Monday, November 3, 2008

Hansen Natural Equity Analysis

Hansen Natural Business Analysis
Branding and Distribution are key competitive advantages; difficult for new entrants to gain market share
  • Hansen has created a strong brand (Monster)
  • Distribution contracts with major Coke and Bud distributors in US as well as six European countries
Consumers are price inelastic between different brands
  • Firms don’t compete on price
Consumers are addicted to a certain extent to particular energy drinks since they provide a quick boost in energy levels
  • Psychological barriers to switching brands
  • Coffee gives bad breadth and brown teeth; energy drinks avoid such problems and have no taste memory
Business model has high operational leverage
  • Incumbents can leverage economies of scale

Monday, September 22, 2008

Phillip Morris International: A costless call option on growth in emerging markets

-->Valuation: JFCG's valuation of PM yields a price of $74, an upside potential of 48% to today’s (09/22) closing price of $50. The valuation model is sensitive to changes in short-term revenue growth (10.1%), sustainable net profit margin (11.4%) and sustainable cost of equity (9.3%). PM’s y-o-y revenue growth for the last two quarters has been in the 14% range and net profit margin has been in the 11-12% range. PM’s revenues are well diversified geographically and it operates in a stable tobacco industry; a cost of equity of 9.3% is quite conservative for such stable firms. PM doesn’t have a long enough trading history but its former parent MO has been trading in the PE range of 13X to 18X in the last five years; PM with its average estimated EPS of $3.75 for 2009 could trade in the $49 to $68 range in 2008-2009.

Scenario & Sensitivity Analysis: A scenario analysis shows that PM’s current stock price reflects low short term revenue growth at 2% or a low sustainable net profit margin of 7%; either one of which has a low probability. PM’s intrinsic value is more sensitive to net profit margins; each percentage point in net margins is equivalent to $5.5/share of intrinsic value. Net profit margins at PM have been very stable and is unlikely to change anytime soon.

Tobacco Sector Analysis: Extensive regulation, taxes and litigations risks have hampered the growth of this industry in much of the developed world. Litigation risk is high in US but almost non-existent in emerging markets. PM is not liable for any litigation in the US since Altria owns all of PM’s brands in US. All these issues have also led to consolidation in the industry in the last few years and increased barriers to entry. Tobacco industry has a HHI of 3100 and the top ten brands from the big four tobacco companies make up about 80% of the market; PM owns seven out of the top 15 brands in the world. The high cost of litigation, lobbying various governments and creating a brand benefits companies with scale in this industry. It is almost impossible to quickly penetrate this market with a new brand and so competition in this industry is more likely to come from existing players acquiring local brands.
Tobacco producers are scattered around the world and hence don’t have a lot of bargaining power while negotiating prices for their produce. On the other hand, consumers can easily switch to cheaper brands if the economic conditions warrant such a change and so brand recognition is the key to retaining consumers. A variety of products compete for the consumer’s tobacco dollars, however, once a consumer is addicted to cigarettes, it is difficult for other products to gain prominence.

