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Blue Harbinger 15

Westar Energy (WR) - Thesis

Rating: BUY
Current Price: $39.92
Price Target: $46.48

Thesis:
We own Westar Energy because it offers shareholders a growing dividend and opportunities for capital appreciation.  We also appreciate the company’s diverse energy generation mix, including its growing renewables capacity.  Lastly, as a utilities company, Westar adds important diversification to our Blue Harbinger 15 portfolio.

Westar Energy is the largest electric energy provider in Kansas.  The company provides generation, transmission and distribution to approximately 687,000 customers.  Westar maintains a flexible and diverse energy supply portfolio.  In doing so, they continue to make environmental upgrades to their coal-fired power plants, develop renewable generation, build and upgrade their electric infrastructure and develop systems and programs with regard to how their customers use energy.  The following chart shows Westar’s mix of energy generation capacity:

The diverse sources of energy, particularly renewables, are important and valuable because Westar faces significant environmental regulation challenges.  Some companies throughout the US generate almost all of their energy from coal, and this exposes them to heightened regulatory risks as coal is the dirtiest form of energy.  Westar acknowledges this risk in their annual report as follows:

“Our costs of compliance with environmental laws and regulations, including those relating to greenhouse gas emissions, are significant, and the future costs of compliance with environmental laws and regulations could adversely impact our operations and consolidated financial results.”

Because Westar has significant renewables capacity, it keeps the company out of the direct cross-hairs of federal regulators who often have little regard for the economic impacts of expensive regulations on the well-being of the surrounding communities.  Additionally, Kansas is a strongly republican state which means it tends to be less extreme with regards to the imposition of expensive environmental regulations.

Important for future growth of the company, Westar operates in economically healthy regions of Kansas including the cities of Topeka, Lawrence, Manhattan, Salina, Hutchinson and Wichita.  Unemployment is low in these areas, and Westar is a large employer.  The strong economy helps ensure Westar also remains strong.  The following chart shows the breakdown of Westar’s customer base:

In March 2015, Westar requested approval from the Kansas Corporation Commission to increase the rates it charges by 7.9% or $152 million to recover Environmental Protection Agency (EPS) costs as well as increased service reliability.  And in August they reached an agreement for a $78 million rate increase.  The approved rate increase demonstrates the region’s support for Westar Energy.

Valuation:
We value Westar at $46.48 per share by discounting its $2.44 expected 2015 earnings per share using a required rate of return of 6% (weighted average cost of capital) and a growth rate of only 0.75% per year which is the long-term rate Westar expects (annual report p.28).  If the growth rate ends up being higher than 0.75% then the stock is worth even more.  Our $46.48 price target gives the stock more than 16% upside, with potential for further increases depending on the company’s future growth and profitability.

Dividends:
In addition to potential gains via capital appreciation, Westar offers shareholders an increasing dividend. Dividends are common for stable utility companies like Westar, and in this case Westar offers and attractive 3.62% dividend yield.  And the amount of Westar’s dividend payments has increased over time (see graph below), and the company expects this trend to continue.

Conclusion:
Westar is a diversified electric utility company that rewards shareholders with a growing dividend and opportunity for capital appreciation.  Additionally, this electric utility company investment adds important sector diversification to our Blue Harbinger 15 portfolio.  It is important to invest across a variety of market sectors (e.g. utilities, consumer discretionary, technology, etc.) to reduce exposure to sector specific risks and to minimize overall volatility in the value of your investment portfolio.

Johnson & Johnson (JNJ) - Thesis

Rating: BUY

Current Price: $95.06

Price Target: $122.60

 

Thesis:
Johnson & Johnson is a blue chip among blue chip companies, and now is an excellent time to buy.  JNJ has an amazing track record of increasing its adjusted earnings for 31 consecutive years and increasing its dividend for 53 consecutive years.  The dividend yield is currently an attractive 3.2%, and the stock price has recently pulled back making now a great time to buy.

Overview:
Operating across its three main segments (Consumer, Pharmaceutical, and Medical Devices), the company is home to many names you’ve heard of (e.g. Band-Aid, Tylenol, Listerine, Visine) and many other great health care products people rely on around the world (you can view the company’s products here).  In fact, Johnson & Johnson sells products in virtually every country in the world.  The company’s global sales gives investors an added level of diversification beyond just the diversified products and business segments.  In 2014, JNJ had $74.3 billion in total sales.  Forty-three percent of the sales came from the Pharmaceutical segment, 37% from Medical Devices and the remaining 20% from the Consumer segment.

Valuation:
We value JNJ using a 50/50 combination of discounted free cash flows and Ben Graham’s (EPSx(8.5+2xGr)) formula.  In both valuations, we assume the company can grow at 5% per year.  The average 5-year earnings growth estimate of the 19 professional analysts included on Yahoo Finance is 4.96%.  We believes JNJ provides will benefit from a global demographic trend which the company aptly explains as follows: “the historic aging rate of the world’s population, along with a growing middle class around the world, brings dramatically greater demand for higher quality health care” (Annual Report, p.3).  Our discounted cash flows analysis uses a 9% required rate of return (CAPM derived), and values JNJ at $131.54 per share.  Graham’s formula assigns the company a $113.65 price per share.  We use the average of the two to value JNJ at $122.60, which is well above its current price.

Cash:
JNJ has a history of returning cash to shareholders through dividends and share buybacks.  As mentioned previously, the dividend has increased for 53 consecutive years.  In aggregate, the company paid $7.8 billion for dividends in 2014.  They also repurchased $7.1 billion of its own stock (this is another way to return cash to shareholders).

Buying Opportunity:
JNJ’s stock price is down this year for two main reasons, and the fact that it is down makes now a good time to buy.  First, JNJ is down with the rest of the broader market.  As bad economic data out of China and jitters about the US Federal Reserve’s upcoming interest rate hike have hit JNJ just like almost every other stock in the market.  And second, JNJ earnings are being hurt by foreign currency fluctuations.  Specifically, the strong US dollar makes international sales less profitable for the company.  However, these two things make JNJ more attractive now than it was before because the broad market pullback is only temporary (the world will go on) and foreign currency volatility is stabilizing. (currency markets have been highly volatile since the “Great Recession” on 2008-2009). 

Conclusion:
The main reason most individual investors buy Johnson & Johnson stock is for the dividend.  It’s a steady stable company, and the dividend payments keep rolling in quarter after quarter.  However, the stock also offers the opportunity for capital appreciation.  And while there is no guarantee the stock price will go up tomorrow, this month, or this year, we believe strongly it will go up over the long-term.  As the company says “the historic aging rate of the world’s population, along with a growing middle class around the world, brings dramatically greater demand for higher quality health care,” and JNJ is a leader in meeting these needs.

U.S. Value Stock ETF (IWD) - Thesis

iShares Russell 1000 Value ETF (ticker: IWD)
Expected Return: 8.75% per year
Expected Volatility: 18.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the “value” portion of the equity markets will increase at a slightly better rate than the rest of the market.  Value stocks are defined as stocks with lower price-to-book ratios and less aggressive earnings growth expectations.  They’re basically stocks that are on sale.  Empirical research has shown that value stocks have outperformed the rest of the market over the long-term (10+ year periods).  Additionally, value stocks have moderately under-performed the rest of the markets over the last several years which makes them even more attractive (because they’re on sale).  We believe the reason value stocks have underperformed in recent years is because the accommodative monetary policies of the U.S. Federal Reserve since the great recession in 2009 have favored “growth” stocks.  Specifically, stocks that need to borrow more money to grow have been able to borrow it at attractively low rates because of the low interest rates set by the Fed.  As the Fed raises rates over the coming market cycle (they next three to 10 years) this will be a headwind to growth stocks and it will favor value stocks.  Regardless of where we’re at in the market cycle, value stocks tend to outperform over the long-term, and the Russell 1000 Value ETF (ticker: IWD) offers reliable exposure to the returns of value stocks while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
IWD invests in over 650 large US companies classified as “value” stocks.  At least 90% of its assets are invested in securities of the Russell 1000 Value Index.  The fund may invest the remainder of its assets in certain derivatives such as futures, options, swap contracts and cash equivalents.  The index is one of the most commonly followed equity indices in the World, and is largely considered the standard benchmark for U.S. large company value stocks.  The performance of IWD has historically matched the performance of the Russell 1000 Value Index very closely, and it should continue to track closely in the future because of its construction methodology.  Investors cannot purchase the actual index, and IWD is the next best thing.

Volume and Liquidity:
As a standard ETF, IWD has significant volume and liquidity (total IWD assets exceed $23.5 billion).  Because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, IWD trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within IWD.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes IWD much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of IWD, and subsequently adversely moving the market price away from its NAV because the volume of IWD is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on IWD is currently 20 basis points (0.20%).  This is extremely low for value stock exposure; it is good for investors because it allows them to achieve better returns on their investment.  For comparison, value mutual funds (a common competitor to ETFs) may charge over 150 basis points (1.5%) per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because IWD can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that IWD is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, IWD pays a quarterly dividend (around 2.49% per year), and this dividend is NOT automatically reinvested back into IWD (this is standard protocol for ETFs and stocks).  This means you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
IWD is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider IWD to be a basic building block for long-term wealth, and we rate IWD as a “Buy.”  For more information, you can view the fact sheet for this ETF here.

