Bought Express Scripts (ESRX)

Had my eye on this for a while; bought because it did not fall when the indexes corrected (22nd Jan to 5th Feb), and the correction is (hopefully) over:

Bespoke Investment also notes that the Drugs and Biotech has been the strongest industry group since the start of tapering (mid Dec), and Healthcare is one of the strongest sectors in the February's post-correction bounce.

Fundamentally:

• ESRX is the largest Pharmaceutical Benefit Manager in the US.  Their business is to act as a middleman between doctors, patients, pharmacies, insurers and employers, to increase efficiency and cut costs (e.g.: by asking a patient's doctor to switch to cheaper generic drug).  ESRX had a 30% share of PBM industry (more after the Medco merger), and 60% of mail order market share.  Their size gives them some competitive advantage against suppliers.
• Valuation: Although sporting an estimated forward PE of 33, it has a high amortization of intangibles.  2012 income was 1.3bn, amortization for "customer related intangibles and non-compete agreements" was 1.4bn, CFO was 4.7bn.  Morningstar has target price considerably higher than the current one.
• Risks: Pharmaceutical distribution is a changing industry: The PBMs' roles change over time (from filling out paperwork, to recommending generics, to handling specialty drugs); their previous roles become commoditized.  Contracts with customers (insurers and employers) are renewed every 3-4 years.  The market structure also changes, e.g.: the move to exchange-based health plans vs employer based ones may cut PBM's margins.  ESRX's pricing and profitability is not transparent.  This is a complex and rapidly changing business, definitely not a Buffet-like stock to hold forever.
• Other information: http://www.drugchannels.net/

Bought 360 shares at $75.77 on 13/Feb/2014.  Total cost USD 27,312.  This is a trade: A strong stock, in a strong segment, in a (hopefully) rising market.

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This is currently my only position, I am still 95% in cash.  I may trade a little, or try to buy some reasonably priced stocks in the meantime, but am still waiting for a steep market market decline before I am comfortable with serious buying.

Is the US market correction over?

Probably.

Long term, we were expecting a correction, but breadth did not indicate the bull market is ending (1) (2).

Friday 24th was a 90/90 day. This Lowry Research paper (from TBP) is worth reading.  "Almost all periods of significant market decline in the past 69 years have contained at least one, and usually more than one," 90/90 day.

They may signify major declines:

• They "typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days."
• Declines containing 2 or more 90/90 down days usually persist until a 90/90 up day (or rarely, 2 consecutive 80 upside days).
• "Impressive, big-volume “snap-back” rallies lasting from two to seven days commonly follow quickly after 90% Downside Days", but for longer term investors they are a chance to sell.

Or short term corrections:

• "A single, isolated 90% Downside Day does not, by itself, have any long term trend implications, since they often occur at the end of short term corrections....a 90% Downside Day that occurs quickly after a market high is most commonly associated with a short term market correction, although there are some notable exceptions in the record. This is also true for a single 90% Downside Day (not part of a series) that is triggered by a surprise news announcement." 

Assuming that this is a correction (until we see another 90/90 day), is it correction over?

• In the bounce back from the 6th onwards, the pattern of down days on higher volume was broken.  Still, there is a divergence as volume trends down while the index goes up.
• In the bounce back, breadth is wide.  Its not limited to the index stocks.

To be sure, we would need to see more of the favorable price/volume action.  Which would lead to the index making new highs.

Air Liquide and Praxair

A look at the numbers for the companies in this industry.

 

Revenues and Profits

Comparing the size of the four largest players, their revenue and profits (in same currency):

Linde's profits are for the Gas Division segment only (probably excluding admin costs), which is why they are so high.  Ignore them.

Air Liquide is by far the largest, in terms of revenue and profit.  

Praxair is far more profitable, with a 20% operating margin in 2012 vs a 14% margin for Air Liquide.  Praxair has also grown profits a lot faster over the 8 years: up 140% vs 87% for Air Liquide.

