Observing O’Reilly (ORLY)

O’Reilly Automotive (ORLY) is a large chain of retail stores in the U.S. that sell auto parts and after-market accessories.  As of June 30^th, ORLY had just over 3600 stores.

O’Reilly was the subject of the monthly Online Stock Study at the BI website for November 2011 and was led by Adam Ritt, editor of the Better Investing magazine.  ORLY’s Value Line and Morningstar reports are available to BI members as are Adam’s Presentation Slides, an audio recording of the online study, and an earlier SSG and report by the Investment Advisory Service (IAS).

The Online Stock Study uses consensus decision-making to complete a SSG in about one hour.  Happily, and for the first time in almost a year, the Consensus SSG is also available as a handout.  Hooray!!

 Company Background:

– O’Reilly’s Sales & EPS growth has been impressive: 19.3% & 16.5% for the past 10 years; up to 26.8% & 17.1% over the last 5; and up again to 22.8% & 41.5% for the last 3 years. 

 – The company’s acquisition of CSK Auto in 2008 increased its store base by 70% as well as its geographical presence in the West, especially California.

 – ORLY’s sales reflected 59% Do-It-Yourself (walk-in customers) and 48% Do-It-For-Me (repair shops) as of June 2011; before the CSK acquisition, 52% were Do-It-Yourselfers.

– The company began in 1957 with one store and Wikipedia as well as IAS reported that much of ORLY’s growth has been fueled by acquisition:

** In 1998, it merged with Hi/Lo Auto Supply adding 190 stores; in 2000, it bought KarPro Auto Parts and its 14 stores; in 2001, it purchased Mid-State Auto Distributors adding 85 stores; and in 2008, it bought CSK with 1342 stores, its largest acquisition.

– ORLY’s 2010 Annual Report explained that the company opened 149 net new stores last year, counting openings and closings, and plans to open 170 in 2011.

** Same Store Sales increased from 4.6% to 8.8% in 2010.

 ** The company also opened three new distribution centers last year, relocated one, and converted another.

** ORLY anticipates “significant market share gains in the Western U.S.” in the next several years and expects to make some $50M capital investment in the acquired CSK stores.

– ORLY’s direct competitors are Auto Zone (AZO), Advance Auto Parts (AAP), and Genuine Parts (GPC) according to YahooFinance.

** Among these competitors over the last 5 years, ORLY had the highest average Sales growth, AAP had the highest EPS growth, and AZO had the highest Pre-Tax Profit Margin;

** Morningstar reported that ORLY faced stiff competition from AZO and AAP which also have been aggressively expanding;

** Because there is little product differentiation among its competitors and low barriers to entry, Mstar assigned no economic moat to ORLY (no competitive advantage).

SSG Discussion:

– The following table compares the Consensus SSG with recent SSGs by Adam (from BI’s First Cut), myself, and Take Stock. 

– After the table, I discuss key judgment issues, ORLY’s Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE), and its Financial Condition.

O’Reilly Auto-       motive (ORLY)	Consensus SSG	AdamR      (from BI’s  First Cut)	ArminF	Take Stock
Date	11-1-11	Same	10-28-11	10-31-11
Data	Mstar via BI	Same	Same	Mstar via SC
Price	$76.45	$78.79	$76.07	Same
52 week High &   Low Price	$77.35 & $53.33	$78.77 &   Same	Same &       Same	Not Used
Last Quarter of     Reported Data	Q3 ending    9-30-11	Same	Same	Same
Software Used	Online SSG	Same	TK 6	TS Online
Project Growth     From End of	Last Q	Same	Same	Last FY
Sales Growth	7.00%	8.00%	15.00%	11.00%
EPS Growth	8.00%	8.00%	15.00%	11.40% start 06.69% end
High PE	18.4	22.0	20.3	21.5
High EPS	$5.39	$5.14	$7.04	$4.45
High Price	$99.18	$113.00	$142.90       (10% > VL)	$95.75
VL Estimated High Price = $95-130 as of 9-5-11 and 11-14-11
Low PE	14.81	Same	12.3	12.6
Low EPS	$3.50	Same	Same	$3.20
Low Price	$51.84	Same	$43.10	$40.32
Upside/Downside Ratio	0.92	1.28	2.0	Impossible to Calculate
Total Return	3.2%	3.75	13.4%	4.7%
SSG Buy Under	Not Available	Same	$68.05	$47.87
RV/PRV	Not Available	Same	Not Used	Not                Available
RV/PRV (no outs)	Not Available	Same	117.9/102.7	Not                Available
Quality	Not Used	Same	S&P = B+     (4th of 8 grades)	TS = 3.2 unacceptable
PTPM – 5 yr ave	11.21%      Trend N/A	Same          Same	11.20%       Trend up	Same             Trend N/A
ROE – 5 yr ave      End Year Equity	11.62%      Trend N/A	Same          Same	11.60%        Trend up	Not Used
ROE – 5 yr ave     Begin Year Equity	Not Available	Same	13.6%         Trend up	14.0%          Trend N/A
Debt to Equity –   5 yr ave	Not Available	Same	16.8%        Trend down	Not Used

The Consensus SSG:

(A) Estimating Future Sales Growth for the next 5 years

– Adam gave the participants four options to estimate ORLY’s future Sales growth: 7.00%, analyst estimates (unnamed) for this year and next; 8.00%, estimate by Morningstar and Value Line, and 3Q actual; 12.00%, Investor’s Advisory Service estimate in January 2011; and 19.00%, ORLY’s long-term historic growth.

** The only website I know of that makes a Sales growth estimate for the next 5 years is Zacks.com;

** Value Line’s 7.00% estimate was for Sales per Share, not Sales, and VL makes no estimate of future Sales;

** ORLY’s historic Sales growth of 19.00% was for the last 10 years and its Sales growth for the last 5 years increased to 23.80%.

– The Consensus (60% of the votes) chose 8.00%; the next highest vote (22%) was for 7.00%.  

(B) Estimating Future EPS Growth

– The participants were given four choices to estimate the company’s future EPS growth: Same as their estimated Sales growth; 8.00%, imputed rate from VL’s dollar estimate from 2011 to 2014-2016; 13.50%, VL’s estimated rate from its Annual Rates box; 15.00%, IAS estimate in January 2011; and 16.50%, ORLY’s long-term historic EPS growth.

** ORLY’s historic EPS growth of 16.50% was for the last 10 years; its EPS growth for the last 5 years increased slightly to 17.1%.

** It’s a mistake, I believe, to impute a rate from VL dollar amounts that’s different from its Annual Rates box as VL uses a unique method to calculate its rates which is explained in a new page [click here].

– The Consensus (52%) chose 9.00%, Adam’s imputed VL rate; the next highest vote (28%) was for 13.5%, VL’s estimate for the next 3-5 years from its Annual Rates box.

Adam‘s SSG:

Estimating Future EPS Growth:

– Adam limited his EPS growth to 8.00%, the same as his Sales growth estimate.

– He then used the NAIC/BI Preferred Procedure to double check his judgment and used these four inputs: Sales growth = 8.00%; PTPM = 12.5% (average of 2006, 07 & 10); 37.5% Tax Rate (from VL); and 133M Shares Outstanding.

– His PP reslted in 7% EPS growth for the next 5 years which Adam thought was a “little low” so he used 8.00% even though he mentioned that unnamed analysts were estimating 16.5%-17.0%.

 Armin’s SSG:

Estimating Future EPS Growth:

– When I did my SSG, the seven long-term EPS estimates I ALWAYS check were averaging 16.4% with CNNMoney via FactSet CallStreet high at 18.00% and VL low at 13.50%. 

 ** Relying on VL without checking other estimates is unwise, as demonstrated by the Online Stock Study, since it may be atypically low;

** Morningstar.com and Zacks via BI were both 17.00%; Yahoo Finance via Thomson/FirstCall was 16.50%; Reuters.com was 16.49%; and Zacks.com was 16.05%;

** For how I estimate EPS growth for all my SSGs, see: Estimating EPS [click here].

– I decided to estimate 15.00% EPS growth which, together with my Estimated High PE, gave me a Forecast High Price that was 10% greater than VL’s estimate as I try to never exceed VL by a substantial amount.

Final Results:

– None of the four analyses resulted in a SSG Buy, maybe because ORLY’s price was close to its 52 week high.

FINAL RESULTS	Consensus SSG	AdamR	ArminF	Take Stock
SSG Date	11-1-11	11-10-11	10-28-11	10-31-11
Price when SSG was done	$76.45	$78.79	$76.07	Same
52 week High &            Low Price	$77.35 & $53.33	$78.99 & Same	Same & Same	Not Used
EPS Growth	9.00%	8.00%	15.00%	6.49%
Forecast High PE	18.4	22.0	20.3	21.5
Forecast High Price	$99.18	$113.08	$142.90 (10% >VL)	$95.75
Upside-Downside Ratio (need 3.0 min to Buy)	0.92	1.28	2.0	Impossible to Calculate
Expected Total Return (need 15% min to Buy)	3.2%	3.75%	13.4%	4.7%
FINAL RESULTS	DON’T BUY	DON’T BUY	DON’T BUY	DON’T BUY

– The Consensus SSG began with a low EPS estimate as well as a low Forecast High PE and resulted in the lowest Total Return;

– My SSG began with a substantially higher EPS estimate but still failed to satisfy the BUY criteria (3.0 U/D and 15% TR).

 Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– PTPM and ROE 5 year averages are both trending up which are good signs and what we want to see from all our SSGs.

– Morningstar places ORLY in the Specialty Retail Industry which is a hodge-podge of companies that sell different things.

– ORLY’s PTPM is substantially better than its Industry Average (11.2% vs 5.79%) and its ROE is also better (11.6% vs 9.87%);

** I no longer pay for a subscription to Stock Central because the only thing I used was its Industry Data (which is the best on the web).

** Now, I use the meagre Industry data at the BI webite which does not provide a company-by-company breakdown so I can no longer identify and eliminate atypical amounts, and recalulate the adjusted average.

Financial Condition:

– Value Line gave ORLY an “A” for Financial Strength, its third highest of nine ratings:

** VL also reported that the company’s cash had increased from $29.7 M in 2010 to $268.8 M eighteen months later.

– Morningstar found that ORLY was in “good financial health”:

** Moreover, the company can “easily service its debt” using internally generated cash flows; and

** Earnings before Interest and Taxes were a comfortable 10 times Interest expenses over the past 5 years and Mstar expects that rate to improve in the future.

– The Annual Report Spreadsheet by Bob Adams gave ORLY’s 2010 A.R. a 73 out of 100 with 9 Bullish results (good things) and 9 Bearish (not-so-goods):

** The Bullish results included: sales are increasing and increasing faster than related costs; debt is decreasing and interest coverage is reasonable; debt to equity at 11.1% is reasonable.

** The Bearish results included: ROE at 13.1% is inadequate and gets a yellow caution flag; Accounts Receivable, Inventories, and Shares outstanding are all increasing and all get a yellow caution flag.

– My SSG shows that ORLY’s Long-Term Debt went from a low of $75.1 M in 2007 to a high of $724.6 M in 2008 and then down to $357.3 M in 2010, the last full year of available data.

** Currently, ORLY’s Total Debt is $797.8 M, its Debt to Total Capital is 20.7%, and its Cash Flow per Share is $2.38 (after being negative three of the last 5 years).

 

Armin

**** ORLY is my 85th post to this SSG Blog which I expect to end soon after 5 years.  It’s a lot of work with very little reward (feedback).  

 

Contemplating Cognizant (CTSH)

Cognizant Technology Solutions (CTSH) is a worldwide provider of Information Technology services.  The company has over 100,000 employees based mostly in India, but is incorporated and headquartered in the U.S.

CTSH was named to the 2010 Fortune 100 Fastest Growing Companes list ranking 37^th with 55% EPS and 30% Sales growth.  Wikipedia reported that Cognizant has made Fortune’s Fastest Growing list for eight consecutive years.

CTSH was the subject of the September 2011 Online Stock Study at the Better Investing website.  It was led by Carol Clemens and Christi Powell, two members of BI’s Heart of Oklahoma chapter.  Handouts available to BI members include the CTSH Value Line and Morningstar reports as well as the audio presentation and power point slides.

Sadly, and once again, no completed SSG is available even though the purpose of the monthly Stock Study is to generate a SSG in about one hour using consensus decision-making by the online participants.  I’ve complained, but these omissions month after month must be deliberate and seem foolish to me.

 Company Background:

– According to Cognizant’s 2010 Annual Report, revenues increased an impressive 40% last year and the company added more than 120 new clients, most ever in its history.

** Revenue growth in Europe was especially noteworthy: sales in the United Kingdom increased 58%; the company began operations in Spain, expanded offices in Stockholm, Paris, Zurich, and Amsterdam, and opened office in Geneva.

– Most of CTSH’s revenues are generated in the  U.S. and Wikipedia reported that 2010 revenues by geography were: 77% from North America; 19% Europe; other 4%.

– According to Value Line, 2010 revenues by segment were: 42% financial related services; 26% health care services; 18% retail-logistics-manufacturing; 14% other.

** IT Services are provided by an on-site technical and account management team supported by development centers located primarily in India.

– To distinguish itself from competitors, Morningstar observed, Cognizant chose to build a U.S.-based management team in order to gain the trust of U.S. customers and, at the same time, delivering the cost savings of offshore outsourcing. 

 ** This model has provided CTSH with a “significant” competitive advantage;

 ** Like other IT providers, Cognizant’s clients are highly concentrated: CTSH’s top 5 and top 10 customers accounted for 20% and 30% of revenues;

 ** Mstar thought it was unlikely that clients would change their IT provider given the high costs of switching and the sticky nature of these relationships.

– The Indian government is ending its tax subsidies on software exports in 2011 and Cognizant’s low tax rates are xpected to rise.

– After the following table comparing four SSGs on Cognizant, I discuss key issues about CTSH’s future growth, its downtrending Return on Equity, its Competitors, and its Financial Condition.

Cognizant                  Technology Solutions (CTSH)	CarolC	ChristiP	Armin	AnnC             (from BI’s First Cut)
SSG Date &                    Study Date	7/27/11 & 9/7/11	Unknown & Same	8/15/11	7/8/11
Data	Mstar via SC	Same	Mstar via BI	Same
Price	$60.84	$72.95	$63.93	$76.40
52 week High &              Low Price	$83.84 & $53.59	Same&        Same	Same &        Same	Same & $52.10
Last Quarter of     Reported Data	Q2 ending 6/30/11	Same	Same	Q1 ending 3/31/11
Software Used	TK6 &     Online SSG	Same &       Same	TK6	Online SSG
Project Growth              From End of	Last Q	Same	Same	Unknown
Future Sales Growth	21.4%	Unknown	20.0%	17.0%
Future EPS Growth	18.9%	19.0%	16.0%	16.0%
High P/E	20.0	31.3	27.9                  (last 3 yr ave)	27.0
High EPS	$6.32	$6.35	$5.59	$5.36
High Price next 5 yrs	$126.40	$198.80 (37% > VL)	$156.00           (5.5% > VL)	$144.72
Value Line Estimated High Price = $95-145 as of 8/19/11and 5/2011
Low P/E	15.50	Unknown	12.5	15.0
Low EPS	$2.66	Unknown	$2.66	$2.55
Low Price next 5 yrs	$41.23	$39.60	$33.30	$38.25
Upside/Downside Ratio	3.34	3.80	3.00	1.79
Total Return	15.75%	22.20%	19.50%	13.63%
SSG Buy Under	Unknown	Unknown	$63.98	Not Used
RV/PRV                         (outliers eliminated)	Unknown	Unknown	118.8/102.6     (06 & 07 out)	Not Used
RV/PRV                           (no outliers)	Unknown	Unknown	87.9/75.9	Not Used
Quality	Not Used	Not Used	S&P = B+	Not Used
PTPM – 5 yr ave	Unknown	Unknown	19.2%          Trend even	19.15% Trend N/A
ROE – 5 yr ave              Ending Yr Equity	Unknown	Unknown	20.9%              Trend down	20.92% Trend N/A
ROE – 5 yr ave         Beginning Yr Equity	Unknown	Unknown	28.4%          Trend down	Not Used
Debt to Equity –               5 yr ave	Unknown	Unknown	-0-                  Trend even	Not Used

 Estimating CTSH’s future growth: the Online Stock Study

(A) Carol&Christi gave participants 5 choices to estimate future Sales growth for the next 5 years: 31.9%, the company’s last 5 year average; 22.0%, Value Line’s estimate; 19.7%, average BI member sentiment; 20.1%, estimate from Manifest Investing, a pay site; and  None of the Above.