U.S. Small Companies ETF (IWM) - Thesis

iShares Russell 2000 Index ETF (IWM)
Expected Return: 8.75% per year
Expected Volatility: 20.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the small cap portion of the equity markets will increase more than the large cap portion, albeit with more volatility.  The iShares Russell 2000 Index ETF (IWM) offers reliable exposure to the returns of the small cap portion of the U.S. equity market while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
IWM invests at least 90% of its assets in securities of the Russell 2000 Small Cap Index.  The fund may invest the remainder of its assets in certain derivatives such as futures, options, swap contracts and cash equivalents.  The index is one of the most commonly followed equity indices in the U.S., and is largely considered the standard benchmark for small cap stocks.  The performance of IWM has historically matched the performance of the Russell 2000 Small Cap Index very closely, and it should continue to track closely in the future because of its construction methodology.  Investors cannot purchase the actual index (the Russell 2000 Small Cap Index), and IWM is the next best thing.

Volume and Liquidity:
As the standard small cap ETF in the US, IWM has significant volume and liquidity (total IWM assets exceed $28 billion).  Because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, IWM trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within IWM.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes IWM much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of IWM, and subsequently adversely moving the market price away from its NAV because the volume of IWM is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on IWM is currently 20 basis points (0.20%).  This is extremely low for small cap market exposure; it is good for investors because it allows them to achieve better returns on their investment.  For comparison, small cap mutual funds (a common competitor to ETFs) may charge over 200 basis points (2.0%) per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because IWM can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that IWM is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, IWM pays a quarterly dividend (around 1.36% per year), and this dividend is NOT automatically reinvested back into IWM (this is standard protocol for ETFs and stocks).  This mean you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
IWM is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider IWM to be a basic building block for long-term wealth, and we rate IWM as a “Buy.”  For more information, you can view the IWM fact sheet here.
 

Paylocity (PCTY) - Thesis

Paylocity (PCTY)
Rating: BUY
Current Price: $29.75
Price Target: $45

Thesis:
Paylocity is a cloud-based provider of payroll and human resource capital management software solutions for mid-sized organizations.  They are generally a less expensive solution than ADP which is the payroll processing industry standard suited for large organizations.  Paylocity is a smaller market capitalization company (~$1.6 billion), headquartered in Arlington Heights, Illinois, that has grown its revenues at an astounding rate in recent years, but has also spent heavily to achieve this growth.  We believe Paylocity’s high spending is acceptable for a small organization that is growing to meet market demand.  We believe the company will eventually reach a point where the heavy spending on growth will become unnecessary, and the company’s high gross profit margin will make it essentially a “cash cow.” 

Valuation:
As a relatively new public company (the initial public offering was March 24, 2014), we value Paylocity using Price-to-Revenue comparables.  More traditional valuation metrics such as discounted cash flow analysis and price-to-earnings ratios are less useful for Paylocity because the company is currently spending very heavily on growth.  Early stage companies often spend more than they collect to fund future growth opportunities that are expected to result in significant future profitability.

Paylocity has been growing revenues at a pace of approximately 40% per year since 2011, and the company expects continued high growth going forward.  During the earning conference call on August 13, 2015, Paylocity forecast 2016 earnings to be $199 to $203 million, representing ~32% growth over fiscal year 2015.  Assuming the company can grow revenues at 27.2% for the next five years (this is the average estimate by the six analysts surveyed by Yahoo Finance) gives Paylocity a “price to five-year-forward-revenue” ratio of 3.2 times ($1,620 million market capitalization divided by $508 million revenues).  This compares favorably to the same ratio of peers ADP and Paychex of 2.3 and 4.3, respectively.  We assumedADP to have a revenue growth rate of 8.15% and Paychex to have a revenue growth rate of 7.15% using the average revenue growth estimates of the analysts (20 and 19, respectively) surveyed by Yahoo Finance.

We believe Paylocity should trade in a price to fiscal year 5 revenue range of 4 to 5 times, given its size and future growth opportunities.  This gives us a target price range of $40 to $50 per share, well above its current price of $29.75. 

What makes the Paylocity valuation even more compelling is the fact that the company has clear opportunities to grow its revenues significantly beyond the $508 million estimate for 2020.  In fact, Paylocity estimates their market opportunity to be closer to $9 billion.  The following passage from the firm’s most recent annual report gives some flavor for how they view the market opportunity:

According to market analyses published by International Data Corporation, or IDC, titled Worldwide and U.S. Human Capital Management Applications 2015 – 2019 Forecast (June 2015) and U.S. Payroll Outsourcing Services 2013 – 2017 Forecast and Analysis (October 2013), the U.S. Market for HCM applications and payroll outsourcing services is estimated to be $24 billion in 2015. The market opportunity is driven by the importance of payroll and HCM solutions to the successful management of organizations.
To estimate our addressable market, we focus our analysis on the number of U.S. medium-sized organizations and the number of their employees.ccAccording to the U.S. Census Bureau, there were over 565,000 firms with 20 to 999 employees in the U.S. in 2010, employing over 40 million persons.
We estimate that if clients were to buy our entire suite of existing solutions at list prices, they would spend approximately $230 per employee annually. Based on this analysis, we believe our current target addressable market is approximately $9.0 billion. Our existing clients do not typically buy our entire suite of solutions, and as we continue to expand our product offerings, we believe that we have an opportunity to increase the amount clients spend on payroll and HCM solutions per employee and to expand our addressable market.

And if Paylocity is able to continue to grow beyond the next five years, then the stock’s valuation is even more compelling.  Unlike the large and more mature ADP, Paylocity has much more significant growth opportunities ahead.

Competitive Advantages:
Cloud-based solutions: Paylocity’s solutions are cloud-based and offered on a subscription basis, making them easier and more affordable to implement, operate and update.  They enable clients to focus less on their IT infrastructure and more on their core businesses.

Underserved market: Paylocity serves small and mid-sized companies (defined by Paylocity as 20 to 1,000 employees) that often don’t need all the expensive bells and whistles, and are also often ignored by bigger competitors that prefer to focus on bigger clients.  Paylocity serves the unique challenges faced by this group, noting that employees in these medium-sized organizations often perform multiple job functions, and many medium-sized organizations have limited financial, technical and other resources needed to effectively manage their critical business requirements and to build and maintain the systems required to do so.

Lower cost solutions:  Mid-sized companies often don’t need all the expensive bells and whistles, and are also often ignored by bigger competitors that prefer to focus on bigger clients.  Paylocity offers solutions targeted towards these organizations.

 

Growth Strategy: According to the firm’s annual report (p.4), Paylocity’s growth strategy includes the following:

  • Growing the Client Base: We believe that our current client base represents only a small portion of the medium-sized organizations that could benefit from our solutions. While we served approximately 10,350 clients across the U.S. as of June 30, 2015, there were over 565,000 firms with 20 to 999 employees in the United States, employing more than 40 million persons, according to the U.S. Census Bureau in 2010. In order to acquire new clients, we plan to continue to grow our sales organization aggressively across all U.S. geographies.
  • Expanding Product Offerings: We believe that our leadership position is in significant part the result of our investment and innovation in our product offerings designed for medium-sized organizations. Therefore, we plan to increase investment in software development to continue to advance our platform and expand our product offerings.  For example, in June 2015 we announced the release of ACA Enhanced, which will provide compliance and reporting for the Affordable Care Act.
  • Increasing Average Revenue per Client:  Our average revenue per client has consistently increased in each of the last three years as we have broadened our product offerings. We plan to further grow average revenue per client by selling a broader selection of products to new and existing clients.
  • Extending Technological Leadership: We believe that our organically developed cloud-based multi-tenant software platform, combined with our unified database architecture, enhances the experience and usability of our products, providing what we believe to be a competitive advantage over alternative solutions. Our modern, intuitive user interface utilizes features found on many popular consumer Internet sites, enabling users to use our solutions with limited training. We plan to continue our technology innovation, as we have done with our mobile applications, social features and analytics capabilities.
  • Further Developing Referral Networks: We have developed a strong network of referral participants, such as 401(k) advisors, benefits administrators, insurance brokers, third-party administrators and HR consultants that recommend our solutions and provide referrals. We believe that our platform’s automated data integration with over 200 related third-party partner systems is valuable to our referral participants, as they are able to access payroll and HR data through a single system which decreases complexity and cost and complements their own product offerings. We plan to increase integration with third-party providers and expand our referral network to grow our client base and lower our client acquisition costs


Risks:
Achieving Profitability: Paylocity faces a variety of risks, and perhaps the greatest and most obvious is noted in their annual report: “we have incurred losses in the past, and we may not be able to achieve or sustain profitability for the foreseeable future.”  This is a company that is spending heavily on future growth.  If the growth is not achieved then the company and it its stock price will suffer.

Competition is another significant risk.  As the company notes in its annual report: “The markets in which we participate are highly competitive, and if we do not compete effectively, our operating results could be adversely affected.”  Paylocity goes on to explain that the “market for payroll and HCM solutions is fragmented, highly competitive and rapidly changing. Our competitors vary for each of our solutions, and include enterprise focused software providers, such as Ultimate Software Group, Inc., Workday, Inc., SAP AG, Oracle Corporation and Ceridian Corporation, payroll service providers, such as Automatic Data Processing, Inc., Paychex, Inc., Paycom Software, Inc. and other regional providers, and HCM point solutions, such as Cornerstone OnDemand, Inc.”

