Walgreens Boots Alliance

I am looking at Walgreens Boots Alliance (WBA), and it seems interesting.

Investment Thesis

  • WBA is a large ($125B sales), growing (5-10%), and reasonably profitable company (ROE: 10-15%).
  • financially and operationally conservative: Its current (debt + liabilities)/EBITDA = 1.5 – 2.5x, depending on how you deal with leases. It pays a consistently growing dividend.
  • operationally conservative: It has avoided the acquisitive path of CVS (where debt/EBITDA is closer to 4-5x), choosing instead, to partner and collaborate. This strategy may attract “partners” wary of the CVS’s ecosystem.
  • horizontal and vertical integration: Consolidation is underway in the industry. WBA is iterative, and works in small steps. It bought a slice of Rite Aid stores, and a quarter of drug distributor Amerisource Bergen. In 2014, Walgreens bought Boots Alliance, which brought in a new CEO.
  • owner operator: CEO Pessina is a well regarded operator, with skin in the game. He bought a chunk when share price was in the $80s.
  • recession resistant, WBA was cash flow positive through the Great recession; plus their balance sheet is conservative.
  • risks are regulatory (can adapt), and Amazon (probably overblown given the complexity and low margins)

Quick Valuation

FCF/sales is steady and approximately 4%. Over periods of time, FCF exceeds net income by about 25%. This is especially so, if you normalize recent flurry of M&A.

Using a growth rate of 5%, discount rate of 12% and FCF of $6-6.5 gives a value of $90-$100/share using a terminal growth model.

It is cheap relative to its past P/S: 0.5 (historical 0.75), EV/EBIT 13.5 (historical 16.5), P/E 16.5 (historical 20). If they mean revert, they all imply a target price close to $100.

Tidbits

  • Comparison with other retailers: Walmart – $505B, Amazon – $193B, Costco – $140B, CVS – $185B, TGT – $72B.
  • Sales growth at Walmart and Target has trickled down to the 0-2% range, while that at CVS and WBA has been steady in the high single to low teens.
  • Rewards Program has about 90M members. This is valuable data.
  • Founded in 1909, invented milkshakes, and popularized soda fountains in the middle of the store.

Resources

  • RGA Investment Advisors slide deck on WBA, and Elliot Turner‘s twitter posts, were helpful in understanding the game WBA is choosing to play, compared to CVS.

 

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Some Updates

This has been an interesting year so far. Despite being 30% in cash, I am down about 1.5%, which is more than the market.

Two relatively large positions are down significantly YTD. LUK is down nearly 20% ($26.50 to $22), and CFX is down nearly 25-30% ($40 to $30).

LUK made quite a few changes including changing its name and ticker to JEF, selling a large part of National Beef and all of Garcadia, and bought back nearly half a billion dollars in stock. For a $8B market cap company that is nearly 6%. While LUK or JEF has been a frustrating stock to hold, I can’t help thinking management is trying to do the best they can. I still think this is a stock worth north of $30, and am happy to hold on.

CFX expects to earn between $2.05 – $2.20/share (slide 20 on Q1 2018 presentation, link) for 2018. It seems like it is getting itself back on track. At a 18x multiple, they should be worth $36-40/share. Plus, it is a cyclical business that gets better with time, and it seems like a lot of its end markets are improving.

My most frustrating holding has been ALJJ. 2018 has been absolutely disappointing for reasons outlined in my last post on the company. Since then an additional “meh” quarter has gone by. The stock has halved from $3.15 at year end to $1.50-$1.60 last week. The company issued updated guidance calling for adj. EBITDA of $31-34m compared to $36-39m at the start of the year. If I assume interest, capex and tax to be on the higher end of previous guidance ($10m, $9m, and $1.5m), and divide by number of shares (37.9m), I still come up with a FCF/share of 28c – 35c. At 10x FCF, the stock could be worth twice its current price! The valuation was too compelling to pass up. I held my nose, and increased my position by 40%. I currently own 7000 shares at an average price of $2.81.

