Loews – Getting Parts Of The Business For Free

downloadLoews (NYSE:L) is a holding company with an interesting assortment of holdings. Through its subsidiaries, it is engaged in commercial property and casualty insurance; operation of offshore oil and gas drilling rigs; transportation/storage of natural gas and natural gas liquids and gathering and processing of natural gas, and operation of a chain of hotels. The Company’s subsidiaries include CNA Financial Corporation (NYSE:CNA); Diamond Offshore Drilling, Inc. (NYSE:DO); Boardwalk Pipeline Partners, LP (BWP), and Loews Hotels Holding Corporation (Loews Hotels).

Loews Companies

History


Loews was founded in 1946 when Laurence Tisch persuaded his parents to buy a hotel in Lakewood, N.J. The company built its first hotel in 1959 and later diversified its portfolio of businesses. Loews’ portfolio today consists of CNA financial which was acquired in 1974, Diamond Offshore in 1989, Boardwalk Pipeline in 2003, and Loews Hotels which has always been owned. The Tisch family continues to be involved with the company today. James Tisch is the CEO and Jonathan and Andrew Tisch are Co-Chairmen of the Board. 21% of the company is owned by Tisch family members. However, there is only one class of stock and all shareholders have equal voting rights.

Financial Overview


L Metrics

Share Repurchases

The management team has an impressive history of buying back stock. Every decade since 1970, Loews has bought back more than one quarter of the outstanding shares. Since 2010, they have bought back more than 18%. Just in the last three quarters, $750 million worth of stock has been bought. This equates to buying back about 5.7% of the outstanding shares.

Recent Financial Results

Over the last few years, Loews has not produced much revenue growth. CNA Financial and Loews Hotels have had revenue growth but that has been largely offset by the revenue shrinkage at Diamond Offshore and Boardwalk Pipeline. Even with the lack of revenue growth, L has been very profitable and shareholder friendly. Historically, they have been very disciplined and patient with a large cash pile. At the end of last quarter, they reported $4.8 billion in cash. In the last few quarters, we have started to see them increase the pace of their stock buyback. Management recently explained that it is frustrated by the discount the market has placed on their stock. They believe their stock is undervalued as well as the stocks in its portfolio. Management has chosen to allocate capital by buying back its own stock to take advantage of this “double discount.”

Portfolio Overview


CNA Financial

  • Commercial P&C insurer with industry leading specialty lines business
  • Focused on operating more effectively through using industry specific expertise to better understand risk and pricing
  • Accounts for 60% of Loews equity and 80% of its FCF today
  • Trades at a substantial discount to BV at 0.71 P/B
  • Continues to operate more effectively shown by decrease in loss and combined ratios

CNA ratios

Diamond Offshore Drilling, Inc.

  • One of the largest offshore drilling companies in the world with five drillships, twenty four semisubmersible rigs, and six jack-up rigs.
  • All five drillships are contracted into 2019 and 2020 translating into $4.6 billion of contract backlog.
  • Strong balance sheet with additional $300 million credit line from Loews if needed.

Do Debt

Boardwalk Pipeline Partners, LP

  • Owns/operates natural gas and liquids pipelines and storage facilities
  • Business has tailwind from replacement of coal-fired electrical power generation by natural gas generators
  • $1.6 billion in capital projects underway to serve growing demand

BWP Demand

Loews Hotels

  • Owns and operates 23 hotels in the United States and Canada
  • Has shown solid growth by posting 12% same store revenue per available room (revPAR) from 2013 to 2014.
  • Grown adjusted EBITDA from $123 million in 2014 to an estimated $160 in 2015. Up 30%.
  • Focused on continuing to grow the Loews Regency brand after opening the Loews Regency San Francisco this year.

Loews Hotels

Loews Hotels often gets overlooked because it is the only part of the portfolio that isn’t publicly traded. Management doesn’t provide as much information about it. However, investors should be excited about its future. With only 23 hotels in the United States and Canada there is a lot of room to grow and compete.

Financials


When looking at the financials, the first thing worth noting is the massive discount on a price/book basis. The stock currently trades at only 0.65 price/book. This was surprising to me considering management has a 7% CAGR since taking office in 1998. It seems like the market might be unfairly punishing Loews because of the companies in its portfolio. Particularly Diamond Offshore and Boardwalk Pipeline. If you perform a relative valuation, comparing Loews to its historical 3 year valuations, it is clear that it is cheap today on a price/book basis. See the chart below.

