Corequity Valuations: July 2016

Sunday, July 17, 2016

Other Examples of Indrustry Pairs with Contrasting Asset Allocation Strategies

Atria Group vs Phillip Morris

Altria Group (MO) spun off Philp Morris (PM) in 2008 and the two have persued strikingly different asset alllocation strategies since. PM has bought back 23% of their shares since 2008 while MO only bought back 5%.

As a result, MO grew their EPS and Net Profit 61% and 52% respectively over the period. This contrasts to +33% and 0% for PM. Had PM invested the $28 billion that they used to buyback stock at a 5.8% return, their 2015 Net Profit would have been $2.3 billion higher or 34% of what they achieved.

Company	MO	PM
INDUSTRY	TOBACCO	TOBACCO
MARKET CAP	LARGE CAP = $125 B	LARGE CAP = $157 B
P/E	23X	24x
YIELD	1.2%	4.0%
2008-15 CASH FLOW - DIVIDENDS	$ 5.0 B	$ 28.3 B
2008-15 STOCK BUYBACKS	-$ 4.5 B	-32.4 B
2008-15 CHANGE IN SHARES O/S	-5 %	-23%
GROWTH OF EPS 2008-2015	+61% or +7.0% pa	+33% or +4.2% pa
GROWTH IN NET PROFIT “	+52% or +6.2% pa	0% or 0.0% pa
REQ’D AFTER TAX % TO = EPS GROWTH[1]	5.3%	5.8%
2015 NET PROFIT WOULD HAVE BEEN	$278 M more or +3%	$2.3 B more or +34%
CORREL'N PRICE vs ANN. % BUYBACK	-.79	-.21

It should be noted that both companies that both companies had a –ve correlation between the annual percentage of the stock that they bought and the price they paid. This is the exception to the rule.

Note on Executive Compensation: PM’s average executive compensation over the last 5 years was 57% more than MO’s or $64.2 million vs$ 40.8[2].

Cigna vs Aetna

Cigna Corporation (CI) and Aetna (AET) also show a contrast in asset allocation. CI bought only 5% of their stock back whereas AET reduced their float by 23%. AET spent $10.3 billion vs $3.9 for CI. As a result, CI grew their Net Profit and EPS at nearly the same rate (+14.4% pa vs 13.3%). AET on the other hand grew their EPS at twice the rate of their Net Profit (10.1% pa vs 5.1%).

Company	CI	AET
INDUSTRY	MEDICAL SRVCS	MEDICAL SRVCS
MARKET CAP	LARGE CAP = $33 B	LARGE CAP = $40 B
P/E	14X	14x
YIE	0%	0.9%
2008-15 CASH FLOW - DIVIDENDS	$ 13.4 B	$ 18.6 B
2008-15 STOCK BUYBACKS	-$ 3.9 B	-$10.3 B
2008-15 CHANGE IN SHARES O/S	-5 %	-23%
GROWTH OF EPS 2008-2015	+153% or +14.2% pa	+96% or +10.1% pa
GROWTH IN NET PROFIT “	+139% or +13.3% pa	+41% or +5.1% pa
REQ’D AFTER TAX % TO = EPS GROWTH[3]	3.3%	9.1%
2015 NET PROFIT WOULD HAVE BEEN	$136 mil or 6% more	$1,046 mil or 38% more
CORREL'N: PRICE vs ANN % BUYBACK	.63	-.63

hand, grew their EPS at

Due in part to the fact that AET was smart about timing their buybacks, as shown by the negative correlation between the annual percentage amount that they bought and the price, the Required Rate to equalize the Net Profit growth to their EPS is quite high at 9.1%.

Had they had achieved that, they would have earned $1 billion more in 2015 than they did. If they had earned only a 6% return, for example, the increase in Net Profit would have been $624 million more or 23% above what they achieved.

Note on Executive Compensation: AET paid their executives an average of $42.2 over the last five years, which was 17% more than the $36 million that CI executives were paid.[4]

Costco vs Target

Costco (COST) spent $2.7 billion on stock buybacks from 2008-2015 but their shares outstanding increased by 1%. By contrast, Target (TGT) paid $11.4 billion to reduce their float by 20%. As a result, COST achieved almost identical growth in the EPS and Net Profit whereas TGT had a divergence of +7.3% vs +4.3% pa over the period.