Their profits are not cyclical, profits barely dipped for Air Liquide and Praxair in 08/09.

A note that profit margins (i.e.: percentage of revenue) cannot be used to spot trends over time in this industry, due to indexing to fluctuating energy prices (e.g.: increased electricity price by $X --> increased end price by $X --> same profit, but reduced profit margin).

 

Geographic Regions

Praxair is mostly in America:

	North America (incl. Mexico)	South America	Europe	Asia
Revenue (%)	50	19	13	12
Profit (%)	58	17	10	10

Air Liquide is mostly in Europe:

	Europe	America  (North + South)	AsiaPac	Middle East/Africa	Others (non-gas)
Revenue (%)	46	20	22	3	9
Profit (%)	47	27	19	3	4

AirProducts only gave revenue, not profit breakdown:

	US/Canada	Europe	Asia	Latin America
Revenue (%)	40	28	27	5

If you think that US or Mexican manufacturing will boom, Praxair would be a good play on this.

 

Segments

The companies have similar numbers when broken down for delivery mechanism:

For Praxair:

• Large Industries 25%, Merchant (liquid) 31%, Cylinder 29%, Others 15%.
• Most Electronics business would be under "Large Industries".  Healthcare is probably under "Cylinder".

For Air Liquide:

• Large Industries 33%, Industrial Merchant (both liquid and cylinder): 34% , Healthcare 16%, Electronics 8%, Other 9%

For Air Products:

• Large Industries 33%, Industrial Merchant (both liquid and cylinder): 38%, Electronics 25%

 

Balance Sheet

This is a capital intensive business.  All 3 companies have quite high debt of 3-5 years earnings:

Company	2012 Long  Term liabilities	2012 PBT	Number of times 2012 earnings to pay off liabilities
Praxair	8.7b USD	2.3bUSD	3.1 times
Air Liquide	9b Euros	2.1b Euro	4.2 times
Air Products	7.2b USD	1.48b USD	4.8 times

Long term debt is mostly financed by 3-10 year notes/bonds.  The repayments are spread out into the future: 10 years for Air Liquide (footnote 25.1) and Air Products (footnote 14), and at least 5 years for Praxair (footnote 11).  Given the stable nature of the industry, this is sustainable - debt is not a problem.

All companies have minimal operating leases and contingent liabilities (mostly guarantees, warranties or legal action).  Praxair is contesting a USD 830m fine from Brazil's CADE for anti-competitive behavior (5 companies were fined).

All 3 companies have underfunded pension plans.  This current underfunding is recognized (i.e.: will not have make provisions in future year's earnings).  However the companies differ widely in their assumptions.

Praxair's pension scheme is only slightly underfunded (~700m), but their assumptions seem aggressive:

• Expected return on US assets - the majority of the plan - is 8.25%.  A lot higher than discount rate (4.7-5.4%).
• 60+ percent of the investments are in stock (target 60-80%).

Air Liquide's pension scheme  is underfunded by 1.9b Euros, but they are more conservative:

• Their expected return on European assets is 4.4% vs a discount rate of 3.2%.  In 2011, Eurpoean expected-ROA was actually less than the discount rate!  Mostly invested in bonds and real-estate.
• They are still aggressive in the US (which forms about 30% of their obligations): 8% expected-return vs 3.8% discount rate.  53% is invested in shares.

No problems for Air Liquide.  I expect some provisions for Praxair's pensions in the future.

 

Cash Flows

For all 3 companies, working capital is minimal.  Cash flow from operations is almost equal income plus depreciation.