Growth Catalysts: PM achieved impressive international growth as a part of Altria and was spun-off in April 2008 with rights to market PM brands in all countries but the US. PM can achieve much better results with its focus on international markets without the baggage of US litigation risk and regulation.
In Dec 2007, PM formed a joint venture with China National Tobacco to manufacture PM branded cigarettes in China and are expected to hit the markets in Q3-2008. PM’s Asian revenues (excluding China) grew at a CAGR of 9% in the past three years and the introduction of PM brands in China could push this growth rate into double digits in 2009-2010. Similarly, India is another growing market for cigarettes and PM is in talks to manufacture Marlboro locally. Chinese and Indian growth has not been factored in the valuation model so far since it is not expected to be materially significant in the next few quarters. In the last three years, EMEA has been the fastest growing region with a CAGR of 11%.
All insiders including the CFO have bought shares in the $50 range without a single insider sell transaction below $52 in the last six months. In May 2008, PM announced a $13 billion two-year share repurchase program; as of Q2-2008, it has spent $2.1 billion out of the $13 billion approved by the Board of Directors. PM’s three year $1.5 billion productivity and cost savings program is on track with the first big element of resourcing of volume from USA factories to PMI factories expected to be about two months ahead of schedule.
Risk Factors: PM’s European volume shipments have been on a decline in the past one year and Europe is the largest revenue generator for PM with a revenue share of 49% in 2007. In the past three years, PM was able to offset lower volume shipments in EU by increasing prices and the overall revenues grew at a CAGR of 3.8%. Overall, PM’s growth in emerging markets has to make up for the decline in EU shipments.
An increase in inflation world-wide could hurt PM’s sales since it sells premium brands and most of its new customers trade-up from local cigarette brands. However, in case of PM, inflation is a double edged sword: it could mean weak sales for PM in certain regions but the underlying reason for world-wide inflation is that more consumers have resources to buy goods, which increases the international customer base for PM products.
Litigation costs and increasing regulation in developed countries is a major concern for tobacco companies. PM doesn’t generate revenues from US and is unlikely to be liable for any litigation in US; it is also immune to any future US regulation. Anti-tobacco laws in other regions of the world are not strict enough to cause any material impact on PM’s bottom-line. The recent acquisition of Rothmans in Canada is the only major source of litigation risk for PM.
Overall, PM has limited downside risk in current volatile market conditions with above average growth potential owing to its strong brands and low penetration in major emerging market countries such as China, India and Vietnam.

Monday, July 28, 2008

Nike Equity Analysis

Portfolio Suitability: In the last three years, Nike’s correlation to consumer discretionary sector is at 0.01. In simple terms, for the last three years, Nike’s stock doesn’t have any relation to the movement of consumer discretionary sector. So, even though Nike is considered to be a consumer discretionary stock, its stock isn’t behaving in line with the sector. The reason for this anomaly could lie in the fact that most consumer discretionary stocks are heavily dependent on US for their revenues while Nike isn’t. Infact, Nike’s three year correlation to the consumer staple sector is at 0.91 and at 0.89 to the utilities sector. This reinforces the theory that Nike will not be severely affected by a further slide in the US economy.

