Get ready to rumble! The largest bank in the US is about to enter a battle royal between management and activist shareholders. And I believe the battle will break the shares out of their seven year slumber.
Edward Lampert's hedge fund, ESL, recently built its position in Citigroup (C) to over 3%. Lampert probably isn't buying $800 million of Citigroup shares to be a passive investor. He joins other major holders, such as Wellington Management and Saudi Price Alwaleed bin Talal, who have in the past joined with activist shareholders to put pressure on management.
C_info Investors have called for CEO Charlie Prince's head. I believe this is a case where investors are simply looking for reasons to get Prince fired because he's not as charismatic as former CEO Sandy Weill. Prince has also over-promised and under delivered on his growth initiatives, which always draws the ire of investors. Who says Wall Street isn't a popularity contest?
Investors have challenged management on the company's perceived under performance relative its peers and are demanding the company be split up because it is "too large to manage." The bulge bracket investment banks such as Morgan Stanley (MS) and Goldman Sachs (GS) have been on fire driven by surging mergers and acquisitions activity, making Citigroup's Smith Barney unit seem like an also-rand. On the consumer side, Bank of America has caught up to Citigroup in terms of deposits, an unheard of feat just ten years ago. And other banks such as Wells Fargo and Bank of New York have built very profitable niches in mortgage and equity custody. Internationally, the company has been mired in problems with its Japanese consumer bank and also has a troublesome relationship with the bankrupt Italian banking concern, Parmalat.
I believe investors have been overly influenced by the negative press surrounding Citigroup. The company has actually increased earnings by 55% and book value by 80% since 2000. Citigroup's above average capital generation enables it to support growth and return capital to shareholders through buybacks. And Citigroup's return on equity has been around 18%, which is above the average diversified financial conglomerates. All in all, Citigroup's stock has actually out-performed its peers since 2003 and is in the middle of the group since 2000.
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Punk, Ziegel & Company's provocative bank analyst, Richard Bove, is one of the analysts who believe Citigroup should remain whole. Bove believes investors are simply trying create value in the short term at the expense of the long term by trying to split up Citi. Large financial institutions are the only companies that have the capital and diversity to compete in today's global capital markets. The vision of a global bank headquartered in the US is what originally lead Sandy Weill to cobble together Citigroup. Bove adds that in banking, unlike in other industries, "the big have gotten bigger and more powerful".
In fact, fifteen years ago, the US was considered to be at a disadvantage to the rest of the world because it did not have a global financial institutions on the scale of Taiwan's HSBC or Germany's Commertz Bank. Today, Citigroup's size and global scale allow it to compete in the worldwide derivatives market and position it for growth in China. The company has taken ownership stakes in Shanghai Pudong Development Bank and Guandong Development Bank. Citigroup has also building its China business organically by building a consumer and business franchise.
Bove says that rather than breaking up Citigroup, shareholder's should reward it with a higher multiple because its businesses are diverse, steady and growing. The stock seems cheap relative to its own history. Citigroup is trading at one of the lowest levels on a price to book basis in its history. And the stock's P/E ratio is slightly below its peers at 11x forward earnings.
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Despite growing earnings at 20% compounded, Amgen's (AMGN) stock has been in an anemic trading range between $80 and $50 for the majority of the past seven years. The company's stock is beset by many of the same problems affecting the drug giant Pfizer (PFE). Amgen's core franchise is under attack from competitors, Medicare is lowering reimbursement rates for its drugs, and the strong pipeline may not make up for the decline in several blockbusters.
Amgen has built a strong franchise in the support treatment for kidney disease and cancer. Amgen's blockbuster products include Epogen for treatment of anemia, Neupogen, a white blood cell stimulant, and Enbrel, for treatment of rheumatoid arthritis and psoriasis. The company successfully launched two next-generation products in 2003, Aranesp (a long-acting version of Epogen) and Neulasta (a long-acting version of Neupogen), which currently drive growth. Several smaller drugs such as Sensipar, which fights a disorder of the parathyroid glands, and Kepivance for mucositis make up the balance of the revenues.
