For October the balance increased 1.1%. It was a wild ride as the markets gyrated pretty violently throughout the month. While I underperformed the S&P 500, which increased about 11% during the month, I am happy that the balance ended up for the month after beginning the month largely in treasuries and ending the month in stocks on a day the S&P 500 declined 2.5%. Treasury prices declined significantly during the month as the yield on the 30-year treasury rose about 30 basis points.
I look forward to comments by both the Federal Reserve and the European Central Bank this week. In both cases I expect at least talk of additional monetary stimulus since the economic outlook remains cloudy. Should the markets begin to anticipate additional stimulus I expect the dollar to decline, yields to rise, and stocks to lift. These types of movement should drive performance going forward.
Monday, October 31, 2011
Friday, October 28, 2011
Sold Unitil Corp. Postion
With inflationary pressures dominating in my Sagflation theme, I have sold my position in the utility Unitil (Ticker UTL). I bought a ~4% position in May 2011 and realized a return of about 10%, including dividends. The main reason for selling the position is my belief that utilities under perform the market in the near-term as inflation likely builds up with monetary stimulus increases.
Wednesday, October 26, 2011
Bought Base Metals as Sagflation Likely Swings Prices Higher
As I continue to round out my portfolio I purchased a ~5% position in Powershares Base Metals Double Long ETN, which is invested in aluminum, copper and zinc futures. This brings my exposure to commodities up to about 20% of my portfolio, with a ~10% position in gold, ~3% position in silver, and ~2% in palladium. My outlook is bullish for these metals, driven by settling of worries about European debt, increasingly expansionary monetary policies with possible new programs announced by the Fed, and stimulus spending in China to re-accelerate growth. This outlook implies rising inflationary pressures within commodities, in general, stabilizing short-term world economic performance, and growth in demand for base metals from China.
Tying my current outlook to a longer-term Sagflation view, I believe we are simply buying time before deflationary forces overwhelm the economy. Sovereign debt in Europe and the US is increasingly hampering economic growth and reducing our ability to pursue Keynesian-like stimulant spending, in my opinion. I simply do not see an easy road out of the corner in which we have painted ourselves. Inflationary pressures within emerging markets are increasingly hindering monetary policies, which likely only worsen as we move forward, in my view, due to monetary policies. Europe is creating a short-term solution to a long-term problem, in my view. In essence, appeasing the markets and the voting populations. The US is also focused on short-term solutions to long-term structural problems, in my view. China has the financial flexibility to act aggressively but I fear time may run out on them at some point soon, as bank loans turn sour.
Sagflation is slow-to-negative real economic growth combined with volatile prices. For a while the prices likely swing up, in my opinion, but keep in my mind that bureaucrats are pushing it higher and higher, not fundamentals.
Tying my current outlook to a longer-term Sagflation view, I believe we are simply buying time before deflationary forces overwhelm the economy. Sovereign debt in Europe and the US is increasingly hampering economic growth and reducing our ability to pursue Keynesian-like stimulant spending, in my opinion. I simply do not see an easy road out of the corner in which we have painted ourselves. Inflationary pressures within emerging markets are increasingly hindering monetary policies, which likely only worsen as we move forward, in my view, due to monetary policies. Europe is creating a short-term solution to a long-term problem, in my view. In essence, appeasing the markets and the voting populations. The US is also focused on short-term solutions to long-term structural problems, in my view. China has the financial flexibility to act aggressively but I fear time may run out on them at some point soon, as bank loans turn sour.
Sagflation is slow-to-negative real economic growth combined with volatile prices. For a while the prices likely swing up, in my opinion, but keep in my mind that bureaucrats are pushing it higher and higher, not fundamentals.
Tuesday, October 25, 2011
Bought Citigroup on Expectations of European Financial Appeasement
Updating a few trades completed recently.
Today I opened a 2% position in Citigroup (Ticker C) as I expand my exposure to financial companies during the market pullback this morning. My Sagflation thesis has turned inflationary and so I continue to increase exposure to companies that likely benefit from a steepening yield curve. Citigroup's stock was down to start the day largely due to concerns about a solution in Europe. While admitting Europe is a risk to financial markets, I also believe that this week or next Europe arrives at some sort of financial appeasement that satiates the markets for the next couple quarters. I don't expect a solution but instead just enough to make the markets move their myopic focus from Europe. With a forward year PE in the mid-single digits I believe I have some cushion on the downside.
Citigroup Inc. (Ticker: C)
Citigroup Inc. is a global diversified financial services
holding company. Citigroup businesses provide consumers, corporations,
governments and institutions with a range of financial products and
services. As of December 31, 2010, the Company had approximately 200
million customer accounts and did business in more than 160 countries
and jurisdictions.
Kimberly Clark Corp. (Ticker KMB)
Also, yesterday I exited my position in Kimberly Clark (Ticker KMB), booking about a 4% return for holding it about a half year. I exited KMB due to worries that rising prices on commodities may pressure margins going forward. The fact that management lowered revenue growth expectations for 2011 only reinforced my decision to exit the position. My take on the lowered revenue guidance is that competitive pressure is growing from generic brands with lower prices, a concern longer-term.
Today I opened a 2% position in Citigroup (Ticker C) as I expand my exposure to financial companies during the market pullback this morning. My Sagflation thesis has turned inflationary and so I continue to increase exposure to companies that likely benefit from a steepening yield curve. Citigroup's stock was down to start the day largely due to concerns about a solution in Europe. While admitting Europe is a risk to financial markets, I also believe that this week or next Europe arrives at some sort of financial appeasement that satiates the markets for the next couple quarters. I don't expect a solution but instead just enough to make the markets move their myopic focus from Europe. With a forward year PE in the mid-single digits I believe I have some cushion on the downside.
Citigroup Inc. (Ticker: C)
| Price Purchased | $30.97 | Mkt Cap | $90.8 Billion |
| 52-Wk Low | $21.40 | Beta | 2.55 |
| CY+1 PE | 6.8x | Rating (# of) | Overweight (29) |
Kimberly Clark Corp. (Ticker KMB)
Also, yesterday I exited my position in Kimberly Clark (Ticker KMB), booking about a 4% return for holding it about a half year. I exited KMB due to worries that rising prices on commodities may pressure margins going forward. The fact that management lowered revenue growth expectations for 2011 only reinforced my decision to exit the position. My take on the lowered revenue guidance is that competitive pressure is growing from generic brands with lower prices, a concern longer-term.
