Tailored Brands – Making Your Portfolio Look Good

People pass by a Men's Wearhouse store in New York

On July 27th I published a post outlining why I thought Tailored Brands was deeply undervalued. Since then, the stock has nearly doubled. The market is up about 4% over that same time period. I want to summarize the events that have happened since July 27th and reevaluate the stock as we move into 2017. My post from July 27th can be found here.

Tailored Brands purchased Jos. A. Bank in 2014 for $1.8B which turned out to be a horrible acquisition. The business was deteriorating when they bought it and the promotional model was not sustainable. TLRD did not have an earnout covenant so they ended up having to write-off $1.24B in goodwill from the acquisition in 2015. This write-off was overly conservative. The $1.24B write-off deemed Jos. A. Bank to be worth basically nothing as the business had $460 million in cash when they acquired it. The following is from my post on July 27th.

Although the deal was terrible for existing shareholders I believe there is value in the stock today. In 2015, Tailored Brands wrote off $1.24B of goodwill from the acquisition. They paid $1.8B. This would mean that they only received $560 million of value. I don’t believe the deal was that bad. Below is a screenshot of Jos. A. Bank’s balance sheet before the acquisition.

Jos BS

Prior to the acquisition, Jos. A. Bank had $935M in assets and only $200M in liabilities. To be conservative, I would write off half of the acquired inventory since we know business has been bad. After that write off, I calculate that $585 million in assets were acquired (935-200-150=585). So we know they acquired about $585 million in assets vs. the $560 on the balance sheet today. This would mean that TLRD’s financials indicate the actual business of Jos. A. Bank is worthless and there were no synergies. We know this isn’t the case. Comp store sales at Jos. have taken a hit but are beginning to recover.

What has occurred since July 27th

On September 7th the company reported Q2 earnings which beat on the top and bottom line. Men’s Warehouse reported 2.9% comparable store sales. Jos. A. Bank reported -16.3% comparable store sales which was worse than I had expected but was inline with the Company’s expectations. The company also gave an update on their transition plan which will achieve $50 million in cost savings. During the second quarter, they closed 86 stores, including 45 Jos. A. Bank factory stores and eight Men’s Wearhouse outlet stores. They remained on schedule to close approximately 250 stores during fiscal 2016. TLRD reiterated their previous full year guidance of adjusted EPS in the range of $1.55 to $1.85 per diluted share. Overall this quarter didn’t impress me all that much. However, the stock jumped 16% because expectations were so low.

On December 7th the company reported Q3 earnings which also beat on the top and bottom line. Men’s Warehouse reported a soft 0.1% comparable store sales. Sales since Father’s day have slowed and management said that trend had continued through December 7th. Management said that the Jos A. Bank turnaround is gaining traction. Jos reported a better-than-expected comparable sales decline of 9.8% in the third quarter. This third quarter number was up against the final “Buy-One-Get-Three Free” event in October. This number was inline with what I was expecting. Management updated full year 2016 adjusted EPS expectations to $1.70 to $1.85 per diluted share from the previous range of $1.55 to $1.85 per diluted share. Jos A. Bank is expected to post mid-to-high-single-digits comps in the fourth quarter with Men’s Warehouse posting a negative low single digit comp. The company also gave an update on their transition plan which will achieve $50 million in cost savings. During the third quarter, TLRD closed 83 stores, including 74 Men’s Wearhouse and Tux stores, bringing the total year-to-date closures to 187 stores.  They expect to close approximately 63 stores in the fourth quarter for a total of approximately 250 store closures during fiscal 2016. This quarter was better than I had expected. The turnaround in Jos A. Bank is on track. The stock soared nearly 40% on this earnings report.

Debt Situation

In my July 27th post I discussed the Company’s debt situation. The liquidity risk in the stock has dropped significantly. TLRD will be net cash flow positive in 2017 while they continue to pay down their debt. Just as a reminder, these are their debt deals.

  • $1.1B Term Loan due June 2021. Terms: LIBOR + 3.5%
  • $500M ABL Facility loan due 2019. Terms: LIBOR (No borrowings as of 10/29/16)
  • $600M in 7% Senior Notes due 2022.

In my last post, I mentioned I didn’t think the Company would be able to retire all of its debt timely. However, TLRD’s cash flow situation has improved in the second half of the year and it now appears probable that they will be able to retire all their debt on time without having to cut the dividend. Management continues to be positive on the trends they are seeing. I believe the Company will be able to achieve $20 million in net cash flow in FY17 while continuing CAPEX trends.

Valuation

The valuation has changed quite a bit since my last post with the large move in the stock. In the last two quarters, we have seen Men’s Warehouse comps begin to weaken while JOSB comps have been stronger than expected. In 2017, I expected MW to have a flat comp and JOSB to have a high single digit comp. Overall I think a TLRD 3.4% comp is achievable. In the July 27th post I valued the stock with the sum of the parts analysis below. Jos SOTP

As we approach my base case price target, I wanted to look at the valuation to evaluate whether the stock is still undervalued. The stock trades at about 13x forward earnings which seems cheap compared to the market at 17.5x. However, the balance sheet is still very leveraged so 13x times isn’t as cheap as it appears. The three year historical forward EV/EBITDA multiple is 7.6x. The stock is now trading close to 8x; about a 5% premium to the three year average. The stock is now pricing a lot of optimism around the JOSB turnaround. At this point, I believe this investment has transitioned from one with a positive skew to one that is now negative. 2017 should be a year where GDP growth is led by consumer spending. However, if that doesn’t transpire there may be limited upside in the stock.

Bottom Line

This stock has been a monster over the last five months. I will continue to hold it in 2017 while I carefully watch the JOSB transition. I am not sure this is a great opportunity to initiate a new position now that the stock trades at a premium to the three year historical valuations. Consumer discretionary stocks did not perform well in 2016 as a group but I think 2017 will be a better year. Management continues to do a good job in getting JOSB back on track.

Disclosure


Long TLRD

 

 

 

 

Under Armour – Chasing Down Nike

UA store

Overview:

Under Armour, Inc. develops, markets and distributes branded performance apparel, footwear and accessories for men, women and kids. The Company’s segments include North America, consisting of the United States and Canada; Europe, the Middle East and Africa (EMEA); Asia-Pacific; Latin America, and Connected Fitness. Its apparel is offered in various styles and fits to improve comfort and mobility, regulate body temperature and improve performance. UA’s footwear offerings include football, baseball, lacrosse, softball and soccer cleats, running, basketball and outdoor footwear. Its accessories primarily include the sale of headwear, bags and gloves. Its accessories include HEATGEAR and COLDGEAR technologies. It offers digital fitness platform licenses and subscriptions, along with digital advertising through its MapMyFitness, MyFitnessPal, Endomondo and UA Record applications.