Insider control is another risk.  According to Paylocity “Insiders have substantial control over us, which may limit Our stockholders’ ability to influence corporate matters and delay or prevent a third party from acquiring control over us.”  Said differently, stockholders cannot do much if the directors, officers and affiliates want to make bad decisions.  The annual report explains “as of August 7, 2015, our directors, executive officers and holders of more than 5% of our common stock, together with their respective affiliates, beneficially owned, in the aggregate, approximately 64.4% of our outstanding common stock. This significant concentration of ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. In addition, these stockholders will be able to exercise influence over all matters requiring stockholder approval, including the election of directors and approval of corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit the ability of our other stockholders to influence corporate matters and may have the effect of delaying or preventing a change in control, including a merger, consolidation, or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control, even if that change in control would benefit our other stockholders.”

Economic growth (or lack thereof) is another risk.  If the overall economy fails to grow, or grows at a slow rate, this may impact the ability of Paylocity to grow its business as expected.

Conclusion:
Paylocity is one of the higher risk (and potentially higher rewarding) companies in the Blue Harbinger 15.  Based on the market opportunity, this company could turn extremely profitable within the next five years.  And any signs of improvement in the near term should cause the stock price to increase towards our price target of $40 to $50 per share.  Realistically, this company could greatly exceed our growth targets and continue to grow dramatically for many years to come.

The Walt Disney Company (DIS) - Thesis

The Walt Disney Company (DIS)
Rating: BUY
Current Price: $101.57
Price Target: $115

Thesis:
The Walt Disney Company (DIS) is a behemoth of valued brands, with lots of cash flows, strong earning power, a decent dividend, and it’s currently on sale.  We value DIS at $115 per share using a 50/50 combination of a discounted cash flow model and a valuation formula first published by Benjamin Graham, Warren Buffett’s mentor, in the 1940’s.  Disney’s stock price declined in August after missing Wall Street revenue estimates, and then it never recovered as market-wide declines kept the stock price down.  Relative to its current market price, we believe Disney has significantly more upside than the overall stock market.  We rate Disney a buy, and we own the stock.

Overview:
Disney divides itself into five business segments: (1) media networks, (2) parks and resorts, (3) studio entertainment, (4) consumer products and (5) interactive media. Media Networks comprise an array of broadcast, cable, radio, publishing and digital businesses across two divisions – the Disney/ABC Television Group and ESPN Inc. Walt Disney Parks and Resorts (WDP&R) is a provider of family travel and leisure experiences. The Walt Disney Studio brings movies, music and stage plays to consumers throughout the world. Disney Consumer Products (DCP) delivers product experiences across thousands of categories from toys and apparel to books and fine art. Disney Interactive is a creator of interactive entertainment across all current and emerging digital media platforms.

Growth:
“Media Networks” (Disney/ABC television and ESPN) contributes the most revenue and operating income, but the company generates growth across its diversified business segments as shown in the following segment results tables:

In addition to the past performance provided in the tables above, Disney management provides forward guidance indicating strong expected future growth.  For example, along with its third quarter earnings release, the company stated that it should see mid-single digit growth in fiscal year 2016 due to the strengthening of dollar and modest subscriber losses at its cable networks.

Additionally, Disney expects its upcoming release of the movie “Star Wars: The Force Awakens” to generate significant growth for the company.  Another source of significant growth is expected to come from Disney’s Shanghai theme park resort which is expected to be operational by Spring 2016.

Valuation:
A quick discounting of Disney’s free cash flow suggests the company is trading at an attractive price.  Calculating free cash flow as cash flow from operations ($9.8 billion) minus capital expenditures ($3.3 billion), and then discounting this by the company’s weighted average cost of capital (~8.3%), and assuming it can grow at 7.5% per year for the next 5 years, followed by 3.0% per year thereafter, gives us a present value of ~$198 billion, which is more than 15% upside versus its current market cap of $172 billion.  Considering Disney has 1.69 billon shares outstanding, this gives us a valuation of $117 per share.

As a second estimate of Disney’s valuation, we use a formula first published by Benjamin Graham (Warren Buffett’s mentor) in the 1940’s (EPS x (8.5 + 2 x growth)).  We assume earnings will grow by 14.0% for the next five years (this is the average 5-year earnings growth estimate, per year, by the 32 analysts surveyed on Yahoo Finance), and then we assume earnings will grow by 3% per year thereafter.  This gives us a valuation of $112 per share which is about 11% upside versus the current share price.  Importantly, this is a conservative estimate because if Disney is able to grow faster than 3% after five years, then the company is worth more than this valuation suggests.

Risks:
Perhaps the biggest risk to Disney is anything that could damage its strong brand reputation.  According to Forbes, Disney is the 11th most valuable brand in the world.   Related to Disney’s brand, the company notes the following risk in their annual report: “Changes in public and consumer tastes and preferences for entertainment and consumer products could reduce demand for our entertainment offerings and products and adversely affect the profitability of any of our businesses.”  Further, Disney notes: “The success of our businesses is highly dependent on the existence and maintenance of intellectual property rights in the entertainment products and services we create.”

Another significant risk noted by Disney is simply that “changes in U.S., global, or regional economic conditions could have an adverse effect on the profitability of some or all of our businesses.”  Certainly a global economic downturn could adversely affect Disney as the company’s products aren’t a bare necessity, and could suffer from a reduction in consumer spending.

Another risk noted by Disney is that “changes in our business strategy or restructuring of our businesses may increase our costs or otherwise affect the profitability of our businesses.”  Certainly, Disney is a large company, with multiple business segments and lots of moving parts.  Any missteps in any part of the company could affect the organization as whole.

Conclusion:
Disney’s stock price is cheap right now relative to its value, and this likely won’t be the case for long.  With great earnings power, strong cash flows, a decent dividend, and growth potential from the likes of the new Star Wars movie and the new Shanghai theme park, Disney is an outstanding blue chip stock to own for the long-term.

U.S. Bancorp (USB) - Thesis

U.S. Bancorp (USB)
Rating: BUY
Current Price: $44.81
Price Target: $61.69

Thesis:
U.S. Bancorp (USB) has a strong balance sheet, an appropriate mix of business segments, it consistently generates lots of free cash flow, it is trading below its intrinsic value, and it has room for continued earnings growth if/when interest rates rise.

Valuation:
By discounting cash returned to shareholders (dividends plus share repurchases), USB is worth $61.69 per share, 37.7% more than its current market price.  In 2014 and 2013, USB returned 72% and 71% of earnings to shareholders (dividends and share repurchases), respectively.  In 2013, the company stated its target was to return 60%-80% of earnings to shareholders annually, and this target has come down since pre-financial crisis (for example, in 2006 USB stated their goal was 80% per year).  Discounting this cash returned to shareholders using a discount rate of 5.75% (weighted average cost of capital) and assuming a 2.0% perpetual growth rate (USB grows at about the same rate as the economy), yields a valuation of: ($5.85 billion [2014 earnings] X 70% [% of earnings returned to shareholders]) / (5.75% - 2%) = $109.2 billion.  Since there are approximately 1.77 billion shares outstanding, this results in a valuation of $61.69 per share.  And potentially more if interest rates rise allowing USB to achieve additional growth from a higher margin on deposits.

U.S. Bancorp’s Business: - Appropriately Diversified:
Headquartered in Minneapolis, Minnesota, the business of U.S. Bancorp (aka US Bank) is appropriately diversified.  The company has chosen to operate across four main market segments, and the company’s revenue generation is balanced between margin and fee businesses.  USB CEO, Richard Davis, believes USB operates in “precisely the markets where we compete the best, and we are confident this mix of businesses has us well positioned for the future.” (2014 Annual Report).  The four main business segment are: Consumer and Small Business Banking; Wholesale Banking and Commercial Real Estate; Wealth Management and Securities Services; and Payment Services.  Consumer and Small Business Banking is the largest generating around 39% of net interest income and 28% of non-interest income.  In 2014, USB’s interest income (taxable equivalent basis) was $11.0 billion and its noninterest income was $9.2 billion.  Consumer and Small Business Banking is largely regional, Wholesale Banking and Commercial Real Estate as well as Wealth Management and Security Services is national, and Payment Services and Global Corporate Trust is international.  


Relatively Safe:
U.S. Bancorp’s business is relatively safe, providing the company favorable funding costs, strong liquidity, and the ability to attract new customers.  For example, the company consistently receives credit ratings among the highest in the industry.  USB already exceeds advanced Basel III risk weighted asset ratios as if they were already fully implemented.  The company’s debt-to-equity ratio has come down considerably in recent years (from over 3.0 to under 1.5, driven in large part by regulatory requirements), and while this also reduces the bank’s earnings power, it also significantly reduces the bank’s risk.