** Value Line’s 22.0% estimate was for Sales per Share, not Sales, and VL makes no Sales estimate;

** BI’s 19.7% average member sentiment was based on some 78 Online SSGs made in the last 90 days which ranged from an estimated 39.4% high to a low of 7.5%;

** “None of the Above” is not a meaningful choice and I will not report it again;

** The Consensus (35% of the votes) chose 19.7%, BI’s average member sentiment; second place (30%) was for VL’s 22.0% estimate.

 (B) Participants were given 4 (meaningful) choices to estimate future EPS growth for the next 5 years: 30.6%, the company’s last 5 year average; 20.5%, VL’s estimate; 17.6%, average BI Member sentiment; 18.5%, Morningstar’s estimate.

** The Consensus (35% of the votes) chose 17.6%, BI’s average member sentiment; 32% voted for Mstar’s 18.5% estimate.

(C) Carol&Christi then used BI’s Preferred Procedure to estimate CTSH’s future EPS growth.  The PP involves making 4 estimates for the next 5 years: Sales growth (less) Pre-Tax Profit Margin (less) Taxes (divided by) Shares Outstanding (equals) EPS growth.

** Instead of using 19.7%, the Consensus choice for future Sales growth, Carol&Christi used 21.4% and offered no explanation; see Presentation Slide #40.

** For PTPM, they used the Online SSG’s default value (19.2%, last 5 year average); they substantially increased Taxes to 28.0% (up from the 16.6% default); and they increased Shares Outstanding  to 310.0 M (up from 304.0 M).

### Their estimated Tax increase is likely due to the 2011 end of India’s tax subsidies, but a major weakness of the PP is that there is little or no guidance regarding the amount of any such a change.

** The PP result was 18.9% EPS which they used instead of the Consensus pick (17.6%), again without explanation.  Carol used 18.9% while Christi rounded up to 19.0%.

** I no longer use the PP because it involves making too many estimates and too much guesswork; see: Pondering the Preferred Procedure,  March 28, 2009

Estimating Future Growth: Armin and Ann’s SSGs:

(A)  I found that CTSH’s historical growth over the last 5 years had been around 33% Sales & 31% EPS, both slowing to 28% during the last 3, and increasing to 40% Sales & 33% EPS over the last 2.

** When I did my SSG, the 7 analysts I ALWAYS check were closely estimating long-term EPS at an average of 21.12% with Mstar high at 21.9% and Zacks.com low at 18.5%.

** If you don’t check all 7, you can’t learn which is high, low or goofy.  For how I estimate EPS for all my SSGs, see: Estimating EPS, March 5, 2009

** I lowered my EPS estimate to 16.0% because I did not want to substantially exceed VL’s High Price estimate which I add as a SSG criteria.

(B) Ann wrote that CTSH’s growth had been stready and strong with Sales and EPS growing at around 45% during the last 10 years and slowing to about 27% over the last few.

** Ann found that analysts (unidentified) were estimating lon-term EPS at 20.0%, but lowered her EPS choice to 16.0%, slightly less than her Sales estimate, to reflect lower profit margins in the next 5 years due in part to wage inflation in India.

(C) SSG Final Results:

	CarolC	ChristiP	Armin	AnnC
Estimated EPS	18.90%	19.00%	16.00%	16.00%
Forecast High P/E	20.0	31.3	27.9	27.0
Forecast High Price	$126.40	$198.80	$156.00	$144.72
Forecast Low Price	$  41.23	$  39.60	$  33.30	$  38.25
Upside/Downside	3.34	3.80	3.00	1.79
Total Return	15.75%	22.20%	19.50%	13.63%
Overall Result	SSG BUY	SSG BUY	SSG BUY	SSG Don’t Buy

–  All of the judgments by the 4 SSGs are similar except for their Forecast High P/Es with Christi high at 31.3 and Carol low at 20.0. 

– Ann’s  was the only SSG that got a Don’t Buy.

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– Cognizant’s 5 year average PTPM is trending even and its ROE is trending down.  Any downtrend could be a red-flag warning sign of deteriorating fundamentals or, on the other hand, a sign of an unsustainably high level.

– The way I evaluate this is to compare the company to its Industry Averages.

– I use the Industry data at Stock Central.com which is the only website I know of that lists six metrics for all companies in each industry and which is the only way to identify whether the 5 year industry average is distorted by outliers.

(A) PTPM:

– Even though Cognizant’s PTPM is trending even, which is not a troublesome sign, I ALWAYS want to know how each company compares to its industry average.

– Morningstar places CTSH in the Information Technology Services Industry which consists of 65 companies total.

– CTSH is substantially better than its Industry Average (19.2% vs 9.8%) and ranks 7^th out of 65;

** Infosys (INFY), a direct competitor, ranks 2^nd with a PTPM of 32.5%.

(B) ROE:

– The Industry data only uses Ending Equity and CTSH is slightly worse than its Industry Average (20.9% vs 21.2%),  and ranks 10^th. 

– However, the Industry Average is distorted by three companies with unusually high ROEs (RSY @ 200%, UIS @ 77.9%, and IPXFF @ 75.1%);

** If these three are eliminated as outliers, CTSH looks substantially better (20.9% vs 13.4% Adjusted Industry Average).

(C) Conclusion:

– I am not troubled by Cognizant’s PTPM or ROE as they are substantially better than its PTPM Industry Average and its ROE Adjusted Industry Average;

– To learn how easy it is to adjust any Industry Average in order to remove distorting outliers, see: Investigating Industry Info, May 8, 2009

– The Online Stock Study did not discuss Cognizant’s PTPM and ROE which is a serious omission in my opinion.

Competitors:

– Competitors can be a confusing issue and easily get mixed up with peers, ordinary competitors, and direct or close competitors.

– BI reports only peer group members which are not necessarily competitors and which I never use.

– Some websites claim to show competitors, but may list a mishmash/hodgepodge: Bloomberg Business Week, for example, shows 5 so-called competitors for CTSH in 4 different industries.

– I most often rely on YahooFinance and Morningstar:

** YahooFinace lists CTSH’s direct competitors as: Infosys (INFY), Wipro (WIT), and Tata Consultancy (private);

** Morningstar, which I get on-line and free from my library, lists CTSH close competitors as: INFY, WIT, Accenture PLC (ACN), and ComputerSciences Corp (CSC).

CTSH’s Financial Condition:

(A) Value Line:

 – VL gave Cognizant an A++, its highest grade, for Financial Strength;

– VL also reported that CTSH had no debt and $2.27 B in Cash as of 7/1/11.

(B) Morningstar:

– Mstar observed that CTSH had a strong balance sheet with more that $2.2 B in cash and no debt.

– Mstar also reported that Cognizant had a strong cash flow averaging in the low teens of revenue in the last 5 years, and expects the company to remain debt-free for the foressable future.

(C) S&P Stock Report:

– S&P found that CTSH had a strong balance sheet, steady cash flows, and rapid revenue growth;

– S&P also reported that Cognizant had a compound annual growth rate (CAGR) in free cash flow of 40% over the past 5 years which, it thought, might decline to 30% in the next 5.

 (D) Bob Adams’ One-Click, Annual Report Spreadsheet:

– This easy-to-use spreadsheet gave CTSH’s 2010 Annual Report a 43 out of 100 with 5 Bullish and 8 Bearish results:

** The Bullish good things included: no debt; sales increased; ROE was adequate; free cash flow margin of 13% was good;

** The Bearish not-so-goods included: accounts receivable increased as did shares outstanding; cost of sales grew faster than sales and got a red-flag warning sign; sales grew slower than cash flow.

Armin

 

 

Learning About LKQ Corp (LKQX)

Addendum: On 5/22/12, LKQ Corp changed its ticker from LKQX to LKQ as a result of its move to the New York Stock Exchange. 

LKQ Corp (LKQX) sells replacement parts to repair cars and trucks, and operates in the U.S. and Canada.  With more than 325 facilities in North America, LKQX is the nation’s largest provider of aftermarket and recycled parts.

LKQX was the Online Stock Study at the BI website for May 2011.  It was led by Dan Rutter, a Director of the Puget Sound BI Chapter and a professional portfolio manager and research analyst. 

The recorded session and Dan’s handouts are available to BI members.  Sadly, the Consensus SSG is, once again, not available and I had to play (and replay) the recording to retrieve the SSG details.  [See footnote 1]

Company Background:

– LKQX operates in three segments: wholesale aftermarket and recycled products, self service retail products, and recycled heavy-duty truck products.

** However, these segments are not reported seperately according to the company’s 2010 Annual Report.

– LKQX is a large operation: in 2010, its wholesale aftermarket and recycled parts unit carried more than 75,000 SKUs and purchased 198,000 vechicles;  self-service retail bought 297,000 vechicles, and its heavy-duty truck unit purchased 4,000 vechicles.

** Total Sales grew 20.6% in FY 2010 and EPS grew 30.7%.

 ** Organic growth in revenues was 6.6%.

** In 2010, Sales of vehicle replacement parts and services represented 86% of Total Sales.

** Sales and EPS grew 33% & 30% over the last 5 years and 13% & 27% over the last 3.

– Since its formation in 1998, the company has made over 100 acquisitions and is the only provider of aftermarket & recycled auto parts with a national presence.

** LKQX considers its geographic locations to be a competitive advantage and strives for next-day delivery.

** Keystone Automotive Industries, a key competitor and a leading distributor of aftermarket parts, was its most significant acquisition in October 2007.

– In 2010, LKQX paid $170.4M for 20 acuisitions: wholesale products (16); recycled heavy-duty truck products (1); self-service retail (2); and tire recycling (1).

– In the first two months of 2011, LKQX made 4 acquisitions: an engine remanufacturer; auto heating and coooling parts; wholesale recycled parts; recycled heavy-duty trucks. 

SSG Discussion:  

After this table, I discuss several key SSG judgments, LKQX’s competitors, its Pre-Tax Profit Margins and Return on Equity, and its Financial Condition. 

LKQ Corp (LKQX)	CONSENSUS & DAN SSG	ARMIN	TAKE STOCK	SEAN P from          BI’s First Cut
Date	4-13-11	4-15-11	Same	11-5-10
Data	Mstar via B I	Same	Mstar via SC	Mstar via SC
Price	$24.39	$23.61	$23.67	$22.59
52 week High &     Low Price	$26.30 & $17.29	Same &           Same	Not Used	$22.66 & $17.06
Last Quarter of     Reported Data	Q4 ending 12/32/10	Same	Same	Q3 ending 9/30/10
Software Used	TK 6	Same	TS Online	TK 6
Project Growth      From End of	Last Q	Last Q	Last FY	unknown
Sales Growth	16.00%	15.00%	12.50%	17.00%
EPS Growth	17.00%	15.00%	20.00% initial  10.40% final	17.00%
High PE	24.9                 (07-08 out)	21.5                  (06-08 out)	22.2               (07 Hi PE out)	27.4                 (07-08 out)
High EPS	$2.53	$2.31	$1.09	$1.96
High Price	$63.00           (26% > VL)	$49.70              (0.60% < VL) [See fn 2]	$41.91	$49.80
Value Line Estimated High Price =$35-50 as of 3-25-11
Low PE	14.4               (06 out)	13.6                  (06-08 out)	13.0               (06 Lo PE out)	14.0                  (03 & 06 out)
Low EPS	$1.25             (ttm)	$1.16                (ttm)	$1.15	$1.00          (ttm)
Low Price	$18.00            (low PE x        low EPS)	$15.80      (Same)	$14.95             (Same)	$14.00        (Same)
Upside/Down	6.1	3.3	2.2 (imputed)	3.2
Total Return	20.9%	16.1%	12.3%	17.1%
SSG Buy Under	Not Used	$24.28	$20.96	Not Used
RV/PRV	107.1/91.4  (07-08 out)	115.9/100.6 (06-08 out)	Not Used	97.1/83.3  (out: 07 High & 06 Low PEs)
RV/PRV                (no outliers)	90.1/76.9	87.6/76.0	Not Used
PTPM – 5 yr ave	09.80%            trend up	Same         Same	Same               trend N/A	9.50%, end 09 trend up
ROE – 5 yr ave    Ending Yr Equity	Not Used	10.30%            trend up	Not Used	N/A
ROE – 5 yr ave    Begin Yr Equity	12.70%          trend up	Same         Same	12.70%   trend N/A	12.7%, end 09 trend even
Debt to Equity –   5 yr ave	52.8%            trend down	52.9%               trend down	Not Used	45.3%, end 09 trend down

Estimating Sales Growth for the Next 5 years:

The Consensus/Dan SSG:

– Dan gave the participants 5 options to estimate LKQX’s future Sales Growth: 25.0%, Value Line’s 5 year historical growth rate; 22.5%, VL’s 3-5 year Revenue per Share estimate; 16.0%, the low-end of management’s suggested range; 15.0%, BI’s “safety” guidance; and 10.0%, an even more conservative estimate.

– The Consensus voted for 15.0%, BI’s “saftey guidance” [44% of the votes], but Dan inexplicably decided to use 16.0%, the low end of management’s guidance [40% of the votes].

– BI’s “safety” guidance is 20.0%, not 15.0%:

** “Don’t estimate sales and EPS growth above 20%.  That level of growth is difficult to sustain over a long period of time, particularly as a company gets larger.” [BI Stock Selection Handbook by Bonnie Biafore, 2003 edition, page 89]

– And, more appropriate than VL’s 25.0% historical growth is the reported history by Morningstar, the data source for our SSGs, which shows that LKQX’s 5 year historical sales growth was 33.4%, declining for the next three years to 12.9%, and rising last year to 20.6%.

Estimating EPS Growth for the Next 5 years:

The Consensus/Dan SSG:

– Dan gave the group 5 options: same as their Sales Growth estimate; 31.0%, LKQX’s 5 year historic growth; 27.0%, VL’s 3-5 year estimate; 21.0%, the company’s latest quarterly growth; 17.0%, slightly faster than its Sales Growth.

– LKQX’s latest quarterly EPS growth was 16.0%, not 21.0%.

– The Consensus chose the same as Sales Growth (15.0 or 16.0%), but Dan decided to use 17.0%, again inexplicably.

Armin’s SSG:

– When I did my SSG, the seven different long-term estimates I ALWAYS check averaged 18.40% with VL unusually high at 27.00% and FactSet CallStreet via CNNMoney low at 15.00%.

