Beer and Power but No Rare Earth
(Guest Commentary by Rick Konrad – December 2, 2010)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick highlights the attractiveness of a major vertically-integrated bottler and one of the largest utilities in the world—with major operations in the UK and the Northeastern US. Rick also highlights the relative unattractiveness of various metal producers, as well as a certain precious metal. Finally, Rick reminds us of the resiliency of Americans to create and innovate. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Avoiding Safety as a Strategy?!” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
An expert has been defined as someone who brings confusion to simplicity. Thrashing out ideas bottom up based on fundamentals has never been a problem but the confounding macro situation, and in particular the deflation versus inflation debate remains unresolved in my mind. The usual inflation "bets" seem woefully over-priced at least based on my value precepts. Though confident may be cool, I think flexibility is even cooler. The Buffett interview a few weeks ago said it all:
"My first question, as I sit there on the couch in his office, is: "What about gold? Is this a classic bubble or what?"
"Look," he says, with his usual confident laugh. "You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"
We think that one of the best protections against inflation is a growing cash flow stream from businesses that have such strong franchises that they can pass through price increases with ease.
This year, in particular, seems to be one of the more confusing years for me, yet some of the simplest, most basic ideas seem to have worked just fine.
About a year ago, we bought Fomento Economico Mexicano SAB also known as FEMSA (FMX). This company holds 54% of Latin America's largest Coke bottler. Its Coca-Cola FEMSA subsidiary is the #2 Coca-Cola bottler in the world (behind only Coca-Cola Enterprises). It bottles Coca-Cola, Sprite, other soft drinks, juices, and water in nine Latin American countries. FEMSA also owns more than 5,500 OXXO convenience stores in 31 Mexican states and plans to expand this to 12,000 stores by 2014. FEMSA was a major beer brewer in Mexico and Brazil, until the unit was sold to Heineken in 2010 for a 20% stake in this major global company.
There was no magic here. A company which has wonderful vertical integration (Wouldn't you hate to be a Pepsi salesman selling to OXXO) plus a 20% stake in a cheaply priced world-class brewer didn't seem like an unreasonable bet. .Operating in nine Latin American countries offers its share of political issues but somehow, the relative risks of Latin and South America (with the possible exception of Venezuela) seem to have improved as we watch the Greek and Irish tragedies play out.
Return on invested capital is about 9% and the business continues to churn out free cash flow. The value of the Heineken stake, Coke FEMSA, plus OXXO based on public market valuations is around $66 at present. At present, FEMSA still sells at a discount to the sum of the parts. Some argue that the company deserves to trade at a conglomerate discount to that value, yet, based on a management that has done nothing but create value over time, I am not sure that the company should be viewed this way.
Ten years ago, in US dollar terms, the business provided cash flow from operations of about $700 million. Last year, this was $2.5 billion. Revenues compounded out for the last ten years at over 15% as did dividends.
Though it is difficult to argue that the stock is dirt cheap, I think this remains a high quality holding. It certainly seems to fit that inflation beating description of franchises that can put through price increases with relative ease.
National Grid (NGG) is a new idea that we have just purchased.
National Grid holds a very enviable position between energy suppliers and consumers in the United Kingdom and the Northeastern United States.
Its dominant position from its UK roots is a result of the government's unbundling of energy generation, transmission, and distribution assets in the 1980s. It now owns or operates nearly every power wire and natural gas pipe in England and Wales and serves 11 million customers through England's largest natural gas distribution network.
In 2000, National Grid entered the Northeastern U.S. and now generates about half of its revenue and 40% of its profits from here. With the acquisition of Keyspan in 2007, NGG became one of the largest utilities in the world.
The regulatory environment is somewhat friendlier in the U.K. than its U.S. regions; hence, we should expect revenues and profits to tip more heavily toward the U.K. in coming years. The UK permitted returns on equity are around 14% as compared to recent rate cases in the US which allow only 9.75%.
At a 6.5% yield and a valuation that could bring the stock into the mid to high $50's, I think this stock should provide decent total return for the next few years. In addition, it provides some non-Euro international diversification.
This was an $85 stock just three years ago. Obviously, weakness in the sterling has been a factor in the stock's fall from glory stateside as well as its earning of dollar denominated revenues has not set well with UK investors. Since that time, financial leverage, which is considerable here as it is in most utilities, has dropped from about 14 times to just under ten times.
