Double, Double Toil and Trouble
Double, double toil and trouble;
Fire burn and caldron bubble.
Cool it with a baboon’s blood,
Then the charm is firm and good.
- William Shakespeare, Song of the Witches, Macbeth
At about the halfway mark for earnings season and with the S&P 500 back to near its highs, this is a good time to review what is working and what isn’t. While the overall stock market moved higher in October by 8.4%, stock performance has been decidedly mixed post-earnings releases. We’re going to review four stocks that highlight the differences not only in this quarter’s releases, but in the way to create shareholder value long-term.
The last 4-5% rise in the S&P 500 at the end of the month was not due to companies creating new products or markets – stock markets went up because of a continuation of the global race to the bottom in rates, in particular after dovish comments from ECB Chairman Draghi and more rate and reserve cuts from China. This re-prices cash flows higher, but it is not, in and of itself, creating value. Companies do that, not central banks. All the central banks can do is change short-term discount rates, which is a one-time shift up or down in the valuation of cash flows, but doesn’t create value over time. It’s a push in the back, but only companies can actually run forward.
Nike (NKE) highlights this difference. After reporting earnings earlier this month (which we talked about in our last Musings), it held its first analyst day in a few years last week. Nike is really running fast and creating value. They expect that between now and 2020 they will increase sales annually by high-single digits to low double-digits percentages (going from $30 billion to $50 billion in sales) while increasing both their gross and net margins. This translates into 15% annual earnings growth over that time frame.
Nike is doing this by creating brand loyalty in new markets. It is extending what it has done in basketball and men’s fitness in the U.S. to women’s fitness (where it has lagged historically), girls sports, and to new markets. In contrast to some of the other companies we will discuss today, Nike is growing fast in China, as a fitness craze reminiscent of what took place in the U.S. in the 1980s takes hold there (Under Armor is also doing well). My quibble with Nike is price – at 21 times EV/EBITDA, a lot of its future success is already in the stock. If it trips, it will get bloodied pretty easily.
Apple (APPL) is in many respects ahead of Nike, but that means to me that is it nearer the finish line where revenues and earnings growth becomes much more difficult. Like a runner nearing the end of a race, it is tiring and slowing rapidly. In fact, it expects to grow its revenue next quarter at a decidedly slow annual rate of 2.5%. That is reflected in its lower EV/EBITDA ratio of 8.1x. Apple in many ways makes an aspirational product that relies on branding, similar to Nike, but Apple is nearing the end of the differentiation stage of its product lifecycle. There really isn’t any functionality that distinguishes an iPhone from a Samsung from a HTC. Making phones is a tough business, yet Apple has been able to maintain margins that rival those of luxury brands, where exclusivity or perceived quality can drive higher margins. If Apple is able to maintain those 40% margins in the future, it will be the first technology company to do so. Blackberry used to make great phones. The first Palm Pilots were amazing. Dell used to have margins that were the envy of the world, with negative working capital to boot. I am constantly reminded of another consumer electronics company that made beautiful consumer electronics, that created a new category of portable electronic devices, that was able to charge a premium for them and whose designers were regarded as the best in the world. That company was Sony (SNE), which not only created a new category with its Walkman music players but also some of the most elegant laptops ever. (The Vaio, which still exists, was light, powerful, and beautiful ten years ago). But Sony was eventually caught and eclipsed by the current king of music players Apple. Who will replace them? We’ll find out someday…
Freeze, freeze, thou bitter sky,
That dost not bite so nigh
As benefits forgot:
Though thou the waters warp,
Thy sting is not so sharp
As friend remembered not.
This does not bode well for the company’s ability to grow earnings long-term. But let’s say that the analysts and I am wrong, and that McDonald’s turns things around, and instead of growing earnings per share by the 8.6% that is implied in the consensus it is able to grow EPS via some combination of drastic expense cuts and stock buybacks by 23.5%, or to $6.00 per share. What is that worth? I’d argue that a company with low-to-no revenue growth should probably trade at or below the overall market, but let’s be generous again and say that McDonalds, being the icon that it is, should trade at a premium. Ok, fine. At 20 times that $6.00, it would trade at $120 per share, or 7% more than its closing price of $112.25 on October 30th. Why would someone be willing to pay 20 times earnings for McDonalds when its clearly struggling to grow and faces an uncertain future for its product? Why not buy Apple at 13 times earnings instead? Or Nike at 33 times? Because the investor buying McDonalds is basically buying a corporate bond at an earnings yield of about 5%, and hoping that if there is inflation in the future that McDonalds will be able to increase earnings enough to keep up with it. That’s it. It’s a bond replacement. Apple trades lower because while it makes great products, investors are aware that it could be the next Sony, and are pricing in that obsolescence risk. The market thinks that McDonalds is unlikely to become obsolete in the very near future, and so it trades accordingly. That said, McDonalds today is not the McDonalds of 20 years ago – for the next generation, it truly is a “friend remembered not”.
