Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Wednesday, December 22, 2010

Investing in Global Shifts: Brazil, Latin America, the Container Trade, and More

While the U.S. economy slogs forward with various pockets of strength (e.g. technology, agriculture, certain industrial areas) and wrestles with well-known fiscal challenges, other parts of the world -- such as Latin America -- are zooming ahead.

For example, the other week, CBS's 60 Minutes had an interesting segment on Brazil, which we share here and recommend watching:
  • Brazil's Rising Star
  • December 12, 2010 5:20 PM
  • As the U.S. and most of the world's countries limp along after the crippling recession, Brazil is off and running with jobs, industry, and resources. Steve Kroft reports.

A number of things stand out in the segment, including:
  • "poised to overtake France and Great Britain as the fifth largest economy in the world"***
  • "GDP-wise, bigger than all other Latin American economies put together"
  • "80% of electricity comes from bio-power"
  • "14% of world's fresh water supply"
  • "largest producer of iron ore in world"
  • "leading exporter of beef, chicken, orange juice, sugar, coffee, and tobacco, much of it bound for China, which has replaced the U.S. as Brazil's largest trading partner"
***IMF estimates via Wikipedia show Brazil may have already passed these countries in purchasing power parity GDP terms)
Now, for the entire regional picture, here's a 2010-11E GDP growth snapshot from the IMF that indicates expected growth north of 5% for much of the region, including Brazil (click to enlarge):

As in other emerging regions, it seems like the train has left the station. What are the implications for the global economy and an investment portfolio? First, put simply: more trade, more consumption, more investment around the world. Second, as an investor, per our prior commentary, we need to keep a global perspective and establish exposure to companies that benefit from ongoing global expansion.

Based on our recent post on Seaspan (SSW) and prior posts on the shipping sector, we know that 2010 trends have been quite positive. BUT, what about long-term trends? What happened with regional trade over the last several decades?

We can look to our April post, Shipping: Container History from 1985 and Outlook, which included insightful graphics from TAL International Group, Inc. (TAL), including:

We can also look to the AAPA, the American Association of Port Authorities, "a trade association which represents more than 160 public port authorities in the United States, Canada, the Caribbean and Latin America." The AAPA includes a "Statistics" section on its Web site that contains a plethora of helpful information.

We share two things from the AAPA here:

  • Brazilian Port Traffic (2009)

  • Click to enlarge and, aside from a weak 2009, notice the long-term increases across various types of cargo volumes for the Ports of Brazil:

  • U.S. Sea Trade Volumes with South & Central America (1992 - 2009)

  • What about U.S. Seaborne trade with all of Central and South America? U.S. exports to the region - click to enlarge (*please see reference link for exports, imports, and total trade):

    We can quickly see the tremendous growth in trade with the region over the past decade. This is a large part of our investment thesis for Seaspan and Global Ship Lease (GSL).

    YET, we don't simply have an ownership position in container ships. Aside from broadly global businesses such as eBay (EBAY) -- which has its own LatAm exposure plus an approximate 18% stake in MercadoLibre (MELI) -- we also own companies with more concentrated exposure in Latin America such as Compañía Cervecerías Unidas S.A. (CCU) and PriceSmart (PSMT). As with our prior brief mention of Compañía Cervecerías and PriceSmart, we should again note that very positive 2010 stock runs leave valuations somewhat less attractive than one year ago.

    However, on the back of favorable, readily apparent secular shifts, we continue to sleep well owning these businesses as well as a critical piece of the global transportation infrastructure via our container shipping companies.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long GSL, SSW, EBAY, CCU, PSMT.
    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Saturday, December 18, 2010

    1-800-Flowers.com (FLWS): Is "Moat" Shallow, Shrinking, or Nonexistent?

    We've made our stance on 1-800-Flowers.com (FLWS) fairly apparent during 2010, starting with our Which Way from Here? video presentation in January followed by our February post, Many Funds Can't Buy FLWS Right Now; But, We Can Because We Can Wait.

    More recently, in our Nestlé Kit Kat series, we alluded to the strength of 1-800-Flowers.com's growing chocolate business, Fannie May. We'll soon share more on Fannie May, but in the meantime we recommend reading this 11/27 AP article:
    • The Associated Press — CHICAGO — A half-dozen years ago iconic chocolatier Fannie May, loved by Chicago candy devotees who passed down their affections for mint meltaways, caramels and vanilla buttercreams from generation to generation, was all but finished.
    While somewhat counter to our Weight Watchers (WTW) thesis and general emphasis on healthy living, we're not shy in recommending Fannie May chocolates because we like the product and believe quality is high. Some of our favorites:

    - Mint Meltaways
    - Mint Meltaways
    - Pixies®
    - Pixies®
    - Trinidads®
    - Trinidads®

    But, let's cut to the chase here. In October, we shared (click link):
    In that post, we emphasized the company's ability to generate free cash flow for owners. Subsequently, a friend and former colleague posed critical questions after his brief review:
    • Seems like revenues and EBITDA have been pressured... So, it begs the question of how sustainable that free cash flow stream really is and also questions the sustainability of any remaining "moat" around the business. A rising tide will lift all boats for sure, but the company seems to have struggled long before the financial/consumer spending downturn.
    Our response was essentially (with a few additions):
    • Please note that the company had pretty solid results through Fiscal 2008 until the recession took hold -- see operating income history for Fiscal 2007 and Fiscal 2008 following the inclusion and growth of new business units -- from Google Finance (GOOG), click to enlarge:
    • We also recommend reviewing the Fiscal 2008 Annual Report for more perspective - here's a summary snapshot of financial results (click to enlarge):