Under Armour is the first company that has been able to give Nike a run for its money. UA has already made tremendous strides into basketball and football. Two sports that have always been dominated by Nike. Over the last few years we have seen numerous big colleges switch from Nike to Under Armour. Last year the University of Texas’ Nike contract was up for renewal and as soon as rumors started spreading that UA was interested, Nike re-signed Texas to a massive 15 year $250 million contract.

Under Armour is run by founder and CEO Kevin Plank. He started the business after finishing playing college football with the idea of creating a microfiber t-shirt to replace the heavy cotton ones in use at the time. Today, most football players wear microfiber instead of cotton t-shirts. In its first year, UA had $17,000 in sales. The Company forecasts that it will have $7 billion in 2018.

Footwear Market

The global footwear market is a $275 billion market. Of this market, the athletic footwear portion of the market is $63 billion. This portion of the market is expected to grow at a 3.6% CAGR over the next decade. The athletic footwear market includes sportswear, trekking shoes, aerobics shoes, walking shoes, and running shoes. The initiative regarding healthy lifestyle that motivates people to engage into some kind of sports activity will drive the industry in the coming years. This has motivated leading brands to come up with innovative and comfortable sports footwear products. Growth in wholesale and retail business, efficient supply chain, consumers’ willingness and increased purchasing power have fueled the global athletic footwear market.

The athletic footwear market is very different than the overall global footwear market from a demographic perspective. Men account for 60% of athletic footwear sales and women account for 25% (Children 15%). In the overall footwear market, women account for 57% and men hold 26%. Today, women are buying more athletic footwear and companies are fighting for this market share. In 2005, women only accounted for 21% of the athletic footwear market. Men have continued to spend on shoes but women have grown their share at a faster pace.

The majority of men select an athletic brand of shoe as their footwear preference. The largest brands in this space include Nike, Vans, Adidas, Converse, Puma, and UA. Footwear sales has been a major initiative for UA and it now accounts for 20% of sales as they steal market share. This trend has been led by basketball where UA has 20% of the market. This is up from 16% of the market in the fall of 2015. Steph Curry is driving growth in basketball and he has been a terrific ambassador of the brand.

Footwear

Asia has been a particularly strong market for Under Armour. Asia now accounts for 40% of all athletic footwear sales and is expected to be the fastest growing global market over the next five years. Steph Curry completed his second Asia tour last month in an effort to build his Curry shoe line. The Curry 3.0 was just released and has high expectations.

Under Armour has a mere 1% penetration into the $63 billion dollar market. Nike has a lot to lose. UA is in the first inning of their footwear campaign and they have great products. The future in UA footwear is driven by the Curry franchise. In 2015, Jordan shoes brought in over $2 billion in sales. UA is looking to develop a multi-billion basketball franchise like Nike has with Jordan. Today, Nike is building LeBron’s franchise and it is going head to head with the Curry franchise. Basketball will be crucial for UA to penetrate as football is being viewed as being increasingly dangerous and responsible for long term health problems in athletes. As more research is performed in the next decade, we will likely see more athletes choose basketball over football if they are gifted enough to choose.

Under Armour is working on incorporating technology into the footwear space. At this year’s CES conference they introduced a shoe with an embedded chip that collects data. The data will be used by Under Armour to communicate to consumers when they need to purchase a new shoe. Their data thus far has indicated that when people have run more than 450 miles, there is a higher risk of injury with old shoes. This type of information will be beneficial for the health of UA consumers.

Under Armour Sportswear Line (UAS)

Last month the Company launched UAS. This is very different market for them. UA believes that it has not been servicing the total addressable market. They have noted that about one third of their key competitor’s sales are derived from lifestyle rather than a pure traditional performance product. The lifestyle product provides a halo effect to the other lines of the business. As such, they have decided to fill this product gap with Under Armour Sportswear (UAS). UAS will initially be offered in a limited number of domestic locations including the SoHo (in NYC) and Chicago Brand House venues, as well as Barneys and online retailer Mr. Porter. The new line should be available in Boston in the coming weeks.

The UAS is geared towards trendy millennials. It is combination of traditional UA performance product with more fashion. The collection has a performance component, with stretch and waterproof fabric’s but has a fashionable look. The collection also offers fashionable footwear. The women’s shoe is not a traditional UA sneaker in that it has some lift in the sole. They are also going after the fashionable boot consumer with this line. Most of the products in this new line are priced in the $129-$250 except for the t-shirts, they are priced in the $49-$89 range.

This collection will not have a material impact to the top line until 2018 at the earliest. As they learn and receive feedback they will expand the breadth of the product and distribution. CEO Kevin Plank has said that UAS is a $15 billion opportunity. In my opinion, this is a very optimistic target and it will take many years to scale. Last year, UA had revenues of $4 billion so there is a chance that it might begin to impact the FY’17 revenues.

Under Armour believes that they will successfully be able to convert existing male customers to buy the UAS product. The new collection will not compete with the existing performance products so there will be no cannibalization. While there is an existing male customer base, UA expects the esthetics on the women’s side to attract female customers. Under Armour has traditionally struggled on the women’s side. It is estimated that only 15% of UA’s revenues are generated by female customers versus 23% at Nike.

Female Customer Base

As previously mentioned, Under Armour has historically been a bit out of favor with women. However, in July 2014 they launched the “I will what I want” campaign with Misty Copeland. As the campaign continued, UA signed Gisele Bundchen.  The campaign was a tremendous success by driving 28% growth in women’s sales and a 42% increase in traffic to the UA website. Today, the Company continues to try to appeal to female shoppers. UAS is the most recent strategy rolled out to create a larger female customer base. Nike continues to have a better perception among women but Under Armour is seeing improvement.

UA recently signed a distribution contract with the retailer Kohl’s. This is a strategic distribution move in an effort to reach women. Kevin Plank noted “The female consumer is there, she’s shopping and she’s buying. We think there is a big opportunity.” The margin mix for these sales in this channel are expected to be in line with existing sales. Kohl’s sold $3 billion in activewear and accessories last year representing 15% YoY growth. It is estimated that $1 billion of these sales were attributed to Nike. Under Armour is now offered in all 1,160 Kohl’s stores. This new distribution channel will be a long term revenue source for UA. I have reason to believe that Kohl’s will add $200 million to UA’s top line next year. This new channel alone will generate 350-400 basis points of sales growth in FY17.

International Growth

Under Armour continues to push into international markets and is having tremendous success. In the most recent quarter, international revenues increased by 80% on a constant currency basis. The direct to consumer channel now includes 191 stores comprised of 161 factory houses and 30 brand house stores. The international segment accounts for 15% of total revenues and they are stealing market share from Nike. The strongest international market for UA continues to be China. UA generated as much revenue in Q3 as it did in Q1 and Q2 combined. The brand is growing quickly in and they now have more than 80 stores there.

