Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
November 8, 2003
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Hello again, my friend. I’m back again with another issue of the Undervalued Weekly. Today we’re featuring an article analyzing the third quarter report from Anheuser-Busch, maker of Budweiser. (disclaimer: The Dynamic Investors hold shares in Anheuser-Busch.) Since the company announced this week that it was on track to hit earnings estimates for the full year, I thought I’d take a look at what’s happening. I think you’ll find the analysis enlightening, or at least needing a beer.
In case you hadn’t noticed, I’m still toying with this opening section. I’m leading towards a week in review, sprinkled liberally with my insight (or lack thereof). I think it would be useful, and down the road we can look back and see what the top stories were. Guess what? That’s what you get this week. So, as my loving wife mutters to herself when I speak, here we go again.
It was a tough week for the S&P, closing up only 2.5 at 1053.21, while the Dow Industrials did little closing at 9809.79, up about 8.7 points. The Nasdaq had a better week, closing up 38.53 points to end at 1970.74. Well, at least we know the bull market isn’t over yet, but with the S&P trading at almost 35 times trailing earnings, how much further do you think we can go? We shall see.
I’m kind of a religious guy, and I believe in karma. I like to think that, to paraphrase H.L. Mencken, people today know what they deserve, and get it good and hard. Well, karma finally caught up with the mutual fund industry this week, with the announcement Monday that Lawrence Lasser, chief of Putnam Investments, would be leaving. The scandal also felled the head of the SEC’s Boston office, Juan Marcelino. Apparently, Marcelino couldn’t be bothered to check his messages, and ignored the Putnam employee who was trying to tell him about the alleged fraud. Hey, we all have priorities, right?
On the heals of the Putnam scandal, 7 Prudential employees were indicted for fraud, based on accusations that they engaged in market timing. Apparently, Prudential encouraged this type of activity, so say the defense lawyers. This is why I stay away from mutual funds. You want to buy a mutual fund, get an S&P Index fund and go back to sleep.
In more Karmic retribution news, Richard Scrushy, former head of Health South, was indicted in Alabama court on 85 counts of fraud. Obviously he denied any wrongdoing, and I’m sure he’s determined to get to the bottom of the matter. Prosecutors claim Scrushy used threats and intimidation to bully people into falsifying accounting entries to inflate profits. He’ll be the first person charged with violating Sarbanes-Oxley, the law that makes CEO’s liable for every mistake made in their company.
On a positive note, the economic data this week was all good. Factory output grew last month at the fastest rate in 4 years. Coupled with strong construction growth, we’ve got a good sign that the economy may be turning around. The services sector also grew, adding jobs to boot. Jobless claims plunged, while productivity soared. And our good friend, Uncle Alan Greenspan said “The odds ... do increasingly favor a revival in job creation,” Fabulous, that’s all I needed to hear.
Of course, bond investors were unhappy with all this good news, sending the 10-year bond yield up from 4.3% to 4.45%. Bond investors are such spoil-sports. The interesting thing is that stock investors weren’t impressed either. This is best week of economic news in a LONG time, and the indexes were relatively flat. Could it be that investors are starting to realize that the market has already priced in this great economic news, plus more?
I can’t help but wonder, in my maddeningly cynical way, when you’ve goosed the economy with cheap credit and extra liquidity, how can you tell what’s sustainable, and what’s not. Absent the cheap money, what’s causing the economic growth? I liken the economy to a drunk whose been given too much coffee to sober up. He’s still drunk, just wide awake.
But maybe I’m wrong. What if the economy really is in recovery mode, and the Fed has triumphed in the face of danger. Maybe I should stop looking at the logical implications of monetary policy, put on my bearskin robe and my face-paint, and dance around the burning dollar bills.
I think I’ll wait just a bit longer.
On Friday, Berkshire Hathaway announced a 58% jump in third quarter earnings, largely based on rising insurance premiums. I mention this as segue into my comments on the Warren Buffett article in Fortune this month. It’s a must read for his analysis of the trade deficit, and why Berkshire has significant investments in foreign currency. (For the first time ever, I might add.) His solution to the problem is kind of goofy, being nothing more than additional tax, but that’s not the important part.
If you read no other article this weekend, read this one…
http://www.fortune.com/fortune/investing/articles/0,15114,525644,00.html
That about does it for the weekly roundup. I’ll leave you with my favorite story from this week…
The best story this week involves AT&T. It looks like Ma Bell might be the first company charged with violating the Do Not Call list. There’s irony here somewhere.