    • No question, since Fiscal 2008, the Consumer Floral segment has been especially hard hit and competition intensified as all stripes of consumer businesses fought (and continue to fight) for market share through the recession. Yet, we believe the company still has number one market share (*formerly around 20% -- uncertain of latest share data) and the "flowers.com" business drives tremendous Web traffic to the company's other branded businesses, including cookie and chocolate businesses (Cheryl's Cookies, Fannie May and Harry London).
    • The cookie and chocolate segments, acquired in March 2005 and May 2006, respectively, materially changed the mix of the business. Further, both have been growing through the recession and have better margin profiles than the floral unit. Also, 1-800-Flowers.com's home grown BloomNet floral wire network, launched in January 2005, has been well received by florists over the past five years. BloomNet is now a fantastic line of business that extends the company's significant economies of scale across products and services to benefit all network participants.
    • Finally, the company is leveraging its April 2008 acquisition of DesignPac Gifts to take on Harry & David in the gift basket marketplace. Notably, 1-800-Flowers.com's brand, products, and capabilities (e.g. skills and scale) provide a strong springboard for growth in this category. For reference, we recommend this 12/22/09 NYTs article, Bringing Bouquets and Gift Baskets Together. Like the floral segment, the wholesale basket business (e.g. sales to large retail stores like Target/TGT) suffered over the past two years as consumers retrenched, but the company should soon face easier Y/Y comparisons on the wholesale side and the retail 1-800-Baskets.com business should begin to contribute more meaningfully to the revenue mix over time. Harry & David -- which admittedly has a great brand -- remains under pressure, with revenue for the September 2010 quarter down 13% Y/Y. We see potential for 1-800-Flowers.com -- via 1-800-Baskets.com -- to garner meaningful market share.
    • HENCE, the key is to understand how the mix of 1-800-Flowers.com's business shifted over the past five years, both via acquisition and organic initiatives. The result is a more stable and durable franchise capable of reasonably consistent excess cash generation.
    • Some offerings from Cheryl's:

    For insight into recent results, the shifting business mix, operating strategies, and future direction, we recommend reviewing 1-800-Flowers.com's recently released Fiscal 2010 Annual Report. The letter to shareholders provides a worthwhile summary and details management's plans to grow the business and enhance shareholder value. Summary financial snapshot (click to enlarge):

    Also, for reference, January 2010 commentary from President Chris McCann on customer relationship management:

    Importantly, rather than a shallow, shrinking, or non-existent moat, we see a strengthening moat for the business and believe our core thesis holds (from our January presentation):

    Accordingly, we've been purchasing more shares in the company in recent months. We'll try to share a bit more in the coming weeks. As always, we welcome questions and alternate viewpoints.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long FLWS, WTW.
    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Wednesday, December 15, 2010

    Seaspan (SSW): Shares Trade Down, What's Wrong? Time to Sell? Or Wonderful Gift?

    Since November 1st, shares of Seaspan (SSW) are down 9% while Global Ship Lease (GSL) and the S&P 500 are up 6% and 4%, respectively. Chart from Google Finance (GOOG):

    What's going on here? First, positive company-specific events came to pass for Global Ship Lease, events that we (and the "Market") contemplated but were still waiting for in our 11/3 post. Second, the overall market is seemingly working higher on generally more favorable economic news (and possibly the year-end "Santa Clause Rally"). OKAY, but what about Seaspan? OR, as someone asked us, why is it trading down?

    Honestly, it's anyone's guess and could be answered with the wise guy (but true) response: more sellers than buyers? In this case, this explanation is somewhat sensible considering that some short-term oriented investors (traders) might be taking profits after solid year-to-date performance.

    From our view, fundamentals remain sound and we can again relay what we shared in our 10/27 post regarding Seaspan and Global Ship Lease after favorable price runs:
    • Why keep holding? In both cases, fair values remain meaningfully higher than current trading levels based on excess cash generation and stable business models that adequately support high levels of leverage (debt). Our February post on Seaspan largely provides the answer for SSW, but we'll come back with more commentary in the near future, including discussion on Global Ship Lease.
    We still owe readers some follow-up on Global Ship Lease. The nutshell version is that we believe the company's stable cash flow and potential for renewed dividend payments next year suggest a higher fair value range.

    For Seaspan, we have recent commentary from CEO Gerry Wang courtesy of Bloomberg via The Washington Post (WPO) - we Tweeted the video link and also include here:
    AND, also from TheStreet.com:
    • Seaspan CEO: Global Trade Not Slowing
    • NEW YORK (TheStreet) - Gerry Wang, CEO of containership owner Seaspan, says global trade is on the rise despite all the tough talk between nations. Mon 12/13/10 10:00 AM EST -- Gregg Greenberg

    What about sector news? As before, industry news remains mostly favorable -- various sector and economic news from The Journal of Commerce over the past week:

    Port Tracker Upgrades Asia Exports Forecast
    The National Retail Federation is revising upward its forecast for U.S. imports from Asia over the next several months, thanks to strong retail sales at the start of the holiday shopping season.

    OOCL Raises Rates on Asian Exports in January
    Like several other carriers, OOCL is raising freight rates on shipments out of China and the Far East next month in what is ordinarily the slack winter season.

    Exports Push NY-NJ Port Volume Up 11.6 Percent
    A strong surge in exports pushed container volume at the Port Authority of New York and New Jersey up 11.6 percent year-over-year in October, restoring recovery momentum at the East Coast's largest port.

    Utilities, Factories Push Industrial Production Up 0.4 Percent

    The U.S. industrial sector rebounded solidly in November, as manufacturing, construction and utilities all posted gains, according to Federal Reserve data reported on Wednesday.

    CEOs Raise Their Economic Outlook
    CEOs of major U.S. manufacturing and service companies in the Business Roundtable gave their best outlook for economic activity since early 2006.
    Hong Kong Sets Air Cargo Record
    Hong Kong International Airport set a monthly record for cargo tonnage in October, beating the previous high set three years ago and regaining growth momentum heading into the peak air freight shipping season.

