Saturday, January 14, 2017

Coach (NYSE:COH)

Coach's sales and profits have dropped for the past 3 years, but the company is now supposed to be in a turnaround.

Before looking at the numbers, the most important thing for luxury goods is branding: a combination of consistent pricing, retail environment and advertising.  Styles come and go.  But consistent branding means a company can survive product flops and style disasters:

Here in Asia, Coach is mid-range luxury, compared to brands such as LV.  All bags are sold through their own stores, or their 'store-within-a-store' in upscale department stores.  Prices start around SGD 500 for a leather handbag.  But occasionally in some places, you could still see piles of the old cheap 'CC' bags on wooden racks, where some enterprising person has imported a few and set up a temporary shop.

And this is the problem - Coach is actually two brands:

  • An "Accessible luxury" brand, around USD 400 to 1000 for a nice bag.  Still expensive, but affordable:

  • A cheap knockoff brand available at "Outlets" and "Factory" stores.  Which has cheaper (MFF - made for factory) versions of the same products:

The factory outlets sell different versions of the same models under the same brand name.  You can tell the two apart by looking at the bag's serial numbers.

Coach has destroyed their brand by opening outlets and selling cheap versions of their products.   Some comments from the purseblog forum about the brand's history:

It used to be a luxury brand about twenty/twenty-five years ago. Coach's quality took a huge nose-dive in the 00's, for sure. The advent of the Coach outlet brought it down. I remember when Coach bags used to be displayed behind the counter and in the glass cases at department stores (late 80s and 90s for me). The bags were all thicker, sturdier leather back then. (link)

It'll be very interesting to see if Coach will be able to backtrack from the endless turnover/scarcity marketing/quick markdown schedules that has characterized their brand for the past 10 or so years. LV still makes Speedy, Chanel still makes GSTs. Does Coach (outside their classics line) make anything from even 2 years ago? That's what keeps them from being considered high end, IMO - they have a lower-end selling scheme. (link)

And about the relentless markdown or copying of boutique products:

Phoebe's ... not valid on PCE ... then they were valid ... since then SAS and outlets ... now they actually *are* a MFF bag. (I literally :lol: out loud when I type that.)

Legacy from five years ago ... some were not valid on PCE ... then were valid on PCE ... then "they'll never go to outlet" ... then they did ... then MFF came up with some very similar versions.

Boroughs ... not valid on PCE ... then they were valid ... then on SAS and outlets (and I got a few through both routes and love them dearly) ... then MFF actually made their *own* Boroughs.  (Feb 2016 - link)

This is another reason I have yet to pull the trigger on the oxblood rogue (plus no boutiques near me carry the rogue to see if it's really worth the $). My boutique swears it will never hit the outlet, go to SAS, or allow PCE but we have all heard that story before. 

...I rarely buy anything full price because I know there is always a department sale or pce coming up. I would be comfortable paying $795 for a rogue if I knew it wasn't going to be deeply discounted at Macy's or hit the next SAS at 40% off. (Feb 2016 - link)

Coach presented a turnaround plan in 2014, which involved:

  • Closing 20% of their boutique stores, and 'consolidating' some of they factory outlets
  • Upgrading their factory outlet stores
  • Selling new designs from Stuart Vevers
  • Limit discounting (PCEs - Preferred Customer Events).
Have they done this?  Yes, and sales/profits have recently improved.

But fundamentally, Coach still sells 2 different priced brands under the same name.  The company does not give a breakdown of revenue/profits from outlets, which is estimated at 70% (1) (2) (3).  But they give the numbers and areas for different store types.  The trend is clear:



Looks like Coach will never get rid of its outlet stores.  And until they fix this, I won't consider the shares no matter how good the finances are.  If you're brand is no good, then you have to compete on fashion/design/fads/whatever, which is unpredictable.

Selling the same brand at two different price points is misleading.  Making cheap knockoff copies of your own products and selling them a discount is lying.  My wife has seen bags that she likes, but won't buy them because they are Coach.

What would make me change my mind?  If they were to put their outlet stores under a separate brand, maybe.


Nice bag, but not buying it.