Air Liquide and Praxair both generate steadily increasing earnings and CFO, even during the 08/09 recession, as expected when for a business operating on long term 10-15 year contracts.  The green bar shows steadily increasing Cash Flow from Operations.  However, Cash Flow from Operations (i.e.: spending on Capex) varies a lot, year by year - see the yellow bar.  Sometimes it is due to large acquisitions (annotated).  We cannot tell how much of this spending is to replace old capacity and how is to add new capacity:

From the above, Air Liquide invests (spends) higher proportion of its CFO on capex.  In detail:

In the ten years from 2002 to 2012, Praxair has spent 80% of its CFO in CFI, while Air Liquide has spent 90%.  Combined with Praxair's greater operating margins, this makes them a better user of capital.  Praxair's earnings increasing more than 3X over this period, while Air Liquide increased less than 2X.

 

Capex and Acquisitions

Since capex is the only varying quantity, lets look at it in more detail.

Praxair had high capex in 2011 and 2012, mostly buying small packaged gas companies - hard to tell as they do not give details and financial terms are not disclosed in their press releases.  In 2013, they spent 1.1b buying NuCo2, a provider of beverage carbonation.  At 9.6X EBITA, management admitted the acquisition is "dilutive to our return on capital", but expect that to lessen over time. From their September Investor Day Conference, 2012 was the peak of the capex cycle:

"CapEx spend. We think going forward we'll be around $1.8 billion, plus or minus. That's about 13% of sales versus the, say, 20% of sales that we had in 2012, where we were at the top of the CapEx cycle.
I've included 1% for acquisitions. We have a strategy to consolidate the packaged gas industry in the United States. So we're going to be spending some money towards that, call it $100 million to $200 million per year. Nothing on the order of NuCO2. I think it could be a decade before we do anything of that size. But this is our plan."

Air Liquide expects more than 2bn capex in 2013.  They will probably spend 2bn (plus acquisitions) for the next 3 years to 2015.

 

Summary

Praxair would be my first choice - with higher profit margin, it has been able to use less capital to grow faster.     Would still consider buying Air Liquide - they have a stable business with barriers to entry, and would provide some diversification as the operate in different parts of the world.

Even though revenues and profits for these companies are not cyclical, the stock price is.  Wait for a correction/crash to buy.  Anyway, valuations are too high to buy now.

Bulk Industrial Gases

This industry is interesting due to its natural barriers to entry.  Because gas is expensive to transport relative to its value - basically they are selling air! - operations are regional.  Once a region is served by an incumbent, it is not economical for a newcomer to make the investment required to enter.  In addition, there are only a handful of global players.

Most of this comes from a Morningstar article, and Air Liquide's 2012 Annual report.

Industry Segments

Because bulk gases are more expensive to deliver than to produce, we segment the industry  by both delivery mechanism and end usage.

For the Large Industries segment: The company builds a plant next to its anchor customers and supplies them through a pipeline.  A plant usually has a regional monopoly within a 250km area.  Anchor customers sign a 15 year take-or-pay contract, indexed to energy costs.  The end users are metal industries (Oxygen), Chemicals (Oxygen, Hydrogen, CO), and refiners (Hydrogen).

For Air-gases (Oxygen, Nitrogen) the anchor customer takes up only about 70% of the output; the remaining 30% can be cross sold to smaller industries (e.g.: glass, automotive) in the area and distributed by truck (liquid) or cylinder (gas) (Industrial Merchant segment).  This includes product  delivered in liquid form (by truck) or gas (cylinder).

Hydrogen has less cross-selling opportunities, as only oil refiners use it.

Another segment is the Electronics segment, which is divided into:

• Bulk Carrier Gases: Similar to the Large Industries segment, delivering a steady supply of these gases (hydrogen, nitrogen, oxygen) requires building production nearby the customer. We also have long term steady contracts: 10 years, indexed to energy, take-or-pay.
• Electronics Specialty Gases are sold in small amounts, so distribution activity is worldwide, not localized. Demand varies with the electronics goods consumption and production cycle. These gases are high purity products requiring high tech expertise.

Lastly, the Healthcare segment involves delivering gases (usually Oxygen) by truck or cylinder to Hospitals and Homes.  This is usually also within a 250km radius, and the keys are coverage density (many customers in same area), quality of support services and efficiency.