    Airbus Forecasts 5.9 Percent Freight Growth
    Airbus forecast on Monday that some 870 new freighters will join the world's air cargo fleets over the next 20 years, a more optimistic outlook for aircraft production than rival manufacturer Boeing gave in November.
    Seaway Cargo Shipments Gain 19 Percent
    Shipping on the St. Lawrence Seaway and the Great Lakes is winding up the year with strong growth based on staples of grain exports along with imports of iron ore and steel.
    Freight Index Climbed 0.2 Percent in October
    The Transportation Department's Freight Transportation Services Index climbed 0.2 percent in October from its September level, rising for the 13th time in 17 months.

    THUS, although industry participants -- including Seaspan (per our November post) -- expect the shipping recovery and freight rates to moderate in 2011 (and potentially decline), most fundamental-oriented headlines are pointing in the right direction. In fact, from a global standpoint, most onlookers would probably acknowledge that underlying global growth trends appear in-tact. Increased trade around the globe is a reasonable prognosis for 2011 and beyond.

    It may come as no surprise then that we see the recent decline in shares of Seaspan as a gift. We have been adding to our stake in the company with a long-term view.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long GSL, SSW.
    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Monday, December 13, 2010

    Part 2: Nestlé Celebrates Kit Kat's 75th Birthday - What Other Chocolate Franchise is Celebrating a Meaningful Anniversary?

    In our "Part 1" post on 12/1, Nestlé Celebrates Kit Kat's 75th Birthday - What Other Chocolate Franchise is Celebrating a Meaningful Anniversary?, we presented our question along with five hints:
    1. Older than Kit Kat.
    2. Smaller scale than Nestlé.
    3. Growing nicely and gaining market share.
    4. U.S. domiciled and focused.
    5. Previously mentioned here on CS$.
    We were pleased when a reader provided the correct answer to our question in the comments section (thank you "Anonymous" whoever and wherever you are!).

    Before we share the answer here, let's relay a bit more on "Good Food, Good Life" Nestlé (NSRGY.PK). As we indicated the other week in mentioning the 7th Nestle International Nutrition Symposium, nutrition may not immediately come to mind since, at least in the U.S., Nestlé is perhaps best known for selling a variety of chocolates.

    YET, Nestlé provides a wide array of products and services that people either need or keep coming back for more, including confections (which, surprisingly, is only 11% of sales). Here's an overview of the company's fiscal 2009 sales by category (from recent investor deck):

    Through acquisition, the company grew into the diverse business that exists today:

    With an impressive variety of disparate, "billionaire brands":

    As a result, the company generates consistent operating margins (mid-teens) and healthy excess cash flow that is used in shareholder friendly means (reinvestment, M&A, debt reduction, dividends, share repurchase). So long as the sun rises and the world-as-we-know-it doesn't end,
    Nestlé will be around and will likely be bigger, better, stronger over time.

    THUS, it may come as no surprise that Nestlé is favored by numerous value investors, including David Winters of the Wintergreen Fund. For those interested, Mr. Winters shares his thesis in various media appearances and articles found on his Web site (e.g. mention in Kiplinger's current issue).

    We can also go back to a Wealthtrack episode from nearly one year, on 12/25/09, where Mr. Winters covers his global, common sense investment approach. He touches briefly on Nestlé around minute 18 and again around minute 22:
    • On this week's Consuelo Mack WealthTrack, a Christmas weekend treat. Noted value investor David Winters, who Smart Money magazine identified as one of the "world's greatest investors," joins Consuelo in one of her "Great Investor" interviews to share where he is finding value in the market now.

    Mr. Winters shares more than a few sensible points, including:
    • "streams of income from around the world"
    • "makes a lot of sense for individuals today"
    • "be buyer when others panic... the richest people in world, this is what they do"
    So, with this background, let's now return to the birthday brand -- Nestlé is celebrating Kit Kat's 75th birthday* this year (*acquired brand in 1988 with acquisition of U.K.-based Rowntree):

    We mentioned that Hershey (HSY) sells the brand in the United States under a longstanding license agreement that pre-dates Nestlé's ownership.

    So, what is the other another chocolate franchise that happens to be celebrating a major milestone this year? The reader got it right: Fannie May Confections, owned by 1-800-Flowers.com (FLWS). Fannie May is celebrating its 90th anniversary this year - cover of recent catalog:

    Fannie May's history is detailed here. Interestingly, Fannie May is actually one year senior to Berkshire Hathaway's (BRK-B, BRK-A) larger See's Candy, which was founded in 1921. We like See's, but we also like Fannie May's chocolates and are confident that the quality of FM's products and service is high. Per our prior posts, we recommend the Pixies. Please don't be shy, give them a try!

    Fannie May is a large part of our 1-800-Flowers.com investment thesis and we've been adding to our position in recent weeks/months. While shares recently nudged higher, we continue to believe the "Market" misunderstands the story.

    We'll soon share a bit more.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long FLWS, BRK-B.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Saturday, December 11, 2010

    Harry Winston (HWD): Whoops, We Can't Forget Key Mining Variables and Risk Factors; Revisiting Earnings Power and Reducing Stake

    We will soon follow-up on our 12/1 post:
    At long last, a reader provided the correct answer to our question in the comments section -- please see the post for details.

    In the meantime, we -- unfortunately -- need to revisit our Harry Winston Diamond Corporation (HWD) post from earlier in the week with a change. Following Harry Winston's results on Thursday evening, we realized that we made two mistakes in our post the other day: (1) improperly calibrating our normalized earnings expectations and (2) not adequately discussing key risk factors that may impact earnings results.

    In our September post, we indicated that normalized earnings power contains many moving parts that create range of possible outcomes. In our post this week, we included a wide range of $1.00-$2.00. While our normalized earnings range was intended as a mid-range estimate assuming global economic conditions continue to improve, we received a wake-up call to revisit key assumptions after Harry Winston's earnings report on Thursday. Namely, in addition to rough diamond prices and retail segment performance as key variables, we can't forget about diamond grade and production volumes as significant components of the equation.

    Based on results and the forward outlook, we can safely say that the near-term earnings outlook is less robust than we expected, which is why shares traded down 13% on Friday. Also, our normalized range is too high, which we should have known even prior to the report since the company provides excellent disclosure around forward expectations for mining production as well as operating and capital expenditures.