L BV

The three year average price to book ratio is is 0.86 versus 0.65 today. A reversion back to the mean would indicate 30% upside in the stock.

A relative valuation is a decent way to look at the company but I think the best way to value it might be a sum of the parts (SOTP) analysis. A SOTP valuation will allow us to look at each part of the portfolio. This might help us draw a conclusion as to whether Loews is being overly discounted because of the companies in its portfolio.L SOTP

The SOTP analysis clearly shows CNA’s driving effect on the total valuation of the company, as the difference between the bear and bull case is about $2.8 billion.

With a current enterprise value of ~$16.7 billion, the market is basically throwing in all of Diamond Offshore Drilling and part of Boardwalk Pipeline for free.

Disclosure


Long L

Gap is Quietly Evolving

Gap

Most retailers had a difficult time in 2015. Between foreign currency headwinds, the West Coast port closure, and unusually warm winter weather it was a difficult environment to operate in. This has left investors wondering who will make adjustments and come back stronger in 2016. The Gap Inc. (NYSE:GPS) is the owner of several brands including Gap, Banana Republic, Old Navy, Athleta, and INTERMIX. It is led by Art Peck who transitioned to CEO February 1st of last year. Art joined Gap in 2005 and prior to being CEO, he was President of the company’s growth, innovation, and digital division. This might explain why so many of the company’s strategies and investments today are around their omni-channel platform and digital shopping experience.

The company is investing in areas of the business that could move the needle in 2016 and beyond. On Art Peck’s first conference call in February, he discussed the company’s initiative of getting its women’s product back on track. There were several issues that were causing women to leave Gap. However, management is adamant that they have identified the issues and they will be resolved. The company made strides in 2015 on adjusting the aesthetic direction of its women’s products. Art and his team have made it clear that they value the opinions of their customers. Fashion trends are changing faster than ever and it’s crucial that they identify them early. Art Peck mentioned that he reads hundreds of customer reviews that help him understand what customers want. Consequently, the company is making product changes especially in the Gap and Banana Republic brands. They are adding more color and will be more disciplined in the fit and quality of products which will drive customer loyalty.

Gap has been investing in its supply chain since 2013 and it is beginning to pay dividends. Gap is now using seamless inventory. This allows the company to use the same inventory for stores and online sales. CEO Art Peck explained that it will result in a higher average unit retail (AUR) because this system allows the company to get the product to the “highest bidder” whether they are online or in a specific store. The company is making itself more flexible and responding faster to customer needs. This inventory management system gives the company the ability to order less inventory initially, test it out with customers, and then respond with what is selling. Not only will this make customers happy but it will also boost sales. In addition, the company is using this model to leverage its omni-channel platform by reducing shipping costs and offering two day shipping to compete with Amazon (NASDAQ:AMZN). Prior to using seamless inventory, there was a ten month lead time before merchandise could actually get on the shelf’s. In 2016, this lead time will be reduced to six to seven months and they will also have flexibility in adjusting merchandise to current trends.

The company has been weighed down over the last year or so by the West Coast port closure as well as foreign currency headwinds. Together these two issues impacted margins by an average of 100 basis points per quarter from Q3 2013 to Q2 2014. This is worth noting because many analysts believe that margins have been in a downtrend and they think it might continue. However, the West Coast port closure is now behind the company and foreign currency headwinds will be eased due to the lag in currency hedging. In my opinion, margins will begin to increase in 2016 and will have plenty of room to expand due to the multi year initiative of investing in the supply chain. Today, gross margins are around 37.5% and I expect them to be closer to 40% five years from now. Operating margins could also move from 10.6% today to around 13% which would be well above the industry average of 11.76%.

Prior to the company’s investor day in June, they announced they would be closing 175 specialty stores in North America and a few stores in Europe. This is an effort to “right size” its store fleet and have an appropriate mix between specialty stores and the more profitable outlet stores. By 2018, the company will have reduced its specialty store count from 685 to 500 and will have opened about 20 more outlet stores in North America. This will bring the outlet store count to 300 in North America. The company believes this is the optimal mix of specialty stores and outlet stores. The net cost of the plan is approximately $150 million and will have annualized savings of $25 million. Closing these stores was a difficult decision for the company but it will create value for investors in the long run.