The company's pipeline includes treatments for cancer, inflammatory diseases, and neurological disorders. Amgen has shown good success in launching new drugs. The FDA recently approved Vectibix, which competes directly with Imclone's Erbitux in the treatment for colorectal cancer. Other promising drugs in the pipeline include Denosumab (AMG-162), which is currently in Phase III trials for the treatment of osteoporosis, and Motesanib (AMG-706), which was granted FDA fast track status for the treatment of tumors. Amgen also has several drugs in Phase II trials for osteoarthritis (AMG-108) and diabetes (AMG-131).
Despite the company's 17% revenue and earnings growth last quarter, the stock has been besieged by several serious issues. Most recently, the Centers for Medicare & Medicaid (CMS) have proposed cuts in reimbursement for Aranesp which were much more draconian that expected. In addition, the FDA has recommended additional warning labels for the drug. If that wasn't enough, Aranesp faces tough competition from Johnson & Johnson's Procrit/Eprex and potentially Roche’s CERA, which AMGN claims violates it's patents in a recently filed lawsuit.
Amgen's other blockbuster, Enbrel, is also facing increasing competition from Johnson and Johnson (JNJ), Abbott (ABT), Genentech (DNA) and Biogen (BGEN). Enbrel actually lost market share in the US in the first quarter because of the increased competitive activity.
Since no one knows exactly what will happen to revenues and EPS after the CMS reimbursement changes, I'll do a quick scenario analysis of AMGN's earnings. My base case is that earnings will remain flat at around $4.00 - 4.20 for the next two years. Growth from Enbrel, Vectibix and Sensipar should offset the decline in Epogen/Aranesp franchise arising from Medicare reimbursement cuts and increased competitive pressure.
Wall Street analysts still model the company for about 6% - 9% growth over the next two years. I believe when these estimates get cut to 0% growth, AMGN's stock will reflect the majority of the negative information. The upside to my base case is that the Wall Street analysts are right and the company manages to continue to grow earnings despite the attacks on its Aranesp franchise. The downside scenario is that Medicare takes an even bigger chunk than expected, AMGN doesn't cut expenses and Enbrel's growth slows, causing earnings fall by 20% over the next two years rather than remain flat.
I believe investors are currently over estimating the probably of an earnings decline, which is making the stock cheap. Given my base case of flat earnings at around $4.10 and applying a market multiple of 17x trailing earnings, the stock looks undervalued. In fact, every time in the past 15 years when AMGN has traded below a market multiple, it's presented an excellent buying opportunity for long term investors. Although the outlook for Epogen/Aranesp looks bleak, I believe the majority of the bad news has already been priced into the stock.
For a company that keeps so many people's hearts beating, Medtronic's (MDT) stock hasn't shown any signs on life in the past seven years. If you have a heart condition, a herniated spinal disc or type 1 diabetes, you likely have a Medtronic product implanted in your body. The company has a leading market share in Implantable Cardioverter Defibrillators (also known as ICD or pacemakers), spinal discs and diabetes pumps, as well as products in the cardiac stent and heart valve market.
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Medtronic is an exceptionally well managed company. Unlike rival Boston Scientific's Guidant unit (BSX), Medtronic has had relatively few recalls for its devices. In addition, Medtronic invests more in research than any other pure-play medical technology company, creating a robust product pipeline. In the next 12 months, the company is expected to win FDA approvals for its drug-eluting stent Endeavor, the hemodynamic monitor Chronicle, and for its three artificial spinal discs (Prestige ST, Bryan and Maverick).
The strong operating performance is matched by its financial performance. Medtronic generates consistent cash flow and has a strong balance sheet. Over the past five years, the company has generated an average of $1.9 billion in free cash flow per year. On top of that, the company already has $6.3 billion in cash and investments versus roughly $5.9 billion in long term debt. Year to date the company has repurchased approximately 10 million shares for a total cost of over $400 million.