Air Liquide illustrates this nicely their 2012 AR:

Competition

For Large Industries: Worldwide, most bulk gas (80% of hydrogen production and 65% of oxygen production) is produced in-house.  The remainder is produced by suppliers.  It is a concentrated market: the 4 largest suppliers (Air Liquide, Linde Group, Air Products and Praxair) had 60-80% of the U$74 billion global market.

In advanced economies: most oxygen production is already outsourced, while the supply of hydrogen is largely in-house.

In developing economies, outsourcing is relatively new, but accelerating.   In China, there are 3 local Chinese player: Yingde Gases (listed), Hangzhou Oxygen Plant Group Co (private), and Hang Yang Group.

The Industrial Merchant segment is also localised, but highly fragmented with many players.  So by itself, it offers lower returns.

Healthcare is also localized and fragmented.  Air Liquide expects growth through acquisitions in this sector.

In Electronics, three companies play a major role: Air Liquide, Air Products and Taiyo Nippon Sanso.

 

Summary

Bulk Industrial Gases is an attractive industry because:

• An established supplier has a sustainable competitive advantage.  After an anchor plant is built, all Large Scale and Merchant Gas customers are served from this plant.  It would not be feasible for a competitor to build another plant in the vicinity. This applies to all segments except Electronics Specialty Gases (which are not bulk).
• The industry is mostly non-cyclical due to long term contracts.  Electronics Specialty Gases and the Industrial Merchant segment are cyclical.
• There are only a handful of large global players for Large Scale and Electronics.  Industrial Merchant and Healthcare are fragmented, with many local smaller players.

Notes on GoodPack

Since I last looked at it, the profile of this company has changed a little.

Note their financial year ends June.

Cashflows

Having being leasing IBC's for the past few years, they have been able to generate free cashflows (yellow below):

But from this year onwards, Capex will rise as they go back to buying IBCs. As of 3Q 2013 (May), they have already spent 102m on PPE.  Both OCBC and DBS-Vickers predicted higher capex for 2013 and 2014.

:

Balance sheet

As of May 2013, total debt was USD 266m, offset by 176m of cash.  Although net debt is about the same as a few years ago, its now only 2X earnings.

Most of their debt is long term fixed rate (~ 4.7+ percent); Medium Term Notes:

• Probably 25m short term bank loans
• 100m MTN due July 2013.
• 120m MTN due in 2016/17.
• 30m MTN due 2023
• 50m MTN due 2023 (issued end-Apr: not part of the 266m debt above)

Looks Like they will be taking on more debt in future.  Their medium term note program has increased from 300m to 600m, to be issued whenever they want.

Operating lease commitments as of Jun 2012 were 14m (vs 177m revenue, 47m profit, and 6m finance costs).  Few of these last longer than a year, but I think that they have to renew them, else risk their IBC suppliers becoming compeditors.

 

Cyclical

Would they be affected by a downturn/recession?  Probably.

From CIMB:  In 2008 and 2009: "there was a temporary dip in Goodpack’s earnings when its major clients (tyre producers) failed to fulfil their contractual obligations of moving promised rubber volumes. The sharp dip in tyre demand had caught many tyre producers by surprise with manufacturers like Michelin, Goodyear and Bridgestone suffering huge losses. With excess inventories of raw materials (rubber), Goodpack’s clients were unable to move their obligated rubber volumes. As an act of goodwill, Goodpack allowed its major clients to renege on their contracts temporarily, which hurt its bottom line. Goodpack was able to mitigate the pain by increasing its market share in the synthetic rubber transportation segment."   They do not see this occurring again.

On the positive side,  DBS Vickers predicted a bounce in tire demand (replacements) in Mar 2013, which they are still waiting for. Also due to 2 new Synthetic Rubber factories being built on Jurong Island, starting production in 2014.