Although Gap, Banana Republic, and Old Navy get most of the spotlight, I would like to take a second to mention Athleta. This brand is known for its women’s active apparel and it has shown strong growth since being acquired by Gap in 2008. Art Peck was responsible for Athleta when he was President of growth, innovation, and digital. It is important to note that Athleta already uses the seamless inventory system that is being interwoven into the other brands. The brand is also much further along in the digital shopping experience. Athleta grows quickly in both of its sales channels. The digital channel is the optimal channel for growth because Gap doesn’t have to build a store to get the growth. Currently, Athleta only has about 120 stores in North America but I would expect many more in the future. This is an exciting brand that could grow into something special.

Gap Inc’s stock is down about 48% from its 52 week high set back in March 2015. The valuation is very reasonable. Analysts expect the company to make $2.45 a share next year which I deem to be conservative especially given the company’s history of buybacks. The company is on pace to buyback about $1 billion worth of stock in 2015 which equates to them buying back about 10% of the company. I expect them to approve another large buyback program for 2016 since the company generates over $1 billion of free cash flow each year. The stock also pays a nice 4% dividend. Sabrina Simmons CFO has made it clear that they would like to maintain about $1 billion worth of cash. The company made a very savvy move last October by borrowing $400 million in short term debt. I say it was savvy because the interest rate terms are LIBOR plus .75%, which means they are only paying about .50% of interest since LIBOR is currently negative. Having this extra cash gives the company the ability to continue to invest in its self, buyback stock, and keep its large dividend.

On an intrinsic valuation basis, my cash flow model suggests the stock could be worth $30 representing almost 30% upside. My model assumes that after tax operating income will decrease in 2016 and then turn positive in 2017. The stock also appears to be cheap compared to the rest of the apparel industry. Please see the chart below.Gap

Gap trades at a discount on all three metrics. It is particularly cheap using the EV/EBITDA metric at only 4.18 versus the industry average of 9.02. This is incredibly cheap for a company that continues to be very profitable even while its restructuring.

Bottom Line

Art Peck and his team are incredibly bullish on the future of the company. Investors should be excited about the investments and changes that have been made. As we get into 2016, both Banana Republic and Gap have much easier comps. In addition, expectations for the company are incredibility low. With the amount of stock the company has been buying back, sales could remain flat in 2016 and earnings would increase 8-10%. The benefits from the investments in the supply chain are beginning to show up which allows the company to be flexible and respond quickly to new fashion trends. I think investors are overlooking the benefits of having a responsive supply chain. 2016 may be the year that Art Peck’s optimism begins to show up in the company’s financial performance.

As always, thanks for reading!

 

Under Armour’s Going Global

UA store

Under Armour (NYSE:UA) is a very interesting company that continues to mature. The stock is down about 35% from its high back in September. Under Armour is run by CEO Kevin Plank who has done an incredible job. The company just celebrated its 10 year anniversary and it has come a long way. The big question for investors is where is this company going? Ten years ago, they started out by making compression t-shirts but they have transformed over the last couple of years and gotten involved in technology.

The company has been investing heavily in its future the last couple years. In 2015, they made a big push to make Under Armour a global brand. The company opened about 100 stores internationally. They particularly targeted China by opening about 75 stores. Prior to 2015, they only had 9 stores open in China. Investing in China right now is tough. We know that their economy has slowed down but no one knows how much economic growth there is today, if any. In addition, future economic growth is hard to predict. On one hand, you could say that this is a good time to be investing because in three to five years their economy might be steadily growing again. On the other hand, things could continue to slow which could impact Under Armour’s growth expectations.

Another growth driver for the company is in footwear. Many analysts have their eye on this segment. The segment has shown solid growth over the last five quarters. Please see the chart below indicating the footwear comps.