** The other five were all around 17.00%.

– I chose 15.00%, the lowest of the seven.  To learn what and which was low, it’s essential to check all seven estimates.

** If you’re interested in learning more about estimating EPS and how to get the seven different estimates, see Estimating EPS [click here].

Forecasting the High PE in the Next 5 years:

The Consensus/Dan SSG:

– Dan gave the group 5 choices: 30.6, five year average, unadjusted; 24.9, three year average after 2007 and 2008 are eliminated as outliers; 34.0, PEG of 2.0 with E at 17.0; 25.5, PEG of 1.5 with E at 17.0; None of the above.

– The Consensus chose 24.9, three year average after 2007 and 2008 are eliminated as outliers [61% of the votes] which Dan also chose.

Armin’s SSG:

– High PEs have been steadily trending down for the last 4 years from 43.1 in 2007 to 20.5 in 2010. 

– When I see such a downtrend, I typically use the latest year or an average of the last two.  Anything lower or higher seems like an uninformed and unsupported guess.

– I decided to use 21.5, the average of 2009 and 2010.

Final Results:

– The Consensus/Dan SSG began by estimating 17.00% future EPS for the next 5 years (Dan’s choice) and a 24.9 Projected High PE which resulted in a $63.00 Forecast High Price, some 26% greater than VL’s estimated $35-50 High Price.  It resulted in a 6.1 Upside/Downside Ratio and a 20.9% Total Return.

** 26% more than VL’s estimated High Price is too high for me.

– I estimated 15.00% future EPS and a 21.5 Projected High PE which resulted in a $49.70 Forecast High Price, just slightly less than VL’s estimate.  My SSG got a 3.3 U/D and a 16.1% TR.

– A minimum 3.0 U/D and a 15.0% TR are needed to satisfy the SSG Buy Criteria.  However, exceeding those criteria does not make for a better Buy.

Competitors:

– Morningstar lists Meritor (MTOR) [formerly Arvin Meritor] as a close competitor and YahooFinance lists Federal-Mogul (FDML) as a direct competitor.

– Morningstar, however, places MTOR and FDML in the Auto Parts Industry while it puts LKQX in the Industrial Distribution Industry.

– Dan thought LKQX’s closest competitor was U.S. Auto Parts Network (PRTS) which Morningstar places in the Specialty Retail Industry.

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– Morningstar’s Industrial Distribution Industry has 32 companies including LKQX.  The industry average is 22.9% for PTPM and 53.4% for ROE, both of which are distorted by one or two atypical companes.

PTPM:

** One company, Shengkai Innovations, has a 5 yr PTPM average of 4056% that significantly distorts the industry average;

** Without Shengkai, LKQX’s 5 year average PTPM is slightly better than the adjusted industry average (9.80% vs 8.53%) and ranks 9^th out of 31.

** PRTS, in the Specialty Retail Industry, has a much worse 5 yr average PTPM than its industry (–3.1% vs 6.2%) and than LKQX (-3.1% vs 9.80%).

ROE:

** Two companies, Shengkai and Royce Resources have a 5 yr ROE average of 405.6% and 148.3% that distort the industry average;

** Without these two companies, LKQX’s average ROE is slightly worse than the adjusted industry average (10.30% vs 13.63%).

**PRTS also has a much worse 5 yr ROE average than its industry (-11.0% vs 18.5%) and than LKQX (-11.0% vs 10.30%)

– To learn more about investigating industry info, and how to identify and remove outliers that distort industry averages, see Investigating Industry Info [click here] .

Financial Condition:

– Value Line gave LKQX a B+ for Financial Strength, relatively low as that ranks 5^th on VL’s seven point scale.

– VL also reported that Long-Term Debt was $548.1M and that cash decreased 12%, to $95.7M from $108.9 one year earlier.

– The Annual Report spreadsheet by Bob Adams gave LKQX’s 2010 A.R. a 40 out of 100 with 7 Bullish Results and 12 Bearish:

** The Bullish good things included: sales increased, debt decreased, and interest coverage got a green flag as it was very good;

** The Bearish not-so-goods included: Free Cash Flow was low and got a red flag warning sign; LT Debt to Equity was high, may be excessive, and also got a red flag; Inventories and the Cost of Sales both increased and both were growing faster than Sales.

** Morningstar expressed no opinion about LKQX’s Financial Health, but did provide some facts: its Interest Coverage Ratio improved to 10.5x from a low of 5.3 in 2008 and it had $95.7 million in cash as of Dec. 31.

– Morningstar’s SSG Data reveals that LKQX’s Annual Debt to Equity was a whopping 88.5% in 2007, after it acquired Keystone Automotive, decreasing to 39.3% in 2010 for a 5 year average D/E of 52.8%.  The trend is down, but the metric is still high:

** LKQX’s Average Debt to Equity is greater than its adjusted Industry Average (38.9% vs 33.1%) after I eliminate four companies with Ave D/E over 100%.

 ** LKQX’s Debt to Total Capital is currently 30% which is high but not excessive as less than 35% is desired (varies by industry) according to “Classes to Go!: Company Debt” by Ann Cuneaz available to members at the BI website.

Conclusion:

 – LKQX easily satisfies the SSG Buy criteria, has a smart business plan, and has no challenging competitor, but I will not buy its stock:

** The 2010 Annual Report was way too difficult to read as it was overly wordy and unnecessarily vague;

** LKQX also took on way too much debt in 2007 (88.5% D/E) and I could never be sure if it would be so unwise again.

– Please let me know wha you think about LKQX and about my assessment.

Armin Fields

 [1] Sevral weeks after the Online Stock Study, BI uploaded a SSG to its First Cut page that purported to be the Consensus SSG, but was considerably different (e.g., Total Return = 20.9% vs 15.3% by the Consensus).

I decided to omit it because the differences were confusing and inexplicable.

[2] In an e-mail to me, Julie W pointed out that I had made a typo in my Forecast High Price which I have now corrected.

 

 

 

Gauging GE (General Electric)

General Electric (GE) is a large and diversified manufacturing, finance, and media company.  From light bulbs to locomotives, household appliances to nuclear reactors, aircraft engines and power generation to financial services, medical imaging, as well as movie and television programming, GE operates in more than 100 countries and employs nearly 300,000 people worldwide.

GE was the monthly Online Stock Study for March 2011 that was led by Adam Ritt, the editor of Better Investing magazine and Communications Director at BI.  The online participants in the monthly stock study use consensus decisions to make their SSG judgments.  Adam’s handouts, presentations slides, and the Consensus SSG are all available to BI members.

Company Background:

 – General Electric is the nation’s largest corporation and 2010 was a very good year for GE.  It reported profits of $14.2B with $5.1B from operations in the United States.

** Astonishingly, GE paid no U.S. taxes and actually claimed a $3.2B tax benefit last year according to the New York Times.

** In the last 5 years, the Times reported, GE has accumulated $26B in U.S. profits and received a net tax benefit of $4.1B.

 – GE’s FY 2010 EPS was up 11.7% and its 4Q EPS increased 25.0% based on Morningstar data via BI.

 – But, GE’s historical growth has been dreadful:

 ** Its EPS growth rate has worsened AND been negative for 8 out of the last 9 years, from -1.6% in 2002 to -19.6% in 2009;

 ### 2010 was the first year of positive growth in a decade!

 ** Its Sales growth rate also has worsened AND been negative for the past 5 years, from -0.1% in 2006 to -4.2% in 2010.

– General Electric is organized into five segments: Energy Infrastructure, Technology Infrastructure, NBCUniversal, Capital Finance, and Home & Business Solutions.  Financial services accounted for 25% of GE’s profit in 2010.  The five segments are:

** Energy Infrastructure [25.4% of 2010 sales, down 8%] makes wind, gas & steam turbines and generators, nuclear reactors, oil and gas extraction equipment; water, waste water and desalination equipment; oil and gas drilling equipment including surface and subsurface gear; electrical distribution and control gear, lighting and power panels, circuit breakers, and commercial lighting systems.

** Technology Infrastructure [25.6% of sales, down 2%] is made up of three sub-segments following a 1/1/11 reorganization: Aviation (jet and turboprop engines); Healthcare (X-Ray machines, CT scanners, MR technologies); and Transportation (diesel-electric locomotives, large mining truck engines, transit cars).

** NBC Universal [11.4% of sales, up 9.5%], consists of the National Broadcasting Company (NBC) broadcast television and radio networks; Universal Pictures; Universal Studies Theme Parks; Cable TV Networks including: USA, Bravo, CNBC, MSNBC and others.  GE plans to sell its 80% share of NBCU in early 2011.

** GE Capital [31.8% of sales, down 5.4%] makes commercial, personal, and home equity loans; finances operating leases and fleet mangement arrangements; issues private-label credit cards, bank cards; provides fixed and floating rate mortgages.

** Home & Business Solutions [5.8% of 2010 sales, up 2.4%] makes, sells and services consumer products such as stoves, refrigerators, dishwashers,  washers, dryers, microwave ovens, room air conditioners, and residential water systems; and its Intelligent Platforms sub-segment makes plant automation equipment.

History:

– GE traces its roots back to Thomas Edison when, in 1892, he merged his Edison General Electric company with Thomson-Houston Electric to form General Electric. 

– In 1896, GE was one of the original 12 companies that made up the newly formed Dow Jones Industrial Average and still remains on the Dow after 114 years.

SSG Discussion:

– The following table compares the Consensus SSG with mine, Take Stock, and with an older SSG by Adam Ritt.

– After the table, I discuss GE’s downtrending Pre-Tax Profit Margin AND Return on Equity as well as its Financial Condition.

GENERAL                 ELECTRIC (GE)	Consensus SSG led by Adam Ritt	Armin	Take Stock	Adam Ritt
Date	3-2-11	3-4-11	3-6-11	6-25-08
Data	Mstar via BI	Same	Mstar via SC	S&P via BI
Share Price	$20.37	Same	Same	$28.48
52 week High &     Low Price	$21.65 & $13.75	Same	Not Used	$42.15 &         $27.20
Last Q of          Reported Data	Q4 ending     12-31-10	Same	Same	Q1 ending          3-31-08
Project Growth from End of	Last Q (maybe)	Last Q	Last FY	Unknown
Software Used	Online SSG	TK 6	TS Online	TK 5
Sales Estimate	05.00%	10.00%	-0.03%	7.00%
EPS Estimate	07.50%	10.00%	-6.10%	7.00%
Est High PE	17.10	17.0                (09-10 ave)	18.7	14.0                  (PEG of 2.0)
Est High EPS	$1.65	$1.85	$0.84	$3.25
Est High Price	$28.22	$31.50	$15.68      (48% < VL)	$45.50
Value Line Estimated High Price = $30-45 as of 1-21-11
Est Low PE	11.22	8.8                  (2009-10 ave)	10.6		10.0                 (PEG of 1.5)
Est Low EPS	$1.15	Same	Same		$2.33
Est Low Price	$12.90       (low PE x low EPS)	$16.30         (80% x current price	$20.37        yield supp    low price		$23.30
RV/PRV                    (no outliers)	Not Used	118.6/107.4	Not Used		66.8/62.4
RV/PRV                (outliers out)	Not Used	137.2/129.8 (2006-08 out)	Not Used		Not Used
Upside/Downside Ratio	1.06	2.7	Impossible to Compute		3.3
Total Return	9.98%	12.80%	-2.80%		13.40%
SSG Buy Under	Not Used	$18.04	$8.67		Not Used
Quality	N/A	N /A	TS = 1.1		N/A
PTPM – 5 yr ave	11.22% Trend N/A	11.2%         Trend down	Same            Trend N/A		15.7%      Trend up
ROE – 5 yr ave ending equity	14.78% Trend N/A	14.8%         Trend down	Not Used		18.1%       Trend up
ROE – 5 yr ave        begin equity	Not Used	15.0%        Trend down	Same             Trend N/A		Not Used
Debt to Equity	Not Used	269.9%       Trend down	Not Used		Not Used

Estimating EPS Growth for the Next 5 years:

– Adam gave participants five options to estimate GE’s EPS growth for the next 5 years: 5.00%, same as their Estimated Sales Growth judgment; 5.50%, historical growth 2000-2010; 7.50%, VL’s 3-5 year estimate; 14.00% Analyst’s Consensus Estimate (unspecified, but may be S&P’s next three year estimate); or 12.00%, ACE less 2.00%;

** GE’s dreadful historical record was not mentioned: negative EPS growth rate for 8 of the last 9 years, from –1.6% in 2001 to -19.6% in 2009.  In 2010, GE’s EPS growth was a surprising 11.7%.

** The Consensus pick was 7.50%, VL’s estimate [47% of the votes, presentation slide 20].

– When I did my SSG, the seven different long-term estimates I ALWAYS check averaged 11.92% with Value Line low at 7.50% and Reuters.com high at 14.58%.

** Zacks.com was 10.33%, Morningstar.com was 11.60%, CNNMoney.com was 12.70%; YahooFinance.com was 12.80%, and Zacks via BI was 13.90%.

** I decided to use 10.00%, low but not the very lowest estimate.

 ** To learn more about Estimating EPS, see: Estimating EPS [click here]  

– Take Stock estimated -6.10% growth (that’s a negative 6.10%) for the next 5 years based solely on GE’s atrocious historic performance and Take Stock’s ultra conservative design.

– In 2008, Adam estimated 7.00% EPS growth, the same as his Sales estimate at that time.

Estimating the High PE for the Next 5 Years:

– Adam gave the group four choices: 18.90, GE’s 5 year historical average; 17.10, its average during 2009 & 2010; 11.25 or a PEG of 1.5, (1.5 PE x 7.5 E); or 15.0 or a PEG of 2.0 (2.0 PE x 7.5 E).

** The Consensus pick was 17.1, GE’s average High PE during the last two years [30% of the votes, slide 23].

– I also picked GE’s average High PE during the last two years because the 5 year historical trend was noticeably down and I eliminated the first three years as outliers.

– I don’t use the PEG ratio because one number, I believe, is not appropriate for all stocks, whether that number is 1.5 or 2.0 or 3.4567 <grin>.

Final Results:

– The Consensus SSG began with a 7.50% estimated EPS for the next 5 years and a Forecast High Price of $28.22.  It got a 1.06 Upside/Downside and a 9.98% Total Return which did not satisfy the SSG Buy criteria of 3.00 U/D and 15.00% TR;

– My SSG began with a 10.00% estimated EPS and a Forecast High Price of $31.50.  I got a 2.7 U/D and a 12.80% TR which also did not satisfy the SSG Buy Criteria;

 – Take Stock began with a -6.10% estimated EPS which seems unreasonably low and nutsy compared to all the other EPS estimates.  It got a U/D that was impossible to calculate and a -2.80 % TR, all because of its weird estimated EPS.

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– PTPM and ROE (with beginning and with ending equity) are all trending down which are typically red-flag warning signs, but are hard to interpret in our current recession/financial slump.

** The BI Stock Selection Handbook says that PTPM and ROE “should both be above the industry average and trend upward….Upward trends indicate that management not only keeps things running, but also makes improvements as a matter of course.” [page 93, 2003 edition]

– Morningstar places GE in the Diversified Industrials Industry which has 168 companies.

** GE is slightly better than its industry average in terms of PTPM (11.2% vs 10.5%) and ranks 43^rd of 168 companies.

** GE is slightly worse in terms of ROE (14.8% vs 15.5% adjusted to remove four companies with ROEs over 100%; the unadjusted industry average was 25.1%) and GE ranks 42^nd in the unadjusted industry.