Valuations

At 1.57 (SGD), trailing PE is 14.4.   Assuming 3c (SGD) earnings in 4th Quarter, forward PE is 13.  Not cheap, but not bad in an expensive market.

During the entire 2011, the stock dropped 40+% on fears of a slowdown, to a trough of 7.7 forward PE.  In 2009, the trough was a (trailing) PE of 7.2.

My guess is that from here, there's equal upside and downside: depending on if there is a slowdown/recession, or if the DBS's projected recovery occurs.

Support at around 1.30 (projected FY 2013 PE of 10.7), would probably buy there.

Still Waiting....

After a 9 month rally: finally a pullback! Due to the Fed's comments on 'tapering'.  And something about China.

My gut feeling is that this will probably be a 10-20% correction.  Don't think we reached the euphoria seen at the end of a bull market.  Maybe we get a *real* bear 1 or 2 years later.

We are also in the twelfth year of a secular bear market, which usually last 12-18 years.  I must consider the possibility, however wrong it feels, that the secular bear is over, and its 1982 again.

And there is the possibility that the market 'corrects sideways' for a long period, without giving me a big crash.

I am changing my investment strategy a little to account for the unknowns.  Using the S&P 500 as a yardstick, but in steps all the way down:
  a) Wait for a 15% decline (for now: S&P 1434), if it occurs, move up to 20% invested.  15% declines happen once every few years.
  b) If a further 15% decline occurs, move up to 60 % invested.  These 30% declines are rare.
  c) If a further 10% decline, go to 100%.

Nothing magical about these numbers, just a way to get *slowly* get into the market.  After a 3 year bull market, be very slow and careful.  I'll still probably be mostly in cash for the next few years.

What to buy?  Looking at the US and European stocks (multinationals), everything is expensive - PEs in the high teens (and these are not trough earnings).  The Singapore market is similarly expensive, but there are a *few* decent companies trading in the low teens.

Wait to see if the correction continues.  The S&P is retesting its trend line and moving averages.

The Car Industry

I like Volkswagen's branding, due to their ownership of multiple brands at different price points.

Unlike Mercedes or BMW, for instance, who risk diluting their brand as the move downmarket to sell cheaper and smaller cars.  Or Toyota, who created an upmarket car, but can't quite break into the luxury market...because its still a Toyota.  Always a bad idea to have your branding based on a single name.

Volkswagen have increased their European market share from 18% in 2005 to 24% in 2012, due to aggressive financing (e.g.: zero percent loans) and scale.

I took a look at their numbers.  It did not take long.  Although revenues and profits have increased nicely:

Free cashflow generation has been low.  Over the last ten years, the 73b profits generated has turned into just 9bn free cash flow:

The culprit is the finance/leasing part of the company.  Despite high capex - higher than depreciation - the Automobile production generated free cashflow every year.  But increased financing of new customers  drains most of the cash generated.

So the long term, increasing car sales consumes most of the cash generated.  As well as the normal drain on working-capital (increasing inventories/receivables), for cars, it also involves financing your customers to buy their vehicles, and building expensive factories.

An optimist could say that 37bn was spent over the past 10 years building the business:  it has quadrupled their revenue, and increased they profits 5 to 10 times.  But companies in other industries can do this and generate free cash flow while doing so (e.g.: Richemont, Coca Cola).

Volkswagen probably will not need to raise money from the stock market soon.   And they are probably better than their European competitors.  But they are the best of a bad lot. 

Toyota has a similar pattern.  Over the same 10 years, 8 trillion yen of profits (net income) turned into 280bn free cashflow consumed:

Again the problem is with the finance segment, though Toyota spent more of this on building up its fleet-for-lease, rather than on financing for buyers.

BMW is even worse, generating free cashflow in 2 of the past 10 years:

Daimler (Mercedes) over the past 8 years:

These are the best companies with the strongest brands in the industry.  The car industry looks like a lousy place to invest.