Saturday, January 7, 2017

Bought UUP and URA

On the 4th & 5th Jan, bought 1507 units of the Global X Uranium ETF (URA), for total cost of USD 20611.24 (average price USD 13.67).  Thats the maximum I'm willing to risk, given operating leverage involved, and the fact that that the uranium price could be low for years.




Bought UUP (US Dollar Index ETF) on December 5th 2016.  800 units at USD 25.97, for a total cost of 20,781.59.  This fund replicates being long USD against other developed countries' currencies, mostly the Euro (Click on 'Portfolio' tab here).  Synthetic fund with a 0.75% management fee.

This is a small bet on the USD rising.  Whether its because of Trump, the falling Yuan, European elections, or whatever.  The main risk is that this is a consensus trade - google around, and you can't find anyone bearish on the USD or bullish on the Euro.
                 ___________________________________________

My portfolio is still 71% cash:

Just taking small bets.  Stocks in general are still expensive, especially the US.  I'm only really comfortable buying in a recession or crisis.

Tuesday, January 3, 2017

Uranium

Introduction

The price of uranium has been going down forever.  For 5 years, since the 2011 Fukushima disaster.  Or for 10 years on a longer term chart:

Source: Cameco

Although uranium use has been falling since 2011, 60 new reactors are now under construction, mostly in Asia:


Source: IAEA.  See World Nuclear Association for an updated & detailed table.

This is a 13% increase in the current 450 operational reactors.  The bull case for uranium is that an overreaction to Fukushima and the multi year slump in prices has undermined sentiment in the industry, halting exploration and curtailing mining.  And prices should see a massive jump when new demand comes online.

Economics of Nuclear Plants

Nuclear fission makes up 11% of the world's electricity.

Nuclear plants have high fixed costs, but have low operational costs and run for a minimum of 30 years.  It is hard to vary their energy output, so they are best suited to base-load power plants.

To startup (or restart) a reactor, you need twice as much uranium in the first year.  Most reactors will stockpile 7 years of fuel before starting.

Nuclear plants need water for cooling, so can only be operated in costal areas.

In the US, cheap natural gas may make nuclear plants uneconomical.  Exelon came close to closing 2 Illinois plants which were losing cash on an operating basis.  Even though the 2 plants were saved, I think its unlikely many new plants will be build in North America, due to the high upfront cost.  This won't affect nuclear plants in Asia - cheap natural gas cannot be exported from the US to Asia - once you do its no longer cheap1.

Solar and wind power are getting cheaper and may already be a parity.  But they don't provide electricity throughout the day unless we get improvements in battery storage.  So the alternatives for base-load production are nuclear (expensive, risky), coal (cheap, dirty) or natural gas (clean, expensive in Asia) or oil (expensive).  So I'd expect that nuclear plants will continue to be used for base-load power generation where cheap piped natural gas is unavailable, water is plentiful, and air pollution is a concern.


Uranium Demand, Supply and Stockpiles

Demand is straightforward as the only commercial use of uranium is for fuel.  The number of reactors operating, under construction and planned is known.  Forecast uranium demand is from up 10% over five years to 26% over 10 years.

Mines supplied 60,469 tonnes of Uranium Oxide concentrate in 2015.  The amount required was estimated at 63,404 tonnes in 20162.    The difference was made up by drawing down stockpiles.

No one knows how much is stockpiled.  Early uranium production first went into military stockpiles, then later on in to civil stockpiles.  Since the 80's, these stockpiles have made up the difference between demand and mine output:


Source: World Nuclear Association

Even the size of civilian stockpiles is uncertain.  It is suggested that China has stockpiled more than one worldwide year's supply of uranium.  Japan has been selling off its stockpile since 2011, and nobody knows how much they have.  Global inventory estimates are all over the place.  Nobody knows.

Cost Curve

The latest cost curve I can find is here, but its not labelled.  The article says that most mines were cashflow positive in 2015, due the falling currencies of commodity producing countries.  Long-term contract prices fell by around 30% in 2016, so some may be losing cash now.

The lowest cost producers are ISL mines in Kazakhstan, and Cameco's mines in Canada.

Cameco (NYSE:CCJ)

The textbook strategy while awaiting a commodity price turnaround is to buy the lowest cost producer.  Cameco is the lowest cost (listed) producer - its two biggest mines, McArthur River and Cigar Lake have ore grades of 16-17%.  Most other mines have grades of less than 1%.