    The more realistic range might include the low-end of our prior range, yet even arriving here requires a number a variable assumptions: successful ramping of underground mining at the Diavik mine, production of high grade ore, reduced and contained expenses, as well as sustained increases in rough diamond prices. In addition, although a recent transaction with Kinross Gold Corporation (KGC) brought Harry Winston's Diavik ownership stake back to 40% (higher earnings potential), related share dilution and potential incremental dilution from the transaction ($70 million promissory note maturing August 2011 that may be repaid with shares) are a headwind to per share earnings estimates.

    To better understand risks around mining segment earnings results, here's a brief explanation directly from Harry Winston's F3Q11 report:
    • "The comparability of quarter-over-quarter results is impacted by seasonality for both the mining and retail segments. Harry Winston Diamond Corporation expects that the quarterly results for its mining segment will continue to fluctuate depending on the seasonality of production at the Diavik Diamond Mine, the number of sales events conducted during the quarter, and the volume, size and quality distribution of rough diamonds delivered from the Diavik Diamond Mine in each quarter. The quarterly results for the retail segment are also seasonal, with generally higher sales during the fourth quarter due to the holiday season."
    In the most recent quarter, the ore mix was notably less favorable:

    (reported on a one-month lag)
    Three Three Nine Nine
    months months months months
    ended ended ended ended
    September September September September
    30, 30, 30, 30,
    2010 2009 2010 2009
    Diamonds recovered (000s carats) 713 331 1,983 1,614
    Grade (carats/tonne) 2.98 4.43 3.28 4.05
    The result: "Although rough diamond prices showed continued strength, increasing approximately 20% over the comparable quarter of the prior year, our achieved price increased 4% due to a change in the ore mix."

    Further, citing a reduction in processed ore and "mud-rich material," the company lowered it's production forecast for calendar 2010 and offered a similar forecast for calendar 2011:
    • In calendar 2010, the original mine plan contemplated open pit mining from the A-418 kimberlite pipe supplemented by the A-154 South kimberlite pipe to be the primary source of ore. Underground ore was expected to be sourced from the A-154 South and A-154 North kimberlite pipes. Production was expected to be approximately 7.8 million carats from approximately 2.3 million tonnes of ore mined and processed.
    • The production forecast for calendar 2010 has now been revised to approximately 6.9 million carats from 7.8 million carats. The revision is primarily the result of two factors. First, a reduction in ore processed to approximately 2.1 million tonnes from the 2.3 million tonnes mined. Certain ore in the A-418 pipe contains mud-rich material, which has reduced processing capacity. Rio Tinto plc, the operator of the Diavik Diamond Mine, expects to make modifications to the processing flow to remediate this issue by the end of the year. Second, a lower grade has resulted from a shift in underground ore mined from the A-154 South pipe to the lower grade A-154 North underground and A-418 open pit while a revised, more efficient underground mining method is reviewed.
    • A new mine plan and budget for calendar 2011 is under final review by Rio Tinto plc and the Company. The plan for calendar 2011 foresees Diavik Diamond Mine production of approximately 6.9 million carats from the mining of 2.0 million tonnes of ore and processing of 2.2 million tonnes of ore, with the increment delivered from stockpile.
    On a related note, the ongoing shift from open-pit mining to underground mining involves higher risk and expense - an image from a recent Harry Winston management deck (click to enlarge):

    HENCE, a number of factors are impacting the near- to mid-term earnings forecast. As a result, Wall Street analyst estimates and target prices have been and/or will likely be reduced from prior levels, negatively pressuring shares. No doubt, results and management commentary reminded all investors of the realities and inherent risks related to the mining segment of Harry Winston's business model.

    For us, Harry Winston was an asset play (CS$ investment caveat number two), trading well below net tangible book value in late 2008 to early 2009. Like gold, diamonds viewed as a store of value may constitute a reasonable investment consideration. Unlike many investors, we have no gold exposure, instead focusing mostly on growing, cash generating businesses.

    Today, the fact remains that Harry Winston has a 40% interest in one of the world's most valuable diamond mines, which are extremely scarce. According to Harry Winston's management deck, economic value derived from diamond exploration is far more scarce than that derived from gold:

    AND, the company is successfully expanding its retail presence around the globe with a targeted plan and vision:

    We rarely flip-flop immediately following results, but sometimes things change and new analysis alters an investment thesis. This was the case with our PetMed Express (PETS) -- if interested, please see Why We Moved to the Sidelines from last August.

    With Harry Winston, our re-calibrated earnings expectations suggest lower implied equity upside for shares of the company. Put another way, we now own shares with a diminished margin of safety. As a result, we plan to reallocate an incremental portion of our Harry Winston position into other ideas where we see higher margins of safety and correspondingly higher potential upside. For now, we will likely retain some exposure to Harry Winston.

    One such idea includes our container shipping company Seaspan (SSW), where we recently added more shares and may continue to add. We've also been adding to our 1-800-Flowers.com (FLWS) position in recent weeks/months.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long HWD, SSW, FLWS.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Tuesday, December 7, 2010

    Harry Winston (HWD): Watching Thursday's Report; Strong Luxury Results and Demand Across Sector Bode Well; Earnings Power is Key to Upside Potential

    Along with certain REITs, Global Ship Lease (GSL), and eBay (EBAY) (prior GSL and EBAY posts here and here), Harry Winston Diamond Corporation (HWD) has been one of our best performers over the past 1.5 years.

    Although we did slightly reduce our position last July in the $13-14 range to fund other purchases, we continue to hold the majority of our initial stake. It's important to remember that just because a company's share price has a large run, an investor who keeps holding isn't necessarily a "pig" nor do "pigs [always] get slaughtered!" (as Jim Cramer likes to say). Let's explain.