Fear no more the heat o’ the sun,
Nor the furious winter’s rages;
Thou thy worldly task hast done,
Home art gone, and ta’en thy wages:
Golden lads and girls all must,
As chimney-sweepers, come to dust.
And then there is Yum! Brands (YUM), which is further along the path of secular decline than the other fast food chains. It reported a fairly bleak quarter on October 6th and lowered its forward guidance, with full-year same store sales in China expected to be in the low single-digits negative. The stock reacted accordingly, falling nearly 20% on the report. (Full Disclosure: As of September 30th, Yum! was my fund’s largest short.) I have been negative on Yum for quite some time, as its almost blind exuberance and faith in the future growth of China (the cover of its annual report a few years ago featured the Great Wall of China and excited tales of the opportunity there) ignored the reality of operating a business in a tightly controlled, state run economy. As I have said many times before, if you build a successful business in China, eventually it will either be copied ruthlessly, forced to partner with a local enterprise, or regulated to death. Yum is experiencing a mix of all three, as food quality issues have created negative brand perceptions, the government has made it the target of investigative reports in state news media, and now competition is increasing rapidly. When YUM first entered China it was a novelty, and people flocked to its stores to experience a piece of Americana. But the novelty appears to have worn off, and it is facing a tough battle ahead.
The recent decision to split the company into two pieces, with a China focused company and a separate company focused on its brands elsewhere in the world, does nothing to address these issues. The company intends to highly lever its balance sheet to buy back stock – in fact, it stated it intends to become non-investment grade as part of its plan. While financial engineering can create incremental EPS growth, over time it stops working as you reach your upper debt limits, and valuations decline accordingly. Yet, despite its recent stock price drop, YUM still trades at nearly 23 times 2015 earnings and 20 times 2016 estimates. While McDonalds is fighting a secular decline in fast-food, particularly for lower-quality, mass produced fare, YUM is fighting the same battle in the U.S. without the benefit of McDonalds stronger brand equity, and is fighting against significant competition in a market that represents about half its revenues. I don’t see how it fixes it.
These four global companies demonstrate the power of brands, and what they can do for your earnings power over time.
Nike is aspirational, and makes its customers believe they can be healthier, better people. It can raise prices and increase its margins over time and its stock trades at a high multiple as a result. I’d love to own it, but I think at these prices it is priced for perfection.
Apple used to be aspirational, but recently its flagship products have been replicated by the competition. It has high, 40% margins on iPhones, but maintaining those margins over time will be difficult. In addition, the consumer technology field is littered with once-great companies that over time lost their pricing power and distinctiveness (like Sony, Blackberry, Xerox, HP, etc.), and its stock trades accordingly.
McDonalds also used to be aspirational, but that was a long time ago. Today, its best case scenario is a slower than expected decline, as specialty chains eat away at its new customers and its core customer base remains extremely price sensitive. McDonalds serves a role in providing low-cost food to a customer base that can’t afford its competitors offerings, but it is not growing. The market basically assumes that it will be stable enough to continue to pay its dividends and buy back stock and provide a low but consistent return.
YUM! Brands is basically McDonalds without the brand equity, and has a weak management team that was blinded by its own hype on China. It has finally faced the reality that China is a tough place to operate, and is going to engage in a spin of the business and financial maneuvers to try and stem a further decline in its stock. However, I think long-term it’s a going to have a tough time fighting against the secular headwinds in the U.S., its China business deserves a single-digit multiple at best (versus 22 times for the whole company today), and levering the balance sheet will only make it more susceptible to the next downturn. As a result, I am staying short the stock for now.
Nike is creating value. Apple did. McDonalds is up because its cash flows are being valued higher in a low rate environment. And YUM is down because its cash flows are uncertain at best and a large part are at risk of going away at worst.
This week’s Trading Rules:
SPY Trading Levels:
Support: 208, 205, 200, then 188/189.
Resistance: 211, 212, 213.5, then not much.
Positions: Long and short U.S. stocks and options, Long SPY Puts. Short MCD and YUM.
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