Image Source: thetaxhaven
We’re making a number of adjustments to the Best Ideas Newsletter portfolio.
By Kris Rosemann and Brian Nelson, CFA
It’s time to take out the trash… that is, trash hauler Republic Services (RSG) from the Best Ideas Newsletter portfolio (it’s not “trash” – it’s actually a fantastic company and has been a great stock, but boy is it pricey now). We’re also adding ~1.5% positions in two new ideas, Dollar General (DG) and Verint Systems (VRNT), in the Best Ideas Newsletter portfolio as both have attractive valuations, in our view. Dollar General’s 27 consecutive years of same-store-sales growth are impressive, and Verint is now at the low end of its short-term uptrend, offering an interesting entry point for consideration.
Just a quick reminder – our best ideas are already included in the newsletter portfolios, so these two ideas are incremental ‘best ideas’ as it relates to fit in the context of broader market dynamics, which are quite frothy. Let’s talk about why we’re making these changes to the Best Ideas Newsletter portfolio, including a discussion of our thought processes supporting the two new ideas, which will collectively account for a relatively minor weighting in the newsletter portfolio. How heavily we weight each holding is key to understanding our conviction in each idea.
Please also note that these changes are to the Best Ideas Newsletter portfolio, the newsletter of which will be released Saturday, the 15th, not to the Dividend Growth Newsletter portfolio, the newsletter of which will be released Monday, May 1. You get two newsletters with a membership to Valuentum – and that’s in addition to the 1,000+ 16-page reports and dividend reports, fair value estimates/ranges, and proprietary, forward-looking Dividend Cushion ratios. It’s easy to understand why many have chosen Valuentum over bloggers and commentators. We’re actually doing the financial analytical work!
That said, the decision to remove Republic Services from the Best Ideas Newsletter portfolio wasn’t an easy one – we love the company!
But Republic’s valuation–and for the most part, valuations across much of the environmental services industry—have become extremely stretched. We’ve let this winner run for some time, collecting lots of dividend checks, but as both its chart and valuation have now become increasingly extended, we feel most comfortable locking in some major profits.
Republic Services was added to the Best Ideas Newsletter portfolio on May 19, 2011 at $31.42 per share, and upon the removal of the position intraday April 13 (shares are changing hands at $62.41), the removal price amounts to roughly double the cost basis of the position. This will be reflected in the newsletter portfolio at the release of the next edition of the Best Ideas Newsletter portfolio.
We’re taking a portion of the cash from the position in Republic Services and adding 1.5% positions (this is their respective weightings in the Best Ideas Newsletter portfolio) in two new ideas: Dollar General and Verint Systems. The position in Dollar General consists of 50 shares at $68.83, and 87 shares of Verint Systems at $38.95.
Let’s take a look at the two ideas in depth. Even if you’re not following the Best Ideas Newsletter portfolio or Dividend Growth Newsletter portfolio closely, incremental idea generation is a valuable part of our service, as are the full reports for each company in our coverage. These are core attributes of any investment research company.
Dollar General
Consumers across the US are familiar with Dollar General. Its track record of same-store sales growth is impressive, and we’re adding this idea to the Best Ideas Newsletter portfolio as the economic environment remains uncertain, despite optimism surrounding the new Trump administration. Dollar stores are often seen as a defensive “play” as cost-conscious consumers look to save money in any of the broad range of products offered by multiline discount retailers such as Dollar General. So what sets Dollar General apart from its peers?
Image Source: Dollar General
First and foremost is its tremendous track record of same-store sales performance. 2016 marked the 27th consecutive year in which it reported positive same-store sales growth, and the measure has come in below 2% only twice over that 27-year stretch (1990 and 2000). Performance often improves in times of macroeconomic pressure, including during the Great Recession of 2008 and 2009 when same-store sales leapt 9% and 9.5%, respectively. Dollar General’s business is recession resistant.
In addition to impressive same-store sales growth, the largest discount retailer in the US in terms of store count also has substantial room for store unit growth, which has been strong in recent years as well. Its current store base is over 13,000 across 44 states, and management anticipates adding as many as 1,000 stores in 2017 alone, after adding 900 in 2016, as it believes it has the potential to roughly double its store count over time. However, the majority of these new stores will be smaller format stores that will enable the retailer to optimize merchandise mixes and reduce occupancy costs. As a result of these expectations, Dollar General is targeting $30 billion in annual sales in 2020, compared to just under $22 billion in fiscal 2016 (ended January 31, 2017).
Though Dollar General’s balance sheet health is not what we would like it to be for a retailer in the midst of such a growth plan–net debt stood at more than $3 billion as of the end of fiscal 2016–its free cash flow generation should be sufficient in handling the debt load and expansion plans, in our view. During the past three years (fiscal 2014-2016), free cash flow has averaged more than $960 million, good for a ~4.7% free cash flow margin over the three-year period, even after a material ramp in capital spending in recent years–capital expenditures grew to $560 million in fiscal 2016 from less than $375 million in fiscal 2014. Such free cash flow generation and an impressively-consistent track record give us confidence in management’s ability to effectively execute its growth plan.