    Per our Sonic Foundry (SOFO) and Key Investment Musings post the other week, we always need to separate a company's market price from our reasonable estimate of fair, or intrinsic, value. If fundamentals are poor/negative and the outlook is unclear -- as it was back in late 2008 and early 2009 for most companies -- this estimate can be informed by balance sheet strength (e.g. net tangible value) and normalized earnings power (e.g. average earnings over a full economic cycle). Later, assuming a share price recovery on the back of better fundamentals and improved visibility, we continue to watch the balance sheet but really need to keep tabs on valuation as a multiple of earnings (which is what garners the Market's attention). In this case, current, expected, and normalized earnings all come into play, as well reasonable assumptions around valuation multiples.

    With Harry Winston, we estimate that normalized earnings power might be anywhere from $1.00 to $2.00 ($1.50 mid-point), depending primarily upon rough diamond prices and retail segment performance. What multiple is appropriate for one of the world's premier luxury brands that also happens to own a 40% stake in one of the world's most valuable diamond mines? Maybe 15-20 times? Assigning this to the mid-point earnings estimate of $1.50, we have a fair valuation range of $22.50 to $30.00. This is somewhat similar to our Sotheby's (BID) analysis in 2009, except that we never purchased this company (primarily because of our concerns around Sotheby's large debt burden coupled with poor luxury fundamentals at the time - unfounded worries in hindsight = our mistake!).

    While past performance is no indication of future performance, it's amazing how many companies now trade around pre-crash levels. Psychology in the "Market" and around particular stocks also plays a role here. We can see that shares of Harry Winston formerly traded in the $30s and $40s pre-recession - five-year chart from Yahoo! Finance (YHOO):

    Looking at prior financial results, we can see former operating income levels were significant before the downturn - from Google Finance (GOOG):

    Okay, the next question: how are fundamentals tracking? We detailed key elements in our August post:
    For those interested, we recommend revisiting the August post. Essentially: (1) the CEO said the retail segment's jewelry sales pipeline into the fall was the best it's ever been since he's been with the company (more than a decade), and (2) rough diamond prices for the quality mined from the company's Canadian interest are "past the peak, by a measurable margin." Sounds very good.

    Another question: what can we learn from the results of luxury peers? Here's one large, well-diversified luxury company to review for a broad look into global luxury trends: Compagnie Financière Richemont SA.
    Here are several slides and brief commentary from Richemont's latest report for the six months ended 9/30/10: (see Web site for more details).

    Noteworthy - Americas retail "nearly back" to where it was and "close to peak":

    AND, drilling into the company's "jewellery" business:

    Jewellery Maisons:
    • in € millions 30 September 2010 30 September 2009 Change
    • Sales 1 619 1 222 + 32 %
    • Operating results 541 349 + 55 %
    • Operating margin 33.4 % 28.6 % + 491 bps
    • The Jewellery Maisons' sales increased by 32 per cent overall, with stronger growth in the Maisons' own boutique networks. Sales of high jewellery pieces were good and the more accessible jewellery ranges also performed well. Sales of watches, from Calibre de Cartier editions in precious metals to classic models in steel, were very strong, benefiting from the Maison's position in premium watchmaking. Cartier's leading position in growth and established markets provided a base for double-digit sales growth, albeit against weak comparatives. Van Cleef & Arpels also saw double-digit sales growth during the period. Due to the Maison's relatively high exposure to Europe and the US, the comparative sales growth was lower than the business area as a whole.

    More detail:

    So, based on Richemont's results, we can surmise that the luxury market continues to chug along nicely despite ongoing macroeconomic concerns. Side-bar: the strong results are consistent with better fundamentals across numerous sectors, a positive sign for the broader economy.

    Finally, what about the global supply/demand dynamic for mined diamonds? An October Bloomberg article provided thorough insights on this topic, including commentary from Harry Winston's Canadian partner, Rio Tinto (RIO):
    • "We have seen a rapid recovery and prices are back to pre- crisis levels," Harry Kenyon-Slaney, chief executive officer of diamonds and minerals at London-based Rio, said in an interview. "What we see going forward is a long decline in production and a significant growth in demand."
    • Diamond miners are struggling to keep pace with growing consumption in emerging economies as older mines are exhausted and producers lack new discoveries. Prices of rough, or unpolished, diamonds have risen as much as 91 percent from a six-year low in early 2009 as jewelry sales collapsed, according to data compiled by WWW International Diamond Consultants Ltd.
    Of course, a cynic might merely say that Rio Tinto is talking its own book. YET, we're pretty sure there haven't been many new discoveries in recent times. As a result, diamond mines remain quite scarce, especially high quality resources like the Diavik Diamond Mine.

    This week, we'll learn first-hand about market fundamentals directly from Harry Winston, which reports fiscal 3Q 2011 results on Thursday after market close. Based on the above and commentary from other luxury vendors, our expectation is that trends remain favorable for Harry Winston.

    Importantly, we believe key risks are mitigated and continue to hold our shares with a margin of safety. In fact, we're hanging onto our shares and see reason for meaningful, incremental upside.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long HWD, GSL, EBAY, SOFO, YHOO.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Saturday, December 4, 2010

    Jobs, Economy, Debt, and Entitlements = Somewhat of a Pickle, YET Record Corporate Profits and Cash to the Rescue?

    We started writing this post with a different theme in mind, but somehow digressed on everyone's favorite topic, the economy. Please bear with us!

    Back in August, we shared historic data that show jobs always lag in economic recoveries. Well, based on the November jobs report, we could say that they're still lagging as the U.S. employment picture remains bleak.

    One key challenge to job creation that will never go away: unless we're talking about rapidly growing companies rolling in cash (which may lead to relaxed purse strings and an increased propensity to spend), about almost every corporation we know remains extremely -- perpetually -- focused on reducing costs and improving productivity. In other words, squeezing more from less. The aim, of course, is to drive better margins and earnings to yield higher returns on capital and share prices. Not a bad thing for shareholders, but bad for job seekers.