** Compared to United Technologies, a direct competitor in the same industry according to Morningstar, GE’s PTPM is slightly worse (11.2% vs 11.6%) but better in terms of ROE (14.8% vs 11.6%).

** And, compared to Siemens (SI), a direct competitor that is in the Conglomerates Industry, GE is much better in terms of PTPM (11.2% vs 5.7%) as well as ROE (14.8% vs 7.7%).

Financial Condition:

– Value Line gave GE a Financial Strength rating of B++ which VL did not explain and which seems moderately low, especially for such an essential company, as A++ is its highest rating and C its lowest.

** UTX, a top competitor identified by Morningstar, got VL’s top rating of A++.

** VL also reported that GE had cash of $1.24B, total debt of $422.4B, long-term debt of $307.5B, and an interest coverage ratio of 1.7x, all as of 9/30/10;

** Compared to GE’s 1.7x, an interest coverage ratio of 1.5 is generally considered the bare minimum for any company in any industry according to Investopedia.

– Morningstar gave a short and skimpy assessment of GE’s Financial Health: that its industrial unit generated a healthy cash flow (14% of 2010 revenue) and held $19 B in cash; and that Mstar was confident GE would be able to repay or refinance its upcoming obligations.

** Note the large discrepancy between Mstar’s report of $19B cash and VL’s report of $1.24B cash.

– Morningstar SSG data from BI showed that GE had $411.3B in Total Debt and a Debt to Capital ratio of 77.5%; and a Debt to Equity ratio for 2010 of 245.6% trending down from 289.7% in 2009 and 311.5% in 2008.

– The Analyzing the Annual Report spreadsheet by Bob Adams gave GE 73 out of 100 with 11 Bearish results (good things) and 5 Bearish (not-so-goods).

** The Bullish goods included: accounts receivable, inventories, debt, and shares outstanding are all decreasing; return on free cash flow is good.

 ** The Bearish not-so-goods included: sales are decreasing; interest coverage at 1.9 is low and got a red flag warning sign; Debt to Equity at 303.3% is high and also received a red flag; ROE is inadequate and   got a yellow caution flag.

 ### You can get this free and easy-to-use spreadsheet (all it takes is to enter the ticker), and an explanation of its many features, by going to my Favorite Links page [click here].

### Bob’s spreadsheet is primarily for anaylzing manufacturing and retail companies.  GE, in addition to its manufaturing, also provides a substantial amount of financial services which complicates any analysis of its financial condition.

Final Thoughts:

– GE seems like a poor long-term investment:

** It did not satisfy the SSG Buy Criteria AND its 5 year average Pre-Tax Profit Margin and Return on Equity were both trending down which are red-flag warning signs of poor quality.

– However, GE was the #1 stock held by BI Investment clubs in terms of the number of clubs (2,748) and shares held (1,831,965) according to a recent survey reported in the April 2011 issue of BI magazine:

 ** Why, what do you think is going on: do these clubs not use the SSG or never do a follow-up assessment?  Are there any other reasons you can think of??

 

Armin

 

Mulling Over Mednax (MD)

Mednax (MD) is a national medical practice that provides specialty and sub-specialty care in two areas: neonatal-pediatric and anesthesia.

MD operates in 33 states and Puerto Rico, and its network of doctors includes 1625 physicians, 925 of which are neonatal specialists.

Company Background:

 – Mednax is organized into two units: Pediatrix Medical Group and American Anesthesiology, according to a November 2010 Investor Presentation available at the company’s website.

** The Pediatrix Group consists of over 1325 physicians and 575 nurse practitioners who staff 275 NICUs (Neonatal Intensive Care Units).  Medical specialties include neonatal, maternal fetal, pediatric cardiology, and pediatric critical care.

** American Anesthesiology, begun in 2007, has over 300 physicians and 350 nurse anesthetists serving 22 hospitals and 38 surgery and pain management centers.

– The Pediatrix Group has made more than 150 acquisitions in the last 15 years with eight in 2010.

– American Anesthesiology has made six acquisitions since 2007 with two in 2010.

– Mednax’s latest 10K report stated that it had acquired 11 group practices in 2009 for $145.5M, seven of which were neonatal groups.  In 2008, MD acquired 13 groups for $260.9M.

 ** In 2007-2009, 56% of patient revenues were generated in 5 states with Texas accounting for 26% on average during those three years.  

– Value Line reported that MD’s cash flow in the 3^rd Q of 2010 remained strong and allowed it to acquire one pediatric group practice in Texas and two anesthesia practices in North Carolina.

 ** VL thought anesthesia would be the company’s primary growth engine as there are 47,000 practicing anesthesiologists in the U.S. while only 300 work for MD.

** VL expects that this year’s spending on acquisitions (around $300M) will be maintained annually for the foreseeable future.

– Mednax’s historic Sales & EPS growth have been robust, based on Morningstar data via BI, with no disturbing dips or downturns: 18.1 & 25.5% growth last ten years; 16.2 & 17.7% last five; and 18.5 & 16.8% last three years.

SSG Discussion:

– I compared the recent  SSG by CarolT, available from BI’s First Cut page, with mine, Take Stock, and the Investment Advisory Service (which was attached to Carol’s SSG).  IAS is a well-respected pay service that uses the SSG.

– After the following comparison table, I discuss several key SSG issues and dig a little deeper into MD’s down trending Pre-Tax Profit Margin and its Financial Condition.

MEDNAX             (MD)	CarolT	Armin	Take Stock	Investment Advisory       Service
Date	2/4/11	2/9/11	2/8/11	1/14/11
Data	Mstar via BI	Same	Mstar via SC	Mstar via BI
Share Price	$61.23	$62.58	$65.00	$68.11
52 week High & Low Price	$70.17 & $44.83	Same &      Same	Not Used	$70.14 &   Same
Last Quarter of Reported Data	Q3 ending 9/30/10	Same	Same	Same
Project Future Growth From	Last FY	Last Q	Last FY	Last Q
Software Used	TK 6	Same	SC Online	TK 6
Est Sales Growth	10.00%	Same	15.50%	14.00%
Est EPS Growth	10.00%	Same	13.30%	14.00%
Forecast High PE	20.0	18.1                     (from Alt-M)	18.1	22.0
Forecast Hi EPS	$6.09	$6.78	$7.06	$8.11
Forecast Hi Price	$121.80           (16% > VL)	$122.70	$127.82	$178.40           (70% > VL)
Value Line Estimated High Price = $70–105 as of 12/17/10
Forecast Low PE	10.0	6.5                        (from Alt-M)	7.6	12.0
Forecast Lo EPS	$4.21                 (ttm)	Same	$4.15	$3.78          (last FY)
Forecast Lo Price	$42.10	$32.00	$31.54	$45.40
Upside/Down	3.2	2.0	2.0 (imputed)	4.6
Total Return	14.7%	14.4%	15.2%	20.9%
Buy Under	Not Used	$54.68	$55.74	Not Used
Quality	Not Used	Not Used	TS = 6.3	Not Used
RV/PRV	97.3/88.7(2005 &           2007 out)	100.0/90.7 (Same)	Not Used	Not Used
RV/PRV                  (no outs)	Not Used	86.6/78.6	Not Used	95.3/95.4          (TK 6 error)
PTPM – 5 yr ave	23.1%              Trend down	Same                  Same	Same                   Trend NA	Same                Trend down
ROE – 5 yr ave Ending Equity	14.3%               Trend up	Same                 Same	Not Used	Not Used
ROE – 5 yr ave Beginning Equity	Not Used	16.4%                   Trend up	Same                Trend NA	Same       Trend up
Debt to Equity	3.8%               Trend up	Same                 Same	Not Used	3.8%                Trend up

Estimating MD’s Future EPS Growth for the Next 5 Years:

Carol’s SSG:

– Carol wrote that she projected 10.00% EPS growth by plotting 2011 and 2012 estimates from YahooFinance and Value Line’s 3-5 year estimate.

** She ignored the YahooFinance’s 5 year EPS estimate of 14.50% which seems bizarre since that is much more relevant to our SSGs than short-term estimates for this year and next year. 

** Moreover, by not checking other long-term EPS estimates, she did not realize that VL’s estimate was the lowest nor did she learn what was high.

Armin’s SSG:

– When I did my SSG, the 7 long-term EPS estimates I ALWAYS check averaged 13.40% and ranged from 10.50 % low (Value Line) to 15.00% high (Zacks via BI);

** Morningstar.com via FactSet was 13.20%, CNNMoney via FactSet CallStreet was 13.50%, Zacks.com and Reuters.com were both 13.79%, and YahooFinance via Thomson Reuters was 14.50%.

** I chose 10.00%, the very lowest estimate by one of the 7 analysts at Reuters.com who ranged from 17.50% high to 10.00% low.

** For how I estimate EPS for all my SSGs, see: Estimating EPS  [click here].

Projection Point for Future Growth:

– Every SSG except Take Stock has the option of projecting future growth from the end of: the last Quarter, the last Fiscal Year, or from the Historical Trend Line.

– Carol chose to project growth from the end of the last FY.  Using the same identical judgments she used and changing only the projection point, her SSG would have improved significantly:

• High EPS would increase from $6.09 to $6.78
• High Price would go from $121.80 to $135.60
• Total Return would increase from 14.7% to 16.7%

– Take Stock always projects growth from the end of the last FY as part of its ultra-conservative design.

Estimating the Forecast High PE for the Next 5 Years:

– Carol eliminated 2005 and 2007 as outliers and used the resulting average (20.0) as her Forecast High PE.

– I used Toolkit’s Alt-M option which eliminates the five highest PEs in the last 10 years and averages the rest (18.1). 

** Alt-M is usually the most conservative option and I tend to use it when trends are not obvious and/or I know next-to-nothing about the company.

Final Results:

– Carol started with a 10% estimate for future EPS growth, and got a Forecast High Price of $121.80, a 3.2 Upside/Downside Ratio, and a 14.7% Total Return.

– I also used a 10.00% EPS estimate (for different reasons), and got nearly the same Forecast High Price ($122.70) and TR (14.45%), but only a 2.0 U/D.

** The main reason for our difference was that Carol decided to use 20.0 & 10.0 for her Forecast High & Low PEs while I used 18.1 & 6.5 from Alt-M.

– IAS started with a 14% EPS estimate (not explained), and got a $178.40 Forecast High Price, a 4.6 U/D, and a 20.9% TR.

** IAS’s $178.40 High Price was a whopping 70% greater than the high end of VL’s $70-105 estimated High Price which seems unreasonable and unbelievable to me. See: Determining What’s Reasonable and What’s Not: An Update [click here].

Pre-Tax Profit Margin (PTPM) & Return on Equity (ROE):

– Carol considered MD to be a marginal BUY and was concerned about its downtrend in Pre-Tax Profit Margin which can be a red-flag warning sign.  She would postpone buying the stock until she learned more about its PTPM.

** Carol did, however, identify TMH as a direct competitor that had a much lower Profit Margin, but that was not sufficient to satisfy her.

– Morningstar via BI placed MD in the Medical Care Industry which, according to the Stock Central website, has a total of 55 companies:

** MD’s PTPM was much, much better than its industry average and ranked 2^nd (23.1% vs 9.7%) while TMH ranked 24^th with a PTPM of 5.6%.

** I am not bothered by MD’s downtrend and conclude that it represents an unsustainable high level rather than a red-flag warning flag.

– Even though MD’s Return on Equity is trending up, which is always a good sign, I still want to know if it was better or worse than its industry average:

** MD’s ROE was substantially worse than its industry average and ranked 14^th out of 55 companies (14.3% vs 23.5%); by comparison, TMH was terrible and ranked 49^th (-55.4%).

Financial Condition:

 – Value Line rated MD a B++ for Financial Strength and reported that it had $75.6M in cash (up from $31.9M in 2009) and only $0.2M in debt.

– There was no Morningstar analyst report.

– The one-click Annual Report spreadsheet by Bob Adams gave the company 56 out of 100 with 4 Bullish results (good things) and 11 Bearish (not-so-goods):

** The 11 Bearish results included: ROE is inadequate and Long-Term Debt is increasing, and both got a yellow, caution flag; cost of sales is increasing faster than sales.

** The 4 Bullish results included: Debt to Equity and Interest Coverage are both very good, and got a green flag.

### You can get a copy of this free, easy-to-use spreadsheet and a description of its many nifty features by going to my Favorite Links page [click here] .

 – My SSG data showed that MD’s Debt to Equity was 4.3% in 2009, down from 14.3% in 2008, and that Cash Flow/Share has been steadily increasing for the last 5 years, from $3.23 in 2005 to $4.87 in 2009.

 

Armin

 

Musing About Medco (MHS)

Medco Health Solutions (MHS) manages the pharmacy benefits for over 65 million people in employee groups, government agencies, and unions as well as for participants in Medicare PartD, and is the nation’s largest Pharmacy Benefit Manager.  Through its mail-order pharmacy and network of retail pharmacies, MHS filled some 900 million prescriptions in 2009.

MHS was the monthly Online Stock Study for January 2011 at the Better Investing website.  It was led by Avi Horwitz, a director of the BI Volunteer Advisory Board and a Director of the BI New York Chapter.  Avi’s handouts, Presentation Slides, Follow-up Q and As, the Consensus SSG, and the recording of the online session are all available to BI members.

Company Background:

– Medco Health Solutions (MHS) went public seven years ago as a spin-off from Merck and was recently featured as the Stock To Study in the November 2010 issue of Better Investing magazine.  According to BI’s thorough article:

– Medco is organized into two reporting sections: Pharmacy Benefit Management (PBM), 84.1% of 2009 revenues, up 16.2% from 2008 and Specialty Pharmacy (SP), 15.9% of 2009 revenues, up 19.5%.

** PBM contracts with retail pharmacies to fill prescriptions at discounted prices to patients covered by drug plans that Medco administers.  In 2009, MHS contracted with some 60,000 pharmacies.

** PBM also operates Medco Pharmacy, its mail-order division and the largest in the industry, which filled 103 M prescriptions in 2009.

** SP operated three mail-order and 78 specialty pharmacies in 2008 which provided higher margin drugs for patients with chronic or complex diseases.

** SP also provides services such as in-home nursing, special packaging, and benefits administration.

– Medco filled a total of 694 M prescriptions in 2009, up 18.5% from 2008.  Mail-order products accounted for 37.4% and retail products 61.2% of MHS’s revenue.

– According to the Morningstar analyst report, MHS earns most of its margins on generic drugs and an unprecedented number of brand-name drugs are about to lose their patent protection.

** In 2012, generic Lipitor may add 8.00% to Medco’s EPS.  Other blockbuster drugs losing patent protection around the same time as Lipitor are Plavix, Seroquel, Singulair, and Cymbalta.

–  And, in the past 5 years, MHS has spent a whopping $10 B on share repurchases, some 40% of its current market cap.

** Shares outstanding have gone down 20% in the last five years, from 576.20 to 481.1 M in 2009.

** As shares go down, EPS goes up (but this is an artificial increase as it is not derived from operations).

Recent Acquisitions and Joint Ventures:

– Acquisitions have been a major part of Medco’s growth:

• In October 2007, Medco acquired PolyMedica, a diabetes care provider and its Liberty Medical Supply brand, for $1.3 B in cash;
• In November 2007, Accredo Health Group (Medco’s specialty pharmacy) acquired Critical Care, a large provider of specialty infusion services, for $220 M;
• In April 2008, Medco acquired a majority interest in Europa Apotheek, a mail order pharmacy serving Netherlands and Germany, for $126.8 M in cash and a $24.1 M purchase obligation;
• In 2009, Medco formed a joint venture with United Drug plc to provide home based pharmacy care to patients covered by the U.K.’s National Health Service;
• In January 2010, Medco bought DNA Direct, a small, privately held fiem that provides utilization review and counseling by telephone for genetic testing (terms were not released); and
• In September 2010, Medco acquired United BioSource, a company that evaluates newly approved drugs and medical devices, for $730 M.

