Question #1
October 1, 2014
Brian:
I have a quick question for you. I read last night that Valuentum eliminated Ford (F) from their portfolio. A few months ago you commented on the strength of Ford’s sales in emerging markets. You have a range of 15-27 on Ford price using the DCF process. With F trading currently under the low end of the range, would it still be prudent to sell the position? I know clients have made gains since your recommendation in your portfolio, but wouldn’t it be more prudent to sell a position that is closer to fair value than one that is trading below its fair value range? If there is an updated report on F, I would be very interested to see what has changed. This is a substantial position for clients and I want to make an informed decision before we make any changes. At this point, I am inclined to keep DRIPing the dividend, accumulating more shares, and let the value catchup happen when the markets settle down.
Thanks Brian in advance for any thoughts you may have around this topic.
Response:
Thank you for the email. One of the most important things about the markets is the information flow and how it can change the outlook rather quickly.
What we found interesting about Ford is that a number of regions–from Europe, South America, and Russia–are expected to be weak. The company also said that profit margins in North America are going to be at the low end of the previous guidance range in the near term. We don’t think the large expected loss in South America can be overlooked, nor do we think the management shift is worth taking too lightly. Former CEO Alan Mulally was quite the turnaround expert, and we were banking on a number of new product launches to continue to propel excitement to drive sales.
However, the new CEO Fields expects to cut global vehicle platforms from 15 to 9. We’re also a bit concerned about the impact that negative operating leverage may have–i.e. usually when things slow, operating income takes a larger hit than sales, especially for large fixed-cost industrials. It may just take some time to get used to the new CEO at the helm. He could also be setting the bar very low, so as to drive better-than-expected performance in coming periods. This isn’t unlike new CEOs.
In any case, the analyst day raised some red flags for us, and taken in conjunction with other information (see link below), it led us to believe that cyclicals could be due for some profit pressure in coming periods. We outlined seven reasons a few days ago about why we thought the market was headed for the fall that we’re currently having. We’ve sent out a few emails along those lines as well, including one regarding put protection. There were a variety of factors that led us to remove the F position from the portfolio–some firm-specific (the Valuentum process requires strong pricing momentum), some bigger picture (per link below), and some portfolio management related (regarding reducing cyclicals exposure). Here’s the link to the article of the seven reasons why we’re very cautious at present:
That said, over the long haul, things are still very bright at Ford. We expect vehicle demand to continue to increase across the globe, and we’re encouraged by the company’s market share gains in China, though we also outline that China’s pace of economic expansion could be waning a bit (see link above). Ford expects that by 2020, its annual global sales will increase 45%-55% to ~9.4 million. That’s a nice runway for expansion. The company’s 2020 targets also reveal earnings potential in the ~$2-$3 per share range at that time, which makes present multiples very enticing, if it can hit those goals. The company still is undervalued, in our view, but there are very real near-term risks. The $15-$27 fair value range on shares is still reasonable and remains unchanged at this time.
The answer on Ford would depend on each client’s goals and risk tolerances. Please let me know if I can provide any further detail.
Question #2
September 29, 2014
Hey Brian,
Hope all is well for you and the team. I had a question for you on Gilead (GILD), and wondered if you might be able to point me in a direction or even forward any resources that might be of help.
I’ve noted the interest in Gilead Sciences, and I’ve begun to go over your reports as well as management discussion and analysis with the GILD 10-k and some sell side forecasts. They can vary widely of course (depending on how an analyst is looking at it –midterm profitability or quarter end estimates) and ultimately I’m left scratching my head. I agree with what I have read about your methodology in thinking about mid cycle profitability more and shying away from the estimate revision game. In practice, however, I can have a hard time in trying to translate that into a top line growth and op. margin estimate. Management for GILD has given some guidance on R&D and SG&A of course so that is helpful in the margin situation.
How does one forecast the product pipeline for a drug company, and the potential demand for a relatively new drug like Sovaldi without being an M.D. or a biopharmaceutical engineer? How can you take that demand potential and translate it into revenue dollars when they are doing deeply discounted product offerings (compared to developed market prices) into developing countries. Obviously more demand would be in the developing markets where HIV infection is much higher, but I still get hung up at this point of the analysis.
Thanks in advance for your time. Always enjoy the newsletters.
Response:
You bring up some fantastic questions, and I will try to do the best I can to show my appreciation in my response. Estimating mid-cycle numbers is one of the most challenging dynamics for any analyst, but it is among the most important. Within industrials, for example, analysts have to deal with one of the most challenging aspects with respect to the financials, that being operating leverage. In many cases, analysts underestimate the amount of operating/fixed-cost leveraging within the business model, and this opens the door to identify mispriced gems. Said differently, mid-cycle margins are much higher than what analysts think can be achieved (in many cases, analysts think linearly, not exponentially with respect to operating leverage). Precision Castparts (PCP) is a good example of this.