Footwear

Footwear now accounts for 20% of the company’s revenues. CEO Kevin Plank has said that he wants to be the number one seller of athletic footwear which takes direct aim at Nike (NYSE:NKE). Under Armour has signed endorsement contracts with some amazing athletes that have tremendously helped drive growth in footwear. Stephen Curry in basketball, Jordan Spieth in golf, along with Tom Brady and Cam Newton in Football. Basketball shoes have demonstrated the strongest growth driven by the Curry 2’s that were launched in China last September. Obviously the company can not continue to grow this segment at an average of 50% per year. In fact, during the Q3 earnings call, the company mentioned that they had to discount some shoes to clear them out going into Q4. This had an impact on gross margins and the company’s average selling price (ASP) per unit metric. ASP’s have increased over the last few years due to the price point of their shoes. It will be important for the company to have strong footwear sales in Q4 or investors may worry.

In 2015, the company took a more definitive stance in fitness technology. They acquired Endomondo and MyFitnessPal in 2015 to go along with the UA Record and MapMyFitness apps it already owned. In Q3 Kevin Plank stated that with all four apps, they have had 150 million downloads. The hard part for investors is we have no idea how to think about this part of the business. It currently doesn’t make much money and there is no way to know if it ever will. Last week at CES, the company announced that the apps have a combined 60 million monthly active users (MAU), over 1.5 billion workouts logged, and over 6.5 billion foods logged. Currently, the company is collecting tons of data from the users and trying to figure out how to best leverage it. Under Armour’s fitness community of 150 million users is larger than Fitbit’s (NYSE:FIT). This part of the business is nearly impossible to value. This is uncharted territory and its hard to know if these apps will drive consumers to buy more apparel and footwear. That seems like what the company is hoping will happen.

Under Armour’s valuation has always been rich. However, investors have been willing to buy the stock because of the growth. Some people justify buying the expensive stock because “The valuation has always been high.” This is a horrible justification. The company has shown incredible and consistent growth by posting 20%+ growth for 22 straight quarters but this won’t happen forever. When I looked into this company, it was clear that they understand how Wall Street works. They always give conservative guidance in Q4 for the upcoming year and then they raise guidance each quarter. It happens year in and year out and Kevin Plank comes up with great excuses for the conservative guidance issued in Q4. In my opinion, companies that use this strategy have a  higher probability of the stock selling off after reporting Q4 than in the other quarters. This could create an opportunity.

When I look at the valuation, it is definitely tricky. It is tough to value it   on a relative basis because it is difficult to find a company with similar risk, growth, and cash flows. An intrinsic valuation is difficult too due       to the explosive growth and uncertainties around China, footwear, and the technology aspect. When I looked at the financials, the SG&A expense financial statement line item is something to note. When I looked at the ratio of SG&A expense to revenues it reminds me of Amazon (NASDAQ:AMZN). The reason it reminds me of Amazon is due to the fact that there is a large disconnect between revenue growth and earnings growth. In Q4 2014, the company gave guidance for operating income of $405 million in 2015. Fast forward to Q3 2015, the company has increased revenue projections by $150 million but operating income projections are still at $405 million. Where is the $150 million going? SG&A expense. The reason I bring this up is because I do not consider all of SG&A expense to be a “true expense.” The company is investing in the future of the company and the brand. They are using this money to invest in fitness apps and opening new stores. In theory, they are creating assets and a better brand with this SG&A expense. For Under Armour, I assumed that 50% of SG&A would be a “true expense” and I amortize the other 50% over twenty years. I deem this to be pretty conservative and it helps me get a better understanding of what the company would be like in a stable growth environment. Using this assumption I reached an intrinsic valuation of $74 representing about 10% upside. Please see the chart below that reflects how my assumption impacts valuation metrics.
UA PE

Using this assumption, the P/E ratios for Under Armour are still relatively expensive. In my opinion, Under Armour is a terrific company that has a bright future but I am not willing to pay for excessive valuations.

Bottom Line

I think that Under Armour is a great company. The company is young and continues to grow. There are just a few issues. Investors have high expectations for the company and the return on the investments of the company is hard to predict. The company reports Q4 earnings on 1/28/15 and will give 2016 guidance. I would like them to give overly conservative guidance once again and have the stock fall. This is a company that I would like to own at a fair price. I plan on staying patient and hopefully the valuation will continue to come down.

As always, thanks for reading!

 

Is Macy’s Cheap For Good Reason?

macys-herald-square-exterior

Among the retailers that have been beaten down in the last 6 months is Macy’s (NYSE:M). The stock made all time highs in July and has since fallen about 45%. The company has come out with a long list of excuses. Among them is warm winter weather and poor sales to tourists traveling to the U.S. The company is now making some investments that could damage the brand in the long run.