Monday, October 24, 2011
Re-Positioned Portfolio For Next Phase of Sagflation
Given my belief that the outlook in my Sagflation theme has now shifted more inflationary, I have established positions that benefit from a steepening yield curve, commodity price increases, and manufacturers that either benefit from higher commodity prices or are able to pass along rising commodity prices.
From a volatility standpoint, I have favored quality larger cap names with a higher beta to benefit from a rising equity market. I believe these names have fallen out of favor over the past few months due to the volatility in the market and uncertain outlook. I have also favored stocks near their 52-week lows with a forward PE in the low teens or single digits to provide some cushion on the downside. Finally, I have favored stocks with bullish analyst opinions to help filter out companies with poor management and unattractive prospects.
Focusing on the next six months, I have established the following positions:
Rowan Companies, Inc. (Ticker: RDC)
Rowan Companies, Inc. is a provider of international and domestic contract drilling services. Rowan also owns and operates a manufacturing division that produces equipment for the drilling, mining and timber industries. The Company operates in three segments: Drilling Services, Drilling Products and Systems, and Mining, Forestry and Steel Products.
Eaton Corporation (Ticker: ETN)
Eaton Corporation is a diversified power management company. It
is engaged in the manufacturing of electrical components and systems for
power quality, distribution and control; hydraulics components, systems
and services for industrial and mobile equipment; aerospace fuel,
hydraulics and pneumatic systems for commercial and military use, and
truck and automotive drivetrain and powertrain systems for performance,
fuel economy and safety.
The Dow Chemical Company (Ticker: DOW)
The Dow Chemical Company is a diversified manufacturer and
supplier of products used primarily as raw materials in the manufacture
of customer products and services worldwide. It operates in eight
segments. Dow provides services to a range of industries, including
appliance, automotive, agricultural, building and construction, chemical
processing, electronics, furniture, house wares, oil and gas,
packaging, paints, coatings and adhesives, personal care pharmaceutical
processed foods pulp and paper textile.
Huntsman Corporation (Ticker: HUN)
Huntsman Corporation is a manufacturer of differentiated organic chemical products and of inorganic chemical products. The Company’s products consists of a range of chemicals and formulations,
which it markets globally to a group of consumer and industrial
customers. It operates through five segments: Polyurethanes, Performance
Products, Advanced Materials, Textile Effects and Pigments.
The Goldman Sachs Group, Inc. (Ticker: GS)
The Goldman Sachs Group, Inc. is a bank holding and a
financial holding company. Goldman Sachs is a global investment banking,
securities and investment management company providing a range of
financial services to a client base that includes corporations,
financial institutions, governments and high-net-worth individuals.
Morgan Stanley (Ticker: MS)
Morgan Stanley is a global financial services firm that, through its
subsidiaries and affiliates, provides its products and services to a
group of clients and customers, including corporations, governments,
financial institutions and individuals. The Company is a financial
holding company. The Company is a global financial services firm. The
Company operates in three segments: Institutional Securities, Global
Wealth Management Group and Asset Management.
Prudential Financial, Inc. (Ticker: PRU)
Prudential Financial, Inc. is a financial services company. It has
operations in the United States, Asia, Europe and Latin America. Through
its subsidiaries, it offers an array of financial products and
services, including life insurance, annuities, retirement-related
services, mutual funds, investment management and real estate services.
It offers these products and services to individual and institutional
customers through third-party distribution networks.
Brookfield Asset Management Inc. (Ticker: BAM)
Brookfield Asset Management Inc. is a global asset management company
focused on property, power and infrastructure assets. The Company
operates and manages assets in the areas, such as Renewable Power
Generation, which include power generating operations, along with a
small number of co-generation and wind energy facilities; Commercial
Properties, in which the Company owns and operates commercial office and
retail properties on behalf of selves and its co-investors;
Infrastructure, in which the Company’s infrastructure activities are
concentrated in the utilities, transport and energy and timber sectors;
Development activities include residential operations, properties held
for development and opportunity investment funds; Private Equity and
Finance business includes restructuring, real estate financing and
bridge lending in the property, power and infrastructure areas.
General Electric Company (Ticker: GE)
General Electric Company is a diversified technology and financial
services corporation. The products and services of the Company range
from aircraft engines, power generation, water processing, and household
appliances to medical imaging, business and consumer financing and
industrial products. It serves customers in more than 100 countries.
Effective January 28, 2011, it held a 49% interest in a media entity
that includes the NBC Universal businesses. Its segments include Energy
Infrastructure, Technology Infrastructure, NBC Universal, GE Capital and
Home & Business Solutions.
Vale SA (Ticker: VALE)
Vale SA is a Brazil-based metals and mining company. The
Company's product portfolio includes nickel, iron ore and iron ore
pellets, manganese ore, ferroalloys, aluminum, fertilizers, copper and
coal among others. Vale is engaged in the mineral exploration in 24
countries around the globe. In addition, the Company operates logistics
systems in Brazil, including railroads, maritime terminals and ports,
which are integrated with its mining operations and it has a maritime
freight portfolio to transport iron ore.
From a volatility standpoint, I have favored quality larger cap names with a higher beta to benefit from a rising equity market. I believe these names have fallen out of favor over the past few months due to the volatility in the market and uncertain outlook. I have also favored stocks near their 52-week lows with a forward PE in the low teens or single digits to provide some cushion on the downside. Finally, I have favored stocks with bullish analyst opinions to help filter out companies with poor management and unattractive prospects.
Focusing on the next six months, I have established the following positions:
| Weight | Name | Ticker |
|---|---|---|
| ~20% | Proshares Ultrashort 20+ Yr Treasury | TBT |
| ~2% | ETFS Physical Palladium Shares | PALL |
| ~10% | SPDR Gold Trust | GLD |
| ~3% | iShares Silver Trust | SLV |
| ~4% | Eaton Corp. | ETN |
| ~4% | Rowan | RDC |
| ~4% | DOW Chemical | DOW |
| ~4% | Huntsman | HUN |
| ~2% | Goldman Sachs | GS |
| ~2% | Morgan Stanley | MS |
| ~4% | Prudential Financial | PRU |
| ~4% | Brookfield Asset Mgmt | BAM |
| ~4% | General Electric | GE |
| ~4% | Vale SA | VALE |
Rowan Companies, Inc. (Ticker: RDC)
| Price Purchased | $34.14 | Mkt Cap | $4.4 Billion |
| 52-Wk Low | $28.13 | Beta | 1.65 |
| CY+1 PE | 8.8x | Rating (# of) | Overweight (33) |
Rowan Companies, Inc. is a provider of international and domestic contract drilling services. Rowan also owns and operates a manufacturing division that produces equipment for the drilling, mining and timber industries. The Company operates in three segments: Drilling Services, Drilling Products and Systems, and Mining, Forestry and Steel Products.