Shares of Dollar General also offer potential from a valuation point of view as they are trading in the lower half of our fair value range, below our fair value estimate of $75 per share. Management’s guidance of non-GAAP diluted earnings per share to be in a range of $4.25-$4.50 suggest shares are changing hands at just under 15.8x fiscal 2017 earnings. The company also offers an uninspiring but healthy quarterly dividend with a current annualized yield of ~1.5% at recent price levels.
We like what Dollar General has to offer as the current economic expansion grows longer in the tooth with each passing day. Its track record of same-store sales performance, thanks to its recession resistant business, is simply incredible, and we love its future growth potential and capability to fund such growth with internally generated cash flows. Such factors have given us the confidence to add 50 shares of Dollar General to the Best Ideas Newsletter portfolio at $68.83 per share.
Verint Systems
As the era of big data becomes more and more of a reality, enterprises are being inundated with more information than ever before. An information overload can be just as useless or frustrating as a lack of information, so how can companies generate insights more efficiently and effectively?
Enter Verint Systems.
Verint Systems is the self-proclaimed leader of actionable intelligence, which it defines as crucial insights that enable decision makers to anticipate, respond, and take action. The company has 10,000+ customers in more than 180 countries and serves more than 80% of the Fortune 100. Its two operating segments, ‘Customer Engagement Solutions’ and ‘Cyber Intelligence Solutions,’ split its total addressable market of actionable intelligence, which has grown to ~$8 billion as of 2016 from ~$3 billion in 2012.
Verint’s ‘Customer Engagement Solutions’ segment is a leading provider of analytical software that is deployable on-premises or in the cloud, helping organizations optimize customer engagement and increase loyalty while generating operational efficiencies and reducing risk. The segment’s solutions facilitate the modernization of customer-centric organizations’ customer engagement operations in our increasingly digital world. The company’s ‘Cyber Intelligence Solutions’ addresses a wide range of security and intelligence challenges via its broad portfolio of data mining solutions.
The ‘Customer Engagement Solutions’ segment is the larger of Verint’s two segments–it accounted for roughly two thirds of fiscal 2017 (ended January 31) revenue–and boasts higher margins than the ‘Cyber Intelligence Solutions’ segment. Though both segments have a high level of repeat business, nearly 60% of the ‘Customer Engagement Solutions’ segment’s revenue is of the recurring variety. We’re big fans of the visibility in future revenue, and management anticipates this level continuing to grow as cloud-based revenue grows as a percentage of ‘Customer Engagement Solutions’ segment revenue–it accounted for more than $100 million of ~$716 million in revenue in fiscal 2017 and is expected to outpace overall company growth in fiscal 2018 at 25%+. Other sources of recurring revenue include recovery resources and maintenance, and even though management is unable to classify its on-premises software products as recurring revenue, it is confident in the ‘stickiness’ of these products and the level of repeat business from its customer base.
Verint’s growth potential and ability to continue advancing the proportion of recurring revenue within its business are supported by its thirst for innovation. The firm has plowed more than $1 billion into research and development over the past decade, an impressive level when considering it surpassed the $1 billion in revenue mark as recently as fiscal 2015. As a result, it boasts more than 800 patents and applications, the defense of which will be necessary to maintain its position as the leader of actionable intelligence.
Such a drive for innovation is expected to help Verint Systems deliver mid-single-digit revenue growth in its ‘Customer Engagement Solutions’ segment and high-single-digit revenue growth in its ‘Cyber Intelligence Solutions’ segment in fiscal 2018. We expect the recent reorganization of Verint’s formerly three operating segments into two to help reinvigorate overall growth via a renewed focus and improvement in its go-to-market processes. Slight operating margin expansion, a trend we expect to continue as economies of scale are realized in its growing actionable intelligence platform, is projected to help drive non-GAAP earnings per share to ~$2.70 in fiscal 2018 compared to $2.51 in fiscal 2017.
Image Source: Verint Systems
Though we are largely positive on Verint’s current outlook, its financial position could be better. As of the end of fiscal 2017, the company had nearly $320 million in cash and cash equivalents compared to just under $750 million in total debt, but its net debt-to-adjusted EBITDA was a reasonable 2.1x. We think the company’s credit ratings are due for an upgrade, as the most recent credit actions regarding its debt took place in mid-2014 when Moody’s and S&P upgraded it to Ba3 and BB, respectively. At the time of Moody’s upgrade, it cited debt-to-EBITDA improving to 4.2x from 5.3x as rationale being the rating adjustment, and that measure sat at a more healthy level of 3.2x at the end of fiscal 2017.
Organic growth, which we are expecting to return in a meaningful way, and the maintenance of leverage at more recent levels should result in a credit upgrade, according to Moody’s credit ratings rationale. Free cash flow generation has been solid in recent years as well, further supporting our growing confidence in the company’s rebounding financial position. In the three-year period ending January 31, 2017, free cash flow has averaged more than 13% of revenue.
In addition to our keenness for Verint’s business model, shares offer a reasonable valuation opportunity at current prices. Our fair value estimate of $50 per share indicates we see material upside potential in shares, which are trading at ~14.7x management’s EPS guidance for fiscal 2018. We find such levels compelling for a company with solid growth prospects in today’s frothy market environment, and as a result, we have added 87 shares of Verint Systems to the Best Ideas Newsletter portfolio at $38.95 per share.
Environmental Services: CLH, CVA, CWST, DAR, ECOL, RSG, SRCL, WCN, WM