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Book Recommendation
This week, I’m recommending Philip Fisher’s book, Common Stocks and Uncommon Profits. Fisher’s advice is timeless, and many of the most successful investors praise his work. Here are a couple quotes…
“I am an eager reader of whatever Phil has to say, and I recommend him to you.”
Warren Buffett
“…everyone will profit from pondering - as Warren Buffett has done – the investment principles Fisher espouses.”
James W. Michaels – Editor, Forbes
This book provides some great tools, and gives you a conservative framework in which to select quality investments. There are three sections:
Each section by itself is worth the price of the book.
Get the book here: Common Stocks and Uncommon Profits
For more must-have books, check out the Dynamic Investors Required Reading.
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Is This Bud for You?
Its football season, and with football comes tailgate parties. Tailgate parties are a great way to get together with friends, enjoy some good food, and partake of the occasional alcoholic beverage. The beverage of choice for most tailgate aficionados is, of course, beer. Being a part-time tailgater, I have sampled my share of beers. And, as an individual investor, I generally like to analyze companies whose products I enjoy. Since I like the King of Beers, I thought I’d give Anheuser-Busch the royal treatment.
Anheuser-Busch is one of my favorite companies, and not just because of its product line. It’s the powerhouse in its industry, with a 50% share of the domestic beer market. I figure that alcohol (and tobacco) will always have a market, so there’s little worry there. The stock trades around $51 per share, or roughly 21 times trailing earnings. It’s got a market cap of $48 billion, about 25 times that of Coors.
From an investor’s point of view, there are a lot of things to like about this company, even if you don’t like beer. But as a smart investor, I know it’s important to get my hands dirty with the company’s financials. So here goes.
By the way, unless otherwise stated, the numbers I looked at are for the nine months ended September 30, 2003 or 2002.
Pawing through the third quarter 10-Q, the first thing I noticed was the 12.8% growth in earnings per share in 2003 vs. 2002. Third quarter EPS rose 12.7%, making it the 20th consecutive quarter of double-digit earnings growth.
So what’s driving this EPS growth? The E in EPS, Net Income, was up about 11% for the nine months, driving most of it. (I know it starts with an N. Just play along.) The S part of EPS, shares outstanding, declined from 870 million to 831 million. Declining shares ratcheted EPS up the remaining 1.8%. Net profit margins were 14.1% and 13.8% in 2003 and 2002, respectively.
What really got me excited, though, was the top line growth for Anheuser-Busch. Sales grew at a modest 4.2% in the first nine months of 2003. Domestic beer volume was up 0.9% and total volume was up 1.4% during this period. For a company of Anheuser-Busch’s size, that equates to 700,000 and 1,400,000 barrels, respectively. That’s slightly more than I can drink in a day. The company’s total domestic market share grew from 48.9% to 50.1% year-over-year. Volume increases contributed $63 million to net sales growth, and here’s the kicker: revenue per barrel generated $268 million in sales growth.
Much of the sales growth came from increased prices. The domestic price per barrel rose 3.5% in the third quarter, 3.3% since the beginning of the year. And lest you think this is a one-time deal, Anheuser-Busch has increased revenue per barrel by at least 2% in each of the last 20 quarters. They’ve actually implemented a strategy of bi-annual price increases to coincide with growing volume. Being able to raise prices during a tough economic period is what I like to call a “good thing”.
So far, so good. Right?
Let’s move on to my favorite measure of productivity: Free cash flow. Free cash flow for the nine-month period was $1.7 billion, an increase of less than 1%. Hey! Wait a minute. Earnings grew at 7%, and the company couldn’t increase free cash flow by at least 1%?
Time to break out the old cash conversion cycle (CCC). The CCC tells me how long it takes to go through the process of making the product, paying the suppliers, selling the product, and collecting the cash for the sale. The calculation is as follows:
Days Sales Outstanding+Days Inventory Outstanding-Days Payables Outstanding
Here are the stats on Anheuser-Busch, for both 2003 and 2002. Because I’m only looking at three quarters of data, I divide the sales and cost of goods sold by 273.75 days, instead of 365.
2003 2002
Days Sales Outstanding (DSO): 18.3 14.3
Days Inv Outstanding (DIO): 23.6 25.2
Days Rec Outstanding (DRO): 45.3 44.0
Cash Conversion Cycle -3.4 -4.5
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A negative cash conversion cycle is a wonderful thing. It means Anheuser-Busch’s customers paid the company 3.4 days before it paid suppliers during the first three quarters of 2003. This, of course, is why the company generated $2.5 billion in operating cash flows. However, customers were paying an average of 4.5 days before suppliers during the same period in 2002. Either the company is taking longer to collect, or it’s paying bills quicker this year.