If the price of Under Armour holds steady, I will have escaped another holding full of drama with a small profit (5%). I started chasing UA to teach myself some options trading, and ended up buying at $20 and $16.50. The stock got halved from $20 to $10 over 2017, and has now jumped back to near $20. I think it is easily worth $15-$20, and might, with good execution, be a worth several times more. However, with the market getting choppy, I thinking there are more lower risk propositions available than last year.

Communications about Charter

Given the recent swoon in Charter Communications (CHTR) and Comcast (CMCSA), they both appear attractive. The economics of the cable business are predictable and compelling.

If you suspect that the market has over-reacted to the loss of (lower-margin) video-subscribers, and that these cable companies will adapt and position themselves as the dominant arteries for the flow of data(i.e. 5G etc. will be a complement, not a substitute), then now appears to be a fantastic time to take a substantial position in these companies.

I’ve taken a nearly 4% position in CHTR, and have significant exposure to CMCSA through options. If prices stabilize or go down further over the next couple of weeks, I plan on making a 10% allocation to cable.

Here are some useful links in chronological order:

  • June 2015: Oracle of Omaha after the announced merger with Time-Warner Cable when CHTR was trading around $170/share
  • September 2015: Punchcard Research did his characteristic deep dive
  • Andrew Walker continues to offer informed commentary on CHTR. He looked at it in June and October 2017.
  • There are numerous writeups on VIC. Here is a recent one (November 2017) by MarAzul.
  • Value Seeker did a deep dive in December 2017. He looked at the cable industry in general and both CMCSA and CHTR in particular.

 

Monte Carlo and Us

This, by Corey  Hoffstein, is the most insightful thing I read yesterday.

You are not a Monte Carlo Simulation” (click title for link)

It presents a simple but profound idea. It helped me pull together and contextualize several “gut feelings”.

  • The average experience of a population (ensemble average) can be very different from the experience of the average person (median)
  • This is especially true when the lower bound is zero and the upper bound is infinity. Income is a classic example
  • It helps understand why we are risk averse: why we feel the loss of $1 to be twice as painful as the gain of $1. The log-scale provides an appropriate measuring tape
  • Our lives are a single replica multi-period game, not multiple replicas of a single game

Check it out!

 

ALJJ: From Gray to Black and White

Last year, I took a 3% position in ALJ Regional holdings at about $3.20 (and wrote about it here and here). Today the stock trades below $2, and I have lost nearly 40% of my invested capital.

The central question is: should I hold on, or cut my losses?

The investment case for ALJJ has morphed over 2018 from something that could take years to play out to something that might take only a few quarters. In less than a year, it is conceivable that ALJJ goes bankrupt, or doubles from here!

The bear case is straightforward:

  • Q1 2018 results were a disaster! Two of the three operating segments are becoming an increasing drag!
  • the company is highly levered, and is uncomfortably close to breaching its debt covenants. Bankruptcy is on the table.
  • the CEO is accused of sexual harassment by a former colleague, and may be distracted

On the other hand, the bull case is:

  • The company is dirt cheap on a cash flow basis! On the Q4 2017 earnings call (Jan 8) about a month before the Q1 2018 results came out, the company projected about $18M in FCF for 2018 (FCF = EBITDA ($36-39M) – CapEx ($7-9M) – interest ($8-10M) – tax ($1-1.5M)). For a $72M market cap company, this translates to $18/$72 = 25% FCF yield!
  • The CEO increased his already large ownership in the stock by 3.7% after the debacle in the stock price (he paid ~$2.25/share). He comes from a distressed debt background, and probably has a more sophisticated understanding of how to navigate the covenants.
  • Dave Waters of Alluvial Capital summarized the bull case pretty effectively.

Because of the binary nature of the payoff, I haven’t added to my holdings. My plan is to hold on to my shares for a quarter or two more, and see which way the wind blows stronger.

Subjectively, I think the risk of bankruptcy is elevated but not overwhelming (if I had to pull a number from my ass, I would guess something like 1/3).

Currently, the expected 2018 FCF/share $18M divided by 37.6M shares is over $0.45/share. If the debt fears go away (perhaps as incremental FCF is directed towards debt reduction), the company might deserve a 10x FCF multiple or be worth $4.50/share. The expected value is then $3 (2/3 * $4.50), which is 50% above the current price.