– These acquisitions have meant a high debt burden for Medco: 46.5% Debt to Total Capital when I did my SSG with long-term debt increasing from $944 M to $4,000 M in the last five years, an increase of 320%.

– Debt to Equity has also increased, from 15.0% in 2005 to 61.8% in 2009.

SSG Discussion:

– The following table compares the Consensus & Avi SSG with mine, Take Stock, and Avi’s 45-day earlier SSG.  After the table, I discuss several key SSG issues and dig a little deeper into MHS’s Pretax-Profit Margin and Return on Equity, and its Financial Condition.

Medco Health           Solutions (MHS)	Consensus & AviH	Armin	Take Stock	AviH from       BI’s First Cut
Date	12-30-10	12-22 Data      12-30 Price	12-30-10	11-12-10
Data	Mstar via BI See fn [1]	Same	Mstar via SC See fn [1]	S&P  via BI       See fn [1]
Price	$61.80	$61.89	$61.67	$59.00
52 week High &          Low Price	$66.94 & $43.45	$66.94 & $43.45	Not Used	$66.94 & $43.45
Last Quarter of       Reported Data	Q3 ending          9-30-10	Q3 ending       9-30-10	Same	Same
Software Used	Online SSG       See fn [2]	TK 6	TS Online	Online SSG       See fn [2]
Project Growth       From End of	Last FY              See fn [2]	Last Q	Last FY	Last FY             See fn [2]
Sales Growth	7.50%	13.00%	09.20%	07.50%
EPS Growth	16.80%	13.00%	20.00% init      06.85% final	16.20%               from Avi’s PP
High PE	25.0	20.0	24.8	25.0
High EPS	$5.67	$5.51	$3.63	$5.44
High Price	$141.75                42% > new VL	$110.20         10% >new VL	$90.03	$136.00              43% > old VL
Value Line Est High Price = 80-100 as of 12-24-10 and $75-95 as of 9-29-10
Low PE	14.0	12.3	14.2	14.0
Low EPS	$2.99 (ttm)	$2.93 (ttm)	Same	Same
Low Price	$41.86                (Low PE x          Low EPS)	$36.80             (Same)	$42.46	$41.02    (Same)
Upside/Down	4.02	1.9	1.48 (imputed)	4.29
Total Return	18.08%	12.2%	7.9%	18.19%
SSG Buy Under	Not Used	$54.79	$45.02	Not Used
RV/PRV            (outliers elim)	Not Used	Not Used	Not Used	Not Used
RV/PRV                       (no outliers)	Not Used	90.8/80.3	Not Used	Not Used
Quality	Not                      Available	S&P =              Not Rated	TS = 6.3 (good)	Not                   Available
PTPM – 5 yr ave	3.06%                  Trend NA	03.10%     Trend even	3.10%                 Trend NA	03.13%               Trend NA
ROE – 5 yr ave          Ending Yr Equity	13.24%               Trend NA	13.20%             Trend up	Not Used	13.13%                Trend NA
ROE – 5 yr ave         Begin Yr Equity	Not Used	13.8%               Trend up	Same                   Trend NA	Not Used
Debt to Equity –      5 yr ave	Not Used	38.6%               Trend up	Same                  Trend NA	Not Used

 [1] On 12-22-10, Better Investing and StockCentral changed their SSG data provider to Morningstar and the new data also comes with a long-term EPS estimate from Zacks.   Previously, BI got its SSG data and EPS estimate from S&P while SC (and Take Stock) got their SSG data from Morningstar-Hemscott.

[2] On 11-19-10, the BI Online SSG added the capability to project future growth from the end of the last Quarter, the last Fiscal Year, or the historical Trend line.  Our TK 6 software always had those options. Previously, the Online SSG only projected from the end of the last FY and here Avi chose to project from the last FY on 12-30-10, but had no choice on 11-12-10.

  Estimating Future Sales Growth for the Next 5 Years:

– Avi gave the participants five choices to make this judgment: 5.0%, next year’s estimate from YahooFinance; 7.0%, Morningstar’s optimistic estimate; 10.0%, historic sales growth for the last 10 years; 16.0%, historic sales growth for the last 2 years; and none of the above.

** “None of the above” is not a meaningful choice that I will not repeat.

** The consensus (40% of the votes) chose 7.0%, Mstar’s optimistic estimate, while the next highest vote-getter (31%) was Yahoo’s estimate of 5.0%.

** The future Sales growth decision is important only because Avi used the BI/NAIC Preferred Procedure to decide future EPS growth and the PP turns on this issue.

– Choices that Avi did not offer the participants were: 11.6%, historic sales growth last 5 years; 15.7%, last 3 years; 16.7% last 2 years; 11.53% Zacks.com sales growth estimate for the next 5 years; and, the most surprising omission, 6.2% Mstar’s conservative estimate.

Estimating Future EPS Growth for the Next 5 years – Part 1:

– Avi provided three (meaningful) choices: 23.0%, MHS’s historic EPS growth; 16.5%, Yahoo Finance’s estimate for the next 5 years; 7.0%, same as the group’s Sales growth choice.

** The Consensus choice (46% of the votes) was 7.0%, same as its Sales growth estimate, and the next highest vote getter was 16.5%, Yahoo’s estimate.

Estimating Future EPS Growth for the Next 5 years – Part 2:

The Consensus/Avi SSG:

– Avi threw out the above two Consensus choices in order to use the NAIC/BI Preferred Procedure to estimate MHS’s future EPS growth

This slideshow could not be started. Try refreshing the page or viewing it in another browser.

.

** The PP is like a simplified income statement and involves four estimates for the next 5 years: Sales Growth (less) Pre-Tax Profit Margin (less) Taxes (divided by) Shares Outstanding (equals) future EPS Growth.

** Avi began with 7.5% future Sales growth and did not explain why he disregarded the earlier 7.0% Consensus choice.

** He gave the participants 4 choices to decide the PTPM: 3.1%, MHS’s 5 year historical average; 3.5%, the most recent year PTPM; 4.4%, the most recent year & Mstar’s best case scenario; and 5.5%, the most recent year & Mstar’s optimistic case scenario.

### The consensus (69% of the votes) chose 4.4% PTPM.

** Avi used the default value for Taxes, the 5 year average of 39.2%, and did not offer any choices to the participants.

** Avi revised the default value for Shares Outstanding from 429.9 M to 405 M shares, and again did not offer any choices to the participants.

*** The mostly-Avi PP resulted in a 16.8% estimated EPS growth rate (compared to the initial 7.0% chosen by the Consensus) which he used for the Consensus/Avi SSG.

*** I no longer use the PP because it involves too many estimates and too much guesswork for me; if you want to learn more about the PP, see: Pondering The Preferred Procedure, click here. 

Armin’s SSG:

– I ALWAYS check 7 long-term EPS estimates for every SSG I do and the average for MHS was 16.37% with 18.00% the highest (by CNNMoney via FactSet CallStreet) and 13.00% the lowest (by Value Line).

** As mentioned in footnote 1, Better Investing and Stock Central both changed their SSG data provider to Morningstar on 12-22-10.  The Mstar data comes with a long-term EPS estimate from Zacks which, I discovered, is consistently different from the long-term estimate that’s available free from Zacks.com.

### I now check both Zacks estimates.

** I decided to use 13.00% which was the lowest estimate (from VL) and also the lowest estimate by one of the 15 analysts at Reuters.com (who ranged from 20.6%-13.0%).

** For how I estimate EPS for all my SSGs and the seven estimates I always check, see: Estimating EPS, click here. 

Final Results:

– The Consensus/AVI SSG started with 16.80% projected EPS growth and a High PE of 25.0 that resulted in a Forecast High Price for the next 5 years of $141.75, a whopping 42% greater than the high end of VL’s current estimated $80-100 High Price.

– Avi’s SSG, some 50 days earlier, was very similar and started with 16.20% EPS growth and a High PE of 25.0 that resulted in a Forecast High Price of $136.00, and was still a whopping 43% greater than VL’s earlier estimated High Price of $75-95.

– I started with 13.00% projected EPS growth and a Forecast High PE of 20.0, both much lower than Avi, and got a Forecast High Price of $108.00, only 14% greater than VL’s current estimate.

** I never want to substantially exceed (or fall below) VL’s estimated High Price, at least not without some good reason, and this is one step I use to evaluate the reasonableness of SSG judgments; see: Determining What’s Reasonable and What’s Not: An Update, click here. 

** The Avi/Consensus SSG got an 18% Total Return primarily because Avi’s Forecast High Price was 40% greater than VL’s estimate and was unreasonably high in my opinion.  And, to ignore VL’s estimate seems irresponsible to me.

Projecting Future Growth:

– Avi made a big deal that it makes little or no difference whether future growth is projected from the last quarter or from the last fiscal year. 

This slideshow could not be started. Try refreshing the page or viewing it in another browser.

– He’s mistaken and that’s not good advice. Our judgment as to where project future growth can be the difference between a SSG Buy and a SSG Don’t-Buy.  See:

** Counting on Coach (COH), August 1, 2010: AnnC projected future growth from the end of the last FY and got a SSG Don’t Buy while I used the same judgments and price as Ann, but projected from the last Q, and got a SSG Buy; for more, click here.

** Appraising Aeropostle (ARO), April 9, 2010: same with BudS; click here.

– These results don’t happen every time, but they can happen any time, especially when the last Q is the third quarter. 

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– Is MHS outperforming or underperforming its industry averages for PTPM and ROE?  Even though these trends are not going down, which is usually a troubling sign, I still want to know if Medco is better or worse than other companies in its industry.  In other words, is MHS a leader or a laggard?

– In terms of PTPM, MHS is well below its industry average with Morningstar data (3.1% vs 5.6%, Health Care Plans industry) and ranks 16^th out of 19 companies with 8.8% high and 2.3% low.

** Express Scripts (ESRX), the only direct competitor in this industry, was 9^th with a 4.8% PTPM.

– In terms of ROE, MHS is slightly below its industry average (13.2% vs 14.8%) and ranks 10^th out of 19 companies with 48.9% high and 7.4% low

** However, if I eliminate the 48.9% as an outlier, MHS is slightly better than its adjusted industry average (13.2% vs 12.7%) and ranked 9^th out of 18.

** ESRX was the #1 company with a 48.9% ROE.

Financial Condition:

– Value Line gave MHS an A+ for Financial Strength and found its Balance Sheet in “decent shape” as of 12-24-10 with cash declining some 63% to $945M due to share repurchases and weaker cash flow.

** Debt also increased by 25% to $45B in order to purchase United Bio Source Corp (UBC) for $730M.

 –  Morningstar found MHS to be in “good financial health” with more than $1 billion in cash and enough operating income to cover interest expense many times over [AF: unnecessarily vague].

** Mstar also observed that Medco spent $10 B in the last 5 years, 50% of its market cap, to repurchase its stock at an average price of $42 per share.

– The one-click Bob Adams’ Analyzing the Annual Report spreadsheet gave MHS’s 2009 A.R. a 54 out of 100 with 9 Bullish results (good things) and 9 Bearish (not-so-goods):

** The Bullish-goods included: debt, inventories, and shares outstanding decreased; ROE at 20% in 2009 got a green flag and was very good; interest coverage at 13.2x also was very good and also got a green flag;

** The Bearish not-so-goods included: Debt to Equity at 62.6% for 2009 got a red flag warning sign and may be excessive; gross profit margin was not growing and got a yellow caution flag; cost of sales was up 17% and was growing faster than sales.

### You can get this free, easy to use spreadsheet and a description of its many features by going to my Favorite Links page, click here.

 

Armin

 ** Your fedback is important to me so please leave a comment below and let me know what you think and/or rate this post by mousing-over and clicking one of stars also below.

** I’m concerned that this post might be too long: if you think so, please let me know which section(s) I might eliminate.

Guessing about GameStop (GME)

 GameStop Corp (GME) is a large chain of 6450 retail stores that sell new and used video games as well as related equipment . Some 69% of GME’s stores are in the US and 20% in Europe.  It also has several e-commerce websites, publishes Game Informer magazine with  4M subscribers, and just began selling downloadable games and add-ons at Internet kiosks inside its stores and from GameStop.com,  its main website.

GME was the monthly Online Stock Study for December at the Better Investing website.  It was led by Patrick Donnelly, a Director of the BI Pittsburg Chapter and the BI Volunteer Advisory Board.  Pat’s presentation slides, handouts, and the recorded session are available for downloading by BI members.

The purpose of the monthly Stock Study is to complete a SSG in about one hour with consensus decision-making by the on-line participants.  Participants made most of the judgments, but Pat also made a few.  No Consensus SSG is available, and may never be, so I had to rely on the recorded session which is awkward and time-consuming.

Company Background:

– In November, Value Line reported that GME has recently set up downloadable game content kiosks in it stores across the U.S. and is revamping its website from strictly e-commerce to a full-featured gaming platform.

– “Dismal long-term prospects” is how Morningstar began its late September report on GME which it called a no-moat retailer.  Pricing competition from rivals and the use of the Internet to play and/or download games, Mstar predicted, would eventually lead to declining revenue and razor-thin margins.

** Used video games represented 20% of revenue and 47% of gross profit in 2009, and are essential to GME’s financial health.  However, Wal-Mart, Best Buy and Target have begun in-store programs to buy and sell used video games.

** Mstar identified three, big risks faced by GME:

• large retailers like WMT, TGT, and BBY are starting to compete in the used video game business;
•  publishers of video games are adopting new initiatives, such as one-time downloadable online game content, that can ruin GameStop’s used gaming business; and
• it seems likely that most games soon will be delivered over the Internet, making GameStop’s (old) business model obsolete.

** Mstar concluded: “In the near term, we think retail rivals will impinge revenues and profits from new games and consoles. In the medium term, we expect video game publishers to disrupt the used game business [AF: by using the Internet to sell directly to gamers]. Thus, GameStop faces a bleak long-term outlook, selling the video game equivalent of vinyl records.”

Recent Acquisitions:

 – In November 2008, GameStop spent $500.4 M to acquire Micromania, a French retailer of video and computer games with 368 locations. [2009 GME Annual Report, page 2]

– In November 2009, GameStop acquired a majority stake in Jolt Online Gaming, an Ireland-based publisher of online games that are free to play on Facebook or with most Internet browsers. 

** Terms were not revealed, except that GME will provide up to $30M in the next 2-3 years for the company’s development.

– In July 2010, GameStop bought Kongregate, a social gaming and game development site, that offers more than 36,000 free games and that Time.com recognized as one of the 50 best websites in 2010.

** Again, the acquisition terms were not disclosed in GME’s press release. 

SSG Discussion:

– The table below compares the Consensus SSG with mine, Take Stock, and with LenD’s SSG from 2009 (which I got from BI’s First Cut). 

** After the table, I discuss several key SSG judgments and dig a little deeper into GME’s Relative Value, down-trending Return on Equity, and its overall Financial Condition.