Additionally, USB’s business mix (i.e. multiple business segments and the split between interest and non-interest income) provides a consistent income stream that can weather a variety of market conditions.  Further, Global Finance Magazine ranked USB as one of the World’s safest banks in 2012, 2013 and 2014.  And in February 2015 USB was named Fortune Magazine’s Most Admired Super-Regional Bank for the fifth consecutive year.  This relative safety helps USB to consistently deliver results.


Growth:
USB has multiple sources of potential growth including expanding margins, growing business segments, and simply increasing business as the overall economy grows.  For example, interest rates in the US are expected to increase within the next year; this will allow USB to earn a higher spread on the rate they pay depositors and earn from borrowers.  Also, USB has opportunity to grow non-interest income (currently roughly 46% of income) by increasing revenue especially from credit and debit card services as well as merchant processing services.  Further, USB’s non-interest income should grow in general as the economy grows.

Risks:
Major risks for USB include increased government regulations and the possibility that interest rates do not increase in the foreseeable future.   Regulatory reserve requirements have dramatically reduced leverage (and risk) in the banking industry, however these regulations have also reduced the earnings power of the banks as well as their ability to return capital to shareholders as they see fit.  If regulators were to increase or tighten requirements this could have an adverse impact on USB’s ability to earn profits.  Regarding interest rates, USB will not be able to grow earnings as quickly if interest rates do not start increasing in the next year as the US Federal Reserve has indicated they will.  Low interest rates have compressed margins for USB (and banks in general), and without raised rates and margin expansion USB’s earnings growth will be challenged.

Conclusion:
U.S. Bancorp (USB) is relatively safe compared to banking sector peers, and has demonstrated the ability to consistently deliver profits in good and bad market conditions.  Our discounted cash flow valuation model indicates the stock price is below its intrinsic value.  Additionally, a rising interest rate environment increases USB’s earnings power and provides additional upside to the stock price.  We value USB at $61.69 per share, and rate the stock a “Buy.”

McDonald's (MCD) - Thesis

McDonalds (MCD)
Rating: BUY
Current Price: $97.10
Price Target: $122.69

 

Thesis: 

McDonald’s earnings have declined recently due in large part to supplier issues in China, an unfavorable lower court ruling that resulted in a large increase to foreign tax reserves, the strong US dollar’s negative impact on non-US operations, and a brand that seems to be in decline.  However, the company continues to deliver enormous amounts of free cash flow, new management is pursuing significant top and bottom line improvements, and the stock’s recent declines are overdone.  Using a discounted cash flow valuation model, we believe MCD is worth $122.69 per share, giving it more than 26% upside versus its current market price.  We rate MCD a “Buy.”


Current Situation:

Things seem bad at MCD.  The company has delivered a negative earnings surprise (versus the consensus estimate) in all but the most recent of the last six quarters (they beat by $0.02 in calendar Q2).  Net income (2014) declined considerably versus previous years, and Q1-15 and Q2-15 EPS was well below Q1-14 and Q2-14.  The CEO was replaced in 2015, and public perception seems to be negative.  Additionally, it seems a daunting task for MCD to deliver significant growth considering it’s already very large, and consumers’ tastes seem to have shifted to prefer higher quality, higher-service competitors.

 

Free Cash Flow:

Despite negative public perceptions and declining earnings, MCD continues to generate an enormous amount of free cash flow.  Cash flow from operations minus capital expenditures continues to exceed $4 billion per year, and will likely increase in the future due to managements plans to limit capex to $2 billion (it’s been $2.5 to $3.0 billion in recent years), and to achieve $300 million of net annual savings in SG&A expenses by the end of 2017.  This will put free cash flow around $5.3 billion per year, leaving plenty of room for the company’s roughly $3.2 billion of annual dividend payments.

However, the free cash flow becomes somewhat concerning considering MCD is in the middle of a 3-year plan (2014-2016) to return $18-$20 billion of cash to shareholders.  It’s concerning because they’re only generating roughly $14 billion of free cash flow during this period.  The shortfall is made up through debt issuances and cash generated by refranchising of restaurants.  It doesn’t seem entirely unreasonable to finance dividends and share repurchases with debt (to an extent) if management believes the stock is undervalued especially considering they’re paying a 3.5% dividend yield on the equity and MCD’s cost of debt is in roughly that same neighborhood.  Further, MCD has plans to refranchise 3,500 restaurants by 2018 which will add to cash inflows.  However, there are only so many restaurants they can refranchise, and there is a limit to the amount of debt they can issue.  Something will need to change for MCD in the long-term because the current operating status quo will not allow this much cash to be returned every year beyond the next few years.

During the most recent post earnings conference call, MCD CFO, Kevin Ozan, announced they’ll be delaying their next dividend payment announcement two months until November which suggests there may be big changes coming with regards to how MCD uses its extra cash.  MCD may be announcing expensive restructuring, expensive growth initiatives, a big acquisition, a reduction in share repurchases, changes to the dividend policy, or some combination of the above.


Valuation:

We value MCD at $122.69 per share using a discounted cash flow model.  Our model assumes approximately $5.3 billion of free cash flow in 2016, a 6% required rate of return and a conservative 1.5% growth rate.  A 1.5% growth rate is very small, and could easily be eclipsed over the next two years simply if foreign currency exchange rates stop working against MCD (for example, MCD’s Q2 investor relations earnings report notes foreign currency translation had a negative impact of $0.13 and $0.23 on diluted earnings per share for Q2-15 and year-to-date, respectively.  And MCD lost 2% of net income to currency in 2014).  If MCD grows at 3% into perpetuity its worth $184.03, and if it grows at 0% it is worth $92.02.  And there is room for growth considering MCD’s 2013 (most recently available data) system-wide restaurant business accounted for only 0.4% of the outlets and 7.5% of total sales within the “Informal Eating Out” segment of the market (2014 MCD Annual Report).

 

Turnaround Plans:

MCD is engaged in a variety of initiatives to stem the company’s slumping sales growth and declining profits.  One major initiative is improving the brand image.  The newly appointed CEO was formerly in charge of branding at MCD, and he will bring expertise in this area to the highest level of the organization.  There is a strong focus on enhancing the appeal of core products and addressing food perceptions; MCD is focused on improving and highlighting the quality of ingredients.  Another initiative is expanding breakfast, which is the company’s strongest day-part.  Market testing around all day breakfast availability continues.  Previously mentioned cost reductions are also an important initiative.  The company plans to reduce capital expenditures to around $2 billion and decrease annual SG&A expenses by around $300 million.  If successful, these reductions will improve free cash flow and profitability.

 

Conclusion:

We’re giving new management time to execute on its turnaround plans; especially considering the company is already worth significantly more than its current stock price suggests (we value MCD at $122.69 per share based on discounted cash flows); and because we are comfortable taking the contrarian stance on a stock that we believe has been overly beat up by public perception.  We own shares of MCD, and we rate the stock a “Buy.”

Procter & Gamble (PG) - Thesis

Procter & Gamble (PG)
Rating: Buy
Current Price: $81.63
Price Target: $99.79

Thesis:
Procter & Gamble’s stock price is depressed because of strong foreign currency headwinds and a variety of sub-optimal market ventures. The currency headwinds will likely subside as global monetary policies continue to normalize as the financial crises moves further into the rear-view mirror.  Additionally, the company’s current multi-year restructuring will increase profitability by increasing efficiency and by shedding sub-optimal market ventures.  Using a discounted cash flow model, Procter & Gamble is worth $99.79 per share, giving the stock more than 22% upside versus its current market price.

Foreign Currency Headwinds:
Approximately 61% of Procter & Gamble’s sales come from outside the United States.  This creates a variety of foreign currency challenges for the company, especially since the US dollar (the company’s reporting currency) has strengthened significantly in the last year.  In fact, the company expects to take an approximately $1.4 billion hit to earnings in 2015 because of the strong US dollar.  This is significant considering PG’s total earnings are only around $11.6 billion per year.  Foreign currencies have weakened versus the US dollar for a variety of reasons.  For example, the US economy is recovering from the global financial crisis quicker than other economies, and while the US is beginning to reduce accommodative monetary policies, non-US economies are still introducing more accommodative policies.  Regardless, recent currency volatility will eventually decline, and P&G will also tweak its foreign currency hedging programs.  The result will be less foreign currency challenges, and P&G’s earnings will pop up.  Also, there could be quarters and years in the future where PG’s earnings are helped by foreign currency moves in which case earnings will pop up even more.

Restructuring:
P&G is currently in the process of shedding a variety of less profitable brands.  According to CEO A.G. Lafley:

"P&G will become a simpler, more focused Company of 70 to 80 brands, organized into about a dozen businesses and four industry-based sectors. We will compete in businesses that are structurally attractive and best leverage our core capabilities.  Within these businesses, we will focus on leading brands or brands with leadership potential, marketed in the right countries where the size of prize and probability of winning is highest, with products that sell. We will discontinue or divest businesses, brands, product lines, and unproductive products that are structurally unattractive or that don’t fully play to our strengths… The 90 to 100 brands we plan to exit have declining sales of -3%, declining profits of -16% and half the average Company margin during the past three years."