Eaton Corporation (Ticker: ETN)
| Price Purchased | $41.67 | Mkt Cap | $14.2 Billion |
| 52-Wk Low | $33.09 | Beta | 1.44 |
| CY+1 PE | 9.6x | Rating (# of) | Overweight (22) |
The Dow Chemical Company (Ticker: DOW)
| Price Purchased | $27.50 | Mkt Cap | $32.6 Billion |
| 52-Wk Low | $20.61 | Beta | 2.32 |
| CY+1 PE | 8.9x | Rating (# of) | Overweight (19) |
Huntsman Corporation (Ticker: HUN)
| Price Purchased | $10.64 | Mkt Cap | $2.6 Billion |
| 52-Wk Low | $8.13 | Beta | 2.23 |
| CY+1 PE | 5.4x | Rating (# of) | Overweight (9) |
The Goldman Sachs Group, Inc. (Ticker: GS)
| Price Purchased | $102.81 | Mkt Cap | $52.3 Billion |
| 52-Wk Low | $84.27 | Beta | 1.40 |
| CY+1 PE | 7.6x | Rating (# of) | Overweight (29) |
Morgan Stanley (Ticker: MS)
| Price Purchased | $17.18 | Mkt Cap | $33.0 Billion |
| 52-Wk Low | $11.58 | Beta | 1.42 |
| CY+1 PE | 8.5x | Rating (# of) | Overweight (28) |
Prudential Financial, Inc. (Ticker: PRU)
| Price Purchased | $53.66 | Mkt Cap | $29.0 Billion |
| 52-Wk Low | $42.45 | Beta | 2.38 |
| CY+1 PE | 7.1x | Rating (# of) | Overweight (23) |
Brookfield Asset Management Inc. (Ticker: BAM)
| Price Purchased | $28.39 | Mkt Cap | $17.8 Billion |
| 52-Wk Low | $24.42 | Beta | 1.54 |
| CY+1 PE | 24.9x | Rating (# of) | Buy (10) |
General Electric Company (Ticker: GE)
| Price Purchased | $16.47 | Mkt Cap | $176.3 Billion |
| 52-Wk Low | $14.02 | Beta | 1.61 |
| CY+1 PE | 10.5x | Rating (# of) | Overweight (18) |
Vale SA (Ticker: VALE)
| Price Purchased | $23.44 | Mkt Cap | $123.5 Billion |
| 52-Wk Low | $21.14 | Beta | 1.64 |
| CY+1 PE | 4.5x | Rating (# of) | Overweight (25) |
Saturday, October 22, 2011
Entering New Phase of Sagflation
Based on recent news articles in Barron's and in the Journal, it appears as though monetary policy in both the US and Europe may be increasingly relied on to counter an economic slowdown. Around the world there has been a recent shift to expansionary monetary policies with loosening in Britain, Brazil, and possibly China. This shift in monetary policies was the main reason I recently sold my large position in 30-year treasuries since there is a greater risk of inflation, in my view.
However, fiscal policies have remained firmly focused on austerity, as shown by cuts in Greece, Portugal, Italy, and with some success in Britain. It would appear as though austerity remains the driving theme in the US with the deficit reduction super committee efforts. If the committee cannot reach a compromise then cuts are automatically enacted.
Under my Sagflation theme I argue that there are fundamental deflationary forces in the economy due to excessive debt and the deflating of previous asset bubbles. Expansionist monetary policies are acting against these fundamental forces. The result is slow to negative economic growth with larger price swings as monetary policies expand and then retreat.
I continue to believe economic growth likely remains slow to negative due to the austerity measures, stagnant house prices, declining income, high unemployment, burdensome consumer debt, and increasingly misallocated investments in an economy where money is cheap. The shift in monetary policies suggests that prices are likely to swing upward in the form of inflation over the next one to two years.
In the short-term, defined as the next 2-6 months, I believe the headline inflation of CPI may not show much increase, and may actually decline somewhat due to the recent slide in commodity prices trickling up to the consumer. Should the widely watched CPI remain tame over the next few months it is likely a positive for stocks as investors assume inflation is under control and stocks benefit from growing liquidity. As I reminder, I view the CPI as more of a 3-9 month lagging inflation gauge right now due to pricing pressure coming up through companies' cost structures from higher commodity prices. If the CPI was rising because demand was out-stripping supply, then I believe it would be a more current measurement. Other than stocks I believe rising bottom-up inflation pressures likely drives price movements in debt, commodity and currency markets.
While the European debt crisis is a black cloud over the markets, I believe the European leaders likely pursue financial appeasement, giving the financial markets just enough reform, bail-out, and stimulus to appease them in the short-term but not fix the longer-term problem. Political realities and economic challenges would tend to push the European leaders in this direction, in my view.
This short term outlook suggests over-weighting high beta stocks and precious metals, in my view. It also suggests the US dollar declines and yields on the 10 and 30 year treasury rise significantly, in my opinion.
Longer-term, however, these trends are setting us up for a period beginning at some point in 2012 that combines higher unemployment, slow growth, and high inflation, in my opinion. Emerging economies rich in natural resources that have historically tilted toward inflation, like Brazil, potentially move closer to the dangers of hyper-inflation. As we move through 2012 I believe rising commodity prices likely again force manufacturers and retailers to constrict labor in an effort to protect margins, eventually raising prices that pushes the CPI higher. US consumers are likely increasingly squeezed between falling income and rising prices. In addition, austerity plans implemented late in 2011 likely begin to have an effect in 2012. This is a potentially explosive combination both financially and socially, as explained in The Economist.
Once we move into 2012 I believe investors should become conservative as inflation worries mount, debt issues remain, and any short-term financial appeasements made in 2011 prove ineffective. At this point I believe we may reach the end game in which fiscal stimulus is neutered by high sovereign debt levels and monetary stimulus is neutered by high inflation. If volatility in 2011 was trying for investors, swings in 2012 may prove fatal.
However, fiscal policies have remained firmly focused on austerity, as shown by cuts in Greece, Portugal, Italy, and with some success in Britain. It would appear as though austerity remains the driving theme in the US with the deficit reduction super committee efforts. If the committee cannot reach a compromise then cuts are automatically enacted.