GameStop                 (GME)	Consensus  SSG & PatD	Armin	Take Stock		LenD
Date	11-30-10	12-18-10	12-16-10		4-21-09
Data	S&P	Same	Mstar-Hemscott		S&P
Price at SSG	$19.92	$21.67	$21.56		$29.80
52 week High &   Low Price	$26.75 &     $17.12	$25.75 &  Same	Not Used		$57.20 &    $16.91
Last Quarter of Reported Data	Q3 ending   10/31/10	Same	Same		Q4 ending  1/31/09
Project Growth           From End of	Last Q	Same	Last FY		Last Q
Estimated                Sales Growth	7.00%	6.60%	2.90%		11.0%
Estimated                EPS Growth	9.00%	6.60%	-6.00%		11.1%
Forecast                        High PE	15.5                  (Hi & Lo PE       5 yr ave)	14.4                 (from 2009)	19.4		18.0
High EPS	$3.71	$3.12	$1.65		$4.06
Forecast                   High Price	$57.50	$45.20	$31.97             (20% < VL)		$73.10
VL Estimated High Price  = $40-60 as of 11-5-10					VL=$70-$110    as of 11-7-08
Forecast                   Low PE	7.0                 (from 2008)	7.0                 (from 2009)	8.2		9.0
Low EPS	$2.41 (ttm)	Same	$2.14		$2.40
Forecast                 Low Price	$9.00       (lowest in       last 5 yrs)	$13.70             (80% x 52     week low)	$17.55          (low PE x       low EPS)		$21.60
Upside/ Downside Ratio	3.4	3.0	1.35 (imputed)		5.3
Total Return	23.6%	15.8%	8.20%		19.7%
Buy Under	NA	$21.58	$15.99		NA
RV/PRV                   (no outliers)	47.5/43.6	49.2/46.0	Not Used		64.6/58.2
RV/PRV             (outliers out)	Not Used	65.7/61.5	Not Used		Not Used
Quality	S&P = NA	S&P = B+	TS = 1.6 (fails)		NA
PTPM – 5 yr ave	6.2%              Trend even (thru 2009)	Same              Same	6.2%             Trend  NA		6.1%              Trend up       (thru 2008)
ROE – 5 yr ave    (with ending             year equity)	Not Used	13.8%      Trend down        (thru 2009)	Not Used		13.3%        Trend up        (thru 2008)
ROE – 5 yr ave    (with starting    year equity)	17.4%           Trend down(thru 2009)	Same             Same	17.6               Trend NA		Not used
Debt to Equity   – 5 yr ave	43.8%        Trend down (thru 2009)	Same            Same	Not Used		NA

 Estimating Future Sales Growth for the next 5 years:

– Pat gave the participants 5 choices: 24.0%, the 10-year historical growth rate; 11.0%, the industry average; 7.0%, Value Line’s estimate; 3.5%, from the latest quarter; and none of the above.

** None of the above is a meaningless choice which I will not repeat;

** Value Line’s 7.00% was for Sales per share (not Sales) and VL makes no estimate of future Sales growth;

** Zacks.com was also estimating 24.17% Sales growth for the next 5 years;

** Historically, GME’s sales growth has been steadily declining since 2006: down to 20.0% growth during the last four years; 13.1% in last three; and 3.1% during the last two years.

### The Consensus opted for 7.0% (from VL) which got 43% of the votes while 11.0% (the industry average) got 21%.

Estimating Future EPS Growth for the next 5 years:

 – Participants were again given 4 (meaningful) choices: 7.0%, same as their Sales growth estimate; 30.0%, last 8 year average; 17.0%, highest of seven long-term estimates that Pat found; and 11.0%, the average of the seven estimates.

** Presentation slide 34 vividly sets forth the distribution of the seven estimates that are all from different data sources;

** The company’s EPS growth, like its Sales growth, has also been steadily declining: 31.0% last four years, 12.3% last three; and -5.4% (that’s a negative 5.4%) during the last two years.  The recent downtrend in EPS and Sales is one negative indicator of quality based on BI standards.

** The Consensus choice was 11.0%, the average of the seven estimates (51% of the votes), while 7.0%, same as their Sales growth estimate, was next (24%).

### Pat decided to use 9.0% because of GME’s stock buyback program.

– I estimated 6.70% future EPS growth, the average of the same seven estimates that Pat checked less 3 Standard Deviations, because I guessed that GME was headed for tough times.

** Excel easily calculates the Standard Deviation and I usually go no lower than the average less 2 SDs (7.96% here) and more often use the average less 1 SD (9.25%);

** For how to find the seven long-term estimates and how I estimate EPS for all my SSGs, see: Estimating EPS.

** For my evaluation of these EPS estimates from seven different sources, see: Evaluating EPS Estimates.

Estimating the Future High PE for the next 5 years:

– Participants were given 4 options: 24.0, 5 year historical average; 26.1, 5 year average PE x 1.5 ; 18.0, estimated EPS x 2 or a PEG of 2; 13.5, estimated EPS x 1.5 or a PEG of 1.5.

** The Consensus chose 13.5 or a PEG of 1.5 (40% of the votes) while the next choice was 24.0 (24%)

### Pat decided to use 15.5, the 5 year average High & Low PE.

– I used 14.4, from 2009 and the lowest High PE in the last 5 years.

Final Results:

– The Consensus/Pat began with 9.00% EPS estimate and got a Forecast High Price of $57.50 (which was towards the high end of VL’s $40-60 estimate) as well as a 3.4 Upside-Downside Ratio and a 23.6% Total Return.

– I started with a very low 6.70% EPS estimate and got a Forecast High Price of $45.20 (near VL’s low end), a 3.0 UD and a 15.8% TR.  My SSG resulted in the most conservative appraisal and still satisfied the minimum SSG Buy Criteria of 3.0 UD and a 15.0% TR.

** I also satisfied another criterion that I impose: to never substantially exceed or fall below VL’s estimated High Price, at least not without a good reason.

– Len began with an 11.1% EPS estimate (in April 2009) and got a Forecast High Price of $73.10, a UD of 5.3 and a TR of 19.7%. 

– Take Stock began with a -6.00% EPS estimate (that’s a negative 6.00%) which seems unreasonably low and stupid.

 Relative Value (RV):

– Relative Value is defined as the current PE divided by the 5-year average PE and an RV between .85 and 1.10 is ideal according to the BI/NAIC Stock Selection Handbook [page 113, 2003 edition].

** Under .85 signals that investors are unwilling to pay more for the stock (and might know something we need to investigate) while over 1.10 suggests that we might be paying too much.

 ** Take Stock does not use the RV concept and the other three SSGs got an RV well under .85 with the Consensus & Pat the lowest at 47.5 while I got 49.2.  That’s a second negative indicator.

– Eliminating outliers changes the RV denominator so I try to report two sets of figures (with and without outliers eliminated).

 ** I almost never discuss RV/PRV because that feature is broken in the TK6 software.  I checked RV five times to make sure I got the same numbers and the software’s defect occurs when outliers are eliminated and then restored.

Return on Equity (ROE) and Pre-Tax Profit Margin (PTPM):

ROE:

– GameStop’s 5 year average ROE is trending down and that can be a red-flag warning sign of deteriorating fundamentals or, compared to its Industry Average, an indicator that the company has an unsustainably high ROE. 

**However, GME’s ROE is much worse with Morningstar-Hemscott data than its Industry Average (13.9% vs 19.5% Electronic Stores Industry) and ranks 4^th out of 5 companies with ROEs that range from a high of 25.9% to a low of 10.7%.

** And, GME’s ROE is slightly worse with S&P data than its Industry Average (17.4% vs 17.6% Computer & Electronics Retail).  There is no company-by-company listing so no ranking is possible.

** GME’s down-trending ROE is a third negative indicator!!

PTPM:

– GameStop’s PTPM is trending up, which always is a good sign, but I also like to know how the company compares to its industry since I prefer to buy industry leaders. 

** GME’s PTPM is slightly better with M-H data than its Industry Average (6.2% vs 5.7% Electronic Stores Industry) and ranks 3^rd out of 5 companies that range with PTPMs from 6.7% high to 3.8% low.

** GME’s PTPM is also slightly better with S&P data than its industry average (6.2% vs 5.7% Computer Electronics Retail). 

Financial Condition:

 – Value Line gave GME a B+ for Financial Strength and reported that it had $289 M in cash (down from $905 M in 2009) and $448 M in debt (all long term) as of 7-31-10.

– Morningstar thinks GME’s financial health is “okay”, but could deteriorate.  On 8-25-10, the company had $290 M in cash and $448 M in long-term debt.

– On Bob Adams’ one-click Analyzing the Annual Report spreadsheet, GME’s latest AR scored 83 out of 100 with 13 bullish and 5 bearish results:

** The Bullish or good things include: debt is decreasing as is accounts receivable and shares outstanding; sales are increasing and increasing faster than related costs; interest coverage at 14.0 gets a green flag (very good) as anything below 5.0 is worrisome to Bob; debt to equity is reasonable.

** The Bearish or not-so-goods include:  free cash flow at 5.0% gets a red, danger flag as anything less than 10.0 is bad news to Bob; ROE is inadequate and gets a yellow, caution flag; and short interest at 22.7% is very high and increasing as 20.0% or more is a warning sign that a sizeable number of investors are betting that GME’s stock price will decline (which might explain GME’s low RV).

– You can get this free, easy-to-use spreadsheet and a description of its many features by going to my Favorite Links page, click here.   

Conclusion: What Does It All Mean?

– Because of its several negative trends and the critical Mstar assessment, I’m way not interested in GameStop.  And, I have little reason to expect that GME knows how to profit from the Internet; even if it soon learns, what will the company do with its 6400+ stores?

– Furthermore, how does GME plan to make money from Kongregate and Jolt, the two free-to-play game sites it recently acquired? Also, what about the large amount of short interest that’s betting on the stock price going down? 

 – Lastly, what’s your guess about GameStop’s future prospects?  Please tell me what you think, especially if you’re a gamer, by leaving a comment in the box below.

 

Armin (happy holidays to all)

Tempted by TEVA (TEVA Pharma)

– TEVA Pharmaceutical Industries (TEVA) is the world’s largest generic drug company.  Based in Israel and sold here as an ADR, TEVA makes generic and branded drugs with its more than 400 generics accounting for 67% of the company’s $13.8 Billion sales in 2009.

– Last year, 61% of its sales were in North America, 24% in Europe, and 6% in Latin America and Mexico.

– The company operates in over 60 countries with 38 finished dosage manufacturing sites in 17 countries, 15 R&D centers, and 21 Active Pharmaceutical Ingredient (API) manufacturing sites around the world.

– Its API business, which supplies ingredients to TEVA and to its competitors, provides vertical integration to the company.

Company Background:

 – According to Morningstar, four companues account for nearly half of all generic drug sales:  TEVA, Sandoz (a subsidiary of Novartis AG), Mylan (MYL), and Watson (WPI). 

 ** Mstar concluded that TEVA was the leader because it had more than double the revenue, broad market coverage, a “massive manufacturing infrastructure, and vertically integrated operations.”

** TEVA stands to earn significant profits in the near term by making new generics as a large number of patents expire in the next few years, such as the widely used cholesterol drug Lipitor.

– Mstar also found that TEVA’s branded drug Copaxone is the world’s leading treatment for multiple sclerosis and accounts for almost one fourth of the company’s gross profits.

** But, Copaxone’s patent expires in 2014 and, even though TEVA is developing an oral MS drug, so are several other drug companies.  Mstar seemed uncertain about TEVA’s long term prospects.

– In October, Value Line reported that the FDA has approved a new, oral MS drug which could threaten TEVA’s most lucrative drug, Copaxone, which is injected.

** However, TEVA plans to introduce a low-dose form of Copaxone and is developing its own oral MS drug..

 ** TEVA also has some 200 generic drug applications as of July pending FDA approval.  And, it also has several late-stage, branded drugs in development.

** VL reported this July that TEVA has plans for additional acquisitions and for increasing its sales to $31 Billion in the next 5 years, a growth goal of 125%.

Legal Matters:

 – In May, TEVA was odered to pay $356 Million to someone who had contracted Hepatitis C from a vial of the company’s sedative drug, propofol.

** TEVA plans to appeal and has also announced that it will stop making the drug which is one of the most common anesthetics in the U.S.

** The New York Times reported in May that TEVA had to stop propofol production last year and recall some of the drug due to “serious manufacturing violations” according to the FDA and is facing numerous money damage lawsuits.

– TEVA has a reputation as an aggressive litigator in numerous patent disputes.  It not only waits for a patent to expire, it also researches possible defects in other company’s patents and, most aggressively, will market some new generic drugs before FDA approval and risk money damages if TEVA  loses its patent challenge. 

Recent Acqusitions:

– Unlike drug companies that grow through R&D, TEVA also grows by acquisition and has the resources to do so, largely from the cash generated by Copaxone.

** Earlier this year, TEVA bought ratiopharm, Germany’s second largest drug maker, for about $5 Billion in cash and debt.

** In 2008, TEVA bought Barr Pharmaceuticals, a rival generic drug maker, for $7.5 Billion.

** In 2008, TEVA also bought Bentley Pharma for $366 Million and CoGenesys for $402 Million.  Bentley was a generic drug maker in Spain and CoGenesys specialized in biogenerics, a new growth area for TEVA.

SSG Discussion:

– The table below compares the SSG by GeneS, which I got from BI’s First Cut page, with two of mine and with Take Stock.  Armin-1 uses S&P data while Armin-2 uses Hemscott-Morningstar data, while both use the same judgments.

– After the table, I discuss several SSG issues as well as TEVA’s Pre-Tax Profit Margin and Return on Equity, and its Financial Condition. 

TEVA Pharma           (TEVA)	GeneS	Armin-1	Armin-2	Take Stock
Date	10-15-10	11-4-10	Same	11-3-10
Data	S&P	S&P	Hemscott -Morningstar	Hemscott-Morningstar
Price	$54.70	$50.63	$50.81	$50.93
52 week High &             Low Price	$64.85 & $46.99	Same &            Same	Same &            Same	Not Used
Last Quarter of Reported Data	Q2 ending        6-30-10	Q3 ending       9-30-10	Q2 ending        6-30-10	Q2 ending        6-30-10
Software Used	TK 6	Same	Same	TS Online
Project Growth      From End of	Last Q	Same	Same	Last FY
Sales Growth	14.00%	10.00%	Same	17.70%
EPS Growth	13.00%	10.00%	Same	-0.70%
High PE	19.8            (last 4 yrave)	18.8            (from 2009)	19.3                     (from 2009)	21.9
High EPS	$6.37	$6.06	$5.48	$2.19
High Price	$126.10	$113.90	$105.80	$61.74               (44% < VL)
Value Line Estimated High Price = $110-135 as of 7-16-10 and on 10-15-10
Low PE	13.6                    (last 4 yrave)	Same                 (from 2009)	14.2                   (from 2009)	18.3
Low EPS	$3.39                 (TTM)	$3.12                  (Same)	$3.40                 (Same)	$2.81
Low Price	$43.50              (PVQ)	$32.80              (Ave Low      Last 5 yrs)	$35.10                (Same)	$42.78              (Low PE x         Low EPS)
Upside/Down	6.4	3.5	3.5	Not Used
Total Return	18.9%	18.5%	17.0%	4.80%
SSG Buy Under	$57.93	$53.08	$52.78	$32.11
RV/PRV                     (no outliers)	N/A	80.8/73.3	Same/Same	Not Used
RV/PRV                           (2005 out)	98.8/86.8	75.0/68.0	Same/Same	Not Used
Quality	N/A	S&P = None	TS = 2.10 (fails)	TS = 2.10          (fails)
PTPM – 5 yr ave	24.5%               Trend down	Same                 Same	21.6%              Trend down	21.6%              Trend N/A
ROE – 5 yr ave with   Ending Yr Equity	N/A	14.3%               Trend even	13.3%                Trend up	Not Used
ROE – 5 yr ave with   Beginning Yr Equity	17.3%                Trend down	Same                Same	16.3%                Trend even	16.3%               Trend N/A
Debt to Equity –          5 yr ave	30.3%                Trend down	30.5         Trend down	31.1%                Trend down	Not Used

Estimating EPS for the Mext 5 Years:

– Gene estimated 14.00% EPS which, according to his First Cut write-up, was more conservative than his Preferred Procedure, Implied Growth Rate, and Analyst Estimates which, he wrote, were all estimating 14.00% (there seems to be a typo someplace).

