Reflections – short balance sheet review of PepsiCo (PEP)

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Noteworthy Items

  • Liquidity ratios for PEP are safe but not stellar
    • Safe when Liquidity Ratios are >1, and the higher the better
    • Notice that Monster Beverage Corp (MNST) has abnormally high Liquidity Ratios. This is because MNST uses equity to finance their projects instead of liabilities (surprisingly, their total debt is 0, which explains why their Debt-to-capital Ratio is also 0). This results in very low liabilities figures and hence very high Liquidity Ratios.
  • Relatively high Debt Ratio for PEP versus competitors
    • Partly because PEP relies more on debt (than equity) to finance projects
  • Much lower Profit Margins versus competitors
    • Coca-Cola Co’s (KO) Net Profit Margin is lower than PEP’s because a large portion of their operating profit was paid to a one-off tax in 2017. KO’s Net Profit Margin in 2016 (0.156) is however higher than PEP’s in 2016 (0.10).
  • Stellar ROE figures versus competitors

Overview

  • PEP’s balance sheet is relatively safe and are mostly superior to their competitors but the relatively low Profit Margins is a source of concern.
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Reflections – Using a Multi-stage Dividend Growth Model to value PepsiCo (PEP)

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Expected Initial Growth (4 years)

  • Assume 7% average¬†annual dividend growth for the first 4 years
    • PEP had average 6.75% annual dividend growth over last 10 years (from $1.65 to $3.17)
    • PEP had average 13.85% annual dividend growth over last 3 years (from $2.76 to $3.17)

Expected Terminal Growth

  • Assume 5% average annual dividend growth after the first 4 years
    • PEP had average 9.51% annual dividend growth over last 20 years (from $0.515 to $3.17)
    • PEP had average 8.32% annual dividend growth over last 10 years (from $1.425 to $3.17)

Required Rate of Return (assume to equal Discount Rate)

  • Am looking for a 12% average annual returns (over 10 years) on my investments
  • Assume 4% PEP stock price growth over next 10 years
    • PEP had average 4.38% annual stock price growth over last 10 years (from $71 to $109)
    • Relatively conservative considering that average stock price rose by 7.84% per annum over last 50years
  • This means I need an 8% annual dividend growth (12%-4%=8%) on the investment

Verdict

  • Current Stock Price: $109.92 (17/04/2018)
  • Valuation based on model: $111.368
  • UNDERVALUED

Sensitivity Analysis

  • 1% fall in Expected Initial Growth (4yrs) results in 3.53% fall in valuation
  • 1% fall in Expected Terminal Growth results in 22.85% fall in valuation
  • 1% fall in Discount Rate results in 51.05% rise in valuation
  • Highly sensitive to changes in Discount Rate

Reflections – attempts to understand Comcast Corp (CMCSA)

For the past week, on top of my busy workload (which explains the lack of content), I’ve been working on trying to understand Comcast Corp’s (CMCSA’s) business. I was mainly curious to see how a competitor of Disney Inc (DIS) was doing and whether it was a company that I would be interested to initiate a position in.

Previously when I initiated a position in DIS I was still relatively naive in my analysis and actually, upon further evaluation, failed to fully comprehend some aspects of the business dynamics. Although I still believe in the strong prospects of DIS, I thought that maybe an analysis into CMCSA as a competitor of DIS may give me a greater understanding of the sector. Perhaps my newer knowledge on business evaluation may give me more insights into the sector and of the competitors that I wasn’t able to fully comprehend.

There were however many problems in trying to understand the business. The most significant being my failure to understand the exact sectors/areas that CMCSA derive their revenues (especially since CMCSA is a huge multi-billion dollar business). It took me long hours of reading the annual reports and researching to help me understand this point (such as revenue from cable subscription, broadcast TV, advertising, internet etc). This difficulty was further compounded by me not being a consumer for most of their products (Xfinity and NBCuniversal were very unfamiliar to me).