One of the company’s largest investments is in a new store roll out called Backstage. Essentially this will be a discount store where Macy’s can discount the merchandise that they can’t sell in their flagship stores. First of all, I don’t think you would come up with this strategy unless you have had a lot of inventory that hasn’t sold or you foresee that to be a problem. There are many high-end retailers that have gone down this path and today they all have more discount stores than traditional stores. Competition in this space includes Nordstrom (NYSE:JWN), Saks Fifth Avenue, and Neiman Marcus among others. All of these companies have more discount stores than flagship stores. Opening discount stores has proven to damage brand value. Just look at the brand destruction that happen at Coach (NYSE:COH) and Micheal Kors (NYSE:KORS). Both of these companies are down over 50% from their highs and continue to struggle. Although brand value is not quantified on the balance sheet, it is there. Macy’s said on their Q3 earnings call that they have seen a trend of customers leaving Macy’s and shopping at high-end discount retailers instead. It seems like the company is now willing to sacrifice its brand value in an effort to get back to positive comps which brings me to the next issue. Macy’s plans on opening an undetermined amount of Backstage stores within existing Macy’s stores but assumes that there will be little cannibalized sales. The strategy is to bring in an entirely new set of customers that will shop at Backstage. I think this will be an extremely challenging task.

Last July, Jeffery Smith of Starboard Value made a presentation on Macy’s at The Delivering Alpha Conference. He contended that Macy’s could be worth $125 a share because its real estate might worth as much as $20 billion. Macy’s does have some impressive real estate and it is valuable. $20 billion might be a stretch, but even if it is worth that much, there is one big problem. Macy’s would have to pay rent on all these properties which would be violently expensive. Rent for a high quality retail building runs on average between 7% and 8% of the real estate value of the property. Valuing the real estate portfolio at $20 billion would equate into about $1.6 billion of rent payments each year. Macy’s net income last year was about $1.5 billion so the company would struggle to turn a profit. Macy’s has stated that they do not think it would create shareholder value to monetize its real estate.

To be fair, the company is also making some moves that could be great for shareholders. They continue to invest in Omnichannel that has been showing strong growth. In addition, they purchased Bluemercury last February for $212 million and they will begin rolling those stores out in 2016. Last week they also announced that they will be closing 36 Macy’s stores that will save $400 million in SG&A expense and they will continue to restructure throughout 2016. The real estate portfolio continues to be a hot topic with investors. The company is doing a good job by evaluating the locations that are least beneficial or have unused space and they are selling them. These strategies may help but the current vision for the company is rolling out Backstage which could be disastrous.

With the stock being down 45% since July, the valuation looks to be cheap. The stock currently trades at a price to sales ratio of just 0.45. Macy’s is expected to make $3.75 per share in FY 2017. Using this estimate, the stock trades at a reasonable 10.3x forward earnings (That is if earnings estimates are right). When I perform a 5 year intrinsic valuation on the company I come to a $40 price which is only about 3% higher than it is today. However, this factors in the estimated reduction in after tax operating income for FY 2016 and assumes that it will continue to decline, just at a slower pace through FY 2020. All valuations are biased, but considering the direction of the company, I have doubts that customers will return. I think the writing’s on the wall that margins may never be as high as they have been the last few years and sales may continue to disappoint.

I want to own wonderful companies at fair prices just like Warren Buffett’s quote says. I want to find companies that have strong demand for their products and a sustainable competitive advantage. Macy’s doesn’t seem to meet that criteria. It is having trouble selling merchandise. They are currently being forced to discount their merchandise to sell it and they are closing stores. They have now decided that the next chapter of the company will be discount stores. This strategy might help in the short-term but I think long-term brand erosion is certainly possible which will keep me from owning the company.

 

 

 

Headwinds In The Market

Headwinds

When I prepare to write a post I outline the topics that I would like to discuss. For this post I had over 50. I could probably write a book about all the stuff that I would like to talk about. Instead, I have decided to select just a few of the most relevant topics to discuss.