– When I did my SSG on 11-4-10, the five analysts I checked were closely estimating long-term EPS at an average of 14.11% with Reuters high at 14.89% and S&P low at 13.80%.

** Zacks.com was 13.57%, Value Line was 14.00%, and YahooFinance was 14.31%.  Reuters’ nine analysts ranged from a low of 9% to a high of 23.10%.  CNNMoney and Morningstar, which usually make a long-term estimate, made none.

** I decided to project 10.00% EPS, close to the very lowest of all analyst estimates (9.00% by one analyst at Reuters).

Forecast Low Price:

 – Gene chose the Price Variant Quotient option ($43.50) for his Low Price estimate, one of six choices offered by our SSG software, which he said was conservative compared to the main option for growth companies ($45.00 from Low PE x Low EPS).

– I chose the most conservative option, the Average Low during the last 5 years ($32.80 for Armin-1 and $35.10 for Armin-2).

Final Results:

 – Gene’s SSG began with a 14.00% estimated EPS and easily satisfied the SSG Buy criteria with a 6.4 Upside/Downside Ratio and 18.9% Total Return.

– My SSGs began with a 10.00% estimated EPS and also easily satisfied the Buy criteria with a 3.5 U/D and 18.5% TR (with S&P data) or 17.0% TR (with H-M data).

** My Forecast High Price also satisfied another demanding standard that I add which is to never substantially exceed (or fall below) Value Line’s estimated High Price.

– Just about any sensible SSG should satisfy the Buy criteria, I think, due primarily to TEVA’s 10% price drop YTD in 2010.

– Take Stock began with a -0.70%  estimated EPS for the next 5 years (that’s a negative .70%) and that is not sensible.

 Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

PTPM:

– TEVA’s 5 year average PTPM is trending down which can be a red-flag warning sign of deteriorating fundamentals or, on the other hand, an indicator that the company has an unsustainably high average.

** With Hemscott-Morningstar data, TEVA’s PTPM is markedly better than its industry average (21.6% vs 15.9%, Drug Manufacturers-Other Industry) and ranks sixth out of 80 companies.

** With S&P data, TEVA’s PTPM is also better than its industry average (24.5% vs 20.9%, Pharmaceuticals Industry).  There is no company-by-company listing so no ranking is possible.

ROE:

** With H-M data, TEVA’s ROE with beginning year equity is better than its industry average (16.3%, trending even vs 14.8% Drug Manufacturers-Other Industry) and ranks 11^th out of 80 companies.  With ending year equity, its ROE is slightly worse than the industry average (13.3% vs 14.8%), but more importantly this ROE is trending up.

** With S&P data, TEVA’s ROE is much worse than its industry average (17.3%, trending down with beginning year equity and 14.3%, trending even with ending year equity vs. 41.6% Pharmaceuticals Industry average). 

### I suspect that the S&P Industry Average is distorted by one or more companies with an abnormally high ROE since the H-M Industry Average is so much lower.

Conclusions re PTPM and ROE:

– I am not bothered by TEVA’s downtrend in PTPM because it is better than its Industry Average with H-M AND with S&P data.

** Moreover, Morningstar reports that “Teva’s profitability is consistently higher than that of its generic competitors,” largely due to its higher-margin branded drug portfolio.

** And, the downtrend began in 2008 with its Barr purchase when PTPM sunk to 8.5% (with H-M data) but then rebounded almost all the way back to 20.3% in 2009.

** TEVA’s latest annual report explains that its higher tax rate in 2008 was mainly due to a non-tax deductible write-off of in-process R&D related to the company’s acquisitions of Barr and Cogenesys which reduced its pre-tax income.  See:  TEVA’s Annual 2009 12-K Report to the SEC, page 49 (PDF page 52).

– TEVA’s downtrend in ROE with S&P beginning equity also is not troubling because H-M data shows an even trend AND because the downtrend seems like an anomaly compared to the three other ROE trends. 

Financial Condition:

– When I did Armin-1, its S&P data showed that TEVA had some $7.2B in Total Debt, a Debt to Total Capital Ratio of 26.8%, and a 5 year Debt to Equity Ratio of 30.3% that had dropped to 22.4% in 2009.

 ** According to “Company Debt” by Ann Cuneaz (slide 26), BI Courses To Go, she recommends that the Capitalization Ratio or Debt to Total Capital Ratio should be less than 35% [TEVA’s was 26.8%];

** Debt To Equity by Jim Hurt (slide 13), BI Courses To Go, recommends a Debt to Equity Ratio of below 50% for non-financial companies [TEVA’s 5 year average was 30.3% and 22.4% in 2009].

– Value Line gave TEVA an “A” for Financial Strength and, as of June 30, reported that the company had $4.9B in Cash and $7B in Debt ($5B Long-Term) with LT debt dropping to an estimated $4.4B in the next 3-5 years.

– Morningstar found that TEVA’s management had maintained a conservative Debt to Equity Ratio of .3 or 30%, an Interest Coverage Ratio consistently in double digits, and that the company had about $2B in Cash as of July 7.

– The Bob Adams one-click Annual Report spreadsheet gave TEVA a 74 out of 100 with 9 Bullish results (good things) and 8 Bearish (not-so-goods):

** The Bullish results include: Debt is decreasing and Interest Coverage at 10.6x gets a green flag which is very good; Debt to Equity at 22.0% is also very good; Sales are increasing and Free Cash Flow Margin at 15% is very good.

### If Interest Coverage is under 5, Bob cautions, it is a warning sign to investigate further; if under 3, he urges moving on [TEVA’s was very good at 10.6 times earnings]. 

### Free Cash Flow Margin over 10 is great, Bob says, and substantially over 10 is excellent [TEVA’s was 15%].

** The Bearish results include: Accounts Receivable and Shares Outstanding are increasing; ROE at 10.4% is inadequate and gets a yellow, caution flag; and the Cost of Sales is up 28% and gets a red-flag danger sign.

** You can get a free copy of this easy-to-use Excel spreadsheet and a summary of its many features by going to my Favorites Page at my SSG Blog: click here. 

Armin

 [feedback is always appreciated so please leave a comment in the box below and/or rate this post by using the easy-to-use star rating scale (also below, just mouse-over and click]

 

Counting On Coach (COH)

Coach (COH) sells expensive handbags and accessories that it designs and has made by independent manufacturers according to COH standards and controls. 

The recession has been tough on Coach: three years ago, it was Better Investing’s Growth Company of the Year, but its sales slumped to 1.6% last year.  Coach has fought back by dropping prices, launching a new line of more affordable handbags, and expanding further into China. 

With a recovery in the U.S., Morningstar expects solid sales growth and increased profit margins this year. Value Line also gave a glowing report and forecasts healthy EPS increases for the foreseeable future.

I just compared AnnC’s SSG, which I got from BI’s First Cut page, with mine and with Take Stock.  I also assessed Coach’s downtrends in Pre-Tax Profit Margin and Return on Equity, its financial condition, and its competitors.

Company Background:

– In FY 2009, handbags accounted for 62% of COH’s sales while accessories were 29%; the U.S. accounted for 72% of sales and Japan 21%.

– According to Coach’s latest 10K annual report, the company is organized into two segments: Direct-to-Consumer and Indirect.

** Direct-to-Consumer consists of Coach stores in North America, Japan, Hong Kong, Macau, and mainland China as well as the Internet and the Coach catalog.  This segment represented 89% of FY 2009 sales, with the North American stores accounting for 61%.

### In North America, COH had 330 full-price retail stores and 111 factory stores at the end of FY 2009.  Coach Japan consisted of 155 stores and Coach China 28.

** The Indirect segment represented 16% of FY 2009 sales with COH products sold at more than 930 department stores (wholesale customers) in the US, in over 20 countries at some 160 department stores, and at 155 in Japan.

### U.S. indirect sales have been flat at around 10% for several years.

** The company has identified four key growth initiatives:

• Increase market share re North American women’s accessories;
• Grow North American retail stores, in both new and existing markets;
• Expand market share in Japan by opening new locations; and
• Raise brand awareness in China by opening new locations.

– Morningstar explained that COH fills a void between designer labels and moderate brands with its high-quality, smartly priced goods.  “Accessible luxury” is how Coach describes its products.

** COH recently reduced its handbag prices from the $300-400 range to $200-300 and also launched its Poppy line which sells for an average handbag price of $260.

** In 2010, the company has plans to open 20 stores in North America, 10 in Japan, 15 in China and 30 wholesale stores in international markets.   

– Value Line reported that COH’s stock price has risen 25% since its February report, mostly on the basis of its third quarter results with Sales up 12% and EPS up 28% (based on S&P data).

** The company has announced plans to open 14 stores in France over the next three years and, within the next year, new stores in the U.K., Ireland, Spain, and Portugal.

** These plans, together with COH’s doubling of its quarterly dividend, prompted VL to substantially raise its estimates in May for the next 3-5 years by 24% for EPS and its High Price estimate from $45-65 to $55-80.

SSG Discussion:

– Armin-1 used the same judgments and price as Ann except that I projected future growth from the end of the last quarter while she projected from the end of the last FY.  I got a SSG Buy, but Ann did not.

– Armin-2 used a slightly lower EPS estimate (12.00% instead of 12.90%) and still got a SSG Buy.

Coach                   (COH)	AnnC	Armin -1	Armin-2	Take Stock
Date	7-9-10	Same	Same	7-14-10
Data	S&P	Same	Same	Hemscott-Morningstar
Price	$36.50	Same	Same	$37.16
52 week High &    Low Price	$44.37 &           $22.94	Same	Same	Not Used
Last Quarter of   Reported Data	Q1 ending              3-31-10	Same	Same	Same
Software Used	Online SSG	TK 6	Same	TS Online
Project Growth   From End of	Last FY	Last Q	Same	Last FY
Sales Growth	10.00%	Same	12.00%	1.5%
EPS Growth	12.90%                 (from PP)	Same	12.00%	-10.8%
High PE	21.0                         (ave 2008-09)	Same	21.1	24.8
High EPS	$3.50	$3.87	$3.72	$1.08
High Price	$73.50	$81.30	$78.50	$26.70            (51% < VL)
Value Line Estimated High Price = $55-80 as of 5-7-10
Low PE	11.0                         (ave 2007-09)	Same	10.7	10.2
Low EPS	$2.11                     (ttm)	Same	Same	$1.76
Low Price	$23.21                   (low PE x              low EPS)	Same                    (Same)	$23.60 (Same)	$17.96 (Same)
Upside/Down	2.71              (under 3.0 criteria)	3.4               (satisfies 3.0 criteria)	3.0	Not Used and Impossible     to Calculate
Estimated Payout Ratio	24.0%	Same	Same	Not Used
Total Return	16.17%	18.5%	17.7%	– 6.2%
SSG Buy Under	N/A	$37.73	$38.20	$13.47
RV/PRV                   (outliers eliminated)	N/A	108.8/96.4          (3 high PEs out & 2 low out)	111.5/98.7 (Same)	Not Used
RV/PRV                 (no outliers)	N/A	83.9/74.3	82.8/73.3	Not Used
Quality	N/A	S&P = B+	Same	TS = 1.1 (fails)
PTPM – 5 yr ave	36.74%                  trend N/A	Same                   trend down	Same              Same	36.2%              trend N/A
ROE – 5 yr ave     End Yr Equity	38.02%                  trend N/A	Same                   trend down	Same             Same	Not Used
ROE – 5 yr ave    Begin Yr Equity	N/A	45.9%                 trend down	Same              Same	46.5%              trend N/A
Debt to Equity – 5 yr ave	N/A	0.5%                  trend up	Same             Same	Not Used

 Estimating Future Sales and EPS Growth:

 Ann’s SSG:

– Ann estimated 10.00% future Sales growth for the next 5 years based on COH’s expansion into international markets, especially China, but mentioned nothing to support her 10.00% estimate.

** COH’s Sales Growth has been declining during our recession and was 20.6% for the last five years, 15.9% for the last three and 1.6% for the last two.

** Morningstar was estimating long-term Sales growth in the mid to high single digits while Zacks.com was forecasting 15.99% for the next five years.

– Ann used BI’s Preferred Procedure to estimate future EPS growth for the next 5 years. 

** The PP involves 4 other estimates: Sales growth (Ann used her 10.00% estimate); Pre-Tax Profit Margin (33.00%, down from the 38.0% default which is the last 5 year average); Tax Rate (38.0% default); and Shares Outstanding (current shares default, 304.2M).

** Ann’s estimate of a 5% decline in Pre-Tax Profit Margin was a guess unsupported by any guidance.  VL, for example, expects COH’s Net Profit Margin to decline slightly from 19.3% actual to 19.1% in the next 3-5 years.

** Moreover, VL was estimating 275.0M future Shares Outstanding and that one change would have substantially increased Ann’s PP from 12.90% to 16.80%.

** I no longer use the PP because it involves too many estimates and too much guesswork; see: Pondering The Preferred Procedure.

Armin’s SSG: 

– When I did my SSG, the SEVEN analysts I always check were estimating long-term EPS at an average of 13.96% with Morningstar high at 16.00% and VL low at 10.00%.

** YahooFinance and Zacks.com were both at 14.00%, Reuters was 14.25%, S&P was 14.50%, and CNNMoney was 15.00%.  Reuters 8 analysts ranged from a low of 12.00% to a high of 15.00%.

** Armin-1 used Ann’s estimate of 12.90% EPS growth while Armin-2 used 12.00%, the very lowest estimate by one of the Reuters analysts.

** To learn more about estimating EPS, see: Estimating EPS.

Final Results:

– Of the four studies, only Armin-1 and Armin-2 satisfied the SSG BUY criteria of a minimum 3.0 Upside/Downside Ratio and a 15.0% Total Return. 

– The only difference between Ann’s SSG and Armin-1 is that I projected growth from the last quarter while Ann projected from the end of the last fiscal year.  In all other respects, we used the identical judgments, data and price.

• Ann got a 2.78 U/D and a 16.17% TR;
• Armin-1 got a 3.4 U/D and a 18.5% TR;
• Armin-2 got a 3.0 U/D and a 16.6% TR; and
• Take Stock got a -6.2% TR and the U/D was impossible to calculate because its Forecast High Price for the next 5 years was lower than COH’s current price (a SSG NO-NO).

– Ann used the Online SSG at the Better Investing website which only projects future growth from the end of the last FY whereas I used SSG software which offers three options for projecting future growth (from the end of the last Q, last FY, or the end of the EPS trend line). 

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE):

– Both PTPM and ROE are trending down which are often red-flag warning signs of deteriorating fundamentals.

** The SSG software I use provides an explicit indication of these trends, but Ann used the Online SSG which does not.  Maybe that’s why she did not comment on them in her First Cut write-up.