Under my Sagflation theme I argue that there are fundamental deflationary forces in the economy due to excessive debt and the deflating of previous asset bubbles. Expansionist monetary policies are acting against these fundamental forces. The result is slow to negative economic growth with larger price swings as monetary policies expand and then retreat.
I continue to believe economic growth likely remains slow to negative due to the austerity measures, stagnant house prices, declining income, high unemployment, burdensome consumer debt, and increasingly misallocated investments in an economy where money is cheap. The shift in monetary policies suggests that prices are likely to swing upward in the form of inflation over the next one to two years.
In the short-term, defined as the next 2-6 months, I believe the headline inflation of CPI may not show much increase, and may actually decline somewhat due to the recent slide in commodity prices trickling up to the consumer. Should the widely watched CPI remain tame over the next few months it is likely a positive for stocks as investors assume inflation is under control and stocks benefit from growing liquidity. As I reminder, I view the CPI as more of a 3-9 month lagging inflation gauge right now due to pricing pressure coming up through companies' cost structures from higher commodity prices. If the CPI was rising because demand was out-stripping supply, then I believe it would be a more current measurement. Other than stocks I believe rising bottom-up inflation pressures likely drives price movements in debt, commodity and currency markets.
While the European debt crisis is a black cloud over the markets, I believe the European leaders likely pursue financial appeasement, giving the financial markets just enough reform, bail-out, and stimulus to appease them in the short-term but not fix the longer-term problem. Political realities and economic challenges would tend to push the European leaders in this direction, in my view.
This short term outlook suggests over-weighting high beta stocks and precious metals, in my view. It also suggests the US dollar declines and yields on the 10 and 30 year treasury rise significantly, in my opinion.
Longer-term, however, these trends are setting us up for a period beginning at some point in 2012 that combines higher unemployment, slow growth, and high inflation, in my opinion. Emerging economies rich in natural resources that have historically tilted toward inflation, like Brazil, potentially move closer to the dangers of hyper-inflation. As we move through 2012 I believe rising commodity prices likely again force manufacturers and retailers to constrict labor in an effort to protect margins, eventually raising prices that pushes the CPI higher. US consumers are likely increasingly squeezed between falling income and rising prices. In addition, austerity plans implemented late in 2011 likely begin to have an effect in 2012. This is a potentially explosive combination both financially and socially, as explained in The Economist.
Once we move into 2012 I believe investors should become conservative as inflation worries mount, debt issues remain, and any short-term financial appeasements made in 2011 prove ineffective. At this point I believe we may reach the end game in which fiscal stimulus is neutered by high sovereign debt levels and monetary stimulus is neutered by high inflation. If volatility in 2011 was trying for investors, swings in 2012 may prove fatal.
Tuesday, October 18, 2011
Exited 30-Year Treasury Position
Today I sold all of my position in 30-year treasuries. The main reason for selling is a growing concern that central banks may increase their efforts to stimulate the world economy. Last week illustrated what likely happens to yields on treasuries if central bankers become more active. Longer-term yields increased, dropping prices.
I continue to believe that if left alone, yields on the 30-year treasury could dip to 2.5%. However, if the ECB or the Fed announce a major effort involving the printing of money under another QE program to stimulate growth the yield on the 30-year could easily move back above 4%, in my opinion. I believe the risk is simply too great over the next few weeks of a major move downward in treasury prices.
While I gave back a little of my profit this quarter on the position, I closed out the position up in excess of 25% from when I purchased the bonds in April and May.
My plan is to watch what happens with treasuries over the next few weeks and potentially re-enter a position in longer term bonds or invest in the ETF TBT, which moves inversely to treasury prices.
I continue to believe that if left alone, yields on the 30-year treasury could dip to 2.5%. However, if the ECB or the Fed announce a major effort involving the printing of money under another QE program to stimulate growth the yield on the 30-year could easily move back above 4%, in my opinion. I believe the risk is simply too great over the next few weeks of a major move downward in treasury prices.
While I gave back a little of my profit this quarter on the position, I closed out the position up in excess of 25% from when I purchased the bonds in April and May.
My plan is to watch what happens with treasuries over the next few weeks and potentially re-enter a position in longer term bonds or invest in the ETF TBT, which moves inversely to treasury prices.
PEP: A Restructuring Story within the Declining Commodity Prices Theme
A couple weeks ago I laid out the theme of falling commodity prices within my Sagflation thesis, ultimately buying shares in Tyson Foods (Ticker TSN). In this post I continue with the deflationary theme but add in a restructuring story. One of my favorite signals when looking at a stock is a re-structuring or re-focusing of a strong brand. I call this the "Bain Capital" method since Bain Capital has a proven track record of buying distressed brand names and turning them around for a profit.
Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.
I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.
A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.
Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when it focused on Gatorade. Management then moved to Tropicana, Pepsi Max, Sierra Mist, and Mountain Dew, each showing improvement. Now management is focused on Pepsi, a potential bigger bang for the buck after the cola fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.
Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.
The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.
Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.
I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.
A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.
Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when it focused on Gatorade. Management then moved to Tropicana, Pepsi Max, Sierra Mist, and Mountain Dew, each showing improvement. Now management is focused on Pepsi, a potential bigger bang for the buck after the cola fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.
Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.
The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.
Thursday, October 13, 2011
The Battle Against Deflation Rises Again
In April I argued that deflationary pressures would likely drive market movements for the rest of the year. One of the points I made was the following:
"Unless the Fed continuously 'raises the ante' by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy. Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth"
- Stock Ideas to Money, April 26 2011
With the Federal Reserve considering becoming more active, foreign central banks increasingly stepping in, and the yield on the ten year and thirty year bonds rising; I return to this thought and ask whether fundamental deflationary forces likely subside. To start, I have summarized an analysis of price volatility in the following table.
The key points to pull out, in my view, are:
(1) The longer-term fundamental trends of declining wages and government austerity remain deflationary. Until either fiscal policies become more expansionary or market imbalances are allowed to correct themselves, I believe these fundamental deflationary pressures remain two of the more dominant forces in the economy.
(2) The more volatile segments of commodity, financial and currency have recently swung towards deflationary pressures after providing inflationary pressure for a couple years. These are the sectors affected most immediately by monetary policy in the current low interest rate environment, in my view. The turn-around during the past week in many of these markets, with equity and commodity markets up and the dollar down, likely is due in some part to recent articles suggesting another round of QE is coming. The primary reason for improvements in these markets, in my view, was increasing signs of progress towards the European bailout. In short, activist government policies but no real change in the underlying problems.