Company	COST	TGT
INDUSTRY	RETAIL STORE	RETAIL STORE
MARKET CAP	LARGE CAP = $68 B	LARGE CAP = $52 B
P/E	28X	16x
YIELD	1.2%	2.8%
2008-15 CASH FLOW - DIVIDENDS	$ 16.3 B	$ 36.4 B
2008-15 STOCK BUYBACKS	-$ 2.7 B	-$11.4 B
2008-15 CHANGE IN SHARES O/S	+1 %	-20%
GROWTH OF EPS 2008-2015	+82% or +9.0% pa	+64% or +7.3% pa
GROWTH IN NET PROFIT “	+82% or +8.9% pa	+35% or +4.3% pa
REQ’D AFTER TAX % TO = EPS GROWTH[5]	-	5.0%
2015 NET PROFIT WOULD HAVE BEEN	-	$658 mil or 22% more

Had TGT invested the $11.4 billion instead and earned a return of 5.0%, they would have earned close to $700 million more in 2015, or 22% more than they did.

Note on executive compensation:

Can you guess which of these two companies paid their executives more?

Target paid their top executives 120% more than Costco did over 5 years! The average was $47 million compared to $22 million. In 2015 alone the comparison was $60 to $24 million![6]

Hypothesis: Executive compensation is positively correlated to the spread between the growth of Earnings per Share and the growth of Net Profit.

[1] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[2] Morningstar

[3] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[4] Morningstar

[5] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[6] Morningstar

Sunday, July 3, 2016

Real Growth vs Growth Lite

Our Net Profit Test: Comparing Buybacks to Investment shows that a company’s purchase of its own shares causes a single increase in EPS (as in simple interest) compared to compounding growth that results from investment. This graph shows the annualized returns of the two asset allocation decisions over time. The sinking annualized return on a buyback explain the relatively low level of return required to grow the Net Profit at the rate that the buybacks achieved due to the fewer number of shares.

(See “Net Profit Test: Comparing Buybacks to Investment” at corequity.blogspot.com)

The sinking annualized return on a buyback explains the relatively low level of return required to grow the Net Profit at the same rate that a buyback achieves due to the fewer number of shares.

To illustrate the advantage of Investment over Buybacks, here are two very similar companies who couldn’t be further apart in their asset allocation choices. The two are Cracker Barrel (CBRL) and Jack in the Box (JACK). They are both mid-cap Restaurant companies trading at 19x earnings.

Company data as of May 31st	CRBL	JACK
INDUSTRY	RESTAURANT	RESTAURANT
MARKET CAP	MID-CAP = $3.5 B	MID-CAP = $2.4 B
P/E	19x	19x
YIELD	3.1%	1.6%
2008-15 CASH FLOW - DIVIDENDS	$1.27 bil	$1.23 bil
2008-15 STOCK BUYBACKS	-$0.16 bil	-$1.20 bil
2008-15 CHANGE IN SHARES O/S	+7%	-37%
GROWTH OF EPS 2008-2015	+144% or +13.6% pa	+50% or +6.0% pa
GROWTH IN NET PROFIT “	+151% or +14.0% pa	-4% or -0.5% pa
REQ’D AFTER TAX % TO = EPS GROWTH[1]	-	4.8%

CBRL’s Cash Flow from Operations less Dividends totaled $1.27 billion from 2008 and 2015. Most of this was invested in its operations as indicated by its book value per share which grew from $4.15 to $22.45. As a result of this investment, their Net Profit growth equaled the growth in EPS over the 7 years (+14.0% vs +13.6%) as their shares outstanding increased slightly.

By contrast, JACK bought $1.2 billion of their own stock, reducing their shares outstanding by 37%. As a result their EPS grew by 6.0% pa entirely due to buybacks but their Net Profit actually declined by 3.7%, or -0.5% pa.

The Shareholders of JACK today would have been much better off had management invested those funds - as much as that may have made the Sharesellers happy. The company would only have to earn a 4.8% return on those funds for the Net Profit to match the “growth” in EPS (the Net Profit Test). That would have generated $64 million more in Net Profit in 2015 alone, or 56% more than they actually achieved ($178 million vs $115).

Much has been said about the role of share buybacks in executive stock options. It is therefore interesting to note how much these two companies compensated their senior management. In 2015, Jack in the Box led by $16.6 to $13.8 million[2]. The five year average number is closer but JACK still wins: $9.9 to $9.6 million.

In JACK’s case, management is clearly not being judged by the Net Profit Test.