In addition to shedding some 90 to 100 brands, P&G is also in the middle of a multi-year productivity and cost-savings plan.  Per the company’s annual report:

"In 2012, the Company initiated a productivity and cost savings plan to reduce costs and better leverage scale in the areas of supply chain, research and development, marketing and overheads. The plan was designed to accelerate cost reductions by streamlining management decision making, manufacturing and other work processes to fund the Company's growth strategy.  As part of this plan, the Company expects to incur in excess of $4.5 billion in before-tax restructuring costs over a five-year period (from fiscal 2012 through fiscal 2016).  Approximately 62% of the costs have been incurred through the end of fiscal 2014. Savings generated from the restructuring costs are difficult to estimate, given the nature of the activities, the corollary benefits achieved (e.g., enrollment reduction achieved via normal attrition), the timing of the execution and the degree of reinvestment.  Overall, the costs and other non-manufacturing enrollment reductions are expected to deliver in excess of $2.8 billion in annual gross savings (before-tax). The cumulative before-tax savings realized through 2014 were approximately $1.4 billion."

P&G’s profitability will increase as the multi-year restructuring is completed and as less profitable brands are exited.  This helps create the room for significant upside to the current stock price.

Growth Opportunities:
In addition to restructuring, P&G does have some growth opportunities.  To some extent, P&G will grow as the total global population grows.  Additionally, the secular trend in emerging markets whereby populations move from rural to more urbanized and suburbanized areas benefits P&G because these populations tend to use more P&G products.

Additionally, P&G spent $2.0 billion on research and development in 2012, 2013 and 2014.  Examples of recent product introductions include the Fusion ProGlide (introduced four years ago, priced at the higher end of the premium segment, grew global share for 31 consecutive quarters, and reached $1 billion in sales faster than any other P&G brand in history) and Crest 3D White (a premium oral care regimen, has grown market share for 17 consecutive quarters, is a billion-dollar business, and is an important driver of toothpaste market share growth in developing markets).

Valuation:
We value PG at $99.79 using a discounted cash flow valuation.  We assume 2014 free cash flow of $10.11 billion grows at 3.5% in the future (conservative estimate roughly equal to global economic growth), $1.0 billion of the estimated $1.4B negative 2015 currency impact returns to a more neutral level of negative $0.4B (remember if the US dollar weakens it could actually help P&G), P&G restructuring amounts to $1.4 billion of additional annual cash flow (conservative estimate, less than P&G’s own estimate) and the required rate of return is 8.5% (long-term capital market assumption):
 [($10.11B x 1.035 + $1.0B + $1.4B) / (0.085 – 0.035) + 13.16B of cash ] / 2.71B shares = $99.79 per share.

As a double check, a “Dividend + Share Repurchase” model suggests the company is worth around $100.06 per share.  This valuation technique is relevant for PG because the company is very stable and consistently pays increasing dividend and buys back shares.  Here is the calculation:  [($6000 of share repurchase + $6900 of dividends) / (8.5% required return – 3.5% growth) + $13160 cash] / 2710 shares = $100.06 per share.

Conclusion:
Procter & Gamble has underperformed the S&P 500 by roughly 14% year-to-date, and trades more than 22% below its intrinsic value per our discounted cash flow valuation model.  A “dividend + share repurchase” discount model also suggests the stock is significantly undervalued.  PG stock is depressed as the company has been hampered by severe foreign currency headwinds (the US dollar is strong) and a variety of (soon-to-be eliminated) sub-optimal market ventures.  PG currently trades around $81.63 per share, and we believe it is worth more.  Our price target is $99.79 per share.

Facebook (FB) - Thesis

Rating: Buy
Current Price: $86.73
Price Target: $ 142.50

Thesis:
Facebook’s opportunities for continued advertising revenue growth are enormous.  Rather than maximizing these opportunities as quickly as possible, Facebook CEO Mark Zuckerberg is focused on continuing to improve the user experience which he believes is ultimately better for the company’s long-term success.  As Facebook continues to improve and integrate the Facebook application, WhatsApp, Messenger, Instagram, and new innovations, the monetization opportunities via advertising make this company worth far more than its current stock price suggests.

Valuation:
Using a Discounted Cash Flow (DCF) valuation model, Facebook’s is worth $142.50 per share.  The model assumes FCF will grow 30% in 2015 to $4.7 billion, and then grow at 27.2% for the next five years before reverting to a more market normal growth rate of 3% beyond 2020.  This five year expected growth rate (27.2%) is consistent with the average estimate of over 40 professional analysts according to Yahoo!Finance.

 

Facebook only needs to grow at about 12% for the next five years to be worth its current market price, and based on the advertising revenue growth opportunities available, Facebook is easily worth considerably more than its current stock price suggests.

Sources of Growth:
According to Facebook’s Chief Financial Officer, David Wehner, the company has three strategic priorities.  First, is to capitalize on the shift to mobile (see Q1’15 conference call).  This has been the highest priority since the company’s initial public offering (IPO) in 2012.  Thus far, the company has allayed fears that they would not be able to profitably convert to the small screens of mobile devices, but there is more opportunity ahead.  The company is still in the early stages of mobile advertising, and has foregone enormous short-term revenue opportunities in favor of building this business prudently for long-term success.  For example, according to the company’s annual report:

“We prioritize user growth and engagement and the user experience over short-term financial results.  We frequently make product decisions that may reduce our short-term revenue or profitability if we believe that the decisions are consistent with our mission and benefit the aggregate user experience and will thereby improve our financial performance over the long term. For example, from time to time we may change the size, frequency, or relative prominence of ads in order to improve ad quality and overall user experience. Similarly, from time to time we update our News Feed ranking algorithm to deliver the most relevant content to our users, which may adversely affect the distribution of content of marketers and developers and could reduce their incentive to invest in their development and marketing efforts on Facebook.”

The bottom line here is that Facebook is trying to build for the long-term and there is huge room for growth.

Facebook’s second strategic priority is to grow advertising revenue.  This goal is noticeably second, not first, because the company recognizes the long-term importance of putting users (not advertisers) first.  During Facebook’s most recent Q1 conference call, Chief Operating Officer Sheryl Sandberg repeatedly pointed out Facebook only has a small portion of companies’ advertising revenue, and this is a truly enormous growth opportunity.

Facebook’s third strategic priority is making their applications more relevant.  This is important because it helps Facebook retain, grow and improve users, which ultimately sets up the company for long-term success.  Facebook’s other applications include WhatsApp, Instagram, Messenger, and other initiatives designed to benefit users.  Facebook recently acquired WhatsApp and Instagram, and the company hasn’t even scratched the surface yet in terms of monetizing these businesses.

Worth noting, Facebook continues to spend a large amount of money on research and development.  This supports the notion that the firm is building for long-term success by serving users rather than simply trying to monetize everything as quickly as possible so the inside owners (e.g. Mark Zuckerberg) can “cash out.”

Risks:
Stagnant or Declining User Base:  Facebook’s number one risk is its ability to retain users.  According to the company’s annual report:

“If we fail to retain existing users or add new users, or if our users decrease their level of engagement with our products, our revenue, financial results, and business may be significantly harmed.”

In other words, if people stop using Facebook, then the advertisers go away and Facebook isn’t able to make any money.  Facebook combats this risk by focusing on user experience across everything they do.  They forgo revenues to improve user experience, they constantly innovate and introduce new features and applications through a large research and development budget and by acquiring businesses (e.g. Instagram, WhatsApp) that pose a threat and/or create integration benefits.  When invetors ask CEO Mark Zuckerberg questions, his go to response always seems to be that the company is just really focused on improving the user experience.

Corporate Governance:

Facebook’s corporate governance structure introduces a variety of risks for shareholders.  For some background, Facebook founder and CEO, Mark Zuckerberg, is the largest shareholder, he has virtually complete control over the company via voting rights (there are multiple share classes, and Zuckerberg own the class with the real voting rights), and Facebook’s board is comprised of insiders and friends.  This allows Zuckerberg to take actions that are not necessarily in the best interest of shareholders, and he has already demonstrated a penchant for taking questionable actions.

For example, Zuckerberg has made some very big acquisitions (WhatsApp, Instagram); these types of acquisitions are often a symptom of a company with more cash than it needs, and rather that returning it to shareholders it is spent on the types of acquisitions which have historically destroyed value for shareholders.  Facebook may be young enough with enough growth opportunity that these acquisitions may bunk the norm and actually add value in the long-term, but they may also be the beginning of a bad habit for Zuckerberg; additional acquisitions could prove quite destructive to shareholders as often is the case.

As another example, Facebook’s board could inappropriately increase the number of shares outstanding which would be dilutive to existing shareholders.  Facebook has historically used shares to pay for acquisitions (e.g. Oculus) and to reward executives with stock options.  These types of share issuances are often not in the best interest of existing shareholders.

Mark Zuckerberg has done an exceptional job growing Facebook, but the company is still early in its public company lifecycle.  For this reason, Facebook is able to do things now that may be totally unacceptable in the future (e.g. big acquisitions, dilutive stock issuances). Inevitably, Facebook will eventually focus less on growth (because Facebook’s untapped markets will continue to decrease) and focus more on increasing the value of the business (because that will become the more profitable priority).  And as this shift occurs, Facebook’s current corporate governance will become more of a risk.

Conclusion:

Facebook continues to have significant growth and monetization opportunities ahead.  Despite some questionable corporate governance for this young public company, and despite the possible risk of a stagnating user base, Facebook is still easily worth more than it's current stock price suggests.  We own shares of Facebook, and we value the company at $142.50 per share.