Sector Performance: Nike belongs to the consumer discretionary sector, a sector which we have been underweight since we started seeing some signs of an economic downturn in the US in June (2007) when an inverted yield curve puzzled everyone. An inverted yield curve is almost always a leading indicator of an economic slowdown since forward yields are low in one of the two circumstances; either the GDP growth is expected to decline or inflation is expected to decrease. However, with central banks worldwide having trouble keeping inflation at bay, the possibility of decline in GDP growth was more realistic. A decline in GDP wouldn’t bode well for the consumer discretionary sector and so we have been underweight on that sector for quite some time now. In the first half of 2008, we have seen a slowdown in GDP growth coupled with high inflation. However, the yield curve is now upward sloping and so GDP growth is expected to pick-up sometime next year (2009). This begs the question if it is a good time to get back into the consumer discretionary sector while it is still reeling from an effect of a downturn and selling at a discount; XLY - Consumer Discretionary SPDR - is selling close to its five year lows in the mid 20s. The yield curve is just one indicator of GDP growth and so I looked at performance of XLY during the last economic recession; I used the last recession as a point of comparison since the macroeconomic conditions would be the closest, if not the same, for companies operating in the last 10 years. As we can see in the first chart, XLY underperformed S&P only for one year – 2000 - during the last recession. We want to check the performance of XLY in the last one year; the next chart compares XLY’s performance with S&P in the last one year and it has underperformed the S&P by about 10 percentage points. However, given the current credit market turmoil, I was still a little wary of this sector. Focusing on companies with extensive international exposure would mitigate the risk of a prolonged downturn in the US markets and Nike tops that list, moreover, Nike is underpriced which makes for a good value investment.
Nike’s Stock Performance: NKE’s stock closely followed XLY during the first recession of this decade and underperformed the S&P for about one year in 2000-2001. In the last one year, Nike has outperformed the S&P by about 15 percentage points while XLY has underperformed the S&P by 10 percentage points. Clearly, Nike is not following declines of the consumer discretionary sector in this downturn and that could be because of its extensive international exposure. In 1999-2000, Nike’s revenues from US were at 52% while 34% of Nike’s TTM revenues are from US. The recent slide in Nike’s price is attributed to flat orders from US for the rest of 2008 and so a slowdown in the US is already priced in the stock. The market ignored Nike’s excellent performance in the international segment. Nike’s revenues are well diversified and a slowdown in any one region of the world is less likely to have a significant impact on Nike’s overall performance.
Growth Catalysts: In the short term, revenue growth from Olympics will continue to provide support to the stock price. Nike is sponsoring 22 of China’s 28 Olympic teams. Moreover, Nike is expanding its distribution in China to 500 cities in the next three years from the current 300 cities. Basketball is the most popular sport in China and Nike is well established in that segment worldwide and has extensive experience in US basketball segment. Soccer is one of the most popular games in Nike’s growth regions – EMEA, Asia Pacific and Americas. Nike was historically a second rung player in the soccer segment but is now pursuing it aggressively; Nike bought Umbro in 2007 to strengthen its position in the soccer segment. Nike’s soccer teams did extremely well in the 2008 European Championships with five of the eight quarter finalists sponsored by Nike. Nike’s focus on Soccer will also boost sales in emerging markets such as Brazil and Russia.
Industry Analysis: The athletic footwear industry is in consolidation mode and Nike’s two top rivals, Adidas and Reebok merged in 2006. The global sports footwear market is almost an oligopoly between Nike and Adidas-Reebok. Oligopolistic competition could be good or bad for the participants based on whether the participants engage in a price war. Oligopolistic competition between Intel and AMD proved to be destructive for the industry due to a price war while the same between Pepsi and Coke without the price war is beneficial to both companies. Fortunately, Nike and Adidas-Reebok have avoided getting into a price war. This may also be due to the fact that consumers of Nike-Adidas sports gear are relatively inelastic to price since that expenditure forms a small part of their total expenditure. The demand curve in such a market is kinked and so is inelastic to price decreases; firms don’t gain a substantial number of customers by reducing prices. In such cases, firms utilize non-price competition in order to accrue higher revenue and market share. By definition, participants in an Oligopolistic market have significant economies of scale advantage and present strong entry barriers. Nike has distribution deals with large retailers which guarantees shelf space; it also has a size advantage when negotiating sourcing and sponsorship contracts.
Valuation: Our valuation model yields a price of $68/share while its current price is $57.24; undervalued by 19%. The valuation model uses a short term CAPM cost of equity of 8% and a long term CAPM cost of equity of 9%. Net profit margin is constant at 10% since Nike has an excellent track record of improving profitability and its TTM net profit margin is at 10.11%.

A scenario analysis of the above valuation model shows that its current stock price of $57.24 reflects a lower net profit margin of 8.5% or a slower short term revenue growth of 6.5%. The probability of an 8.5% net profit margin or a 6.5% revenue growth is extremely low and hence its current price has sufficient built-in margin of safety.
Nike maintains a lower effective tax bracket (24.7% for the last quarter) since it doesn’t repatriate earnings from international operations and instead uses it to grow in those regions. We view this arrangement to be very beneficial since Nike’s stock value is extremely sensitive to net profit margins; a one percentage point change in net profit margin is equivalent to $6/share while each percentage point in revenue growth is equivalent to $3/share in Nike’s intrinsic value. In the last five years, Nike has traded in the range of 14x to 25x earnings and at an estimated EPS of $3.95 for FY 2009, Nike’s stock should trade in the range of $55 to $98. Nike will also have support on the downside from a $2.2 billion share buyback approved for the next two years; in Fiscal 2008 (May 2007 to 2008), Nike spent $817 million on buybacks. Nike is relatively inexpensive at a PEG of 1.1 and has doubled its dividend in the last two years. Moreover, insiders haven’t sold a single share in the last one year below $57.08 with majority of the sell trades above $66 levels. Given the current uncertain market conditions, Nike is a perfect defensive (beta at 0.85), underpriced stock and has significant upside potential once the markets get out of the bear territory. Overall, it’s a consumer discretionary stock with the downside risk of a consumer staple and upside potential of a consumer discretionary stock.