However, the slow recovery in the Implantable Cardioverter Defibrillator market and the slowdown in the drug eluding stent market have eclipsed the potential upside from other divisions of the company. MDT recently lowered the upper end of its revenue guidance, which reflects the company’s slower-than-expected recovery in the ICD market.
In part due to the ongoing disruptions in the emergency response systems business, the company withdrew its FY08 guidance. In January, the company voluntarily halted sales of its external defibrillators in the US, pending resolution of quality issues with the FDA. The company does not expect to begin shipping until fiscal year 2008 and has announced plans to spin the unit off into a separate company.
Despite the issues, management has reiterated that it can achieve long-term EPS growth of 15% without acquisitions. The company expects to add several new growth divisions and plans to more actively reallocate resources to growing businesses while divesting less attractive ones.
New products, easier comps, an eventual pick-up in ICDs should all lead to accelerating growth. Medicare recently expanded reimbursement for ICDs and Medtronic will introduce several new products which should allow that division to return to growth. The artificial spinal discs are expected to be important growth drivers for Medtronic’s overall spine franchise in the long term. And international sales remain an untapped market for growth.
Medtronic's valuation looks attractive, especially compared to its historical valuation range. While the estimated price to free cash flow multiple of about 28x will turn off hard-core value investors, the price to earnings estimate of 20x hasn't been lower in the past 12 years. If investors believe in management's initiatives, the stock could be considered attractively valued at these levels.
Since trading sideways is so unfulfilling for most investors, I chose one stock that has just broken out of its seven year slumber. CDW (OTCPK:CDWD) is a distributor of name brand computer hardware and software to small and medium sized businesses. The company differentiates itself from competitors by offering a high level of customer service. The company has over 2,100 account managers, many of whom are certified technical sales specialists who can help customers solve their technology issues. The sales force is well trained, the company stocks over 120,000 products and the company offers overnight shipping all in an effort to create long term relationships with its customers.
CDW is an exceptionally well-managed company in all respects. One of the things that makes CDW really unique for a technology distributor is that it generates significant and consistent free cash flow. Most technology distributors such as Ingram Micro (IM) and Scan Source (SCSC) don't generate much cash flow, and if they do, it's very volatile and difficult to forecast. However, CDW has been generating an average $181 million annual free cash flow since 2000. In addition to the strong cash flow, the company has posted very high returns on equity, which have averaged well above 25%.
Despite the tech meltdown from 2000 to 2002, CDW grew steadily. Over the past seven years, the company's revenues have grown at 11.5%, which is well above the industry growth rate. Last year was a transition year for the company during which management invested heavily in its sales and distribution systems. This created a drag on operating and net margins, as well as hampering sales growth.
But growth has recently picked up which is driving the shares higher. In the most recent quarter revenues grew 17% and EPS grew 27%. In addition, CDW finally showed some gross margin expansion. The company raised its gross margins estimates which should help earnings grow faster than sales. One of the main knocks against the company is its inability to get earnings leverage. However, with the majority of the company's investments behind it, I believe margins can begin expanding.
The strong growth has reignited the shares but the stock is still attractively valued. I believe that EPS can approach $5.00 in 2009. CDWC has traded at a median 21x forward earnings multiple. Therefore, I believe CDWC can trade over $100 by next year. In addition, CDWC is trading at the low end of its historical price to sales multiples. If you assume CDWC trades at its median price to sales multiple of 1.1x, then the stock should be valued above $100 in 2008, as well.
I believe all seven of the slothful stocks are attractive for long term investors. You won't win any trading contests with these ideas, but you should be able to beat the market over a two to five year period. All seven stocks are are very high quality companies that generate substantial free cash flow and have solid balance sheets. Aside from some operational problems, none of the companies are beset by strategic problems that can't be fixed. And after trading sideways for seven years, the stocks are attractively valued and are held by patient investors that won't flip the shares as soon as the stocks tick up. That's a recipe for long-term, tax efficient gains.