As a result of these difficulties, I have terminated (postponed) the project for now with the below calculations. Please understand that given my ignorance about the business and sector, I may not have properly represented all the significant competitors of CMCSA in the table.

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Perhaps one important lesson from this whole fiasco is to never invest in businesses that I cannot fully comprehend yet. As mentioned previously, I do not consume most of CMCSA’s products and I hardly even watch television these days, which resulted in me having huge difficulty trying to understand the specific area of competition between CMCSA and its competitors. Many top investors (including the legendary Warren Buffett) has constantly warned investors of not investing in businesses that they cannot understand and only now can I fully grasp the weight of that message.

For now, before I can better comprehend the sector, I shall be moving on to businesses in areas that I am much more familiar with.

Reflections – short quantitative analysis of Home Depot (HD)

“The Home Depot, Inc. (The Home Depot), incorporated on June 29, 1978, is a home improvement retailer. The Company sells an assortment of building materials, home improvement products, and lawn and garden products, and provides various services. The Home Depot stores averaged approximately 104,000 square feet of enclosed space, with over 24,000 additional square feet of outside garden area, as of January 29, 2017. The Home Depot stores serve three primary customer groups: do-it-yourself (DIY) customers, do-it-for-me (DIFM) customers and professional customers. The Company had approximately 2,278 stores located throughout the United States, including the Commonwealth of Puerto Rico and the territories of the United States Virgin Islands and Guam, Canada and Mexico, as of January 29, 2017.”

-Reuters.com

  • HD beat its closest competitor, Lowe’s (LOW), in nearly all areas
    • Better Profitability Ratios:
      • Higher profit margins due to lower relative expenses (and higher relative returns)
      • Higher ROE due to lower reliance on equity to fund investments (notice that Debt-to-capital ratio is 0.95 which reflects high reliance on debt as compared to equity in funding projects)
    • Better Activity Ratios
      • More efficient in converting assets into revenue
    • Better Liquidity Ratios and better Coverage Ratio
      • More able to pay off their debts using current assets
      • More able to cover interest expenses using EBIT
    • Worse Debt Ratio
      • Huge amount of liabilities relative to LOW
      • Mainly because HD relies more on debt rather than equities to fund projects (as seen from high Debt-to-capital ratio)

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  • Strong dividend growth track record
    • Current dividend yield of 2.32% ($4.12/$177.44)
    • 10year average annual dividend growth = 17%
    • 3year average annual dividend growth = 23.8%
    • Low dividend payout ratio (using Net Income) at 48.8% ($4212m/$8630m)
  • BUT expensive price of shares relative to valuation based on growth
    • Current price of $177.44 is 41.2% premium to intrinsic value based on simple Valuegrowth model (assuming zero future growth)Screen Shot 2018-04-05 at 5.00.43 pm.png
    • Using simple DCF analysis, assuming values of 8%, 6%, and 4% for growth after first 2 years, next 3 years, and terminal growth, valuation as followsScreen Shot 2018-04-05 at 5.03.44 pm.png
    • Current PE ratio of 24.3 which is expensive relative to earnings (EPS=$7.29)
  • Fair valuation based on dividend growth potential
    • Use past year dividend value of $3.56 to estimate
    • Using Gordon constant growth dividend discount model, assuming discount rate of 10% and constant future dividend growth rate of 8%, we get a valuation of $192.24 per share ($3.56*1.08/(0.1-0.08))
    • Using Two-Stage dividend growth model, assuming discount rate of 10%, initial dividend growth rate of 23% for the next 2 years, and a 7% terminal growth rate, we get a valuation of $190.90 per share

Verdict

  • Despite strong fundamentals of company and stellar historical growth track records, price of shares very expensive as compared to valuations. Might initiate small position in company to take advantage of dividend growth but will wait for correction before initiating a full position in the company.

Reflections – added SBUX to watchlist

Performed some basic fundamental analysis on Starbucks (SBUX) today and really like the strong fundamentals.

