Value Investing using Economic Value Added (EVA)

Lowe's Scales Back Expansion

Lowe's joined its rival Home Depot in scaling back its real estate growth plans - looks like we will not have a home improvement warehouse in every town in every state.  Lowes joins McDonalds, WalMart, Sears Holding and Home Depot in focusing on growing intrinsic value per share instead of growing a real estate empire that hurt profitabilty for all concerned.

This also means that both companies now are "resigned" to profitable slower growth on the top line but large increases in per share value as cash flow will be used to repurchase shares.

It's about time - per share intrinsic share value growth is all that matters.

Lowe's Scales Back Expansion

You can see from the two charts above generated at afgview.com that Home Depot (HD) has been and continues to be more economically profitable than Lowe's (LOW) as measured by each company's economic margin (EM) over time. HD's peak EM was 11.3 in 2006; LOW's peak EM was 8.6 much less.  You can see below that HD stopped spending on expansion and even divested assets as HD's asset growth was less than LOW's for most of the past 15 years.  This makes sense since LOW's was playing catch up to the first mover HD.  But playing catch up in a saturated market is expensive.  It shows up in consistently lower velocity - sales/assets (asset turnover) - than HD.

The home-improvement retailer on Tuesday also tempered its longer-term sales plans as it scales back on store openings until housing markets and the economy improve enough so that homeowners resume work on their list of remodeling projects. - WSJ  9.23.2009

As consumers slowly start making home more comfy again LOW and HD are ready to accelerate EM growth to test previous highs as more rational growth and shareholder friendly uses of cash become the new normal for the two giants.

BERK

Dell (NASDAQ:DELL) Should Reboot Perot Systems (NYSE:PER) Acquisition

The ValueExpectations blog was quick to show, not just state, how unlikely DELL's purchase price of Perot Systems (PER) will prove to be value-adding. 

Beginning with PER’s historic profit margins, what can Dell expect from the unit going forward? Looking at the EBITDA Margins in the chart below from 2000 through 2008, PER delivered EBITDA margins ranging from a low of 2.8% to a high of 11.8%. For our analysis, we will use what seems to be a reasonable figure of 11% to represent PER’s normalized long-term EBITDA Margin. In fact, given the volatility of PER’s margin historically, many can argue that 11% is a generous assessment. That said, let us use 11% nonetheless. Next, review the chart depicting PER’s Asset Turn Over ratio, which tracks how much a company must invest in its balance sheet to support a dollar of sales. For PER the figure recently was about 1.4x, or for every $1.40 of sales the company generates, it must invest $1.00 in assets to support those sales. Though PER has been much more efficient historically, its trend has been towards requiring more and more capital to support a dollar of sales. By using the most recent figure, we will assume it will minimally arrest that slide.

What sales growth PER needs to generate to justify a $30 share price? An astounding 26% each year over the next 4 years! This compares the to the 13% annual growth PER has delivered over the past 5 years, the 6.4% it delivered in 2008, and an expected but rather certain decline of 10% in 2009.

Bottom line, Dell’s management team believes it will double PER’s growth rates over the next four years relative to what PER achieved during the past economic boom, while maintaining historically aggressive profit margins. While it is not impossible, it seems very unlikely. In fact, Dell executives did not give any targets for revenue, saying more details would come after the deal closes. They did touch upon expected opportunities for cost savings, saying the two companies spend a combined $4 Billion in the areas they plan to integrate, and its sees cost savings of about 6-8% in 2 years. If Dell hits those synergies, which justifiably the market rarely pays for, the new Perot would likely have profit margins approaching that of Accenture, arguably the best in class provider of these services. Again, while such an outcome is possible, it is much like betting on the expectation of hitting an inside straight – generally not a very good strategy.

What then is the strategy?  How can Dell claim "profitable growth" as their primary objective - rather than market share or margins and still justify paying a high premium?

It's government services and health-care IT in particular.

Peter Altabef, President and CEO of Perot Systems said this on yesterday's conference call:

I'm glad you asked the question because as important as health-care is to Perot Systems, it represents about 48% of our revenue, 25% of our revenue is generated by the government sector. Obviously, Dell is a major player in the government sector as well, and we think combining our relationships with Dell's current relationships in government will be actually a very powerful force.

With respect to commercial, that's 27% of our existing revenues and includes some very exciting areas for us. I would tell you one of the things that this transaction does for our capabilities is greatly expand our ability in the commercial sector. And when you look at Dell's footprint and you look at their existing customer base as well our customer base, we think there are great opportunities for the commercial businesses to expand on the services side.

So we really are looking at this from the services side across the board, from commercial to government to health-care, and we think there are significant opportunities throughout that spectrum.

And when asked directly about the high price paid, DELL CEO Brian Gladden said:

...the key value drivers for us really were, this is a really an anchor acquisition that for us gives us a lot of potential strategic flexibility going forward around services. We saw it as really a premier IT services asset and with revenue growth potential that we think is significantly better than other targets that we looked at. In addition, the size makes sense from a scalability standpoint, given our direct customer relationships, we think we can grow it quickly.

On a standalone basis the price is difficult to justify.  But the 26% revenue embedded in DELL's purchase price is high from Perot Systems vantage point, it's not so much from the DELL vantage point.  I'm the last guy to accept management's synergy fantasies until they show us they can make it work, but DELL is slowly, if not carefully, building their services business from a scalable, read high economic margin, model based on intellectual property and more remote infrastructure management.

Sounds good - we'll have to see.  In the meantime this investment and the expected value destruction does very little to the fair value estimate for DELL's shares.