Some quick back-of-the-envelope numbers for Cameco:
  • Profits in 2014, 2015 and 9-months 2016 were CAD 183m, 63m and 85m respectively.
  • You could add another 40m to 9-month 2016 profit, due to one-off costs in winding down Rabbit Lake 3
  • Debt is around 1.5bn.  Long term notes, mostly due between 2019 and 2025.

The trouble with Cameco is their massive tax dispute with the Canada Revenue Agency (CRA).  They are alleged to have engaged in transfer-pricing from 2003 to 2015, by selling to Swiss subsidiary at below market prices.  They may receive tax expenses of up to 1.7bn (maybe more 4), plus interest and penalties.  The case for years 2003, 2005, and 2006 is under trial now with a result is expected in 2H17 - the company says the amounts claimed for these 3 years are 'modest' and can be covered by cash.  But the results may be later applied by the court to the other years.  Cameco says they have not broken the law, and have only recorded a provision of $54 million (as of 3Q16).  The case is too complex for a layman to understand (1) (2).

The possibility of such a large payment adds an unknown binary element to investing in Cameco.  There's a small possibility the company is screwed.  In the worst case for example, having to issue 1.7bn in bonds at a 6% interest gives an expense of 100m, raising doubts about their ability to survive when uranium prices are so low.  Or issuing more shares, which would dilute shareholders, and come close to nationalising the company.


Global X Uranium ETF (URA)

Due to Cameco's potential tax problems, its may be better to buy the URA ETF instead.  It holds:
  • 22%: Cameco
  • 39%: Other Uranium E&P companies, that are currently producing.
  • 24%: Uranium exploration companies, not currently producing - more speculative.
  • 8%: Nuclear companies (involved in mining, processing and building/running reactors).
  • 7%: Uranium ETF (holding actual uranium)
Around 50% of their holdings operate primarily in North America, 10% in China/Kazakistan/Mongolia, and 8% in Europe.

Risks

Risks to the bull case are:
  • China's nuclear plans do not work out, perhaps due to economic problems.
  • Advances in battery technology make solar feasible for base-load generation.
  • We may simply still be in the downward part of the cycle - people have been saying that uranium will recover for years.  There still may be years more to go, especially since the size of stockpiles is unknown.
  • Cheap supply from Kazakhstan.
                 ___________________________________________

1 Majority of LNG price is from liquefaction - see the third slide here.
2 This was not actual demand, as it excludes some outages, but it was potential demand.
3 See question by Greg Barnes in 3Q16 Transcript.  Care and maintenance for shutting down the mine is immediately expensed from COGS, not capitalised over time.
4 Its unclear, see page 11

Saturday, November 26, 2016

LLoyds Bank

A quick look at Lloyds, the largest bank in the UK.

The only two UK-listed banks serving the UK market are Lloyds and RBS.  Both went under in 2008 and had to accept government bailouts - pages 3 and 4 here give a brief history.  They are slowly mending, though still making large provisions to pay for past misdeeds.  Lloyds is the stronger of the two.

Market Share

The UK banking market is highly concentrated for savings, less so for mortgages:
  • For savings accounts: A UK government report states "The four largest banks (LBG, HSBCG, RBSG and Barclays) in Great Britain (GB) accounted for approximately 70% of active PCAs (Personal Checking Accounts) and 80% of active BCAs (Business Checking Accounts) in 2014".
  • For home loans: Moodys is cited saying that in 2014 the top 5 players had 2/3rds of the market: "Lloyds was the industry leader, controlling 24 per cent1 of the market share, followed by Santander UK with 13 per cent, Nationwide with 12 per cent, and Barclays and Royal Bank of Scotland (RBS) with 10 and eight per cent, respectively."