However, I consider the current price too high (current price at $57). The TTM PE ratio is 19 which is acceptable but the PE ratio based on 2017 EPS is 28.9 which is high. Additionally, applying a Valuegrowth model (assuming zero future growth, risk-free rate of 3% from US 20yr Treasury yield, Equity Risk Premium of 4%), the intrinsic value per share of the business is at $38 which gives a PE ratio of 19.2 using 2017 EPS. More details of the calculation can be seen on my watchlist page.

May consider initiating a small position when it falls to $48 (down 15% from current prices) and will complete a full position at $38-$40 or lower.

Investment Thesis – Walt Disney Co (DIS)

“The Walt Disney Company, incorporated on July 28, 1995, is a worldwide entertainment company. The Company operates in four business segments: Media Networks, Parks and Resorts, Studio Entertainment, and Consumer Products & Interactive Media. The media networks segment includes cable and broadcast television networks, television production and distribution operations, domestic television stations, and radio networks and stations. The Company’s Walt Disney Imagineering unit designs and develops new theme park concepts and attractions, as well as resort properties. The studio entertainment segment produces and acquires live-action and animated motion pictures, direct-to-video content, musical recordings and live stage plays. The Company also develops and publishes games, primarily for mobile platforms, books, magazines and comic books.” – Reuters.com

Disney business segments (by operating income) as per Annual Report 2017:

  • Media Network (46.71%)
  • Parks & Resorts (25.54%)
  • Studio Entertainment (15.94%)
  • Consumer Products & Interactive Media (11.8%)

Historical Growth data

  • Stable revenue and EPS growth over past 5 years
  • Large FCF available (FCF yield = 5.9%) and consistent growth over last 4 years
  • Dividend yield of 1.7% with average dividend payout ratio (earnings) of 30% which is very safe
  • Consistent dividend growth over past few years but slowing growth (dividend growth of 25% average before 2015 and 8% average after 2015)

Competitive Advantage (Moat)

  • Efficient Scale: the ESPN network
  • Intangible Assets: Brand name of Disneyland theme parks, distributive rights to Disney, Marvel, Pixar, and Lucasfilm products (films, games, merchandise)

Future Growth potential

  • Has been able to churn out hits in box office (Marvel universe, Star Wars films, etc) which can translate into more revenues in all the other segments of the business
  • Huge size and FCF makes acquisitions at the very least safe (e.g. recent acquisitions of 20th Century Fox and BAMTech)
  • Huge success of theme parks and ongoing investments into them continues to be high quality attractions for visitors
  • Entrance into paid streaming services is potentially highly profitable and can have synergies with ESPN but has risks of competition from similar services like Netflix

Micro-related risks

  • FY17 Total Debt/FCF = 4.42 which is slightly higher than threshold of 3-4
  • Long-term debt has been growing substantially for the past 5 years

Macro-related risks

  • Global economic downturn can negatively affect demand for Disney’s products
  • Challenges to Disney’s ESPN network in the form of cord-cutting due to increasing popularity of off-television live sports programming platforms (Amazon and Twitter)
  • Challenges to Disney’s niche in providing child-friendly programming (mainly from Netflix)
  • Challenges by Comcast stealing away Sky from the Disney-Fox deal would reduce the benefits of the deal

Current valuation

  • PE ratio of 13.98 (based on P=$98.54, E(TTM)=$7.05) is very low
  • Lowest PE ratio in 7 years
  • PE ratio lower than industry (25.73) and sector (18.34)
  • PE ratio lower than S&P500 PE of 25.7

Verdict

  • Disney faces serious challenges from the ESPN network (which makes up majority of operating income) and high uncertainty in the Disney-Fox deal, which probably resulted in the very low PE valuation. However, I consider the company to have a strong brand moat and high potential from box office hits and theme park investments. The safe dividend payout ratio and consistent dividend growth is also a strong positive. Will initiate a large position in Disney and continue to accumulate if prices continue to fall.