Intl

As the company expands internationally, they will steal market share from companies in new sports. The growth in EMEA is targeting Nike as well as ADIDAS. UA has not made soccer a growth initiative yet but I expect them to make a run at ADIDAS in soccer in the future. Soccer is the most popular sport in the world and is ranked as the most popular sport among today’s teens. To break into this sport, UA will need to begin signing endorsement deals with young soccer elites. We have seen that one dominant player like Curry or Spieth can really move the needle for UA. Signing the right athlete will be crucial.

Under Armour will be growing internationally for a significant period of time. For a comparison, Nike generated almost $16 billion in international sales last year which is almost 50% of their revenues. Under Armour has yet to reach the $1 billion threshold. I expect them to have $1 billion of international sales in 2018. This will be another important year as it will be an Olympic year. The Olympics provided a boost to international sales in Q3 as a result of an excellent advertising campaign around the Olympics. Under Armour is fairly well known in the U.S but as a brand, it is still in its infancy on an international scale. Worldwide sporting events like FIFA and the Olympics give UA an excellent platform to introduce their brand to the world.

Under Armour has been rolling out their international growth plan and entering new countries. This year alone, they entered into France, Turkey, North Africa, South Africa, Indonesia , Vietnam, Paraguay, and Uruguay. Next year they will enter into Argentina, Eastern Europe, and Russia. UA announced at last year’s investor day that they expected a 50% international CAGR through 2018. Thus far, it looks like they might even exceed that impressive expectation. UA is planning to have operations in over 40 countries by 2018, taking its total international locations to over 800. By the end of 2018, 80% of its global door count would be located outside of the United States, up from 41% currently. Most of the new stores will come via partnerships with distributors, especially in China, Japan, and Korea. UA expects to own and operate only about 30% of the total number of locations worldwide, or about 300. Charlie Maurath is UA’s President of International and he has done a terrific job rolling out their strategy. He has communicated that UA will strive to be the premium brand in every market that it enters. The premium strategy will be consistent regardless of the method that UA exercises to enter a market.

Applications

Under Armour has invested billions into their Connected Fitness strategy. The way that people consume media has dramatically shifted in the last five years from traditional channels like TV to new channels like mobile. The company is using its apps to integrate the brand with users. E-Commerce growth over the next five years will be driven by its MapMyFitness, MyFitnessPal, Endomondo and UA Record applications.

UA also sees strong growth from mobile devices. Mobile traffic grew to 59% of total e-commerce traffic in 2015. That’s up from 5% in 2011 and 28% in 2013. The company is looking to raise mobile traffic fourfold over 2014–18. Total business generated from mobile was up 128% in 2015.

Under Armour’s Connected Fitness platform has over 190 million registered users. Athletic engagement implies more use of its gear and therefore more sales. Going by the current rate, Connected Fitness would have about 385 million registered users by 2018. The Connected Fitness platform allows UA to gain exposure to the $2 trillion food and nutrition market and the $8 trillion health and fitness market. These two markets make the $250 billion sports apparel market look small.

The global wearables market has turned into a battleground for many companies like Fitbit and Apple in recent years. UA is attacking the market from the software side which is probably the only way they can. One in five wearable devices is able to sync to UA’s fitness platform which helps drive sales.

Q3 Earnings Report

The Company surprised investors on their Q3 conference call and updated their long-term guidance. Management indicated that EBIT would be about $200 million lower than they had previously guided. The top line revenue growth guidance was in line with expectations. I believe that half of this $200 million is the result of unfavorable expected currency headwinds and the effects from the Sports Authority liquidation which were not baked into previous guidance. The other half will be used for accelerating infrastructure build, people, and Connected Fitness. I expect CapEx to move towards the 8% mark next year and FCF to swing positive in 2019. I believe the long term growth opportunity in Under Armour remains healthy.

In Q3, UA saw footwear up 48% Y/Y and international was up 74%. These two drivers remain key focal points going forward. In fact, management indicated that during the back-to-school timeframe UA’s footwear market share nearly doubled. In addition, management highlighted that while they sold 30MM pairs of shoes last year, they anticipate selling 40M pairs this year-still well below the 500M pairs that Nike sells. During the quarter, running was highlighted for footwear and the Company has continued to make inroads with women’s footwear. In basketball, the Curry 3.0 were released two weeks ago. This follows the tour that CEO Kevin Plank and Steph Curry made through Asia in September.

Valuation

So how much do you have to pay for all of this? In short, a lot. This is another one of these story stocks that you have to pay up for to get involved. However,the valuation has come down quite a bit since the stock dipped after their Q3 miss. The question is, what is a fair price for the Company?

IS Estimate Pic

IS Product Estimate Pic

After this most recent pull-back, shares are trading at 46x next year’s reset number and about 40x my FY18 estimate. Historically, shares of UA have traded at an average three-year forward P/E multiple of 59.3x (peak: 73x; trough: 40.1x). Since the Q3 miss, the P/E has been more in focus vs. P/S (given that earnings are revised down with higher investment). On a P/S basis, UA is trading at 2.5x FY’17 estimates. Historically, shares have traded at an average three-year average forward P/S of 3.4x (peak: 4.2x; trough: 2.5x). Today the shares are trading at the trough P/S valuation.

Conclusion

UA is a terrific business and a great story. However, the valuation is difficult for me to get comfortable with. The stock may go much higher from here but I can’t buy UA at 46x forward earnings. There is too much risk if the Company were to guide down again. The expensive valuation is pricing in continued robust growth in athleisure. Short seller Jim Chanos believes that athleisure is a bubble. He might be right, he might be wrong. I know there are some value guys that are buying the stock right here. However, if growth in athleisure slows, you do want to be stuck in a stock that trades at 46x forward earnings. I would love to own this name at a more reasonable valuation.

Disclosure


 

No Position

Hain Celestial – Is It Your Cup of Tea?

Hain Logo

Overview:

The Hain Celestial Group, Inc. (HAIN) produces, distributes, markets, and sells various natural and organic foods as well as personal care products with operations in North America, Europe and India. The company offers popular better for-you groceries (non-dairy beverages and frozen desserts, flour and baking mixes, cereals, condiments, cooking oils, infant and toddler food, etc.), snacks (potato and vegetable chips, organic tortilla style chips, whole grain chips and popcorn, etc.), and tea (include herb teas such as Lemon Zinger, Peppermint, Mandarin Orange Spice, Cinnamon Apple Spice, Red Zinger, etc.).