There are new entrants:
  • There has been new entry into retail banking in recent years. Metro Bank (PCA and SME) was the first organic entrant to the UK banking market in more than 100 years when it received its banking licence in March 2010.  Aldermore Bank (primarily SME but not BCA) entered in 2009. Several other new entrants have their roots in ancillary financial/retail services such as Tesco Bank (PCA 2014), the Post Office (PCA 2013/14), Virgin Money (PCA 2014), and Marks & Spencer Bank (M&S Bank) (PCA 2012). Handelsbanken (PCA and SME) has also significantly extended its UK operations more recently almost doubling its network between 2011 and 2015.
  • There are also a number of banks that have just been authorised or are in the process of being authorised including Atom Bank (authorised in June 2015, digital-only PCA and SME), Starling Bank (digital PCA), Civilised Bank (SME) and OakNorth (authorised in March 2015 SME but not BCA). In addition to traditional bank lending, alternative finance has been growing very rapidly in recent years. It has been estimated that the alternative finance sector had grown by around 160% in the year to 2014. Despite the rapid growth, alternative finance currently accounts for a very small share of SME lending (less than 2% of SME lending). 

Non-Interest Income

Trading and Insurance

Lloyds says that they do "not have a programme of proprietary trading activities".  So why is their "Net Trading Income" so high?

The "Net Trading Income" is tied to its insurance profits 2 , 3.  I can't untie the numbers in any meaningful way, so I add them all together:


This follows the stock market.  Looks like a typical insurance operation where they lose money on insurance and make it up by investing the float.  As expected, a large part of their "Trading and financial assets" held are equities (43%), followed by bonds (33%) and Loans/Advances to Customers (21%) 4.  So the above number is gonna drop when the stock market falls.

Fee and Commission Income

Fees do not seem to be affected by the economy.  Gross fees (i.e.: ignoring their direct costs) are broken down below.  "Other income" includes "Fiduciary and other trust income", Insurance Broking, and others:

Combining all of the above categories, and deducting costs, gives us net fees:


Bank fees in the UK are high, and have been the target of a government inquiry.

Other Operating Income 


Operating Lease income (blue above) is from Lex Autolease.  The increase in 2009 is when Lex Autolease was created from the takeover of HBOS.  Since it happened after the recession, we can't tell if operating lease income is affected by the economy.

Other Income (red above) is very spiky. I have removed one-off items from it 5.  Fortunately its low in 2015, so we can ignore it.

Overall

To get an idea of how much of their earnings come from interest vs non-interest, the above income categories are shown for 2015:


This excludes operating costs, and any provisions deducted from interest income.

Other Numbers

The CET1 ratio was 13% at end of 2015, which is OK.   However, RWA does not account for systematic risk.  Tangible Assets were 18.6 times Tangible Equity6, which is too high.

In 2015, (non-interest) operating costs were 2.5% of Deposits.

For Derivatives: The notional amount of derivative exposure is 5.9X total asset value - very high.  Lloyds says that they only hold derivatives for their customers or use them for hedging.

Valuation

After removing the one-off items from their 2015 results (PPI provisions and TSB sale), their EPS rises from 0.8p to 6.7p.  At a share price of 60p, thats a PE of 9.

Other Risks

The two main risks are:
  • A falling pound, from Brexit
  • UK house prices have been rising for 4 years, and are due for a correction.


The previously rising pound and rising house prices may have fed on each other on the way up, and might unwind now.

Conclusion


I like it because its simple bank which makes most of its profits from deposit, loans, and fees, with a little insurance on the side.  It has minimal proprietary trading.  And operates in one country.  When its legacy problems eventually go away, it will be cheap at today's price.

Its operations are simpler than the Singapore banks.  However, leverage based on the assets/equity ratio is too high...I don't fully trust the CET1 ratio as RWA can be manipulated and doesn't detect systematic risk...like falling house prices.  I prefer to use both.

The main risk is the economic and housing cycles: is this the top?
                 ___________________________________________

[Edit: 28th Nov 2016: Bought 7191 NYSE:LYG ADRs at USD 2.9192.  1 ADR equals 4 shares.  Total cost USD 21,000.92.]

                 ___________________________________________

1 Lloyds market share will have dropped since then, as TSB was 50% owned by Lloyds in 2014 and sold off in 2015.

2 See table 1.35 in 2015 AR: Of the 140,536m of "Trading and other financial assets" on the balance sheet, almost 2/3rds (63%) is held for insurance. 

3 From the A lot of their insurance products are ILPs, whose value rises or falls based on some underlying investment. The rise/fall in value of previously sold insurance products is recorded under "Insurance Claims" (See 2015 AR's footnote 10, the entries "Change in insurance and participating investment contracts" and "Change in non-participating investment contracts"). However this is offset by LLoyds holding the underlying investment, and the offset is recorded under "Net Trading Income".