(3) The one segment that shows obvious signs of inflationary pressure is goods and services. However, an important distinction needs to be made about this indicator. The CPI is relatively high right now because businesses have been trying to pass along rising costs to customers, in my view. I do not believe it is high at the moment due to excessive demand relative to supply. This point is illustrated by the relatively weak shipments ahead of the Christmas season.
The conclusion is that my Sagflation theme remains in play. I believe fundamental deflationary pressures remain in place but if governments around the world keep announcing new fiscal and monetary stimulants I likely need to exit my 30-year treasury position.
"Unless the Fed continuously 'raises the ante' by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy. Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth"
- Stock Ideas to Money, April 26 2011
With the Federal Reserve considering becoming more active, foreign central banks increasingly stepping in, and the yield on the ten year and thirty year bonds rising; I return to this thought and ask whether fundamental deflationary forces likely subside. To start, I have summarized an analysis of price volatility in the following table.
| Segment | Direction | Argument |
|---|---|---|
| Commodity | Deflationary | Commodity prices have been falling for the last few months, applying deflationary pressure in the cost structure of the world economy. |
| Wages | Deflationary | Wages have declined 10% since December 2007, due primarily to the significant number of unemployed in the country. |
| Financial Assets | Deflationary | With the S&P 500 down significantly from its highs, financial assets have generally declined over the past few months, reducing the wealth of many in the country. |
| Tangible Assets | Stable | Housing prices remain well off their highs from a few years ago, but appear more stable than in the past. However, banks appear more aggressive in acting against owners who have missed a payment, which could push prices lower if the banks choose to try to expedite the foreclosure process and sell the property. |
| Currency | Mixed | The US Dollar index has strengthened recently due largely to weakness outside the US. That said, the strength of the dollar has begun to weaken again. If the dollar continues to slide, inflationary pressure may return to the U.S. economy. |
| Fiat | Deflationary | Governments remain fairly committed to austerity measures as countries in Europe attempt to reduce debt levels and the right-wing in the US continues to favor a balanced budget. Reduced spending is likely a deflationary force in the economy. |
| Goods & Services | Inflationary | The CPI-U increased almost 4% annually in August, a lagging indicator, in my opinion, of inflationary pressure from higher commodity prices earlier in the year. Weak consumer demand suggests this segment could turn deflationary once cost pressures subside. |
The key points to pull out, in my view, are:
(1) The longer-term fundamental trends of declining wages and government austerity remain deflationary. Until either fiscal policies become more expansionary or market imbalances are allowed to correct themselves, I believe these fundamental deflationary pressures remain two of the more dominant forces in the economy.
(2) The more volatile segments of commodity, financial and currency have recently swung towards deflationary pressures after providing inflationary pressure for a couple years. These are the sectors affected most immediately by monetary policy in the current low interest rate environment, in my view. The turn-around during the past week in many of these markets, with equity and commodity markets up and the dollar down, likely is due in some part to recent articles suggesting another round of QE is coming. The primary reason for improvements in these markets, in my view, was increasing signs of progress towards the European bailout. In short, activist government policies but no real change in the underlying problems.
(3) The one segment that shows obvious signs of inflationary pressure is goods and services. However, an important distinction needs to be made about this indicator. The CPI is relatively high right now because businesses have been trying to pass along rising costs to customers, in my view. I do not believe it is high at the moment due to excessive demand relative to supply. This point is illustrated by the relatively weak shipments ahead of the Christmas season.
The conclusion is that my Sagflation theme remains in play. I believe fundamental deflationary pressures remain in place but if governments around the world keep announcing new fiscal and monetary stimulants I likely need to exit my 30-year treasury position.
Tuesday, October 4, 2011
Revisiting the S&P 500 Falling Below 700 Call
On June 1, 2011 I wrote that the S&P 500 may drop below 700. In the article I wrote the following based on my Sagflation theme:
"I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt."
- Stock Ideas to Money, June 1, 2011
In the article I also said that I believed the yield on the 10-year treasury may drop to 2% and the yield on the 30-year treasury may drop to 2.5%, suggesting "the place to make money is in treasury bonds as prices rally as investors flood to the safe haven." Since the yield on the 10-year is now below 2% and the yield on the 30-year treasury is around 2.7%, I felt it appropriate to re-visit the article.
One thing I had not anticipated when I wrote the article was the Federal Reserve's Operation Twist. While long-term yields were likely on their way to current levels, in my view, the Fed's announcement likely hastened the move. This week the Fed actually began buying longer duration treasury bonds, likely the primary reason for the fall in 30-year yields yesterday. So I continue to believe yields on the 30-year treasury move down to 2.5%, at which point I plan to further evaluate the position.
Turning to the S&P 500, the index has a long way to fall before dropping below 700. Two points that I have made in the past, but are worth reiterating: (1) the bottom in the stock market most likely does not coincide with the nadir of yields, and (2) on an inflation and cyclically adjusted basis, the valuation of S&P 500 remains above the historical median of 15.8x and well above historical lows in the single digits, which have occurred during extraordinary times. A single-digit PE, as defined by Robert Shiller, would translate to the S&P 500 below 600.
Source: Robert Shiller, Yale Department of Economics
If 2008/09 is any guide, we can look forward to the following steps:
(1) Capitulation in the markets, defined as record, or near record, volume combined with intraday price swings in excess of 5%. This occurred on October 10, 2008.
(2) Bottoming of the 10-year and 30-year yields. This occurred on December 18, 2008.
(3) Actual stock market bottom, which occurred on March 9, 2009.
Going back to the 30-year treasury yield, if the yield drops below 2.5% before an obvious capitulation day in the equity markets, I may hold the position a little longer.
"I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt."
- Stock Ideas to Money, June 1, 2011
In the article I also said that I believed the yield on the 10-year treasury may drop to 2% and the yield on the 30-year treasury may drop to 2.5%, suggesting "the place to make money is in treasury bonds as prices rally as investors flood to the safe haven." Since the yield on the 10-year is now below 2% and the yield on the 30-year treasury is around 2.7%, I felt it appropriate to re-visit the article.
One thing I had not anticipated when I wrote the article was the Federal Reserve's Operation Twist. While long-term yields were likely on their way to current levels, in my view, the Fed's announcement likely hastened the move. This week the Fed actually began buying longer duration treasury bonds, likely the primary reason for the fall in 30-year yields yesterday. So I continue to believe yields on the 30-year treasury move down to 2.5%, at which point I plan to further evaluate the position.