Credit Cycles

Understanding credit cycles can be very valuable to investors. The expansion or contraction of credit (or money) is highly manipulated by the central bank. The Federal Reserve expands and contracts credit in an effort to help Americans. When the economy is slow, the Fed increases the supply of money and vice versa. However, it is important to understand that money isn’t just dollars. It is also the availability of credit, which is a huge driver of our economy. When the supply of money contracts, credit tightens and it makes it more difficult for businesses to get credit. The ripple effect reduces the net income of companies. Today we can see the beginning of credit tightening showing up in the high yield bond market. This is just a fancy name for junk bonds. Many people have said that the .25% December interest rate hike is virtually nothing and won’t have much of an impact at all. However, Dr. John Hussman wrote an article explaining why this .25% hike may have a much bigger impact than most realize. Essentially, Dr. Hussman explains that there is now a massive pool of zero-interest cash that was created by the Fed’s quantitative easing (QE) so this .25% will have a much greater impact than people understand. Here is a link to the article if you are interested in reading it. Personally, I think he makes an excellent argument. There are a lot of parallels between what is going on in the U.S today and what happen in Japan years ago. They had zero-interest rates after stimulating their economy and they attempted to raise interest rates. Unfortunately, their economy slowed down forcing them to have to cut interest rates about a year later. As a result, their stock market plummeted. We could be at risk for the same type of event if our Fed is forced to do the same thing.

Correlation between QE and stock market performance

For anyone that doesn’t understand what QE is, it is pretty simple. The Fed purchases financial assets with cash in the open market. The Fed has purchased almost $2 trillion dollars of bonds since 2009. This purchasing of bonds manipulated the market, forcing yields on bonds through the floor. As a result, investors piled into stocks which has inflated stock prices. Since QE3 ended in October 2014, stock market performance has been challenged. To see the correlation that I am referring to please look at the chart below that Doug Short produced. Doug’s website can be found here.

qe

In the chart above, the green sections indicate where the Fed was pumping cash into the system though QE. You can see the market pull backs that happen after both QE1 and QE2. In addition, stock prices have been virtually flat since October 2014. Historically the Fed has been able to stimulate the economy by lowering interest rates. However, this last cycle they felt the need to have zero-interest rate policy (ZIRP) and additionally pump money into the system. I think it’s important to understand how this has affected our markets in the last few years and how it could again if the Fed were to perform a QE4.

Yield spreads between the stock market and bond market

In the last few years, there have been a lot of investors that have bought dividend paying stocks for the yield. Investors have been chasing these higher yields and taking on the extra risk because bond yields have been so low. Today, equity yields continue to be higher than bond yields. Tom Lee of Fundstrat Global Advisors has said that this is a reason to be bullish on stocks in 2016. But he is right? Personally I think investors recognize the risks in the stock market and I think that they are having second thoughts about chasing an extra 1% of yield in stocks. Historically investors have continued to chase yields in stocks until the yield in stocks and bonds reached parity. I have doubts that this will happen this time do to the increased risks in stocks caused by the Fed’s manipulation through QE. It is hard to say at what spread investors are willing to take on the extra risk in stocks but I think by observing the market, it is more than that extra 1% of yield.

Market Cap to GDP

Warren Buffett has said that one of his favorite long-term valuation indicators is market cap to GDP. He has said that “it is probably the best single measure of where valuations stand at any given moment.” To see what market cap to GDP looks like today please see the chart below that was produced by Doug Short.

Buffett-Indicator

As you can see, we are about two standard deviations above the mean. The market was actually close to the mean in 2009 before the Fed began pumping money into the system with QE. Warren Buffett has acknowledged that this indicator suggests that market valuations are stretched. Warren Buffett’s Berkshire Hathaway made a couple of billion dollar purchases in 2015 but their cash pile grew throughout the year. Berkshire has over $66 billion in cash and it continues to grow demonstrating that it is tough to find reasonable valuations in the market.

Bottom Line

In the last week, I have heard several people say that we are in a 2008 type of situation. I personally think it is irresponsible to make these assumptions. There are a lot of things that could happen. One of which is stocks could drift sideways for a long period of time while companies grow into their expensive valuations. Another scenario is one in which stocks drift down for a period of time until valuations and equity yields align with investor risk appetites. Things don’t always have to end with a bubble popping. I don’t think anyone really knows what is going to happen. It is an extremely complex situation. However, I think it is important for investors to understand the environment that we are in.

As always, thanks for reading!