The Hain Celestial Group is the largest manufacturer in the natural foods segment and has several leading brands. Some of the prominent brands are Celestial Seasonings, Earth’s Best, Ella’s Kitchen, Terra, Garden of Eatin’, Sensible Portions, Health Valley, Arrowhead Mills, MaraNatha, SunSpire, DeBoles, Casbah, Rudi’s Organic Bakery, Hain Pure Foods, and Spectrum.

The company also provides natural personal care products under brands such as Avalon Organics, Alba Botanica, JASON, Live Clean and Queen Helene. The products of the company are principally sold to specialty and natural food distributors and are marketed nationwide to supermarkets, natural food stores, and other retail classes of trade including mass-market retailers, drug store chains, food service channels and club stores.

The company completely acquired Hain Pure Protein Corporation (HPP), which processes, markets and distributes antibiotic-free chicken and turkey products. The company also has a 50% stake in a joint venture, Hutchison Hain Organic Holdings Limited (“HHO”) with Chi-Med, a majority owned subsidiary of Hutchison Whampoa Limited.

 Markets:

Healthy Snack Foods

The Healthy Snack Food Production industry, which creates goods such as healthy chips, pretzels, roasted nuts, peanut butter, popcorn and other similar snacks, benefited from increased demand over the past five years. As the economy has continued to strengthen, discretionary income levels have climbed. In turn, renewed consumer spending has boosted sales of healthy chips, along with nuts and seeds. The price of key ingredients such as corn and wheat has also fallen for much of the period, reducing costs and expanding profit margins. Overall, industry revenue is anticipated to increase at an annualized rate of 5.8% over the next five years. This includes anticipated growth of 6.8% during 2016, bringing total revenue to $16.0 billion.

Shifting food consumption trends have affected the strategies of snack food producers. Specifically, growing health concerns about eating foods high in sodium, fat and sugar have made some consumers wary of consuming traditional snacks. Companies like Hain have entered the market with innovative products such as kale chips and roasted chickpeas. Demand for nuts and seeds have also grown as Americans have increasingly reached for trail mix and other healthy snacks. Additionally, as consumers demand more healthy versions of existing snacks, producers are expected to introduce a wider variety of products. The array of nontraditional ingredients currently used for snack production, such as taro root and butternut squash, indicates creativity will also be a key factor in future success. Hain has an extraordinary portfolio of brands that continue to innovate this industry.Snack Brands

Tea

Growing health awareness among Americans, coupled with new studies touting the healthful, antiaging benefits of tea, has bolstered industry demand considerably over the past decade. The tea industry is growing nearly twice as fast as coffee. According to the Tea Association of the USA, Americans drank over 80.0 billion servings of tea in 2015, representing a 10.0 billion serving increase from the 2014 figure. The overall industry is expected to grow at an annualized rate of 2.8% over the next five years.

Consumers are changing their dietary patterns to incorporate low-fat and low-sugar products, such as tea, as alternatives to staples like soft drinks and coffee. This dietary change is in response to the wave of publicity encouraging healthy eating and living habits; scientific findings and media reports are constantly reminding consumers to adopt healthier lifestyles. The increasing age of the population represents a potential for growth in the industry. While the aging baby boomers are usually not in the market for ready-to-drink iced teas (e.g. Arizona or Snapple), they are the main drivers of specialty teas like Hain produces.

 Poultry/Protein

In recent years, adverse health effects associated with red meat consumption have driven some consumers toward alternative protein sources. Among these sources are poultry and meat alternatives. New consumer trends have emerged around livestock feed and how those animals live their lives. Poultry and meat producers have responded by increasingly differentiating their products (e.g. grass-fed beef, free-range or caged chickens and organic products). The poultry and alternative meat industries are set to grow at an annualized 4.1% over the next five years.

Disease outbreaks are becoming social concerns which are pushing people towards organic meats. Concerns about the use of antibiotics and chemicals in meat production are leading some consumers to shift into new products. As customers move away from red meats, meat substitutes like seafood and eggs are also gaining market share.

The primary risk in this industry for Hain is around the cost of feed. Current forecasts expect poultry feed costs to rise over the next five years. These cost increases could be worse than forecasted if competition and demand for organic feed rises. However, Hain’s poultry and protein segments are positioned well in the marketplace to take advantage of social trends.

Personal Care

The cosmetic and beauty industry is a mature industry that will grow in line with US GDP growth. Hain’s primary focus in this market is in skin care products. Skin care is the largest product segment within this industry, accounting for an estimated 28.9% of total revenue. This part of the market has grown faster than the rest with anti-aging creams and other facial creams. This category includes facial creams and cleansers, functional products (products that serve a specific purpose, such as anti-acne or wrinkle-reducing agents) and men’s skin care products. Skin care products can command some of the highest price tags in the industry, with two ounces of some skin products selling for upwards of $200.00. A focus on antiaging treatments has boosted this segment’s visibility in the past five years. Companies looking to gain market share often invest in the creation of new products aimed at preserving a youthful appearance.

In the last five years, research has linked certain cosmetic ingredients to long-term health problems like cancer, which has led many consumers to shy away from traditional makeup. As a result, products featuring natural and organic components are increasingly gaining favor in the market. This will be a huge tailwind for Hain going forward.

Mergers & Acquisitions

Since its founding in 1993, the company has used acquisitions to drive growth. Revenues quadrupled from 1998 to 2000, when Hain and Celestial merged. Since the financial crisis, Hain has been on a buying spree. In the last five years, they have made 19 acquisitions that have expanded their product offerings into new markets. Hain has posted a 24% CAGR since 2010 and revenues are expected to be close to $3 billion this year. Irwin Simon, CEO and his team have done a terrific job with creating synergies and shareholder value. They have a superior knowledge base and understand consumers better than their competitors.

Brands

Greek God’s

Greek God’s produces all natural, Greek-style yogurt, which is sold in natural and grocery retailers. Greek-style yogurt sales have grown over 400% in the last five years. I use a company like Chobani for the comp. Chobani has grown Greek-style yogurt sales from $78 million in 2009 to a projected $1 billion in 2016. Greek God’s had sales of $25 million in 2010. I expect them to reach $125 million or more this year. The Greek-style yogurt industry is expected to grow another 120% over the next five years.

Hain purchased Greek God’s in 2010. The terms of the deal were not disclosed. However, even if Hain paid 4x revenues, this has still be a terrific acquisition. The industry continues to grow and the move by Whole Foods to drop Chobani in 2013 has benefited Greek God’s. A conservative sales estimate of $125 million for 2016 and a 2x revenue multiple translates to a valuation of $250 million. As the Greek-style yogurt industry continues to grow, this brand could be worth $500 million in the next five years.