Turning to the S&P 500, the index has a long way to fall before dropping below 700. Two points that I have made in the past, but are worth reiterating: (1) the bottom in the stock market most likely does not coincide with the nadir of yields, and (2) on an inflation and cyclically adjusted basis, the valuation of S&P 500 remains above the historical median of 15.8x and well above historical lows in the single digits, which have occurred during extraordinary times. A single-digit PE, as defined by Robert Shiller, would translate to the S&P 500 below 600.
S&P 500 PE Ratio
If 2008/09 is any guide, we can look forward to the following steps:
(1) Capitulation in the markets, defined as record, or near record, volume combined with intraday price swings in excess of 5%. This occurred on October 10, 2008.
(2) Bottoming of the 10-year and 30-year yields. This occurred on December 18, 2008.
(3) Actual stock market bottom, which occurred on March 9, 2009.
Going back to the 30-year treasury yield, if the yield drops below 2.5% before an obvious capitulation day in the equity markets, I may hold the position a little longer.
Monday, October 3, 2011
Stock Ideas During Falling Commodity Prices
The idea is to invest in companies that should benefit from falling commodity prices but not get hurt by slowing economic activity. Ideally, the company would also have strong brands or other competitive advantages that allow for stable prices of their products. This should enable margin expansion, and thus EPS growth above the average.
From the top down, I'm looking for companies with stable, almost annuity-like, revenue during economic cycles combined with a large percentage of expenses from materials. An example in my portfolio is Kimberly-Clark (ticker KMB), a consumer staple company that sells products like Kleenex and has significant costs associated with wood due to its paper-based products.
Of course, this idea assumes commodity prices continue to fall. Based on my Sagflation theme of slow-to-negative growth combined with volatile prices, in which I believe the current direction of prices is moving towards deflation, commodities should continue to decline. Significant government intervention in the form of fiscal and monetary stimulus could change this outlook.
In this article I review my investment in Kimberly Clark (ticker KMB), analyze a few companies with similar margin improvement potential due to falling commodity prices, and conclude with a decision to make 2-4% investment in Tyson Foods, ticker TSN.
First, a look at some commodity prices and their change this year:
Source: CNNMoney (http://money.cnn.com/data/commodities/)
The charts above illustrate that the largest price drops over the past year have occurred in copper. Over the past six months there has also been a significant drop in oil and cotton prices with more moderate pullbacks in corn and wheat. Not included in the charts is lumber, which has also seen a modest pull back in prices over the past couple months. Cattle prices have actually rallied strongly over the past. While I expect commodity prices, in general, to continue their decline as deflationary pressures strengthen, for the purposes of the current analysis I shall focus on oil, copper and agricultural products, excluding livestock.
Kimberly-Clark (Ticker: KMB) Cost of Products Analysis
Source: SEC Filings
In 2010 cost of products sold accounted for about 67% of revenue, highlighting the importance of raw material costs in the actual products and used during the manufacturing process. The primary raw materials in the company's products are recovered paper, synthetics, kraft pulp, cellulose pulp and recycled fiber. Natural gas, electricity, and petroleum-based products are key costs during the manufacturing process. Therefore pulp prices and oil prices can have a material impact on financials.
As seen in the charts above, oil prices have declined about 22% since the May peak. The Forestweb North American Pulp Index has dropped over 9% since the June peak. The gross margin for KMB dropped more than 400 basis points from 33.8% in 2Q10 to 29.6% in 2Q11, largely due to higher raw material costs, much of which the company does not hedge. Should oil and pulp prices continue to decline I expect to see the margins improve for the business, enabling above average EPS growth.
Looking over some other key metrics: annual dividend yield is a healthy 4%, the dividend increased 6% this year, TD/ EBITDA is a comfortable 1.5x, PE on '12 EPS is an okay 13.5x, and last month the consensus recommendation moved up to Overweight from Hold because one analyst upgraded. Five analysts have a Buy, ten have a Hold recommendation, and one Sell. I believe the stock is reasonably valued and the dividend yield combined with stable revenue should attract buyers in a weak market.
Sysco Corporation (Ticker: SYY) Cost of Sales Analysis
Sysco is a food distributor with significant fuel and food costs. Because of this position, I decided to look at the margin potential. For the purposes of this analysis, in which I am looking for potential margin expansion due to falling commodity prices, the key disclosure in the company's filing is the following, "we make a significant portion of our sales at prices that are based on the cost of products we sell plus a percentage markup." As a result, falling commodity prices are likely passed along to the customer in the form of lower prices, instead of retained by the company for margin improvement purposes.
Campbell Soup Company (Ticker: CPB) Cost of Products Sold Analysis
Campbell Soup is a food company whose significant costs include agriculture commodities like tomato paste. Therefore I looked at it as a candidate for margin improvements. The key disclosure in their SEC filings is the following, "The company also enters into commodity futures and options contracts to reduce the volatility of price fluctuations of diesel fuel, wheat, natural gas, soybean oil, aluminum, sugar, cocoa, and corn, which impact the cost of raw materials." Therefore there is likely not the upside to margins as commodity prices fall.
Cracker Barrel (Ticker: CBRL) Cost of Goods Sold Analysis
Cracker Barrel is a family-dining restaurant plus retail chain that are typically located next to highways. While not immune to economic slowdowns, their relative low average check, locations near highways, and established brand name can provide healthy revenue trends when gas prices fall, encouraging more people to drive. Thus the company is fairly unique in that falling gas prices can actually drive revenue. The concern is that the company's niche is largely in the lower-to-middle class income segment, which may be hurt proportionally more during an economic slowdown.
Source: SEC Filings
Gross profit was 68% in the fiscal fourth quarter (FYE July), down 170 basis points from the previous year. The primary cause of the higher cost of goods sold was a 2.9% increase in food commodity prices for the fiscal year. Looks promising so far. Dairy, including eggs, accounted for 13% of food purchasing expense in fiscal 2011. Beef, poultry, and pork each accounted for 11% of food purchasing expense. Together, these four segments accounted for 46% of food costs. The company raised menu prices 2% last year to offset the rising costs but the traffic declined about 2%, which may be due to the higher menu prices, weak economic environment, and also higher gas prices.
