When I took a look at the Against the Sky Portfolio at the end of last quarter, I noted that I was going to be targeting stable large cap companies. I’ve spent some time taking a close look at some core portfolio stocks. I’ve added most of these to the portfolio during the quarter. Below is a summary of these companies as well as my investment thesis for each.
ADP (ADP) is a leading provider of business outsourcing solutions focused on payroll processing, HR, and benefits administration. Their website notes that they have 570,000 clients worldwide. In addition, the company provides integrated computing and financial management tools to auto, truck, and marine dealers (15% of revenue). The company has strong cash flow and earnings even as employment has suffered as well as returns on equity well above 20%. Operating efficiencies gained in the downturn should provide even more benefits as employment improves. Shareholder friendly management has used excess cash flow for dividends and share buy backs. The company has increased its dividend for 35 consecutive years and currently pays $1.36 annually, resulting in a yield of over 3% based on recent prices.
Procter & Gamble
Procter and Gamble (PG) is a consumer products company that owns some of the most well-known consumer brands in the world. In fact, the company reports that it has 23 brands that gross a billion dollars in sales per year and 20 additional brands accounting for $500 million or more in sales. In 2009, the company produced $14.9 billion in operating cash flow. Returns on equity are right around 20%. Consumers likely traded down to lesser brands during the recession as growth was reversed in 2009, but Procter and Gamble brands are often clearly superior in the minds of consumers. The company has a history of returning money to shareholders in the form of dividends and share repurchases.
Pepsico (PEP) is more than just a beverage company. They also own Frito Lay and Quaker Foods. Their beverage brands also include Tropicana and Gatorade. Pepsico has shareholder friendly management that seeks to invest cash flow for strong returns or return money to shareholders, as evidenced by their recent announement of an increased dividend and $15 billion stock buyback. In 2009 they had operating cash flows of $6.8 billion, capital spending of $2.1 billion, $2.7 billion in dividends paid. Their return on equity for 2009 was almost 49%. This number is likely not repeatable as there was a large share repurchase the previous year, but investors can still expect returns on equity of about 20%.
Pepsi paid out 46% of net income in dividends in 2009.
Costco (COST) operates 566 membership warehouses (413 in the U.S.) serving 56 million cardholders and 30.6 million households. The company effectively sells their goods at cost. Membership fees represent the company’s profits. In 2009, the company spent $1.3 billion to remodel and upgrade existing stores and open 20 new stores. Operating cash flow was just over $2 billion in 2009, so the majority of their cash flow was invested in the growth and maintenance of the business. Returns on equity look weak at 11.8%, but on more of an owner earnings basis they are 19.7%. The company paid $296 million in dividends in 2009. There is still room for growth at the company, so the majority of cash flow is reinvested in their business. Their net income dividend payout is 27%, and their owner earnings payout is 16%.
Intel (INTC) is the largest manufacturer of semiconductors in the world. The company has benefited from the huge boom in personal computers and mobile devices over the past couple of decades. In the near future, the company should see increased earnings through the next PC upgrade cycle. Longer term, shareholders should continue to benefit from a company that is a market leader and rewards its shareholders. In 2009, the company made $6.6 billion in net income or $1.17 per share before European Commission fines and their AMD settlement. Net income was $4.4 billion, or $0.77 per share. Capital expenditures are about equal to depreciation, requiring no adjustment for cash flow. In 2009, $3.1 billion was paid to shareholders in dividends (70% payout). Their 2009 return on equity before the fines and settlement was 13%. This during a tough recessionary year.
AT & T
AT&T (T) is a company reborn after the former spin-off, Southwestern Bell (SBC), purchased the former parent AT&T. The legacy AT&T name was kept. Since then, the story has been about wireless subscribers growing at a pace greater than the old wireline users. In 2009, there was negative sales growth of about 1%. The story of AT&T is not about strong growth, but about cash flow that both flows to shareholders and is invested in new infrastructure to meet future wireless and data needs. In 2009, the company had $32.6 billion in owner cash flow consisting of net income totaling $12.8 billion and depreciation totaling $19.7 billion. $16.6 billion flowed back as capital expenditures while $9.7 billion was paid in dividends. In 2010, the company will pay a quarterly dividend of $0.42 per share. Based on the current share price of $26.00, this is a 6.46% yield. Growth will not be great from this company, but steadily increasing owner cash flow should result in income growth keeping ahead of inflation.
I’ve written about Markel (MKL) before. The company is a specialty insurer that has demonstrated an ability to underwrite policies profitably. Their 2009 combined ratio of 95% continues this discipline. The company does not pay dividends, but has demonstrated an ability to invest insurance float and excess capital profitably. In their 2009 annual report, they note that book value per share has grown at a compound rate of 21.2% since their initial public offering in 1986. This compares to the 9.3% return for the S&P 500. Their investment tradition has led them to form Markel Ventures, which invests in non-insurance holdings. These are cash flow businesses that will provide unrestricted funds for future investments. Their superior performance had previously led to a price to book value ratio of 2.0x. Right now they are priced at 1.3x book. Expansion to 2.0x book would equate to a share price of $565 per share. Today shares are priced at around $370 per share. The success of this company and its current discount to historical valuation makes this stock a keeper.
Johnson & Johnson
Similar to Procter & Gamble and Pepsi, Johnson & Johnson (JNJ) produces many products that consumers encounter every day. In addition to their consumer products, they also produce medical devices and perscription drugs. Also similar to Proctor & Gamble, their size produces a scale that leads to strong shareholder returns. In 2009, a down year for the company and the economy, Johnson and Johnson produced a return on equity of almost 29%. They also have a history of returning money to shareholders. In 2009, they had earnings of $12.3 billion, depreciation and amortization of $2.8 billion, and capital expenditures of $2.4 billion. This results in owner cash flow of about $12.7 billion. Of this $5.3 billion was paid in dividends (42% payout) and $2.1 billion was used to repurchase shares.
Valuations and Conclusion
Obviously these stocks are not buys at any price, but they all have shareholder friendly management and should provide steady growth. It is probably more appropriate to value Markel based on book value, but I’ve chosen owner cash flow yield as a method of comparison for the rest of these core portfolio stocks.
|Company||Recent Price||FCF Yield||Target FCF Yield||Target Price||Div. Yield at Target|
In most cases, free cash flow is equal to net income plus depreciation and amortization less capital expenditures. Because Costco plows so much of their cash flow back in to new store expansion, maintenance capital expenditures were estimated at $250 million.
In determining the target free cash flow yield, I’m demanding less yield from the companies with more growth potential. I would look to add shares at their target price, which is certainly possible if the market has a pull back later this year.
Disclosure: I hold shares or manage funds that hold shares of all the companies noted above except for Johnson & Johnson.