    Meanwhile, to combat the debt/deficit problem, many U.S. federal, state, and local government organizations are shedding jobs, as are other developed markets/regions such as Europe. Plus, the long cycle real estate market will likely remain slow no matter what the Fed does (long cycle = traditionally seven years up, seven years down, seven years up, etc. -- the last up-cycle lasted nearly ten years and we're probably in year four of the current down cycle). In perverse fashion, extremely low interest rates propping up what we see as still inflated home values across much of the country.

    Highlighting government data, Calculated Risk Blog points out the following: Real Estate Brokers' Commissions Lowest since 1982 as Percent of GDP (click to enlarge) -

    As if all of that isn't enough, we have the growing entitlement problem to rectify - from Wikipedia's U.S. Federal Budget page:

    AND, expected shortfalls (per 2007 estimates, also from Wikipedia):

    Although upside down demographics and political differences complicate this challenge, clearly something must be done. The retirement age should be increased and certain benefits reduced so that programs (and the U.S. government) remain viable. For an excellent read on Social Security, we recommend Fortune Magazine's thorough piece from last July:
    Fortunately, a number of groups are working to raise awareness and provide informed plans on how to address our dilemma, including the Peter G. Peterson Foundation. The foundation is sponsoring the OweNo.com campaign:

    Let Our Kids Pay from Peterson Foundation on Vimeo.

    Considering all of the above, we can reach an obvious, wide-spread conclusion: We're in somewhat of a pickle without easy solutions.

    Of course, all of the challenges are well-documented in the press. The consensus view is seemingly that we're doomed and that the U.S. (and Western Europe for that matter) is a slow shipwreck, something akin to the fall of the Roman Empire. Maybe. Importantly, investors can mitigate this risk by holding a globally diversified portfolio and investing in companies with expanding international exposure.

    For the stock market, volatility is par for the course as headlines sensationalize the problems (as usual) -- such as that from CNBC commentator Art Cashin: Spain Could Be the New 'Lehman'. High debt obligations coupled with high unemployment are serious issues, but -- last we checked -- Spain was/is a country, not a highly levered financial institution. For those interested, here's the latest news on Spain from the WSJ.

    Yet, interestingly, all of our problems are self-created, which suggests that -- one way or another -- the world can find solutions. We remain in the more optimistic camp and keep tabs on corporate fundamentals across sectors. Here, we see mostly favorable news. Before we touch briefly on "fundys," we should note that November's unemployment report also included some good news: for what it's worth, previously reported October and September figures received positive, upward revisions -- directly from the BLS report:
    • The change in total nonfarm payroll employment for September was revised from -41,000 to -24,000, and the change for October was revised from +151,000 to +172,000.
    On the fundy front, earlier in the week, we Tweeted this news - Fed survey: Economic growth picks up in most of US. Also, in our 11/21 post, How's the Economy Doing?.... Hmmm, Really? Yes, Let's Give a Quick Look, we noted four signs that suggest things are, at least, stable, and in many cases, improving. Accordingly, we also commented that we believe additional economic stimulus is not necessary.

    Finally, an 11/29 headline from Bloomberg out of Europe:
    • While European countries slide deeper into debt, the region’s companies are paying off creditors and boosting profits at the fastest rate in seven years.
    • Liabilities as a percentage of earnings in the benchmark Stoxx Europe 600 Index dropped 22 percent last quarter, the most since 2003, according to data compiled by Bloomberg. Analysts say annual profit growth in Europe will average 46 percent in 2010 and 2011, more than at any time in the previous seven years. The projected income would push valuations down to the lowest levels on record excluding the three months after Lehman Brothers Holdings Inc.’s bankruptcy in September 2008, the data show.
    THUS, as with American companies, European corporations are generating gobs of excess cash and are, as a result, flush with cash. Strong balance sheets can be used to not only repay debt, but to also reinvest in the business. As earnings increase, valuation multiples continue to compress, creating very attractive earnings yields for owner-oriented investors.

    SO, no question, we certainly need more job creation. BUT, continued improvement in the global business environment should lead to more jobs, as we've seen in past cycles.

    In sharing key investment musings the other week, we included commentary from Peter Lynch's One Up on Wall Street. Given our economic discussion here, let's conclude with several pieces of advice from Mr. Lynch:
    • "Predicting the economy is futile."
    • "Predicting the short-term direction of the stock market is futile."
    • BUT, "the long-term returns of stocks are both relatively predictable and also superior to the long-term returns from bonds." (for reference: our stocks versus bonds post)
    In a nutshell: ignore headlines and focus on fundamentals with a long-term view.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: n/a.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Wednesday, December 1, 2010

    Part 1: Nestlé Celebrates Kit Kat's 75th Birthday - What Other Chocolate Franchise is Celebrating a Meaningful Anniversary?

    A few weeks back, in our Weight Watchers (WTW) post, we shared the 7th Nestle International Nutrition Symposium, which was in late October in Switzerland:
    Per our mention at the time, we found the topic truly fascinating and recommended viewing at least some of the presentations. Worth at least a brief review.... But, wait a second - Nestlé and nutrition?

    Admittedly, when thinking of Nestlé, nutrition may not immediately come to mind. In the U.S., Nestlé (NSRGY.PK) may be best known for selling chocolates and competing against Hershey (HSY), Mars, and other giants such as Cadbury (Kraft/K).

    Yet, chocolates and confectionery -- e.g. Nestlé, Crunch, Galak/Milkybar, Kit Kat, Smarties, Butterfinger -- represent only ~11% of the company's highly diversified business. Further, Nestlé's motto is "Good Food, Good Life" and the Nestlé Research Center conducts extensive research in "food, nutrition, and life sciences." From its Web site:
    • Welcome to the Nestlé Research Center.
    • Located in the rolling hills above Lausanne, Switzerland, the Nestlé Research Center (NRC) is one of the world’s leading research institutions in food, nutrition and life sciences. With a diverse staff of premier researchers from a broad range of scientific competencies, NRC possesses a unique blend of talent and expertise.
    • The role of the Nestlé Research Center is to help fulfil Nestlé's vision of Good Food, Good Life, with good food central to a balanced, healthful lifestyle for consumers. Knowledge on Nutrition and Health, Food Science, Food/Consumer Interaction and Food Quality and Safety are combined to develop Good Food as a source of Good Health throughout life.
    However, in this post, we focus on chocolate.