The key issue, in my mind, concerns the following disclosure about the fiscal 2012 outlook, "we presently expect the rate of commodity inflation to approximately double in 2012 as compared to 2011. We expect to offset the effects of food commodity inflation through a combination of menu price increases, supply contracts and other cost reduction initiatives." On the one hand, expectations are already set for higher commodity prices, providing room for upside should food prices actually fall. The problem is that beef prices are rising due to the droughts around Texas. On the chicken side you would think poultry prices would decline with lower corn prices. However, producers have been getting squeezed due to higher corn prices and thus have cut back production, suggesting poultry prices may remain firmer. Pork belly prices have declined about 5% since peaking in May, so this segment may offer some upside.
My conclusion is that food prices impacting Cracker Barrel may not go down as much, offering less upside to margins. Couple this with the uncertain impact of a weaker economy and I have decided to put this idea on the shelf.
Tyson Foods (Ticker: TSN) Cost of Sales Analysis
Tyson Foods, Inc. is a meat protein and food production company. It produces, distributes and markets chicken, beef, pork, prepared foods and related allied products. Its operations are conducted in four segments: Chicken, Beef, Pork and Prepared Foods. The largest revenue segment is beef, followed closely by chicken, which together account for almost three-quarters of revenue. Revenue is typically fairly stable during economic cycles, although can fluctuate due to prices for beef, chicken and pork.
Source: SEC Filings
After looking at Cracker Barrel, and trends in poultry prices, I found the chart below interesting. Basically, it summarizes the ratio between broiler prices (chicken) versus feed. The higher the ratio the better the margins for a chicken producer. The chart's labels are horrible, but basically the time line is from 2007 to the end of September 2011. I love this chart because it illustrates an unsustainable state in the market. Chicken producers are actively cutting back production because their margins are under pressure, suggesting broiler prices should remain at least stable in a weak economy. Additionally, I believe with corn and wheat prices declining the feed prices should decline, enabling the ratio to recover back above 1.0x.
Source: The Market Oracle blog. http://www.marketoracle.co.uk/Article30748.html
Because of the rising feed costs associated with corn and wheat prices, Tyson saw its gross margin decline 370 basis points in the quarter ended July 2. The company does actively enter into derivative and longer-term contracts in order to manage the volatility of prices like corn, live cattle, lean hogs, and natural gas. Thus how well they manage these positions likely impacts the margin potential, in my view.
A couple additional key metrics: The PE on C2011 is an attractive 8.5x. The consensus recommendation is Overweight, which has been stable for the past quarter. The company has met or exceeded EPS estimates each quarter during the past two years. The consensus EPS estimate for the September quarter is $0.31, a drop of over 50% from the previous year. Dividends have been stable over the past two years and the current annual dividend yield is about 1%. The company's debt has been upgraded twice by both Moody's and S&P over the past two years. TD-to- TTM EBITDA is just over a healthy 1x and the company plans to repurchase debt outstanding with cash on-hand. As of July 2, the company was authorized to repurchase over 18 million shares.
In conclusion, I plan to establish a 2-4% position in Tyson Foods based on what I believe is an outlook of stable protein commodity prices and falling feed costs, offering upside potential to estimates through margin improvements. In addition, I believe the valuation builds in a cushion for higher expected feed costs and worries about a demand slowdown.
From the top down, I'm looking for companies with stable, almost annuity-like, revenue during economic cycles combined with a large percentage of expenses from materials. An example in my portfolio is Kimberly-Clark (ticker KMB), a consumer staple company that sells products like Kleenex and has significant costs associated with wood due to its paper-based products.
Of course, this idea assumes commodity prices continue to fall. Based on my Sagflation theme of slow-to-negative growth combined with volatile prices, in which I believe the current direction of prices is moving towards deflation, commodities should continue to decline. Significant government intervention in the form of fiscal and monetary stimulus could change this outlook.
In this article I review my investment in Kimberly Clark (ticker KMB), analyze a few companies with similar margin improvement potential due to falling commodity prices, and conclude with a decision to make 2-4% investment in Tyson Foods, ticker TSN.
First, a look at some commodity prices and their change this year:
Oil (Light Crude)
 |
Copper
 |
Corn
 |
Wheat
 |
Cotton
 |
Live Cattle
 |
The charts above illustrate that the largest price drops over the past year have occurred in copper. Over the past six months there has also been a significant drop in oil and cotton prices with more moderate pullbacks in corn and wheat. Not included in the charts is lumber, which has also seen a modest pull back in prices over the past couple months. Cattle prices have actually rallied strongly over the past. While I expect commodity prices, in general, to continue their decline as deflationary pressures strengthen, for the purposes of the current analysis I shall focus on oil, copper and agricultural products, excluding livestock.
Kimberly-Clark (Ticker: KMB) Cost of Products Analysis
| 2Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $5,259 | + 8.3% |
| Gross Margin | 29.6% | - 4.2% |
| Op. Margin | 11.9% | - 2.7% |
| Dil. Op. EPS | $1.18 | - 1.7% |
Source: SEC Filings
In 2010 cost of products sold accounted for about 67% of revenue, highlighting the importance of raw material costs in the actual products and used during the manufacturing process. The primary raw materials in the company's products are recovered paper, synthetics, kraft pulp, cellulose pulp and recycled fiber. Natural gas, electricity, and petroleum-based products are key costs during the manufacturing process. Therefore pulp prices and oil prices can have a material impact on financials.
As seen in the charts above, oil prices have declined about 22% since the May peak. The Forestweb North American Pulp Index has dropped over 9% since the June peak. The gross margin for KMB dropped more than 400 basis points from 33.8% in 2Q10 to 29.6% in 2Q11, largely due to higher raw material costs, much of which the company does not hedge. Should oil and pulp prices continue to decline I expect to see the margins improve for the business, enabling above average EPS growth.
Looking over some other key metrics: annual dividend yield is a healthy 4%, the dividend increased 6% this year, TD/ EBITDA is a comfortable 1.5x, PE on '12 EPS is an okay 13.5x, and last month the consensus recommendation moved up to Overweight from Hold because one analyst upgraded. Five analysts have a Buy, ten have a Hold recommendation, and one Sell. I believe the stock is reasonably valued and the dividend yield combined with stable revenue should attract buyers in a weak market.
Sysco Corporation (Ticker: SYY) Cost of Sales Analysis
Sysco is a food distributor with significant fuel and food costs. Because of this position, I decided to look at the margin potential. For the purposes of this analysis, in which I am looking for potential margin expansion due to falling commodity prices, the key disclosure in the company's filing is the following, "we make a significant portion of our sales at prices that are based on the cost of products we sell plus a percentage markup." As a result, falling commodity prices are likely passed along to the customer in the form of lower prices, instead of retained by the company for margin improvement purposes.