Let’s look at the drivers in the cash conversion cycle. Notice how the days sales outstanding increased by four? That’s what happens when accounts receivable increase by more than sales (34% vs. 4%). There may be a very good explanation for the increased receivables, but I can’t find it. I dug through the third quarter report and found no answer.
This is not a good sign, and could indicate the company is having problems collecting payment from its customers. I’ll be staying on top of this, because all the sales in the world don’t mean a thing if you can’t collect the cash.
Now that we know why free cash flow didn’t really grow in 2003, let’s look at how the company put what free cash flow it had to use. First of all, they invested $116 million in two convertible bonds issued by Tsingtao, the largest brewer in China. The conversion of these bonds into shares is guaranteed in the contract and according to the company, an additional $66 million will be invested over the next nine months, giving Anheuser-Busch a 27% stake in Tsingtao. China’s a fast growing economy, with a billion or so people. Tapping into this market sounds like a good use of cash.
After the Tsingtao investments, the company had $1.6 billion in free cash flow left. $507 million was used to pay dividends, and another $402 million was used to pay off long-term debt. At this point the company was down to about $705 million in free cash, or about a billion dollars short of what was used to purchase treasury shares. The difference was made up by the proceeds from stock option plans and an increase in long-term debt. For the nine months ended September 30, 2003, new borrowings of long-term debt totaled $929 million.
Let’s see if I can get this straight. In order to decrease the share count and provide less than a 2% boost to EPS, the company added $530 million in net new debt. Jumping over to the balance sheet, I notice that the company has a total of $7.1 billion in long-term debt! That’s 2.7 times the shareholder equity, which is about 2.7 times too many. One of Benjamin Graham’s risk-reduction criteria is that long-term debt be no greater than shareholder’s equity, and I kind of trust his opinion. Anheuser-Busch certainly falls short here.
Goodness, I’m not quite as excited about Anheuser-Busch as I was before. Income and sales growth have been strong, but that doesn’t necessarily make this company into a great investment. Free cash flow barely grew, while the company’s debt level jumped. Add the fact that accounts receivable outgrew sales by a huge margin, and you have a company that may be looking at a cash flow problem coming up. These could all be one-time issues, but somehow I doubt it.
I wouldn’t say that I’m ready to sell my stake in Anheuser-Busch just yet, but I certainly can’t recommend buying it at this level. With a worsening balance sheet, and possible cash flow problems looming, a price of 20 times earnings is too much to pay.
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Quotes of the Week
“Through perseverance, many people win success out of what seemed destined to be certain failure.”
-Benjamin Disraeli
"Have you noticed that signs on bathrooms today no longer say "Men" and "Women," but have little pictures? I used to think they were for foreigners."
-Fred Reed, on the state of American education
The Fab Five
Last week I pointed out Coinstar (CSTR) as part of my look at small-cap value stocks, at a price of $14.70. I picked up on this stock back in the August-September time frame, and recommended it in my previous newsletter service, The Undervalued Investment Report, at $13.75. It finished this week at $15.91, an 8% gain from last week, and 16% since I first recommended it. And I still think it’s cheap.
This week we’ll focus on balance sheet criteria. A good criterion for determining value is the price-to-book ratio, which takes the market price of the stock divided by the shareholder’s equity per share. Any stock that trades for less than book value can be considered cheap, and it’s been found that low price-to-book is an indicator of above-average future performance.
In order to avoid looking at companies that are cheap because they’re in trouble, I’ve added a few more criteria to the search. The company must have a P/E below 12, a current ratio of at least 1.5, and no more debt than equity. Finally, I like small-cap companies, so I filtered out any company over $1 billion in market cap. Here’s this weeks list.
Symbol Name Price (COB 10/31/03)
WEB Webco Industries $ 3.20
NPO Enpro Inds Inc $ 9.90
ALOY Alloy Inc $ 4.54
BDR Blonder Tongue $ 2.20
DUCK Duckwall-Alco $ 14.85
Remember that stock screening is a beginning, not an end, when trying to find good investments. It’s important to always do your detailed research before making any buy or sell decisions.
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
Have you checked out the Dynamic Investors Marketplace?
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