In other cases, product launches could impact the 5-year discrete horizon that we pursue in the model. For example, an analyst must assess, in Apple’s (AAPL) case, the trajectory of iPhone 6 upgrades and what normalized measures might be appropriate for its iPhone program as well as other platforms including the iPad (not to mention new launches with respect to mobile payments and wearable technologies). Certainly this is not an easy task, but focusing on the mid-cycle expected performance provided investors with an excellent entry point in shares when they were trading at a split-adjusted ~$50 per share not too long ago. Even under pessimistic mid-cycle estimates, a bargain was to be had. A focus on mid-cycle estimates aided in this example as well.
With respect to Gilead, a similar type of thinking applies. In the spirit of Benjamin Graham, we strive to be roughly right, rather than precisely wrong. In investing, the only thing that we know about being precise is that it can never be had. This is why we use a margin of safety around the fair value estimate. We willingly accept that our point fair value estimates will change. Not only should they, as a result of the passing of time (cash flow generation, time value of money), but our estimates are often tweaked time and again as new information becomes available. To us, Gilead is trading at a steep discount to intrinsic value on a DCF basis and on a relative value basis versus peers. The market is also showing us confirmation in the idea, with the stock price increasing. Under these circumstances, we feel that the risk/reward is tilted into investors’ favor.
To your question, how can we have confidence in our forecasts without being an MD or a biopharmaceutical engineer? The answer is similar to that of the Precision Castparts and Apple examples. The ability to identify mispriced ideas rests on a value versus price misalignment in the markets. Do we need an aerospace engineering degree to understand that the commercial aerospace cycle presented to us in the burgeoning backlogs at the airframe makers is going to aid metal-bender Precision Castparts and that the Street will underestimate its operating leverage? The answer was no, because investing comes down to identifying the big outliers (steeply discounted stocks). The same is also true in the case of Apple. Did we need an electrical engineering degree, or equivalent, to know that Apple would come out with another refresh of its iPhone or that it would continue to innovate to drive future results? The answer here is also no. The market was too product driven with respect to Apple, and not long-term oriented. This provided opportunity.
What I’m trying to get at is that in instances where the discount to intrinsic value is so large, the odds are stacked in the investors’ favor. Could we be wrong with our estimate of the company’s true intrinsic value? Of course. But in any investment, the future is what drives intrinsic value, and the future is always going to be uncertain. We can’t ignore this significant risk. That’s why the margin of safety is so important in the analysis. In sum, as it relates to Gilead, because there is a significant margin of safety applied to the fair value estimate, and shares are still rather cheap, we’re comfortable with stating that it is an interesting idea for consideration. It meets the criteria, much like other ideas that we’ve added to the newsletter portfolios.
Gilead is certainly a more challenging example than Precision Castparts or Apple, but the systematic application of the process is the same. Importantly, however, we have to be cognizant of the broader market environment as well, especially with market valuations above their 5 and 10-year averages and how long we’ve been in the current recovery (more than 5 years off the March 2009 bottom). New ideas such as Gilead may take much longer to pan out in a difficult market environment than one that has been genuinely sanguine, as in the past several years.
Please let me know if I can be of any further assistance. You have excellent questions.
Question #3
September 17, 2014
Hi Brian –
Thanks for your recent “Four Important Topics” article. I think the personal touch is very valuable; also Elizabeth has been very responsive and helpful to me in my requests.
I would like to suggest that you provide some commentary in whatever media you think appropriate concerning a figure in the valuation analysis listed as “Free Cash Flow to the Firm CAGR %.
Mostly this figure ranges positively and is understandable, however, oftentimes a figure is presented that is negative, and quite high at that. Witness the recent rating for Boeing (BA). In this report, the above referenced line item is -281.4%. My observation is that this figure when negative appears to be most always a high number, say over ~ -200%.
One possible reason is that you have factored in some large projected capex figure, although it’s hard to understand why the CAGR would be so high, unless every year for 5-years there will be growing capex. What goes into that assumption?
Any light that you could shed on this subject would be much appreciated.
Response:
Thanks for the question. Boeing is an interesting company, in an interesting period within its history. The company has just finished up a massive capital investment and working capital-build program with the 787 Dreamliner, and this is going to cause some material variability on the growth rates of annual enterprise free cash flow, in particular, from last year to this year.
In Boeing’s case, for example, a small negative FCFF number turned into a rather large positive number this year, resulting in a large negative growth rate, influencing forward averages, etc. We target normalized working capital and investment by year 5, and getting to that point can influence near term growth rates quite a bit. Though at times we use ‘NMF” to denote when growth rates aren’t meaningful, we sometimes leave them in there to reveal inflection points in operations.
I have attached the Boeing model (please contact us) and have left the cursor on the relevant line for your review. The build of FCFF is also displayed near that location. Please let me know if I can be of any further assistance.
Thank you for your continued interest.
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