The risk in NGG as with all utilities is regulatory risk. The allowed returns just rewarded by the State of Massachusetts in the most recent case are the lowest in 50 years. Realistically, so are bond rates. We are taking advantage of this dip to buy NGG.
Exotic metals seem to have drawn a lot of people's attention. Molycorp (MCP) is a case in point. I think that capital gains derived from purchases at these prices will be rarer than any of the metals that MCP will mine.
Less rarified is Allegheny Technologies (ATI). ATI describes itself as one of the largest and most diversified specialty metals producers in the world, after being essentially a stainless steel manufacturer. The company is also a titanium producer, a market that it shares in North America with two others. Other specialty metals include cobalt, nickel, and titanium alloys as well as zirconium and hafnium.
For a complete outline of its products, please link http://tinyurl.com/363ayko
High-performance metals and specialty alloys generally bring better profitability than commodity metals, as they have a stickier customer base that often has strict product certification requirements. Much of this customer base is highly cyclical, particularly the aerospace industry and energy. The company does have a long term contract relationship with Boeing as a supplier of titanium, however, Boeing has similar contracts with all North American producers and a joint venture (50-50) with a Russian titanium producer. Needless to say, the impact of Boeing's continued problems with the 787, now known as the Nightmareliner rather than the Dreamliner, will have impact on Boeing suppliers.
Titanium has the strength of steel but is 45% lighter, hence its popularity in aerospace applications.
Though many investors have viewed this as a means of accessing the growth in Boeing, it is important to remind ourselves that titanium capacity is growing fairly rapidly over the next five years with almost a 40% addition expected by 2015. Almost 25% of the company's revenues are still tied to stainless steel. Viewing stainless steel as a growth industry is a little like being in a plastic time warp on the set of the movie, "The Graduate." It was growth then; it ain't now.
This remains a highly cyclical business with operating margins that have varied in the last five years from 3% at the low end (last year) to a high of 21% in 2007. The return on invested capital at 2.5% has been well below the cost of capital in recent years and is well below the average for the S&P 500.
The balance sheet is fine with debt representing about 33% of invested capital and interest coverage is adequate at 3.8 times.
The recently announced acquisition of Ladish, a company that ATI has supplied for some years, adds forging, casting, and machining capability to ATI but at a very high price in our opinion. Ladish also finds itself with operating margins around 2.5% after being as high as 16% four years ago. At least Ladish management was smart in saying "Thank you very much" when presented a deal at about 15 times EBITDA.
ATI has been in a heavy capital expenditure program. Capital expenditures have exceeded operating cash flow last year. It is the only titanium producer in the world that has all three melt technologies. Vacuum Arc Remelt is the lowest technology, electron beam is very efficient from the utilization of low-cost scrap. It has added a premium melt technology called Plasma Arc Melt or PAM. It's a technology that's preferred especially for the high-end rotating quality material that goes into a jet engine because it produces very clean metal, with fewer “inclusions.”
However, the benefits of this technology have yet to appear in the financials. Gross profit margins are about half of where they were two years ago currently running at 13%.
I think ATI is over-priced and has only compounded its difficulties with the LDSH deal.
A few additional thoughts as we have just finished our Thanksgiving festivities, enjoy Hanukkah tonight, and are less than a month from Christmas.
Though this country's problems are frequently depicted in sensationalist terms, I remain optimistic. Our resources are great. Our needs are great. Is it really rocket science for Americans to figure out how to match the two? We have the talent. What is lacking is political civility to cooperate on matters which benefit all and stop wrangling about what we disagree on.
We gain useful perspective from Council on Foreign Relations senior fellow Walter Russell Mead who wrote that “we are not like dozens of other countries who are struggling with the consequences of decades and even centuries of failures to keep up with a changing world. America's failures are the failures of a country on the cutting edge. Countries like China and India are doing some amazing things, but they are playing catch-up. They are trying to get where we are, while the United States is moving forward into unexplored terrain. They are building industrial societies; we are seeing what comes next.”
In many ways, we do seem to be at an important turning point for this country not unlike the end of the Depression and the period before the start of World War II. There is excess capacity galore with high unemployment, capital on the sidelines, and businesses operating well below capacity and potential. Rather than wringing our hands, it is time to roll up our sleeves.
Disclaimer: I, my family, and clients currently own a position in FMX and NGG. We hold no position in any other securities mentioned in this post.