 

S&P 500 ETF (SPY) - Thesis

SPDR S&P 500 ETF (SPY)
Expected Return: 8.5% per year
Expected Volatility: 16.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the SPDR S&P 500 ETF (SPY) offers reliable exposure to equity market returns while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
SPY generally holds all of the securities in the S&P 500 Index (it may omit a few during transitional periods, but not enough to significantly impact performance).  The index is one of the most commonly followed equity indices in the world, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.  Unlike other ETFs, SPY does not hold risky derivative instruments such as futures and swaps.  The performance of SPY has historically matched the performance of the S&P 500 index very closely, and it should continue to track closely in the future because it has essentially the same holdings as the index (investors cannot purchase the actual index, and SPY is the next best thing).

Volume and Liquidity:
SPY is the world’s largest ETF, and the world’s most highly traded ETF and equity security.  This scale has two significant benefits to investors.  First, because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, SPY trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within SPY.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes SPY much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of SPY, and subsequently adversely moving the market price away from its NAV because the volume of SPY is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on SPY is currently less than 10 basis points (0.0945%).  This is extremely low for an ETF and extremely good for investors because it allows them to achieve better returns on their investment.  For comparison, mutual funds (a common competitor to ETFs) may charge 1-2% per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because SPY can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that SPY is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, SPY pays a quarterly dividend (around 2.0% per year), and this dividend is NOT automatically reinvested back into SPY (this is standard protocol for ETFs and stocks).  This mean you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.


Conclusion:
SPY is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider SPY to be a basic building block for long-term wealth, and we rate SPY as a “Buy.”  For more information, you can view the SPY fact sheet here.

American Express (AXP) - Thesis

Rating: BUY
Current Price $77.55
Price Target: $91.46

To paraphrase Baron Rothschild, “Buy when there is blood in the streets.”  American Express is currently suffering from several serious wounds (the stock price is down 17% year-to-date while the S&P 500 is essentially flat).  First, AXP’s stock price took a hit this year from its ending exclusive card relationship with Costco.  And second, AXP has been attacked by the US government’s antitrust ruling which will allow merchants to discriminate against American Express cards for charging higher point-of-purchase fees (in theory, merchants will be incentivized to do this because AXP charges merchants higher discount fees than other cards like Visa and MasterCard).  However, the impacts of these two wounds may be less serious than perceived, and AXP may still have a few tricks up its sleeve.

Regarding the antitrust lawsuit, it’s helpful to understand how American Express’s business model is different from competing cards like Visa and MasterCard.  AXP issues its own cards through its own banks (American Express Centurion Bank and American Express Bank, FSB).  And AXP’s primary source of revenue is the discount fee charged (as a percent of the charge amount) to merchants that accept American Express cards.  Therefore, AXP’s revenue depends on the total amount spent by customers and not on the volume of transactions.  On the other hand, Visa and MasterCard are not banks, and they make money based on the volume of transactions.  As a result, the charge card industry has evolved so it is cheaper for merchants to accept Visa and MasterCard over AXP.  AXP has defended against this risk by requiring merchants to sign agreements saying they will not encourage customers to use Visa and MasterCard over AXP.  Unfortunately for AXP, recent antitrust rulings have decided these agreements are unlawful and must be eliminated.  So now the question becomes, how much business will AXP lose as a result of the antitrust ruling (which by the way, the details of the implementation of this ruling are still being determined).

For some added color, in 2014 Visa had more than 2 billion cards in use worldwide and processed more than 60 billion transactions, while AmEx had just 107 million cards in force and processed just 6 billion transaction.  Despite this disparity, American Express had annual gross revenues of $33 billion while Visa brought in just $14 billion (Forbes).  The disparity exists because American Express has built its business to attract high credit quality high transaction size customers, whereas Visa has built its business simply to attract a lot of volume (they don’t care about credit quality because they’re not on the hook for defaults like AXP is).

Regarding the loss of Costco exclusivity, the media has spun this as a very bad thing for AXP, but in reality this may not be nearly as bad as perceived.  For some background, starting in April 2016, Citigroup will replace American Express as the exclusive issuer for Costco credit cards in the U.S. (AXP’s deal with Costco in Canada ended last year) because AXP and Costco couldn’t come to terms.  Costco accounts for roughly 20% of AXP’s loans.  According to Warren Buffett (his Berkshire Hathaway is AXP’s largest shareholder) “Somebody was going to get the bid, and American Express learned a week or two ago that they were not the one that was going to get it... I don’t know the terms of the new deal, but I don’t think Citi will get rich off of it."  Merchants (such as Costco) have been pressuring card issuers for better deals, and the loss of Costco likely isn’t as big of a hit to future earnings as many people perceive simply because the terms Costco was demanding were likely less profitable for AXP than the old terms. 

Valuation:
Regarding Valuation, it is important to remember the impact of these two wounds (loss of Costco exclusivity and antitrust rulings) are already baked into the price.  What matters at this point is whether you believe the market over- or under-reacted to these events, and what do you think will happened to American Express’s business going forward.

Regarding the antitrust rulings, I believe American Express’s high-end business (remember the company targets higher spending customers) may be “stickier” than perceived.  For example, even if merchants offer a 1% discount to use non-Amex cards, customers may use AXP anyway if they know AXP is still offering them a 2% reward for the transaction.  Additionally, AXP may be able to re-optimize its discount rate to attract the customers it wants and to maintain profitability.  Further, some merchants will do anything they can to serve customers therefore some merchants simply won’t discriminate against American Express.  Another alternative for AXP is to focus more on its small but fastest growing segment (GNMS) which utilizes a business model similar to Visa and MasterCard and therefore is not being targeted by government antitrust laws.

Regarding the loss of Costco, American Express has other growth opportunities.  For example, the company has the world’s largest integrated payments platform (i.e. a global network connecting millions of consumers, businesses and merchants) which is a source of powerful data and creates many growth opportunities to better serve customers.  For instance, AXP has recently integrated with the Uber app to let AmEx card members earn double rewards points or redeem points for rides.  AmEx also formed a significant partnership with Apple Pay. Apple has designed a simple, secure, user-friendly payments feature into its latest-generation iPhones, and AmEx believes that integrating their capabilities with Apple Pay can help fuel growth in mobile payments. AmEx is also active in the startup community with ventures in a range of startups combining commerce and data science.  More broadly, AmEx has large untapped potential to benefit from the ongoing global shift into electronic payments and away from cash and checks.  According the AXP CEO, Ken Chenault “It’s not easy to see a longstanding partnership [Costco] end. But when the numbers no longer add up, it’s the only sensible outcome.”

Forward Price-to-Earnings Ratio:  Based on historical data, AXP averages a forward price-earnings ratio of 95%-100% that of the S&P 500 Index.  Using a 2015 AXP EPS estimate of $5.72 (Yahoo!Finance) and the S&P 500 forward P/E ratio recently sitting at 16.4 times, that gives American Express a price target of $91.46/share (5.72 x 16.4 x 0.975).


Financial Management:
From a financial standpoint, American Express is well-run.  First off, AXP has come under intense regulatory scrutiny since the financial crisis, and as a result its financials are very strong.  Even though AXP generates more cash than it needs to profitably operate, it still requires regulatory approval before issuing dividends or repurchasing shares.  According to the American Express annual report

“Historically, capital generated through net income and other sources, such as the exercise of stock options by employees, has exceeded the annual growth in our capital requirements. To the extent capital has exceeded business, regulatory and rating agency requirements, we have historically returned excess capital to shareholders through our regular common share dividend and share repurchase program.”

AXP has a dividend yield of around 1.5% and it has a regular share repurchase program (it repurchased over 4% of its total shares outstanding in each of the last two years).  The company returns four times as much cash to shareholders through share repurchases versus dividends signaling that AXP management may believe its stock price is undervalued.

AXP continues to make significant reallocations of its resources to optimize its business.  For example, at the end of 2014 AXP sold its investment in Concur Technologies (a travel management company) for $719 million (pre-tax), and reallocated a large portion of the proceeds to other area of its business such as marketing, promotion and awards.

Additionally, with over $44 billion of customer deposits, AXP will likely benefit if and when interest rates rise as they’ll be able to more easily cover the costs of deposits and earn an increased spread between the rates they pay and the rates they earn.


Risks and Challenges:
American Express faces a variety of risks and challenges in growing and maintaining its business.  For example, expanding outside the US presents challenges; the US economy is growing, but growth outside of the US is weak.  Additionally, the strong US dollar makes international growth a challenge.

As mentioned earlier, new regulations and the cost of co-brand relationships are both increasing.  Antitrust rulings against AXP’s discount fees and the loss of the Costco relationship are examples.

Competition in general is intensifying as both traditional players and new entrants want to disrupt the marketplace.

The derivatives used by AXP may lower volatility, but they are expensive, reduce profitability, and slow long-term growth.  For example, the forward contracts AXP uses to reduce foreign currency volatility are good for short-term earnings consistency, but bad for long-term profitability and they are making the groups that underwrite them very rich.  The same can be said of the interest rate swaps used by American Express.