4 2015 AR footnote 15

5 See the text in footnote 9 in the ARs. Lists costs for restructuring, or managing liabilities for their past misdeeds.

6 I am including the "Other Equity Instruments" (Convertible notes issued in 2014 - see footnote 45) as part of the Shareholders Equity.  Otherwise it jumps to 20 times.

Friday, November 25, 2016

Bought OCBC

Bought 3,400 shares of OCBC @ SGD 8.74 on 23rd Nov 2016.  Total cost SGD 29,887.70.  Thats a a TTM PE of 9.6 (or 11, excluding "Trading Income"), and a yield of 4.1%.

I'm buying bank stocks cause I'm holding lots of cash, and they're still reasonably cheap, after 7 years of ZIRP.  Which looks like its ending now.  But they could still get cheaper if theres a recession or crisis.

I am still more than three-quarters in cash:


Thursday, November 17, 2016

Singapore Banks and Rising Rates

If US rates go up, how much will Singapore banks benefit?

SIBOR tends to follow the fed funds rate:


And the banks' Net Interest Margins (NIM) roughly follow it:


Its hard to tell, because the correlation is not direct, and there is probably a lag.  I'll assume that NIM goes back up to 2%, which is about halfway back to the highest level, and roughly what it was in 2010.  If this happens, I estimate that all three banks would increase their earnings by 15-20%.

Tuesday, November 15, 2016

US Drug Wholesalers

Introduction

Part 1: The Good

Drug wholesalers handle the logistics of buying, warehousing and transporting drugs from manufacturers to retailers.  Three companies: McKesson (MCK), Cardinal Health (CAH) and AmerisourceBergen (ABC), form an oligopoly with an estimated 90% of the US market.

Its a low margin business where you make money on turnover.  Operating margins average around 2%.  All three companies are profitable, generate free cashflow, and have low debt1.  As expected in a business like this, their main costs are inventory (COGS) and SGA.

Most of the growth in this industry is by acquisition, which consumes part of the free cashflow.  This industry was previously fragmented, and over time consolidated into the oligopoly it is today.  Even in today's concentrated industry, all three companies make acquisitions every year to expand their offerings and move into new fields, such as specialty drugs and oncology.

The long term trends look good.  The population is getting older and weaker.  Drug usage is expected to grow 5% pa.  As the middleman, these companies take their small cut off the drugs passing through their pipelines.  When analysing them, we don't have to worry about patent expiry, competition from other generic suppliers, or the intricacies of insurance payments in the US health system.  We just sit back, let the drugs flow through, and collect our money.  Whats not to like?


Part 2: The Bad

When we look at the details of this industry, there are some issues.

First: retailer consolidation.  Distributors are most profitable when they work in "barbell" model.  That is: a small number of distributors in between a large number of suppliers and a large number of customers.  Giving pricing power to the distributor.  But one side of the barbell is shrinking.  The pharma retail industry has consolidated, with more and more sales going to the largest players (Walgreens and CVS) - see point 2 here.  This gives two problems:

  • Distributors margins for their small customers, such as independent pharmacies, are a lot higher that for their large ones.  Distributor operating margins average around 2%, but this is estimated to drop to 0.5% for their large customers.  Even these large customers make up 20-30% of a distributor's revenue, most profits come from their many smaller customers.
  • When retailers are taken over, they usually switch their drug distributor to the acquirer's one.  This makes it harder to project future revenue and profits.  For example, Walgreen's first indicated it will takeover Rite Aid in the middle of the year. Rite Aid's distribution contract with McKesson expires in March 2019, but will probably be terminated before then.  McKesson still does not know when, except to say that they will probably service Rite Aid at least till March next year.

To overcome this, all three companies have started franchises to help independent pharmacies start up.  They provide a broad range of services to help the viability and profitability of their smaller customers.  They have also been acquiring the smaller distributors that supply the independent pharmacies.

Second: pricing is complicated.  Distributors do not earn a fixed fee, like a postage rate.  Instead they buy drugs at some discount to the manufacturer's list price ("buy side profit") and sell at a profit ("sell side profit"), which may still be less than the list price.  See here for a good diagram of payments.  The distributors also benefit from price inflation when the price of items in their inventory increases, though less than before2.  