    This year, Nestlé is celebrating Kit Kat's 75th birthday* this year (*acquired brand in 1988 with acquisition of U.K.-based Rowntree):

    If you were confused at Halloween and saw Hershey on the Kit Kat label, that's correct. In the United States, Hershey sells the brand under a longstanding license agreement that pre-dates Nestlé's ownership. For those interested, the Nestlé press release (link above) includes the full history of KitKat, including this statistic: "around 540 Kit Kat fingers [are] consumed every second worldwide and 17.6 billion fingers [are] sold every year as noted by the Guinness Book of Records in March 2010."

    While we have no position in Nestlé, we hold an ownership position in another chocolate franchise that happens to be celebrating a major birthday this year - can you guess which one? Please take a stab -- comments below are welcome!

    Five hints:
    1. Older than Kit Kat.
    2. Smaller scale than Nestlé.
    3. Growing nicely and gaining market share.
    4. U.S. domiciled and focused.
    5. Previously mentioned here on CS$.
    We'll come back with more.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long WTW, SOFO.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer

    Wednesday, November 24, 2010

    Sonic Foundry (SOFO): Passing the Torch, Plus Key Investment Musings

    Per our Sonic Foundry (SOFO, $15.31) post just over one week ago, we hoped to provide additional commentary headed into the company's earnings report last Thursday morning. Two things happened:
    • First, it was a hectic week.
    • Second -- and more significantly -- along with our colleagues, we received information last week that limits us from blogging on the information technology (IT) sector.
    The first challenge is no doubt the normal course of life for most of us. But, alas, we regret to relay that the second development prevents us from discussing global trends in Webcasting, lecture capture, and rich media. In other words: all things around Sonic Foundry's Mediasite.

    However, let us digress for a few moments to discuss general investment considerations and our CS$ approach, starting with one of several leading headlines from Yahoo Finance (YHOO) last Friday:
    The article opens with the following:
    • NEW YORK (Reuters) - Leanne Chase took her money out of stocks in early June 2008 before the collapse of Lehman Brothers sparked a near-panic. She said she and her husband had the same feeling they had during the dot-com bubble: The market had become just "weird."
    • Though the couple had been in and out of the market before, Chase, a 42-year-old part-time consultant and self-described conservative investor, said she has no intention of getting back in again.
    • "It makes me nuts when I get out early and there's more money to be made, or I get out late when I could have made more if I'd gotten out early," she said. "The stock market's not an investment, it's gambling."
    • The faith -- and money -- individual investors once held in the stock market has severely eroded. Two painful major stock market crashes over the last decade combined with the advent of arcane, complicated trading practices has created widespread suspicion of Wall Street, which many people now regard as no better than a roulette table.
    • The last crash wiped out all of the gains made during the 2000s after the dot-com wipeout. The worry now is that a Lost Decade will create a Lost Generation of investors who avoid the market in a way not seen since the Great Depression.
    Her story reminds us of something a friend's father used to say: "There's no happiness in investing: when something goes up, you wish you had more; when something goes down, you wish you'd sold."

    No question: timing share price moves is near impossible, especially in the short-run, and sometimes even over the medium term, as share prices can fluctuate widely without relation to underlying business fundamentals. Yet, we wholeheartedly disagree with her view that "the stock market" is "gambling."

    In this regard, we share advice from one of our favorite reads, Peter Lynch's One Up on Wall Street (first published 1989 and mentioned before):
    • "The basic story remains the same and never-ending. Stocks aren't lottery tickets. There's a company attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you'll do well. Corporate profits are up fifty-five fold since World War II, and the stock market is up sixtyfold. Four wars, nine recessions, eight presidents, and one impeachment didn't change that."
    At CS$, the view that "stocks aren't lottery tickets" is one of our fundamental beliefs. As such, we approach every investment from an owner's perspective. This means we ask a set of questions detailed in our February post, Which Way from Here? An Investment Strategy for All Markets + Stock Ideas, included here with a slight change in ordering:
    1. What would happen if the business went away tomorrow? Would anyone care?
    2. Will the business be bigger, better, stronger if five years?
    3. Does the business have a strong financial position?
    4. Is management capable and motivated? Is disclosure full and adequate?
    5. Can the business be acquired with a margin of safety?
    6. Price is extremely important
    Points one to three speak to quality of a company's economic "franchise," while points four through six cover management and valuation. Point number six is included to emphasize that, as Fairholme Fund’s Bruce Berkowitz puts it, “Investing is all about what you pay and what you get.” This statement is a variation of advice from Ben Graham and Warren Buffett.

    Let's drill further into valuation to make a point we consider paramount to making money through equities over time:
    • People often look at a share price and think, well, this must be what the business is worth. If the price is low, then management and/or the business are horrible. If the price is high, then management and/or the business must be fantastic.
    • YET, based on the events of the last several years, we're not sure who still subscribes to this perspective, which is essentially the efficient markets hypothesis. Our own investing experience over time directly contradicts "EMH," as does the performance of other long-term oriented investors.
    • In reality, manic market prices of equities swing widely and are often completely disconnected from reasonable estimates of intrinsic (fair) values based on earnings power, private market valuation, and/or other sensible valuation approaches.
    • Understanding that market value and intrinsic value are two entirely different things enables informed investors (business owners) to buy and sell companies against the broader Market, taking advantage of Ben Graham's "Mr. Market."
    Moreover, here's another important point: just because shares of a business are up 100, 200, or even 300% from extremely depressed levels does not mean we need to sell our position because, as Jim Cramer says, "pigs get slaughtered." How do we make the decision to buy more, keep holding, or fold? We again refer to our estimate of intrinsic value while also considering the fundamentals of the underlying business.