Ella’s Kitchen

Ella’s Kitchen is a manufacturer and distributor of premium organic baby food under the Ella’s Kitchen brand and was the first company to offer baby food in convenient flexible pouches. They perform research that indicates sensorial interaction with food is the key to cultivating positive attitudes towards eating, which in turn can create healthy eating habits that will last a lifetime. The organic baby food industry has experienced dramatic growth in the last five years. It is expected to continue to grow as more research indicating potentially harmful effects of chemicals and pesticides on children. Organic baby food sales are expected to grow at an annualized 20% over the next five years.

Hain purchased Ella’s Kitchen in 2013 for an undisclosed amount. Ella’s generated $70 in sales in 2012. I expect Ella’s to make $110 million in sales this year.

Spectrum

Spectrum is a California-based manufacturer and marketer of natural and organic culinary oils, vinegars, condiments and butter substitutes under the Spectrum Naturals brand. They also sell essential fatty acid nutritional supplements under the Spectrum Essentials brand, sold mainly through natural food retailers. Spectrum is also a supplier of natural, organic and non-genetically-modified oils to food manufacturers in the United States through its Spectrum Ingredients Division.

Spectrum was purchased in 2006 for a mere $34.5 million. Spectrum is likely to reach $125 million in sales this year as their products are sold in broad array of retail stores. The company has expanded their product mix and entered new markets since the acquisition. The Spectrum brand is worth as much as $250 million today.

Revenue Recognition Issue

On August 15th, Hain Celestial filed a press release disclosing the Company had identified concessions made to certain distributors in the US that they would be reviewing. The review is around the timing of the revenue recognition. The Company is currently evaluating whether the revenue associated with these transactions were recorded in the correct period and is evaluating internal controls over financial reporting.

While I have not spoken to the company directly, I am fairly confident that the issues called out surrounding concessions and revenue recognition are minor in nature. The language used in the press release is challenging to understand at best. Based on what was disclosed, there are a couple of different accounting questions surrounding concessions/deductions and the pass-through of final discounts Hain makes to retailers. In the press release, Hain noted questions around whether revenue associated with distributor concessions was accounted for in the correct period, as historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” My interpretation, although with no specific guidance from Hain, I believe this is related to sales to distributors that are eventually pushed to retailers with some form of growth rebate and/or charge-back accounting estimates.

ASC 605-10-25-1 is the revenue recognition standard that outlines the two factors that must occur for revenue to be recognized. 1) Must be realized or realizable. To be realized, products, must be exchanged for cash for the right to cash. 2) Being Earned. Revenue is not recognized until earned, revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. This standard is fairly straightforward. The wildcard is the concessions/deductions and pass-through of final discounts Hain makes to retailers. To be recognized, the amount of revenue must be determinable. In this circumstance, this would not occur until the distributor has sold the product to the retailer. Historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” A screenshot of their revenue recognition practices from their 10-k is below.Rev Rec 10-K

In Hain’s 10-K filing, it notes sales incentives and promotions are used to support the sale of product but the expense recognition is estimated. While Hain noted these alterations are normally insignificant and generally in the same period, when factoring in two layers of selling the accounting treatment becomes difficult.

Financial Statement Impact

The Company has already indicated the amount of revenues will not change, only the timing of revenues. The change in timing will have some effect on margins. Assuming concessions make up 10% of revenues would imply a mere 1% revenue timing impact. I assume “concessions” refer to manufacturer charge-backs (MCB’s) deductions, growth rebates, and discount terms. There is a bit of a difference in the accounting treatment between rebates and manufacturer charge-back (MCB’s). For rebates, a company earns a “growth” rebate, earning extra bps of purchases for the year if they reach a growth target. If they are targeting 7% and they grow 2%, the customer doesn’t accrue rebate (works opposite way also). For charge-backs, Hain might say to a retailer “You earn X% off every case you sell”, If they estimate 60 cases and sell 100 cases, an accrual needs to be based on 100 cases now, and visa-versa. The ending charge-back is sometimes a waiting game which creates the timing issue. Assuming that 10% of Hain’s total revenue is associated with “concessions”, the timing issue should be small in nature.

Result of Review

I believe the outcome will be a revision to previous financial statements. This would be much better than a restatement of previous financial statements. I have reason to believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I think it is likely the concerns around revenue recognition are overblown.

Project Terra

Over the next three years, (FY17-FY19), Hain indicated it expects $100 million in global cost savings from its project Terra in addition to the $50 million in cost saving initiatives in FY16. Hain has retained Boston Consulting Group (BCG), and hired new COO Jim Meier’s to support the initiative.

Five Key Areas

Procurement & Logistics

Set up a procurement group in Lake Success with will oversee global purchasing and cost reduction. Will rebid freight lines and revisit transportation routing guides and contracts.

SKU Optimization

Identify low volume SKU’s to rationalize and replace with high-volume SKU’s. To date, Hain targets brands representing a total $30M in sales to package for divestment.

Optimizing Co-Packing Network

Reducing the number of co-packers, rebidding key categories and identifying joint purchasing opportunities with vendors and suppliers.

Facilities Rationalization

Reevaluating make versus buy across entire network or facilities

Reduce Spoilage & Discards

Reinvesting in systems, processes and reevaluating spoilage allowances.

Margin Effects

With the anticipated savings from Project Terra, I believe Hain could return its US segment operating margins to FY15 levels (17.1%) with limited investment efforts. The cost savings are expected to be reinvested to generate growth in US brands. If Hain can achieve US segment operating margins in FY17 of 17.1%, then, even with no revenue growth, Hain would generate EPS of $2.13 (consensus $2.15). If they can achieve these margins and also hit their goal of mid-single digit revenue growth, I believe they can generate EPS of $2.20 or higher.

Risks

There are several risks to my thesis primarily because this is a competitive and growing market.

Increased Competition

Retailers have added investments in natural/organic private label offerings. Food retailers across channels are slowly adding natural/organic private label products. Furthermore, many large CPG competitors are shifting strategic focus towards expanding their natural/organic food portfolio either through M&A or strategic shifts in brands. Either of these strategies could place potential market share pressure on Hain’s portfolio.

Change in Tastes

A slowdown in consumption of natural/organic foods caused by an economic slowdown, or consumer trends is a risk to the company. A change in consumer tastes away from healthy foods or another negative event resulting in a decrease in demand for natural foods.

Organic Food Supply

A tightening in organic food supply could cause sourcing issues. 95%+ of Hain’s portfolio is non-GMO. Both organic and non-GMO products have experienced supply tightness as demand has outpaced supply at times. While Hain has operated in this environment for over 20 years, unfavorable input prices and/or product shortages could impact Hain.

