinking about BUD, of course.  But for other food companies, it might make sense for HNZ to combine with them.  Thinking about the fact that they can get 7% of revenues in cost out in the first year, imagine what they could do to an undermanaged food company if they can get the synergies too.

There seems to be plenty to do!