Thus, while the position has a lot of hair, a lot of the bad news is more than baked in, and I plan on holding until 2Q or 3Q 2018.

Thoughts on BRK and GOOG

Berkshire Hathaway

  • Semper Augustus 2017 Client letter (link) continues a annual tradition by taking a deep dive. They figure BRKB is worth somewhere around $250/share.
  • Whitney Tilson (presentation) updates his valuation to $230/share, probably rising to $250 by the end of the year.

Either way, BRK looks about 20% undervalued at current prices near $200.

Google

This is not a stock I own, but one I have looked at many times over the past 5 years hoping for a pull back. Here are two different takes:

  • Whitney Tilson (presentation) argues that we aren’t paying much of a premium over the market to own a high-class business (PE ~ 21x 2018). If we consider the optionality of YouTube and “Other Bets” then one can argue that its valuation is very reasonable.
  • Geoff Gannon, on the other hand (link), does a back of the envelope calculation on the limits to the advertizing spend. Google and Facebook capture a large (and rapidly increasing fraction) of a slowly growing pie, and will have to contend with slower growth in the future. This will result in lower multiples, and hence unspectacular returns.

 

Brookfield Asset Management

Brookfield Asset Management (BAM) is well known among value investing circles. It is a leading global manager of real assets.

It is easy to get lost in BAM’s complicated structure. It is both: an asset manager, and an asset owner. It owns significant portions of publicly traded names (listed issuers like BPY, BIP, BEP, BBU), and private flagship funds that it manages like a traditional asset manager.

BAM eats its own cooking, and it is a good cook.

The funds and companies have provided superb returns in the past. As a part owner, some of these earnings and distributions flow to BAM. As an asset manager, it charges other investors and partners sharing the ride (fee bearing capital), and earns a performance-based carried interest (like a 2 and 20 hedge fund).

There is a lot of great commentary and information on BAM. Here is a small subset:

  • The Brooklyn Investor looked at BAM in June 2015 and did not seem particularly impressed by the value proposition
  • “Value by George” revisited it around that time, and had a more favorable take
  • There is a decent (and recent) stab at valuing BAM on SeekingAlpha by Eric Sprague
  • The 2017 Investor Day presentation provides a fine overview of the key drivers

Here are some important takeaways:

  • It is hard to argue that they have great management. BAM is a well run machine. The annual and quarterly (!) letters are a treat to read. The business is global and complicated, but the management seems quite transparent. They have strong culture, and a deep bench.
  • The business model is unique. As asset managers, they can leverage their investment gains on the assets they own by levering it with outside capital. They also earn a base fee on the outside AUM.
  • There are structural tailwinds, as allocations to real assets are increasing.
  • BAM is also a growth story. The AUM has grown 10%/year (2012 – $158B to 2017 – $258B)

Valuation

The 2017 investor presentation provides a glimpse at what the company might look like in 2022. They value the asset owner and asset manager parts separately, and add the two portions together.

I am unsure if one can come up with an estimate of intrinsic value without finding the intrinsic value of its holdings separately.

It is preferable to be simple and approximately right, than to chase down every moving part in this intricate operation.

In the presentation, they subtract the debt/corporate capitalization ($10B) from the total invested capital ($65B) for a $55B asset owner value.

For the asset management business, they slap a 20x multiple on fee related earnings ($1,689M * 20 = $33.8B) and a 10x multiple on carried interest (10 * $1, 054M = $10.5B). Adding them and dividing by the total number of units gives a value per share of $100.

I prefer to tone this number down.

For example, assuming ~3% dilution in the number of shares brings this number down to $80/share. Nevertheless, at today’s prices of ~$42, even the lower number implies a nearly 14% return.

What about just looking at the 2017 numbers? Using a similar methodology, the asset owner stake is worth $38.5B – $9B = $29.5B. The asset manager stake is worth $14.6B (FRE) and $6B (carried interest) for nearly $50B in intrinsic value. Dividing by the number of shares (1,065M), we get a per share value of approximately $47. Thus, even by this reckoning, shares are about 20% undervalued.

I took this opportunity to start a 1.5% position. I hope to add to the position, as I get more comfortable with it.