Goodwill Impairments

Hain has created material goodwill on its balance sheet from historical M&A activity. Unexpected impairment of goodwill would adversely affect the price of the stock.

Valuation

The Company is trading near 52-week lows today at about $35. The stock traded down to where it is today back in January before running to $55. Due to the Company delaying its earnings announcement, it has made a round trip. As I have mentioned previously, I am not relying heavily on forecasts or valuations. My forecasts are biased and therefore, often wrong. The biggest advantage I have is understanding a particular business better than most and focusing on pieces of information being overlooked by the market. I have looked at Hain several different ways.

DCF Model

The Company has a fiscal year end of June so they are well into FY17. My income statement estimates are shown below. Results from Project Terra begin to show up in FY18 as margins begin to widen. From a financial perspective, the company was operating better in FY14 than today. Notice how they have cut SG&A to keep income margins 7-7.5%. However, current initiatives from the company will boost margins.

IS Estimates

Using the inputs above we get to the valuations in the chart below.

Hain Stock Valuation

In a normal growth valuation, a 9% growth rate was used. This is significantly slower growth than the 24% CAGR the company has posted since 2010. Project Terra will allow the Company to operate more efficiently and most importantly cut down on SKU’s. The median value of the stock is about $45. This represents about 29% upside.

Sum of the parts

Hain SOTP

A sum of the parts valuation indicates the stock is worth about $55. This represents about 55% upside. The sum of the parts story is tough considering this would be an M&A price. Today, the company might have too many SKU’s for a Craft Heinz or a Mondelez to be interested. However, if Project Terra cuts SKU’s, Hain will become more attractive. As the Company executes Project Terra, it may find groups of brands that would be attractive to a General Mills or Craft.

Bottom Line

The Company should be wrapping up their accounting review soon and will release delayed earnings. I believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I anticipate a revision to previous financials. I think it is likely the concerns around revenue recognition are overblown. Once the accounting review clears, investors will once again focus on the business. I have bought some HAIN near $35.

Disclosure


 

Long HAIN

 

 

 

Liberty Global’s LiLAC Group

Liberty-Global-470x260LiLAC was spun off as a tracking stock from Liberty Global last year. LiLAC is a provider of video, broadband Internet, fixed-line telephone and mobile services. After being spun off, it acquired Cable & Wireless, who owns a combination of cable and mobile assets in the Caribbean. LiLAC previously held large market share in the Chile and Puerto Rico markets and now looks to expand. Liberty Global is looking to acquire an array of cable assets in Latin America as they have done in Europe. With their acquisition of C&W it looks like they are on their way. Creating the LiLAC tracking stock gives management focus as well as a currency with which to potentially execute acquisitions.

Cable & Wireless Acquisition

Prior to being acquired by Liberty, CWC acquired Columbus Networks, a Caribbean cable operator owned by Canadian entrepreneurs and John Malone. Cable & Wireless paid 12.3x EBITDA for Columbus before any synergies. Columbus was growing EBITDA at 15% a year with a presence in predominantly Caribbean countries such as Trinidad, Jamaica, and Barbados. What was interesting about the combination is this would effectively give the combined entity a quad play in many of the countries in which they competed. It is very valuable to be able to have a mobile and fixed infrastructure presence as it reduces churn and creates an incremental, potentially low cost position. When you think about a mobile only player trying to compete against a fixed-mobile operator, the mobile only player should have structurally higher costs as they have to depend on expensive spectrum to transmit data. The combined hybrid player can use a fixed infrastructure presence to offload bits via Wifi at a much lower cost. In markets where the combined Cable & Wireless did not have a fixed infrastructure presence, they have started to selectively deploy the cable infrastructure in these markets being able to leverage the competitive video product. Cable & Wireless has continued the differentiation of their video product through exclusive rights to key sports content such as the Premier League and additional sports and high definition content. When looking at cable assets in the Caribbean region compared to the US or Europe there are a couple of key factors that make the Caribbean substantially more attractive: you have substantially lower penetration of services (around 40% penetration in the Caribbean) providing for a much higher and longer growth runway and the competitive landscape is much more benign especially with broadband given the very limited fiber overbuild. In addition to the consumer platform, the combination of Cable & Wireless and Columbus Networks strengthened the B2B firepower of the combined entity. Given the increased reach of the combined entity into the region as well as critical subsea fiber and backhaul, this combination creates a more compelling telco supplier for enterprises with multiple offices in multiple regions. CWC identified $125 million in synergies from the Columbus Networks combination, Liberty Global believes it can harvest additional synergies both from the Columbus Networks integration as well as from the combination of LiLAC with CWC. Given Liberty Global’s track record in harvesting synergies in previous acquisitions, the subscale nature of LiLAC, and the vast scale of Liberty Global, there should be some level of incremental synergy from items such as the rationalization of overlapping corporate costs and increased purchasing power leading to lower costs. Financially, the combined CWC and Columbus have historically grown revenue high single digits and EBITDA low double digits (not including any synergies). The CWC acquisition gives Liberty Global a significant quad play offering in a growing market. LiLAC is also in good position to acquire assets and continue to consolidate the Latin American market. A potential target would be Millicom. The former head of LiLAC’s Chilean business now runs Millicom. I believe there is a good possibility that John Malone goes after Millicom in the next 12 months.

John Malone

John Malone is a legend in the cable television industry. He became CEO of TCI in 1973 and more recently was CEO of Liberty Media. Liberty Global was spun out of Liberty Media in 2004 and merged with United Globalcom in 2005, shortly after UGC came out of bankruptcy. The company is structured so that Malone has voting control. It has three classes of stock: Class A shares get 1 vote, Class B shares get 10, and Class C shares get none. Malone owns 1% of Class A shares, 85.8% of Class B shares, and 3.5% of Class C shares. John Malone has a terrific track record of allocating capital. I believe the market is discounting the earnings power of the evolving LiLAC Group.

Chile 

The Chile market represents about 28% of LiLAC’s EBITDA. LiLAC’s Chile segment is called VTR. It has been showing very strong growth and has a long runway as penetration remains low.

VTR Growth

VTR’s network is a complete hybrid fiber coaxial network which can attain broadband speeds comparable to high speed cable networks in the US and Europe. They offer speeds up to 160 mb/s. This is much better service than its competitors. Additionally, they offer triple play packages that are far superior.

VTR Bundle

VTR’s biggest competitor is Movistar. As you can see, the pricing for the bundle is about the same but the broadband speed is more than twice as fast. VTR has existing infrastructure that gives them this competitive advantage. As VTR continues to add revenue generating units (RGU), I believe incremental revenues will drop straight to the bottom line.