Campbell Soup Company (Ticker: CPB) Cost of Products Sold Analysis
Campbell Soup is a food company whose significant costs include agriculture commodities like tomato paste. Therefore I looked at it as a candidate for margin improvements. The key disclosure in their SEC filings is the following, "The company also enters into commodity futures and options contracts to reduce the volatility of price fluctuations of diesel fuel, wheat, natural gas, soybean oil, aluminum, sugar, cocoa, and corn, which impact the cost of raw materials." Therefore there is likely not the upside to margins as commodity prices fall.
Cracker Barrel (Ticker: CBRL) Cost of Goods Sold Analysis
Cracker Barrel is a family-dining restaurant plus retail chain that are typically located next to highways. While not immune to economic slowdowns, their relative low average check, locations near highways, and established brand name can provide healthy revenue trends when gas prices fall, encouraging more people to drive. Thus the company is fairly unique in that falling gas prices can actually drive revenue. The concern is that the company's niche is largely in the lower-to-middle class income segment, which may be hurt proportionally more during an economic slowdown.
| F4Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $613 | 0% |
| Gross Margin | 68.4% | - 1.7% |
| Op. Margin | 6.2% | - 1.2% |
| Dil. Op. EPS | $0.25 | + 14% |
Source: SEC Filings
Gross profit was 68% in the fiscal fourth quarter (FYE July), down 170 basis points from the previous year. The primary cause of the higher cost of goods sold was a 2.9% increase in food commodity prices for the fiscal year. Looks promising so far. Dairy, including eggs, accounted for 13% of food purchasing expense in fiscal 2011. Beef, poultry, and pork each accounted for 11% of food purchasing expense. Together, these four segments accounted for 46% of food costs. The company raised menu prices 2% last year to offset the rising costs but the traffic declined about 2%, which may be due to the higher menu prices, weak economic environment, and also higher gas prices.
The key issue, in my mind, concerns the following disclosure about the fiscal 2012 outlook, "we presently expect the rate of commodity inflation to approximately double in 2012 as compared to 2011. We expect to offset the effects of food commodity inflation through a combination of menu price increases, supply contracts and other cost reduction initiatives." On the one hand, expectations are already set for higher commodity prices, providing room for upside should food prices actually fall. The problem is that beef prices are rising due to the droughts around Texas. On the chicken side you would think poultry prices would decline with lower corn prices. However, producers have been getting squeezed due to higher corn prices and thus have cut back production, suggesting poultry prices may remain firmer. Pork belly prices have declined about 5% since peaking in May, so this segment may offer some upside.
My conclusion is that food prices impacting Cracker Barrel may not go down as much, offering less upside to margins. Couple this with the uncertain impact of a weaker economy and I have decided to put this idea on the shelf.
Tyson Foods (Ticker: TSN) Cost of Sales Analysis
Tyson Foods, Inc. is a meat protein and food production company. It produces, distributes and markets chicken, beef, pork, prepared foods and related allied products. Its operations are conducted in four segments: Chicken, Beef, Pork and Prepared Foods. The largest revenue segment is beef, followed closely by chicken, which together account for almost three-quarters of revenue. Revenue is typically fairly stable during economic cycles, although can fluctuate due to prices for beef, chicken and pork.
| F3Q11 | Y/Y | |
|---|---|---|
| Revenue ($mm) | $8,247 | 11% |
| Gross Margin | 6.4% | - 3.7% |
| Op. Margin | 3.8% | - 3.0% |
| Dil. Op. EPS | $0.46 | - 31% |
After looking at Cracker Barrel, and trends in poultry prices, I found the chart below interesting. Basically, it summarizes the ratio between broiler prices (chicken) versus feed. The higher the ratio the better the margins for a chicken producer. The chart's labels are horrible, but basically the time line is from 2007 to the end of September 2011. I love this chart because it illustrates an unsustainable state in the market. Chicken producers are actively cutting back production because their margins are under pressure, suggesting broiler prices should remain at least stable in a weak economy. Additionally, I believe with corn and wheat prices declining the feed prices should decline, enabling the ratio to recover back above 1.0x.
Because of the rising feed costs associated with corn and wheat prices, Tyson saw its gross margin decline 370 basis points in the quarter ended July 2. The company does actively enter into derivative and longer-term contracts in order to manage the volatility of prices like corn, live cattle, lean hogs, and natural gas. Thus how well they manage these positions likely impacts the margin potential, in my view.
A couple additional key metrics: The PE on C2011 is an attractive 8.5x. The consensus recommendation is Overweight, which has been stable for the past quarter. The company has met or exceeded EPS estimates each quarter during the past two years. The consensus EPS estimate for the September quarter is $0.31, a drop of over 50% from the previous year. Dividends have been stable over the past two years and the current annual dividend yield is about 1%. The company's debt has been upgraded twice by both Moody's and S&P over the past two years. TD-to- TTM EBITDA is just over a healthy 1x and the company plans to repurchase debt outstanding with cash on-hand. As of July 2, the company was authorized to repurchase over 18 million shares.
In conclusion, I plan to establish a 2-4% position in Tyson Foods based on what I believe is an outlook of stable protein commodity prices and falling feed costs, offering upside potential to estimates through margin improvements. In addition, I believe the valuation builds in a cushion for higher expected feed costs and worries about a demand slowdown.
Saturday, October 1, 2011
Third Quarter Review - Up 18%
| Position | % of IRA | Q Performance |
|---|---|---|
| 30-Yr Treasury | ~65% | up ~29% |
| KMB | ~5% | up ~7% |
| BWP | ~4% | down ~12% |
| UTL | ~3% | down ~2% |
| FGP | ~3% | down ~12% |
| CA | ~1% | down ~15% |
| TEVA | ~1% | down ~23% |
| Cash | ~18% | N/A |
My defensive strategy worked quite well during the quarter as I significantly under-weighted equity and significantly over-weighted government debt with a long duration. My equity positions were focused in the more defensive sectors of consumer staples, US-based natural resources, utilities, healthcare, and stable customer-based technology.
Overall performance in the quarter was an increase of 18%. For the quarter, all but my two smallest positions outperformed the S&P 500, which was down about 14%.
The treasury position also paid out a coupon in excess of 2%, on top of the approximately 29% bump in principle, increasing my cash position. I also received dividends during the quarter, raising my cash balance.
I did close two positions during the quarter on August 3, CALM at $33.88 for a 6% gain in the quarter and TNH at $150.93 for a 10% gain in the quarter. I did not open any new positions during the quarter.
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