– These downtrends don’t bother me because COH’s metrics remain outstanding:

** Morningstar-Hemscott data places COH in the Textile: Apparel, Footwear & Accessories Industry with 14 companies total:

• COH’s PTPM is way, way better than its industry average (36.5% vs 13.0%) and ranks 2^nd  out of 14; and
• COH’s ROE is also way, way better than its industry average (38.6% ending/46.5% starting equity vs 15.2% industry) and also ranks 2^nd.

** S&P places COH in the Apparel, Accessories and Luxury Goods Industry.  There’s no company-by company listing so no ranking is possible:

• COH’s PTPM is again way, way better than its industry average (36.7% vs 10.4%); and
• COH’s ROE is again way, way better than its industry average (38.0% ending/45.9% starting equity vs 18.1% industry). 

– I conclude that COH’s PTPM and ROE are trending down because they are unsustainably high and do not represent a troubling decline.

– This is the third time I have reported on Coach and its PTPM and ROE have always been high. See:

** Checking Out Coach (COH), November 5, 2009;

** Coach (COH): Better Investing’s Growth Company for the Year 2007 , September 3, 2007.

Financial Condition:

– Value Line gives COH an “A” for Financial Strength with $907M in cash and $25M in debt as of 3-27-10.

– Morningstar concludes that COH is in excellent financial health with little debt and the ability to turn 20% of its sales into free cash flow.

– The super-duper one-click spreadsheet by Bob Adams gives COH’s latest Annual Report a 52 out of 100 with 11 Bullish results (good things) and 10 Bearish (not-so-goods):

** The Bullish, good stuff includes: ROE, free cash flow, and long term debt to equity all rate a green flag (tops), and sales are increasing while shares outstanding are decreasing;

** The Bearish, not-so-goods include: accounts receivable, inventories and long term debt are all increasing, and the cost of sales is increasing faster than sales.

Competitors:

– No competitors are named in COH’s latest 10K report and the company says that it “competes with European luxury brands as well as private label retailers, including some of Coach’s wholesale customers.” [page 9, PDF page 12]

– According to YahooFinance, COH’s direct competitors are Dooney & Burke, kate spade, and Michael Kors, all three of which are privately held.

– Dooney & Burke’s website shows handbags selling for $165 to $395, kate spade from $195 to $695, and Michael Kors from $148 to $2295.  Cole Haan, still another private company, sells handbags for $129.95 to $498.

– On the other hand, Coach’s website shows handbags selling from $118 to $1200 with the Poppy line ranging from $118-$598.

– The unnamed European competitors referred to in Coach’s 10K are probably Louis Voitton (French and one division of LVMUY, handbags from $500 to $4260), Gucci (Italian, croodile handbag at $29,900, crocodile trim at $2450), and Prada (Italian, handbags from $410 to $3200). 

** It may be wishful thinking by Coach to consider “European luxury brands” as competitors since their purses are way more expensive.

 

 Armin

 

 

 

 

 

 

 

 

 

 

Auditing Abbott Labs (ABT)

Abbott Laboratories (ABT) is a large, global and uniquely diversified drug company that consists of four, main segments: Pharmaceutical Products, $16.5 billion in 2009 sales (54% of total); Nutritional Products, $5.3 billion (17%); Diagnostic Products, $3.6 billion (12%); and Vascular Products, $2.7 billion (9%).

Its strong and diverse product line-up led Morningstar to conclude that the company had a wide economic moat and, as a result, a competitive advantage.

ABT was the Stock To Study in the May/June 2010 issue of Better Investing magazine.  The STS is expected to double in investment value (appreciation and dividends) within five years which is Better Investing’s goal. 

I just compared CarolT’s SSG, which I got from BI’s First Cut page, with two of mine and with Take Stock.  Both my SSGs use the same judgments, but Armin-1 uses S&P data (like Carol did) while Armin-2 uses Morningstar-Hemscott data.  Carol’s SSG and First Cut write-up were also reprinted in the May/June issue of BI.

Company Background: 

– Acquisitions are a major driver of ABT’s growth.  In recent years, the company has substantially invested in increasing its low-cost drugs and broadening its geographic presence, especially in underserved growth markets: 

• May 2010: announced that it would buy the Indian drug company Pirmal Healthcare for $3.7 Billion.  Pirmal does contract manufacturing and research for other drug companies and also makes 350 generic drugs;
• April 2010: bought Facet Biotech for $722 Million which had an experimental drug for multiple sclerosis and several treatments for cancer;
• Feb 2010: bought Solvay Pharmaceuticals, a unit of the Belgian company Solvay, for $6.2 Billion which is expected to add nearly $3 Billion to ABT’s 2010 Sales, mostly outside the U.S.;
• Nov 2009: acquired the remaining stake in Evalve, a leader in the non-surgical treatment of structural heart disease, for $320 Million;
• Oct 2009: bought Visogen, a privately-held company specializing in intraocular lens technology for cataract patients, for $400 Million;
• Feb 2009: acquired the remaining stake in Advanced Medical Optics, the leading seller of LASIK surgical devices, for $2.8 Billion;
• Jan 2009: bought Ibis Biosciences, a maker of diagnostic products to detect infectious diseases, for $175Million.

– Humira, ABT’s best selling drug and a treatment for rheumatoid arthritis, generated $5.5 Billion in 2009 sales, up about 22% from 2008.   

** Humira is approved for six uses and is a leading therapy for autoimmune diseases. 

– Depakote, once one of Abbott’s blockbuster drugs, lost its patent protection in 2008 and accounted for only $331 Million in 2009 sales, down 74.5% from 2008; 

– ABT’s nutritional products are leaders in the infant formula market (Similac and Isomil) as well as in the adult nutritional market (Ensure and Glucerma);

– ABT’s Xience line of drug-coated stents was approved for sale in July 2008 and its Model V reportedly became the top seller in the U.S in 2009; 

** ABT acquired the vascular business and the Xience stent from Guidant Corp as part of its acquisition by BSX which, by agreement, also sells the Xience under the Promus name. 

** ABT is developing a new type of stent made of an absorbable material rather than metal and could be three years ahead of its competitors.   

– Much of the info in this Company Background section came from the STS article in Better Investing magazine supplemented by ABT’s latest Annual Report and Wikipedia. 

– ABT’s direct competitors according to Yahoo Finance are Merck (MRK), Sanofi –Aventis (SNY), and Roche Holding (RHHBY) while Morningstar reports its close competitors as Pfizer (PFE), Baxter International (BAX) and Johnson & Johnson (JNJ). 

Legal Problems: 

– ABT’s 2009 Annual Report mentions numerous lawsuits, mostly in a vague and unsatisfying manner: 

• An (unspecified) number of patent infringement lawsuits are pending and ABT is also appealing a $1.67 Billion judgment against it in a federal jury trial regarding its Humira drug;
• In May 2006, the U.S. Department of Justice intervened in a civil whistle-blower lawsuit claiming that ABT had wrongfully inflated prices for drugs paid by Medicare and Medicaid (potential liability unspecified);
• Several civil actions by State Attorney Generals are pending seeking to recover damages on behalf of state Medicaid programs (number of lawsuits, issues and potential liability unspecified);
• Several other civil actions are also pending that claim ABT and other drug makers reported false pricing info (number of lawsuits, issues and potential liability unspecified);
• The company has identified its potential liability for environmental cleanup at not more than $3 Million per site and $15 Million total;

– ABT estimates its possible loss from these legal matters at around $170-310 Million, and has recorded $215 Million as a reserve.  [2009 Annual Report,  page 55]                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

** Apparantly, this reserve does not include anything for the $1.67 Billion judgment against the company and Abbott seems to be hiding much of the potential bad news.  

 SSG Discussion: 

– After the comparison table that follows, I discuss several key SSG issues, ABT’s declining ROE, its high Debt, and overall Financial Condition.

Abbott Labs               (ABT)	Carol	Armin-1	Armin-2	Take Stock
Date	5/3/10	5/4/10	Same	Same
Data	S&P	Same	MStar-Hemscott	Same
Price	$50.87	$50.79	Same	$50.19
52 week High &          Low Price	$66.79 & $42.10	Same & $42.00	Same & Same	Not Used
Last Quarter of     Reported Data	Q1 ending 3/31/10	Same	Q4 ending 12/31/09	Same
Software Used	TK6	Same	Same	TS Online
Project Growth      From End of	Last                 Quarter	Same	Last                Quarter	Last                  FY
Sales Growth	6.00%	10.00%	Same	4.00%
EPS Growth	4.80%                  (from PP)	10.00%	Same	4.00% initial 1.09% final
High PE	18.4	15.3       (from 2009)	15.0    (Same)	19.9
High EPS	$4.81	$6.14	$6.16	$4.04
High Price	$88.50                  (7% < VL)	$93.90           (1% < VL)	$92.40	$80.17               (16% < VL)
Value Line Estimated High Price =$95-115 as of 4/16/10
Low PE	11.0                      (from 2009)	Same	10.9	15.4
Low EPS	$3.81     (TTM)	Same	Same	Same
Low Price	$41.90                (Low PE x          Low EPS)	Same	$41.50 (Same)	$58.67               (exceeds        curr price)
Upside/Down	4.2	4.8	4.9	Impossible    to Calculate
Total Return	14.0%	16.2%	Same	12.9%
SSG Buy Under	N/A	$52.95	$51.93	$45.96
RV/PRV             (outliers removed)	83.2/79.2            (2007 out)	(no outliers)	Same	Not Used
RV/PRV                          (no outliers)	N/A	79.0/71.7	Same	Not Used
Quality	A                          (2nd highest)	Same	Same	2.6                     (fails)
PTPM – 5 yr ave	22.00%              Trend even	Same              Same	20.90%   Trend up	Same                  Trend N/A
ROE – 5 yr ave             Ending Year Equity	26.70%        Trend down	Same     Same	24.60% Trend up	27.1%              Trend N/A
ROE – 5 yr ave            Beginning Yr Equity	N/A	29.40% Trend up	29.10% Trend up	Not Used
Debt to Equity –          5 yr ave	46.80%              Trend up	Same     Same	46.60% Trend up	Not Used

Carol’s SSG: 

Estimating Future Sales and EPS Growth: 

– Carol checked three estimates of future Sales growth (from Morningstar, Value Line, Manifest Investing) and used the lowest of the three (6.00%) from Morningstar. 

** Value Line’s 7.50% was for Sales per Share (not Sales) and VL makes no estimate of future Sales growth.  

** Overlooked was Zacks.com which estimated 9.59% Sales growth for the next 5 years. 

– Carol then used the Preferred Procedure to estimate future EPS growth which involves four estimates for the next 5 years: Sales growth, Pre-Tax Profit Margin, Taxes, and Shares Outstanding. 

** Carol relied on her 7.50% Sales estimate and made no changes in the PP’s defaults which resulted in 4.80% EPS estimate.   

** Had she checked some analysts, Carol might have seen that her 4.80% EPS estimate seems unduly low.  

Armin’s SSGs: 

Estimating Future Sales and EPS Growth: 

– When I did my SSG, the seven analysts I ALWAYS check were estimating long-term EPS at an average of 11.06% with the high at 12.00% (S&P and CNNMoney via FactSet CallStreet) and the low at 9.90% (YahooFinance via Thomson First Call). 

** Value Line was 10.00%, Reuters.com was 10.34%, and Morningstar and Zacks.com were 11.60%.  The seven analysts at Reuters ranged from 13.00% high to 4.20% low. 

** I decided to estimate future EPS growth at 10.00% based on the estimate from Zacks (rounded), the lowest of the seven. 

 ### To learn more about Estimating EPS, click here 

Final Results: 

– Only Armin-1 and Armin-2 satisfied the SSG Buy Criteria of a minimum 3.0 Upside/Downside and a 15% Total Return.  Moreover, I add another requirement: not to substantially exceed or fall below Value Line’s High Price estimate: 

•  Carol (with S&P data) got a 14.00% TR and a 4.2 U/D with a Forecast High Price that was 7% below the low end of VL’s $95-115 High Price estimate;
• Armin-1 (with S&P data) got a 16.2% TR and a 4.8% U/D with a Forecast High Price that was 1% below VL;
• Armin-2 (Hemscott-Morningstar data, but with the same judgments as Armin-1) got a 16.2% TR and a 4.9 U/D with a Forecast High Price that was 1% below VL; and
• Take Stock (Hemscott-Morningstar data) got a 12.9% TR, doesn’t use the U/D concept, and a Forecast High Price that was 16% below VL.

– Carol considered ABT a Buy even though her SSG got a 14.00% TR: 

** BI’s Stock Selection Handbook says that 15.00% is only a goal for our entire portfolio and not something that every stock must achieve.  [Handbook, pages 65-66, 2003 edition]. 

** I disagree and seek a 15% TR for every SSG Buy: that way, my criteria are clear and unambiguous, and don’t depend on the vagaries of my (unspecified) portfolio. 

Return on Equity (ROE): 

– ROE with Ending Equity (26.70%) is trending down with S&P data and any downtrend is often a red-flag warning sign of deteriorating fundamentals. 

** However, this downtrend does not trouble me for several reasons: 

• ROE with Starting Equity (27.10%) is trending up;
• The difference between the two ROEs is insignificant;
• ROE with Ending Equity is better than its S&P Industry Average (26.70% vs 19.80%, Pharmaceutical Industry); and
• Both ROEs with Morningstar-Hemscott data are trending up.

DEBT: 

– ABT had $16.5 Billion in total debt as of 12/31/2009, according to the company’s latest Annual Report, largely incurred to finance recent acquisitions. [2010 A. R.,  PDF page 63]

– Carol was not concerned with ABT’s Debt and her First Cut write-up mentioned:  “Debt and Return on Equity may be a cause of concern for some.  Interest coverage of about 15; they have managed well over 10 years with this higher level of debt.”  

– However, ABT’s Debt to Capital Ratio (40.49% with S&P data) is much higher than five of its direct or close competitors: MRK @ 28.22% and SNY @ 14.32% identified by YahooFinance and PFE @ 21.30%, JNJ @16.63% and BAX @ 35.93%) identified by Morningstar.   

** Moreover, ABT’s 40.49% Debt to Capital Ratio is also higher than its 38.70% S&P Industry Average (Pharmaceuticals). 

– The one-click Annual Report spreadsheet by Bob Adams found that ABT’s Debt was a concern, but not it’s Interest Coverage: 

** The 49% Long-Term Debt to Equity Ratio got a red-flag warning and may be excessive since normal is less than 25%; 

** The Interest coverage at 14.8x (Pre-Tax Profit exceeds interest paid on LT Debt) got a green flag or very good.  

Financial Condition: 

– VL rated ABT an A++ for Financial Strength, its highest grade, with $16.5 Billion in Debt ($11.3 Billion Long-Term) and $8.8 Billion in Cash as of 12/31/09. 

– Morningstar observed that ABT held less cash than its peers because of acquisitions, but that its cash flow was more than adequate to meet interest expenses. 

– The Bob Adams’ one-click spreadsheet gave ABT’s 2009 A.R. a 41 out of 100 with 9 Bullish and 8 Bearish results: 

** The Bullish-good things included: Sales are increasing and increasing faster than Cash Flow; ROE and Free Cash Flow/Sales are very good. 

** The Bearish not-so-goods included: Accounts Receivable and Inventories are increasing and the Cost of Sales is increasing faster than Sales.  

 ### You can get this super-duper, free and easy-to-use spreadsheet, and a summary of its many features, by going to my Favorite Links page: click here 

Armin