Chile Broadband Market

VTR Internet

The broadband market in Chile is a duopoly with Movistar and VTR. Combined they have over 75% of the market. We know that VTR is far superior to Movistar. The overall broadband market is growing rapidly with a 12% CAGR over the last decade. VTR has kept its share of the market and has attained double digit broadband growth.

Puerto Rico

Liberty has entered into the Puerto Rico by way of mostly mergers and acquisitions. They are now the largest cable provider in PR. Puerto Rico accounts for about 12% of EBITDA. Similar to Chile, Liberty has key competitive advantages in PR with existing infrastructures allowing them to offer superior services while minimizing costs.

Broadband Market

Lib PR MKT

The broadband market in PR is also a duopoly. However, I believe Liberty has an even bigger advantage against Claro Puerto. Liberty offers speeds up to 200 mb/s where Claro fastest is 20 mb/s. The market continues to grow but not as fast as Chile. The pricing of their broadband has room to move higher. I believe Liberty is focused on stealing more market share from Claro so they can dominate the market. Having access to 80% of the homes in PR gives them a long runway for growth. The fiber deep hybrid-fiber-coaxial cable infrastructure that Liberty has is dominant compared to Claro’s DSL-infrastructure. I don’t see how Claro will be able to compete.

Bundles

Puerto Rico has a very strong bundling rate at 47%. This is the same rate as Chile. The triple play offering in PR outguns Claro or Dish. The broadband is four times as fast and it is priced less than Claro.

PR Bundle

The penetration in Puerto Rico is very low. It is expected to increase 100 basis points each year. This is a terrific opportunity for Liberty. Given that they have a first-class bundle, I expect them to capture the majority of new customers. With limited competition and access to most of the island, Liberty has pricing power. Anyone who wants fast broadband will use Liberty as there is no other option. As the demand for data and streaming increase, broadband will become more important. Liberty’s broadband is 10x faster than Claro’s and this is a long-term advantage.

Economy

It is not a big secret that Puerto Rico’s economy has been struggling. The American territory has stagnated since 2011. The economy has been depending on tourism and even that has now stagnated due to zika concerns. Governor Alejandro Garcia Padilla has said that the debt of PR is now too large to pay. The House of Representatives passed the Puerto Rico Oversight, Management, and Economic Stability Act, a bill meant to help Puerto Rico restructure its debt and prevent the island from being sued for defaulting on bond payments. I believe this will be positive in the long-term. John Malone was well aware of the issues in Puerto Rico when he decided to enter the market. He knew that economic activity might be slow for a period of time. Economic activity is already begin to tick higher now that Congress has passed the law. Puerto Rico has a bright future and as the economy recovers, it will benefit Liberty’s RGU’s.

Demand For High Speed Data

I expect high-single digit residential broadband revenue growth on the back of 1) Increasing broadband penetration from a 40% footprint penetration today, to closer to 50%-60% 5 – 7 years from now, and 2) Mid-single digit growth in data ARPU, driven by a mix-shift towards higher speed tiers and modest inflationary pricing increases. Broadband sells for near 100% incremental EBITDA margins excluding subscriber acquisition costs and is a much more attractive business than video as there are no programming expenses.

The Federal Communications Commission (FCC) actively monitors broadband and video pricing in Puerto Rico. Liberty will have to be careful about price increases in PR because of the FCC. Price increases would also open the door to new competitors. Data usage demand is expected to grow at a 36% CAGR over the next five years. In the last couple years, customers have been demanding more data due to bandwidth-intensive applications. Today there are multiple devices in most homes and we are spending more time on these devices. Demand for streaming HD movies and shows is not going to slow down. It will likely accelerate which will drive customers towards higher priced broadband options like Liberty.

Liberty has acquired terrific businesses in Latin America and the Caribbean. These acquisitions will allow them to scale their business cost effectively and meet demand. Liberty has the only hybrid fiber coaxial network in the markets it competes in. The current DOCSIS 3.0 technology is capable of providing downstream speeds of up to 1 gbps. The fastest speeds they offer today are 200 mb/s which is 10x faster than their competitors. LiLAC can increase broadband speed significantly with minimal costs. The only way their competitors could have similar broadband speeds would be to spend billions on network infrastructure. I do not believe there is a way to do this with a positive ROIC. Google is attempting to do this in the US and it is going horribly. You can read about it here, here, and here. Cable companies like Liberty have a monopoly on high speed broadband. Data can only be transported so fast using wireless technologies. There is major demand for wireless data do to its convenience. However, as more people use wireless data platforms, the traffic slows down the speed of the service. Due to the direction of technological applications, we will see more people turn to high speed broadband over the next decade.

Barriers To Entry

The industry is characterized by increasing barriers to entry. Smaller ISPs can often purchase data capacity from larger ISPs or internet backbone providers at wholesale prices and then sell these services to consumers. This is often the case with smaller companies, which do not have the resources to invest in infrastructure and networks. However, smaller ISPs are usually subject to lower margins and often depend on regulators to set competitive access pricing.

For ISPs that seek to have national coverage and be a major player, barriers to entry can be substantial. As a non-incumbent operator, competitors must either build a copper or fiber network, which is prohibitively expensive for entrants with limited access to capital. Accordingly, most new entrants will invest in “last mile” services, which connect business or residential customers to the internet via a larger ISP or backbone carrier’s infrastructure. On the other hand, new entrants with limited capital are unlikely to succeed in regions without existing network infrastructure.

Risks

The primary risks are related to the Latin American macroeconomic environment and political environment. Currency movements will impact profitability. LiLAC is a levered equity as most Malone businesses are. The cost of capital is relatively high indicating that moderate to accelerated growth is a must. There is a risk that incumbent operators in Chile/Puerto Rico will seek to overbuild Liberty’s infrastructure with fiber which would result in increased competition. However, due to the fact that this option is prohibitively expensive, it is unlikely. Finally, LILAK is a tracking stock, therefore holders will not be legally entitled to the assets associated with the tracker which could lead to a discount to intrinsic value.

Valuation

The valuation of LiLAC looks to be very reasonable. The stock appears to be trading at about 6.8x EBITDA. This is dirt cheap when looking at some of its peers.

LiLAC Estimates

2017 will be the first full year of financials inclusive of the CWC merger. In the years following, I expect a moderate 5-7% revenue growth with EBITDA margins around 45%. Depending on synergies, EBITDA margins could be closer to 46-48%.

