Sunday, February 12, 2006

Intrinsic Value

“Many shall be restored that are now fallen and many shall fall that are now in honor.”
Horace, the Latin lyric poet and satirist, Ars Poetica

That is a quote Benjamin Graham used in the first edition of Security Analysis in 1934. Any value investor should know it by heart. It is very difficult to make investment decisions which defy herd mentality on Wall Street especially when those decisions mean ignoring the hot stocks de jour.

The discipline of value investing is a powerful and time-tested approach which has rewarded its disciples through bear markets, bull markets and recessions. Bruce Greenwald’s Value Investing – From Graham to Buffett and Beyond does a superb job laying out the fundamentals as they have evolved since Graham pioneered this school of thought. The book uses case studies to reinforce the concepts including a detailed look at Intel in the late ‘80s and early ‘90s. The second half of the book consists of 8 chapters devoted to the investment approach of some of the most celebrated value investors of all time including Buffett, Greenberg, Klarman and the Schlosses.

This book will become an invaluable investment resource and you will end up referring back to it over and over again. Here is a quick primer on how you estimate the intrinsic value of a security:

  1. Calculate the Net Asset Value of the company. You do this by calculating the Reproduction Cost of the assets. In other words, if a competitor were to enter the market, how much would it need to spend to get in the game. The NAV is calculated by making adjustments to the Book Value which include R&D and Marketing and Advertising expenditures a competitor would need to spend in order to become a genuine challenger. You can use the adjusted book value to calculate a Market Value to NAV ratio as an initial gauge of how expensive a stock may be.
  1. Calculate the Earnings Power Value of the company. To calculate EPV, you start with operating income (EBIT) and make adjustments which include adding back depreciation and amortization and subtracting capital expenditures. This is the same as the distributable cash flow to shareholders assuming no growth. A hard core value investor never assumes any growth when calculating the intrinsic value of a company. We will get to this later. This number is then divided by the cost of capital to calculate EPV. Note that a value investor does not have to contend with the practically impossible task of estimating what a company’s growth prospects may be five or ten years down the road. This eliminates a lot of uncertainly. Incidentally, the difference between the EPV and the NAV, when positive, is called the franchise value. In other words, the company’s moat. The EPV must then be adjusted so you can compare it with the current market cap of the company. To do this, you subtract interest bearing debt and add back all cash in excess of 1% of sales (1% of sales in cash is about how much is needed to operate a company). For a value investor, this is the intrinsic value of the company. Ideally you want to buy the stock when it is trading below the EPV to provide yourself with a Margin of Safety.
  1. So what about growth? What value can we ascribe to growth when we are calculating the intrinsic value of a company such as Intel? The answer is simple. You have to assess whether the company can grow without destroying shareholder value. I won’t get into the details, but basically if the company is going to reinvest excess cash into its operations, it must earn in excess of the cost of capital to create value for existing shareholders. Greenwald calls this growth within the franchise. To calculate what I will call the Growth Factor which is the ratio of the Present Value of Future Cash Flows (PV) to EPV, you need to estimate a growth rate and calculate two ratios: Return on Equity/Cost of Capital and Growth Rate/Cost of Capital. Don’t worry about the math, but with those two ratios in hand you can calculate a Growth Factor. This is how it works. A ratio of 2.0 means the company’s intrinsic value could be twice the calculated EPV. Conversely, if you decide to buy the stock at EPV, the company’s growth should provide you with a 50% Margin of Safety.

A lot has changed since Greenberg wrote the 2001 edition of his book. But keeping his assumptions constant for a quick back of the envelope calculation justifies a $27 intrinsic value for Intel (Nasdaq: INTC). At today’s price this provides only a 25% Margin of Safety. Not enough for a value investor.

Monday, February 06, 2006

Timmy and Wendy

Canadians love their Tim Horton’s coffee. Canada’s version of Starbucks Coffee (NASDAQ: SBUX), affectionately referred to as Timmy’s, has been an enormous success since its first store opened in 1964. In 1995, Wendy’s International Inc (NYSE: WEN). merged with Tim Horton’s and facilitated its entry into the US market. Over the past 5 years, Timmy’s has carried Wendy’s on its back and has masked the dismal results at the Wendy’s franchise.

Last July, a hedge fund run by Bill Ackman, Pershing Square Capital, demanded that Wendy’s management raise dividends, initiate a more substantial share repurchase program and implement a partial spin-off of Timmy’s. The shares jumped on the news from around $45 to just above $50 and then retrenched before resuming their upward trend. Ackman has been successful in his recent bid to shake things up at MacDonald’s.

In December of 2005, another well-known hedge fund manager, Nelson Peltz, entered into the picture and made more demands. Most significantly, Peltz asked management to implement a complete spin-off of Timmy’s, sell ancillary businesses improve Wendy’s abysmal operating margins by bringing then on par with industry peers. Previously, he successfully turned around Arby’s and Snapple.

In their regulatory filings, Peltz and his Trian partnership disclosed a 5.5% stake in Wendy’s shares at prices ranging from $48 to $51. After that filing, Wendy’s shares jumped to $55. Trian’s filings lay out the recipe for unlocking value for Wendy’s shareholders. The 13D filing is available on SEC’s web site and makes for educational reading. Trian pegs Timmy’s worth at $32 to $36 a share. These numbers were floating around in a few articles on the internet earlier in the year. Trian’s main thesis is that operating margin at Wendy’s franchise can be almost doubled implying a share value of at least $45 for a total valuation of $77 or higher.

I did not catch wind of all this until middle of January. At $45, Wendy’s shares were a huge bargain. If you believed the rumors that Timmy’s would float at $36, Wendy’s franchise was available at $9 a share! While Wendy’s restaurants’ results have not been spectacular, there is no reason to believe that a competent management team could not turn things around. In any case, perhaps hindsight is 20/20. The question we should ask now is if the shares are worth a look at current prices, hovering around $57?

Rumors are that Timmy’s shares will be in high demand. The IPO share price may be as high as $38. The recent success of MacDonald’s (NYSE: MCD) Chipotle Mexcan Grill (NYSE: CMG) spin-off highlights the market’s appetite for this sector right now. Plus, without getting into much detail (I will let you read Timmy’s S1 on your own spare time), Tim Horton’s is a solid growth story. If the shares float at $38, Wendy’s implied valuation per share is about $19. This means there is plenty of value left in the shares if you believe Trian’s pitch and management’s ability to institute a turnaround. Moreover, by buying Wendy’s shares today, you will “lock in” any potential appreciation in Timmy’s shares after the IPO.

Peltz may not get all his wishes. Today, Wendy’s management announced that Timmy’s shares will be fully distributed in 9 to 18 months after the IPO citing tax efficiency reasons. Peltz had hoped for a speedier distribution. On the other hand, Wendy’s management laid out numerous other initiatives to improve efficiencies, sales and margins. While they did not acknowledge Peltz, it seems to me they are on the right track and have effectively endorsed Peltz’s recipe for a turnaround. It will be interesting to see how Peltz reacts to these initiatives.

In my opinion, Wendy’s shares offer a compelling valuation at these levels. While some of the margin of safety may have been eroded over the past 6 months, I believe the prospect of a well received Tim Horton’s IPO warrants taking a position in Wendy’s shares today. Wendy’s franchise will not be fixed overnight, but there is no reason why the operational efficiencies cannot be brought inline with industry peers over the next two to three years. We have taken a position just above $57. May Tim Horton, the National Hockey League legend, work his magic once again.