AXP’s investment securities have a very large concentration of state and municipal obligations.  While these instruments may offer higher yields than treasuries they concentrate risk and have a higher likelihood of default.

Conclusion:
Buy low, sell high.  American Express (AXP) stock price has suffered in 2015, but it’s not going out of business anytime soon.  The market has reacted very negatively to recent antitrust rulings and the loss of AXP’s exclusive relationship with Costco.  However the company is still extremely profitable, it has opportunity for continued growth, and the market is valuing the stock too low.

International Developed Market ETF (ACWX) - Thesis

iShares MSCI ACWI ex U.S. ETF (ticker: ACWX)
Expected Return: 8.5% per year
Expected Volatility: 20.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the international (non U.S.) developed market (countries with developed economies) portion of the equity markets will increase at a similar rate as the U.S. markets, however they provide very important diversification benefits that are not available by investing in U.S. markets alone.  The iShares MSCI All Country World Index (ACWI) ex U.S. ETF (ticker: ACWX) offers reliable exposure to the returns of international markets while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
ACWX invests in over 1,100 non-U.S. stocks from twenty-one developed market countries.  At least 90% of its assets are invested in securities of the MSCI ACWI ex U.S. Index.  The fund may invest the remainder of its assets in certain depository receipts and derivatives such as futures, options, swap contracts and cash equivalents.  The index is one of the most commonly followed equity indices in the World, and is largely considered the standard benchmark for non-U.S. developed market stocks.  The performance of ACWX has historically matched the performance of the MSCI ACWI ex U.S. Index very closely, and it should continue to track closely in the future because of its construction methodology.  Investors cannot purchase the actual index, and ACWX is the next best thing.

Volume and Liquidity:
As a standard ETF, ACWX has significant volume and liquidity (total ACWX assets exceed $1.8 billion).  Because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, ACWX trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within ACWX.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes ACWX much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of ACWX, and subsequently adversely moving the market price away from its NAV because the volume of ACWX is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on ACWX is currently 33 basis points (0.33%).  This is extremely low for international market exposure; it is good for investors because it allows them to achieve better returns on their investment.  For comparison, international mutual funds (a common competitor to ETFs) may charge over 200 basis points (2.0%) per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because ACWX can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that ACWX is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, ACWX pays a quarterly dividend (around 2.93% per year), and this dividend is NOT automatically reinvested back into ACWX (this is standard protocol for ETFs and stocks).  This means you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
ACWX is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider ACWX to be a basic building block for long-term wealth, and we rate ACWI as a “Buy.”  For more information, you can view the fact sheet for this ETF here.

 

Union Pacific (UNP) - Thesis

Rating: BUY

Current Price: $95.55

Price Target: $136.20

 

Thesis:

We own Union Pacific because it is a great business and the stock is currently undervalued.  It’s a great business because Union Pacific has a significant amount of pricing power, access to strategic ports, room for increased efficiency and it will grow as the US economy grows.  It is currently undervalued because of a decline in coal shipments (natural gas’s current price makes it a cheap substitute) and because of an extended west coast port shutdown.  However the decline in revenue from coal is temporary because if coal shipments don’t revert to higher levels then Union Pacific will replace it with shipments of other goods.  Also the west coast port shutdown is mostly temporary.

We value Union Pacific at $136.20 per share using a 50/50 combination of discounted cash flow analysis and a valuation formula first published by Benjamin Graham (Warren Buffett’s mentor) in the 1940’s.

Pricing Power:

According to Warren Buffett “the single most important decision in evaluating a business is pricing power,” and Union Pacific has a tremendous amount of pricing power over its customers.  Buffet claims “if you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”  Through its fuel surcharge program, Union Pacific has the power to raise the price of its railroad services according to fuel prices, and this is one of the reasons UNP is a very good business.  Additionally, there is more railroad demand than there is supply (people often use trucks and barges when they can’t use railroads), and this also gives UNP pricing power.  When demand for one line of UNP’s business softens (for example coal) UNP can offset the softening with another line of business (for example Agricultural products). 

 
 

Access to Strategic Ports:

UNP also has access to strategic Pacific Coast and Gulf of Mexico ports which are barriers to entry for competitors, as well as serving all six major gateways to Mexico (also a barrier for others to reproduce).  Union Pacific’s railways are an integral part of the United States transportation infrastructure, and conveniently connect to a variety of other railroads and modes of transportation.

Room for Increased Efficiency:

Even though railroads are already a more efficient and less expensive form of transportation than trucking (another common form of transportation), there is still room for increased efficiency.  According to the CEO of another US railroad company, Burlington Northern Santa Fe, long-haul trains are three times more fuel efficient than trucks.  Additionally, “William Nickle, supply chain and operations management professor at Rutgers University Business School MBA Program, explained… “One of the biggest differences between roads and railroads is that the infrastructure for trains is financed by private individuals, and the infrastructure for trucks (roadways, bridges, etc.) is financed by the government. A government that is as in as much debt as ours has not been able to invest enough to revitalize and resolve all of the current issues with the infrastructure the trucking industry relies upon.” Of course, there is still a need for intermodal transport, such trucks (and some trains) to take the freight the final leg of its journey to its destination. 

Valuation:

Discounted Cash Flow (DCF) Analysis

A DCF analysis suggests Union Pacific is worth $145.66 per share.  Union Pacific’s 2014 Free Cash Flow was around $3.14 billion (We're calculating this as Cash from Operations (+$7.385) minus Capital Expenditures (-$4.346) and adjusting for other Investing Cash Flow Items (+$0.097)).  We're assuming UNP’s required rate of return is 7.5% (this is essentially a long-term equity market assumption).  We also assume UNP can grow about 3.5% per year organically, and it’s FCF per share outstanding can grow another 1.5% per year simply by way of continued share repurchases resulting in higher future free cash flow per share because there will be less shares outstanding: FCF / (r-g) = $3.2 billion / (0.075 – (0.035 + 0.015)) = $128 billion.  $128 billion / 0.87878 billion shares outstanding = $145.66 per share.

Ben Graham Formula:

We also like to use a valuation formula first published by Benjamin Graham (Warren Buffett’s mentor) in the 1940’s:  EPS x (8.5 + (2 x growth)).  Assuming 2016 earnings per share (EPS) of $6.85 (taken from 29 professional analyst estimates on YahooFinance), and a growth rate of 5% (this is the same growth rate used in the DCF model above.  This results in a share price of $126.73 = 6.85 x 8.5 + 2 x 5.

Risks:

Union Pacific outlines a variety of risk factors in their annual report, and it is worth reviewing some of them here.  First, UNP explains:

“We Must Manage Fluctuating Demand for Our Services and Network Capacity.”  This risk is apparent in the slowdown in coal transport demand in the first half of 2015 which negatively impacted the stock price, and created a more favorable entry point for “would be” buyers of the stock.  UNP must now manage this risk by either waiting for coal business to revert back upward to historical levels, or make the changes in the mix of shipments to replace lost revenues.

“We Are Subject to Significant Environmental Laws and Regulations.” In some sense, this risk may have been reduced by the recent Supreme Court ruling against the Environmental Protection Agency which said the agency didn’t take into enough consideration the cost impact of new regulations.  While this ruling doesn’t directly impact UNP, it does impact coal plants, and it does create a regulatory environment less hostile to business. 

“Strikes or Work Stoppages Could Adversely Affect Our Operations.” This is a big one as a large percent of the workforce is unionized which can lead to significant work stoppages.  Also, this can impact shipments that UNP makes to strategic West Coast ports.  The Wall Street Journal reported “The labor dispute that caused months of gridlock at West Coast ports may be over, but the disruption is expected to redraw the trade routes that goods take to reach U.S. factories and store shelves… This is bad news for West Coast ports, truckers and railroads already worried that the expansion of the Panama Canal, due for completion next year, would begin to divert more business to the East Coast. Already it is expected to take three to six months for West Coast ports to return to normal.” (Wall Street Journal, March 5, 2015)

“We May Be Affected By Fluctuating Fuel Prices.” This noticeably impacted the company in 2014 as oil (and subsequently diesel fuel) prices declined sharply.  This was a good thing for UNP, but volatile fuel prices could move higher and hurt UNP’s profits.

Conclusion:

Union Pacific is a bet on the US economy.  As an integral part of the US economy, Union Pacific will grow as the economy grows.  As a strong free cash flow generator, UNP also has the ability to return cash to shareholders (via dividends) and increase earnings per share (by reducing the number of shares outstanding with share repurchases).  UNP’s share price has underperformed the broader stock market in 2015 due to temporarily lower revenue from coal shipments, lower revenue due to West Coast port shutdowns, and volatility in fuel costs.  The decline in share price has created an attractive entry point for investors.  We own shares of Union Pacific (UNP).

Accenture (ACN) - Thesis

Rating: BUY

Current Price: $99.48

Price Target: $116.40

We own Accenture stock because we believe the market continues to underestimate the company's ability to deliver results.  We expect the stock price to consistently outperform the market in the future because of Accenture's workforce, culture, business model, balance sheet, pipeline, relationships, brand name, management and valuation. 

 

WHAT DOES ACCENTURE DO?