    When evaluating fundamentals, let's revisit a piece of advice we previously shared from the late investment legend Philip Carret in March. Augmenting a video with Mr. Carret relayed in February, our March post included an insightful article from 1999 where he directly shares his investment advice - we'll again note that it's well worth a read.

    On when to sell, Mr. Carret says, "How long should you hold a stock? As long as the good things that attracted you to the company are still there." We might add that valuation discipline also remains important, particularly whenever multiples move well beyond a reasonable range (e.g. our posts on alternative energy/clean tech and Blue Nile/NILE in October 2009).

    On what to buy, similar to Peter Lynch's familiar recommendation to buy what you know, one of Mr. Carret's guidelines is as follows -- directly from the article:
    • For your best investment ideas, look around you. I've been following this strategy for more than 70 years.
    • Example I: In the early 1920s, not all water was metered in New York City. That wasn't going to last forever because water is a scarce resource, and there was no incentive for people to conserve water. Sooner or later, they were going to have meters for everyone. So I bought stock in a company called Neptune Meter, and it turned out very well.
    Put another way, what are the market sectors or areas we encounter daily poised for growth? What business models are fundamentally disrupting the way things were done previously? The Internet arena immediately comes to mind. And, we don't need to look too far -- we're all familiar with Amazon.com (AMZN), Priceline.com (PCLN), and Netflix (NFLX).

    We've long admired these businesses, touching briefly on Amazon last December and incorrectly calling out Netflix's rich valuation several times only to see shares surge much higher - whoops! We actually started a post on Priceline.com in summer 2009 but never found time to finish it.

    In addition to being primarily online businesses -- putting aside physical supply chain, distribution, etc. for Amazon and Netflix -- these businesses all have another attribute in common: customers love their products/services and, thus, brand equity (economic goodwill) continues to build and build. Hence, franchise value continues to accrete for these consumer-facing companies.

    While we don't own these companies, we continue to own shares in disruptive secular growers such as eBay (EBAY), Yahoo (YHOO), and our microcap Sonic Foundry (SOFO). Admittedly, wide debate has surrounded, and continues to surround, the two Internet giants, which are not delivering the blistering growth of the aforementioned companies. We discussed Facebook versus Yahoo and eBay's franchise in prior posts. We've done well with both names, although nowhere near the approximate eight times return of Priceline.com and Netflix over the past two years (assuming entry points at their respective bottoms), or even better over the past five years. Although we're making money on all three of our chosen holdings, our opportunity cost has been significant. Here's Priceline's long-term chart from Yahoo Finance:

    Side-bar: our Netflix-like investment was Audible.com (formerly ADBL), which was [for us] unfortunately scooped up by Amazon.com on the cheap in 2008. Although we still received a decent premium to our cost basis, Amazon made quite a deal, buying an asset-light (no inventory), rapidly growing subscription business for less than ten times trailing free cash flow. But, this is another story.

    A couple more important points: our investment approach is sector agnostic and, in fact, not primarily focused on Internet or other "growthy" companies. We go where we find value, whether in forlorn container shipping companies such as Seaspan (SSW) or Global Ship Lease (GSL), or off-the-run companies such as Parlux Fragrances (PARL) and Casella Waste Systems (CWST). With Parlux, recall that one dollar of tangible value can be had for only ~60 cents, which makes no sense whatsoever for a viable business! Lastly, we believe that the best kind of business is the kind that keeps on giving in the form of increasing net cash flows that can be used to (1) further expand the business with favorable returns on capital or (2), if option one is not feasible, return to shareholders.

    OKAY, back to Sonic Foundry. While we can no longer provide commentary on IT-related happenings, we can say that the recent Capital Times article, Sonic Foundry rebounding with new focus on online teaching tools, correctly revealed that we initiated our position in 2006. Our original cost basis was in the low teens (after reverse split) and we added to our position in the mid-$5s and $6s over the past two years.

    Why take such action?
    1. Favorable fundamentals -- revenue grew 19% Y/Y in fiscal 2009, margins improved, and cash operating income was near break-even (not for the most recent fiscal 2010 year, but for the prior year - for the year ended September 2009).
    2. Confidence in our estimate of the company's reasonable private market valuation and the growing Mediasite franchise.
    Importantly, the recent and ongoing M&A frenzy supports our fair value estimates and, as with the June quarter, the company's report last week provides more evidence of earnings power. On this basis, we can look to our March earnings scenario range, remembering that significant NOLs should shield cash taxes for a very long time to come. One caveat is the degree to which incremental dollars are funneled into marketing and selling, which is okay so long as this investment accelerates top-line growth.

    Given our stake in the company, we will continue to follow Sonic Foundry and, where possible, include Mediasite presentations into CS$ posts, such as those included in our recent Weight Watchers (WTW) post. Truly fascinating information. We'll also try to Tweet interesting/helpful links such as this re-Tweet (please feel free to follow us):
    Summarizing: we need to remember that the "Market" does what it does and is also often irrational because of human psychology, which tends to accentuate extremes. Likewise, shares of a company may behave like a yo-yo as traders whip them around day to day or week to week, not to mention countless mutual funds that churn through portfolios 200 or 300% per year (which we think is crazy and casino-like).

    Fortunately, fundamentals always win. Always.

    THUS, over the long-term, the market (lower-case "m") is efficient as share prices track earnings and should continue to appreciate so long as a business grows bigger, better, stronger. This means short-term heart burn can be mitigated or avoided by thinking of equity positions as a business owner, asking the right questions, and acquiring ownership with an initial margin of safety.

    While all investors have their own risk profiles and circumstances, we are fairly confident that a common sense approach can help individual investors such as Ms. Leanne Chase regain confidence in equities and generate the necessary returns to help fund retirement. Even with lingering economic worries on many fronts, there are always opportunities.

    Happy investing,

    Jeffrey Walkenhorst

    Disclosure: long SOFO, EBAY, YHOO, PARL, CWST, WTW.

    © 2010 Jeffrey Walkenhorst
    Please see important Risk Factors & Disclaimer