BERK

Eight Reasons Why Government Spending Hurts Economic Growth

Executive Summary

This Center for Freedom and Prosperity Foundation video analyzes how excessive government spending undermines economic performance. While acknowledging that a very modest level of government spending on things such as "public goods" can facilitate growth, the video outlines eight different ways that that big government hinders prosperity. This video focuses on theory and will be augmented by a second video looking at the empirical evidence favoring smaller government.

BERK

The Empirical Evidence Against Big Government

Washington, D.C., Tuesday, September 15, 2009) The Center for Freedom and Prosperity Foundation (CF&P) today released a video on the empirical relationship between the size of government and economic growth. Entitled "The Empirical Evidence Against Big Government," the educational video comes at a crucial time as government spending rose rapidly during the Bush years and Obama is continuing the same failed policies.

Executive Summary

Building on a previous mini-documentary that focused on theory, this video from the Center for Freedom and Prosperity Foundation presents real-world data and research showing that the burden of government spending is far too high – not only in the United States (where the Bush-Obama policies have increased the federal budget by more than 100 percent), but also in other nations where government budgets sometimes consume more than one-half of an economy's output.

The protests over Obamacare are really about federal government growth as a percentage of the economy and about its influence and control over more and more of everyday life in America - not necessarily about health-care per se. 

And it is essential that we understand what greater control by the federal government means for future prosperity before we institutionalize a much bigger welfare state.  

President Obama was elected last year to bring change.  Many of us feared that the change would mean a much larger role for the federal government in the economy.  But many thought that change meant genuine reform and a new pragmatic, smarter government.  Instead, we got an unprecedented leap toward much more government involvement in everything - trade, spending and now health-care. 

As you will have seen in the video above, the US is a wealth creating machine whose success correlates with much smaller centralized control than other comparable western democracies like Germany, France, Japan and the United Kingdom.  The issue before all of us is whether a larger "smarter" government can efficiently direct and coordinate an extraordinarily complex system whose success seems to have sprung up from the individual's freedom to innovate in a self-organized way.

The evidence seems to suggest that, no matter how well intentioned government policies appear to be, at some point, government technocrats do not get better results than those emerging from the complex, self-organizing system that is the US economy.

BERK 

Insider Trading Signaling U.S. Stock Market Top - for Now

From the latest report from Insiderscore.com:

Insider Selling Accelerates Again

•Russell 2000 Insiders Reverse Sentiment Into Strength
•Another Weak Week for S&P 500 Sentiment
•Technology, Industrial Goods Insiders Keep Foot On Selling Peddle
•Healthcare Insiders Contrarians No More
•Bankers, Oilmen Not Interested In Buying

(As of 08/26/09) The improvement in sentiment that we saw two weeks ago appears to have been a head fake as the bears reared their heads again last week. Our Weekly Score posted its second-worst showing in two years, bested only by the ugly number recorded for the week ended August 11, 2009. The big drivers were a strong reversal amongst Russell 2000 constituents; a move from bullish to modestly bearish sentiment within the Healthcare sector; and, continued very bearish sentiment within the Technology sector. Overall, companies with selling outnumbered companies with buying by a more than 2-to-1 ratio for just the second time since the week ended February 27, 2007 (the other time being two weeks ago) as net companies with buying fell more -21% week-over-week compared to just a -7% drop in net companies with selling.

Insider Selling – A Warning?  (From our 2nd Qtr Investor Letter)

After buying heavily in early March as the market collapsed, company insiders (CEO, CFO,  Directors and large holders) started selling throughout most of the quarter.

Insiderscore.com’s Weekly Score hit its lowest level in over two years as the S&P 500 climbed to its best level since January. Overall, the insider sentiment was very negative for the quarter as insiders used the market bounce to unload boat loads of company stock.

So far the market has absorbed this supply in stride and hasn’t taken the selling as a negative signal. The first two weeks of each quarter show very light insider activity due to the number of insiders constrained from selling because of closed insider windows around the time of earnings reports. We start seeing activity in the fifth and sixth week.

The last time insider sentiment was this bearish three weeks into a quarter was the second quarter of 2007. And the last time the Weekly Score was this bearish for three weeks was the third quarter of 2007. Of course, we reached the market high in that third quarter. Insiders were smart sellers right before the bear market.

But corporate insiders are people too. They are subject to the same emotions that we all are. As the market comes off the “generational low” in March, a bunch of insider selling should be expected.

Many of the sellers now were the same people that were worried about their companies going bankrupt just a few months ago. This round of insider selling is likely signaling a pause in the ferocious rally of late – but just a pause to refresh we think.

BERK

So You Need Income - Beware the Yield Hogs

The Official Blog of Dorsey Wright warns that individuals seem to have given up on the stock market.  And judging from my clients' questions about where to stash their cash earning less than 1% at the banks and money funds, they have given up on holding cash too.  Of course, that is what the Fed wants to happen - stir the "animal spirits" - to get investors to take some risk to earn bigger than cash returns.

The problem is that when you are part of the herd, you are likely to get trampled.  Notice that flows into bond funds are now 5x the money going into stock funds.  Beware reaching for yield.  Bond yields have crashed (prices are way up) as leading economic indicators around the world have rose.  It seems that reaching for yield has already occurred.

 

 

Gentlemen Prefer Bonds

Although flows into equity funds have picked up recently, flows into bond funds are currently five times higher than flows into stock funds.  (The link to the graphic is here.) See below too.

Many investors have apparently given up on the stock market and now they are all about income.  This is an interesting proposition with $11.7 trillion in U.S. debt outstanding and no clear way to pay it back.  The bonds with the most income, high-yield corporates, are expected to have rapidly rising default rates.

Maybe nothing bad will happen to all of the income seekers, although I would point out that more money has been lost reaching for yield than at the point of a gun.  At the very least, it might be a positive sign for the equity markets in a contrary opinion sort of way.

BERK
 

Stock bond flows -