Accenture is a management consulting, technology services and outsourcing company with over 300,000 employees and offices and operations in more than 200 cities in 56 countries.  Accenture does NOT produce any products, but rather provides business and consulting services to help clients improve business performance.  The types of services Accenture provides to its clients are difficult for many investors to understand (which is part of the reason we believe the company is undervalued).  Here are a few examples of the types of services Accenture provides: Accenture helped:

HarperCollins Publish Their Entire Catalogue of about 36,000 Books on a New Digital Platform. More from Accenture.

Shell Implement a New Logistics Strategy, Improving Service Levels and Lowering Costs Up to 25%.  More from Accenture.

The London Police Force Fight Gang Crime with Analytics. More from Accenture.

Gas Natural Fenosa Transforms Their HR Practice, Improving Employee Satisfaction by 26 Percent in One Year. More from Accenture.

  

AN IDEAL BUSINESS MODEL:

We love Accenture’s business model.  It is ideal because its workforce has the ability to change dramatically, quickly and smoothly to meet demand.  Much of the global workforce is still stuck on this idea that a company hires a person, that person works for 40 years, gets a gold watch, and then retires.  That model is not efficient or even realistic for much of today’s world.  Accenture is hired by companies for a specific time period (often several months at a time, to several years at a time) to complete a specific project or task, and that’s it.  It’s often unrealistic for companies to hire full time employees just to complete a specific project because the company has no need for them when the project is complete.  Accenture solves this problem because when a project for one company is complete, Accenture sends its people to work on a project for another company (many Accenture people travel domestically and internationally on a regular basis).  It’s this adaptable, mobile workforce that enables Accenture to meet the needs of its clients, and it is an ideal business model for today’s rapidly changing business environment.

 

ACCENTURE’S VALUE PROPOSITION:

Accenture brings high quality people with specialized skills to complete specific client projects, and then the Accenture team gets out.  It prevents the client from hiring full time employees and then laying them off, and it allows the client to benefit from the very specific skill sets and experiences that Accenture people bring.  Accenture is not cheap, but client companies regularly find Accenture’s services worthwhile from a dollars and cents perspective.  Management is willing to pay for Accenture because of the improvements and successes they are able to achieve with the help of Accenture.

 

EXCEPTIONAL PEOPLE AND CULTURE:

Accenture’s greatest asset is its people.  The company’s diverse and inclusive workforce combined with its opportunities for upward career advancement enables Accenture to attract some very bright people.  The typical Accenture employee is in their twenties or early thirties, enjoys living in one of the large cities where Accenture offices are typically located, and is willing (even excited) to travel domestically or internationally to client sites.  Obviously, not all employees fit this typical description (some are older, and many positions don’t require travel) but many of them do, and it fits well within the workforce.  There tends to be a pyramid shaped workforce where younger workers make up the majority of the bottom of the pyramid, and there are a lower number of employees as you move up the ranks.  This works well for Accenture because as many employees get older and want to settle down with families they depart Accenture for less demanding jobs.  This natural attrition helps Accenture manage its workforce when demand is low because natural attrition is generally easier and cheaper than layoffs.  And when demand increases, Accenture’s culture and business model enable it to quickly attract additional high caliber, hard-working, determined people.  The high quality workforce model also enables Accenture to perform at a higher level than many other companies, which is part of the reason we believe the company is such a great investment.

 

BRAND NAME:

Having a strong brand name is one of the most valuable assets in business because it allows you to attract employees and customers, and it allows you to charge a premium for your services.  Accenture is not usually a recognizable name to the average person walking down the street, but within the ranks of corporate America, Accenture is a very strong brand name.  A long history of delivering exceptional performance to clients is the number one reason Accenture’s brand name is strong (the Accenture brand name has been around since 2001, but the company existed long before that).  There are other important contributors to Accenture’s strong brand name such as the diverse and inclusive workforce which often receives praise from the media.  For example, Accenture was named one of the 100 best companies to work for in 2015.

According to its website, Accenture takes: “the widest possible view of inclusion and diversity, going beyond gender, race, religion, ethnicity, abilities, sexual orientation and gender identity and expression to create an environment that welcomes all forms of differences. Every employee is a respected member of our team; we value individual similarities and differences, recognizing them as the thousands of diverse pieces—or tiles—that contribute to our entire mosaic.”

According to Chief Executive Officer, Pierre Nanterme, Accenture: “gives clients access to a rich range of talent, representing different styles, perspectives and experiences. This diversity is a critical strength that we work hard to maintain and foster. It makes us a better company on every dimension.”

 

ACCENTURE’S FINANCIAL STRENGTH:

A quick look at Accenture’s balance sheet reveals it has almost zero long-term debt.  This demonstrates the company hasn’t required debt to grow its business recently, but they do have the ability to take on debt in the future if need be.  Since the company does not produce actual products (it’s a service company) there is no need for large capital expenditures to enable growth (other than an occasional office upgrade – Accenture had only $322 million of capital expenditures in fiscal 2014 on an enormous $3.2 billion in free cash flow).  It’s nice to know the company is not burdened with massive amounts of debt.  Accenture also has $4.9 billion of cash on hand to meet liquidity needs.  The strong balance sheet and cash flow also allows Accenture to comfortably maintain its 2% dividend and repurchase shares as management stewards capital.

FUTURE GROWTH:

Accenture’s estimated earnings growth rate over the next five years is 10.13% according to 28 professional analysts covering the stock.  This exceeds the 7.28% those analysts are forecasting for the S&P which suggest they believe Accenture will grow faster than average.  We tend to agree Accenture will grow faster than the market, but we also believe it will grow faster than these analysts’ estimates.  Wall street consistently underestimates the value of this company because they do not have a strong enough appreciation for Accenture’s business model, it’s exceptional workforce & culture, and it’s powerful brand name within corporate America.  We also believe Accenture’s business is difficult for many people to understand, which causes them to avoid and under appreciate the stock. 

Near-term growth is expected to be generated across Accenture’s business groups, however Accenture Digital is the “hot” area right now.  According to Accenture’s 2014 annual report, the company recently launched Accenture Digital by combining their capabilities in digital marketing, analytics and mobility.  With more than 28,000 professionals, Accenture Digital is the world’s largest end-to-end digital capability and works with many industry leaders—including all of the top 10 global pharmaceutical companies as well as all of the top 10 consumer products companies.  In our view, there is a new “big thing” at Accenture with every market cycle (this time it seems to be digital).  However, it’s Accenture’s dynamic and adaptable workforce that enables it to profit from the market’s needs across market cycles.

  

VALUATION:

Ben Graham Formula:

We use a modified version of the valuation formula published in the 1930’s by Benjamin Graham (Warren Buffett’s mentor) to value Accenture at $116.55 per share.  Using Graham’s original formula (assuming a 5% growth rate), Accenture is worth only $101.97 per share [share price = EPS x (8.5 + 2 x growth) + cash per share = 5.18 x (8.5 + 2 x 5) + 4.9/0.79758.  However, we bump the growth rate up to 7% ($116.55 = 5.18 x (8.5 + 2 x 7) + 4.9/0.79758) because the company’s strong free cash flow will allow it to consistently strengthen EPS growth incrementally (as needed) with share repurchases, and we believe management is incentivized to do this as their compensation is tied to the stock price.

 

Discounted Cash Flow (DCF) Model:

Using a discounted cash flow model, we value Accenture at $116.25 per share.  Our model assumes Accenture can grow its 2014 free cash flow of $3.2 billion by 5% for the next five years and then 3% into perpetuity.  We assume a CAPM-derived required rate of return of around 8.3% and a long-term equity market return assumption of 7.5%.  We used a discount rate of 3%, and factored in the $4.9 billion of cash on hand.

 

RISKS:

The number one largest risk to Accenture’s business is anything that could hurt its brand name.  Because it doesn’t actually produce products (it’s a services company), a lawsuit or bad publicity could destroy the company’s ability to attract new business.  Accenture knows this lesson very well because of its history. Accenture was formerly part of Arthur Andersen, an accounting firm that was completely destroyed a little over a decade ago when the fraudulent actions of a few partners destroyed the company’s reputation and forced it to lay off thousands of employees and go completely out of business.  Accenture separated from Arthur Andersen several years before the scandal.  Accenture was known as Andersen Consulting when it first separated and then brilliantly changed its name to Accenture before the Arthur Andersen scandal allowing it to avoid unnecessary fallout from Arthur Andersen.  As another example of Accenture’s extreme aversion to bad publicity look to the Tiger Woods example.  Tiger Woods was paid huge sums of money to be the face of Accenture’s advertising and marketing initiatives, until a few years ago when news of Tiger’s indiscretions hit the news.  Tiger’s face had been pasted all over Accenture’s website and advertisements around the world, but within hours of the news Accenture’s leadership decided to drop Tiger Woods and remove his image from everything as quickly as possible.  This is a perfect example of how committed Accenture’s leadership is to protecting its pristine brand name, and of the lengths it will go to defend it.  Accenture leadership gets it.

 

CONCLUSION:

Accenture is a well-run, highly-profitable business, with a workforce well-suited for a rapidly evolving marketplace.  Its stock price is also inexpensive relative to its value.  We believe the market continues to underappreciate Accenture’s ability to deliver and its overall value.  We own shares of Accenture stock.

 

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