This leads to three more points:

  • The industry is hard to analyse.  Contract terms are not disclosed, so analysts have to estimate the revenue and profitability of each customer.  When analysing profitability, we end up making estimates based on other peoples estimates.  Its not modelling, just guessing.
  • In the past few years, wholesaler profits have been artificially boosted by price inflation in generic drugs.  This "generics bubble" was caused by few generics being approved for use - this pipeline is now clearing.  So those excess profits have gone down.
  • Theres a risk that the whole pricing model will have to change, so its no longer based around the manufacturer's list price.  Or medicaid may eventually be extended to everyone as a "single payer" system, like in a civilised country.  Even though drug wholesalers are performing an essential task in the system, with sustainable (that is, low) margins, any uncertainty associated with an industry overhaul could play havoc with healthcare stock prices.

Part 3: The Ugly

In October, McKesson said in their conference call that AmerisourceBergen has started a price war in the independent segment.  The stock fell 22% overnight.

I think the price war is temporary,and won't last in a market with 3 players.

Still, the level of stock volatility is sickening.  I may hold a smaller amount.


Comparing the companies

The companies are pretty similar in terms of cashflows generated, debt and the industry they serve. There's no point comparing their profit margins, since they vary so much between the large and small customers.  The main thing I want to look at is valuation.  How much would I be willing to pay for them?

I'm leaning towards McKesson or Cardinal.  Among independent pharmacies - the most profitable segment - AmerisourceBergen's market share has been falling, and they have a lower estimated margin3.  And they are the ones starting the price war.

GAAP vs Non-GAAP

All three companies report both GAAP and non-GAAP earnings.  Non-GAAP is supposed to exclude one-off items.  Guidance is only provided for non-GAAP.

The differences are:

  • Changes to LIFO Reserves: Stock is sold on a FIFO basis, as with any perishable good.  But the accounting is done on a LIFO basis.  When prices are rising, this lowers profits and taxes.  In other words, the profits on paper are lower than the cashflows.  The difference is added back to their non-GAAP earnings.  I think this is makes sense, and the amount is objective and easily calculated.
  • "Acquisition costs" and "Amortisation of acquisition related intangibles"4.  This is the largest part of the difference.  Since all three companies are serial acquirers, then do we ignore this by considering it a one-off cost that should be excluded from earnings?  Not sure, but I can probably accept it - its better than leaving the costs on the balance sheet as goodwill.
  • Litigation costs.  McKesson has such large and frequent litigation costs which makes me wary.  I'm wondering if they can conduct their business for another 5 years without getting their asses sued off.  Cardinal's litigation costs are small enough to ignore.

Earnings Estimates

For MCK, after accounting for:
  • the loss of OptumRx, Omnicare, Target, Rite Aid, partially offset by Rite Aid and Safeway
  • less generics price inflation than in FY2015.
  • a price war for supplying independent pharmacies, assuming operating margins are halved.
I get an EPS reduction of $3.84. This would give an non-GAAP EPS of $8.51.  At 12X earnings, thats a target price of $102.12.  At 15X, its $127.65.

If we exclude the price war, its $112.24 (12X earnings) and $140.31 (15X earnings).


For CAH, after accounting for:
  • the loss of Safeway, plus the potential loss of Pharmerica
  • less generics price inflation than in FY2015.
  • a price war for supplying independent pharmacies, assuming operating margins are halved.
I get an EPS reduction of $1.12. This would give an non-GAAP EPS of $4.24.  At 12X earnings, thats a target price of $51.03.  At 15X, its $63.78.

If we exclude the price war, its  $58.39 (12X earnings) and $82.87 (15X earnings).




                 ___________________________________________

1 Less than 2X EBIDTA
2 McKesson2Q17 Conference call: "90% of our [branded] income is fixed, 10% is variable."  And Cardinal 1Q17 Conference call: "about 15% of our branded margins are based on a contingent basis, which means that generic or a branded inflation is a piece of the driver of the value that we receive."
3 From the DrugChannels 2016-17 Wholesalers and Specialty Distributors Report.  All my estimates are calculated from the estimates in the report. 
4 Defined in Supplemental non-GAAP information here.