LILAK SOTP

Looking at LiLAC another way, I performed a sum-of-the-parts analysis. It appears that the market is undervaluing the business. The long-term competitive advantages of the business provide a terrific moat. As I have mentioned previously, I am not relying heavily on forecasts or valuations. My forecasts are biased and therefore they are often wrong. Valuations are being run on every company by computers everyday with the most accurate information available. The biggest advantage I have is understanding a particular business better than most and focusing on pieces of information being overlooked by the market. In this circumstance, I believe the market is overlooking the value of the existing fiber coaxial infrastructure. Their competitors are at a huge disadvantage and building an infrastructure is not really an option. This should pave the way for solid growth for a long period of time. I have taken a position in LILAK this week under $28 a share. I believe LILAK will outperform the market over the next ten years.

Disclosure


Long LILAK

 

 

 

 

 

 

Wal-Mart Just Declared War On Amazon

amazon-versus-walmart-780x439On January 7th, I posted my first article about Wal-Mart. I posted another on March 23rd. You can read these here and here. Wal-Mart has performed well this year. It is up 19.6% YTD. The market is up 7.1% YTD.

Last week it was announced that Wal-Mart purchased Jet.com for $3.3 billion. What is Jet.com, you ask? It’s a 1-year-old online shopping site selling groceries, furniture, and small appliances. It has some pricing gimmicks, but it’s basically the same old business model: an online marketplace where third-parties source the products and sell directly to consumers.

Wal-Mart’s E-commerce

Wal-Mart’s e-commerce has been a hot topic among analysts for the last 18 months or so. I wrote about their online business in my first two posts. Wal-Mart was expected to spend $1.1 billion this year and $1.3 billion next year on e-commerce. Online sales were expected to grow 20-30% a year which would be consistent with Amazon’s growth. However, last year they fell short of expectations by only growing online sales by 12%. In Q1, they only grew online sales by 7%. Is buying Jet.com the answer? In short, No. I was very supportive of WMT’s e-commerce strategy and investments. I thought they were doing a good job. However, buying Jet.com is a key long-term strategic move for the company and I cannot support it.

Store Productivity

Boosting store productivity of an existing retail store is very difficult. You have to create strategies, goals and initiatives that flow throughout the entire business. Most importantly, the employees that are directly interacting with customers must understand and believe that they are the backbone of the business. No one did this better than Frank Blake at Home Depot in 2010. The company had serious productivity issues and he executed one of the best retail turnarounds ever. (I discussed this in my previous article here.) The reason I mention this again is because we are seeing WMT shift away from these proven strategies. At the beginning of the year, Wal-Mart boosted wages for all employees. This worked very well because it improved customer service and Wal-Mart employees purchased more merchandise when they shopped at Wal-Mart.. The other strategies that WMT put in place were to invest in inventory management systems and close underperforming stores. Both of these were good. Finally, they shifted capex dollars to boost the buyback which has been accretive to shareholder value.

Now they are heading a completely different direction. Instead of focusing on improving the customer experience, they are going after a zero margin business. No one is going to stop shopping on Amazon and start shopping on Jet.com because their dish soap is $0.02 cheaper. That isn’t going to happen. If Wal-Mart tries to cost cut Amazon, they will lose.

Now there are two directions that Wal-Mart can go. 1) Keep Jet.com separate from Wal-Mart.com and try to grow it as fast as possible. 2) Integrate Jet.com into Wal-Mart.com and have a Wal-Mart.com powered by Jet model. I don’t know what they plan to do but either one will cost a lot more than the $3.3 billion they already paid.

Merging Businesses and Cultures

Mergers are extremely difficult. Combining two existing businesses and maximizing synergies is complex and time consuming. It requires excellent planning and perfect execution. The fact is, 83% of mergers fail to increase shareholder returns. Most of the time they don’t work. This acquisition will probably not work out well for existing shareholders. Although $3.3 billion is not a lot of money to Wal-Mart. This is just the beginning. They will probably spend another $3 billion in the next two years merging the businesses.

The capital isn’t the only problem. All companies have limited time and attention. Where they spend that time and attention drives shareholder value. Wal-Mart will be spending an immense amount of time and attention on this merger. Time they could be spending on improving their customer experience. Companies get in trouble when they spend 90% of their time on 10% of the business. This is what WMT is doing and this is a zero margin business. The core business is doing very well posting 1.5% comps and 6.5% comps for neighborhood stores. I fear the company will not appreciate how well this piece of the business doing and not give it enough attention going forward.

Merging Cultures

The Wal-Mart and Jet.com cultures could not be more different. Jet.com has made many moves that sacrifice profit for growth. Wal-Mart is the opposite, they continue to look for ways to boost the bottom line (buybacks, closing stores ect.). Jet.com does not make money and won’t as long as they push for transaction and user growth. Jet.com’s goal is to undercut Amazon’s price which means they are going to have a very difficult time boosting margins. I really don’t know how Wal-Mart will merge these cultures. They are complete opposites.

Current Valuation

Wal-Mart’s valuation does not look as compelling as it did when I posted the article last January. The stock is up about 20% since then so that is part of it. Analyst estimates have slightly fallen in the last eight months. Wal-Mart is expected to make $4.91 in FY2019. We know that historically it has traded with a 15 P/E. This gets us to a valuation of about $73.50 which is where the stock is today. I expect revenue growth to accelerate after the Jet.com deal but I think it will hurt EPS.

The bull case is that the stock will demand a higher valuation with the Jet.com acquistion. I wouldn’t be surprised if the stock does get a higher valuation based off of the deal even though I don’t like it. It wouldn’t shock me if the stock trades at a 17 or 18 P/E which would push the stock closer to $80.

My Portfolio

Wal-Mart is a large position for me. I bought the stock last November and I have done very well with it. However, I want to own great businesses at reasonable prices. A business that is at war with Amazon sounds like a miserable business. I plan on holding Wal-Mart through November for tax purposes. The Jet.com deal will take months to close and I don’t believe the core Wal-Mart business will be affected in the next 12 months. Looking out over the next 10 years, Wal-Mart is going to be in a expensive fight with Amazon.

I currently hold 35% cash in my portfolio. I have only slightly underperformed the market by 28 basis points through July 31st. Owning companies like Wal-Mart (Up 19.6% YTD), Loews (Up 8.4% YTD), Nexpoint Residential (Up 59% YTD), and Post Properties (Up 12.1% YTD) has helped me. Post Properties was purchased last week by Mid-America Apartments for about $72.50 a share. That deal will close in a few months.

There is a good probability that I will sell my Wal-Mart position before the end of the year. This will take me to close to 50% cash. I continue to look for value one company at a time. It is not easy to find great businesses that are trading with reasonable valuations. I am remaining patient and disciplined. Don’t follow the herd. I am prepared to underperform the market in the short term in order to achieve long term outperformance. Charlie Munger says that envy is the worst human emotion. It is 100% destructive. Being envious that others are getting richer faster than you will do nothing for you. When there is an opportunity, I will be ready.

Disclosure


Long WMT