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Tony Abbate, CFA
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Tony Abbate, CFA is founder and Managing Director of Granite Value Capital, a Hanover, NH based investment management firm. Tony received his BBA in Finance and Business Economics from University of Notre Dame in 1992. He received his Chartered Financial Analyst designation in 1997. Prior to... More
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Granite Value Capital, LLC
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  • Pepsico: Why It's Time To 'Back Up The Truck' And Buy The Stock
    Quality stocks like PepsiCo have underperformed since the stock market bottomed in early October. I believe the reason for the recent underperformance is the due to the massive monetary stimulus implemented by the Federal Reserve and the ECB. This stimulus may continue for weeks, months or the rest of the year. If that is the case, PepsiCo will continue to underperform the market. However, as a fundamentally based value investor, I find PepsiCo to be extremely attractive. It is an above average business priced at the same level as the overall stock market. I believe over the next five to 10 years the odds are very high PepsiCo will generate an attractive return.

    PepsiCo is a leader in the snack food and beverage industry. About one-third of its sales are Pepsi related soda products. Two-thirds of their sales are snack food products under brands such as Frito Lay and Quaker Oats. On a qualitative and quantitative basis, PepsiCo's underlying business is very attractive. On a quantitative basis, in 2011 the company had a 14.5 percent operating margin and generated a return on invested capital of 67 percent. One of the reasons why the stock is cheap is that these two financial metrics are trending down. This is evident by the fact that over the last 10 years operating margins have averaged 17.5 percent and return on invested capital has averaged 77 percent. Regardless of the trend, it is still an outstanding business. The company has also generated consistent growth in sales, revenues, cash flow and book value per share. Below are the 10 year annualized growth rates for each financial statement item:

    Annualized Growth from 2001 to 2011

    Sales/Share: 10.4%

    Earnings/Share: 10.6%

    Cash Flow/Share: 8.8%

    Book Value/Share: 10.0%

    Average of Four: 10.0%

    All four financial statement items are within a couple percentage points of each other and average 10 percent growth per year. The similar rates of growth also represents sound accounting and a high quality of PepsiCo's earnings.

    The qualitative aspects of the business is high due to the fact that one-third of its sales are in emerging markets. Hence, I believe they have the ability to grow their business in what I think is going to be a difficult economic environment over the next five to 10 years. It is reasonable to expect PepsiCo to grow its business at a high single digit percentage rate.

    The management of the company has also been stewards of the company's capital. This is evident by a consistent increasing dividend and frequent stock buybacks. I think if the stock continued to underperform, there is a possibility management may break up the company into its snack food and beverage units. There have been rumors about this and the company spun-off Yum Brands 15 years ago. This possibility acts as a potential call option on management unlocking shareholder value.

    All attractive investment opportunities start with an undervalued situation. PepsiCo meets this requirement in spades- on both an absolute and relative basis. On a relative basis, the company is trading at 99 percent of the S&P 500 Index. (PepsiCo's recent P/E ratio is 15.5. The S&P 500 Index's P/E Ratio is 15.7.) Below is a chart illustrating PepsiCo's Relative P/E Ratio (against the cyclically adjusted P/E ratio of the S&P 500 Index) compared to the relative price of PepsiCo to the S&P 500 Index since 1985.


    There have been three occasions where PepsiCo has traded at a discount to the S&P 500 Index. (Each of these three times are indicated by a black circle.) In each case PepsiCo outperformed the S&P 500 Index as the market applied a premium multiple to PepsiCo over the market. In each of the three cases the market applied a 50 percent valuation premium to PepsiCo over the market within three years. (The outperformance is indicated by a rising red line after each black circle.) It is pure speculation to assume PepsiCo will trade at a 50 percent premium to the market in the future. However, I think given the fact that PepsiCo is a high quality, brand name company selling at a market multiple, the chances are very high PepsiCo will outperform the S&P 500 Index over the next five years.

    On an absolute basis, there are three ways to value a company like PepsiCo. The first way is to look at where the company has traded on a historical basis. Below is a chart illustrating PepsiCo's P/E ratio since 1985.

    You will notice two things. First, the stock has rarely traded below 15 times earnings. Second, when it has traded near this level, the downside is limited and the probability of making money over the next five years is high.

    The second way to value PepsiCo is to compare it to similar companies that have been acquired in the public marketplace. Since 1999 there have been five similar food or beverage companies acquired. Below is a summary of these five companies and their EV/EBITDA acquisition multiples:

    Worthington Foods: 15.4

    Best Foods: 15.4

    Wrigley: 14.6

    Anheuser-Busch: 13.9

    Quaker Oats: 13.8

    Average: 14.6

    At its recent closing price of $62.52, PepsiCo currently trades a an 11 EV/EBITDA multiple. Assuming a 14.6 EV/EBITDA multiple was applied to PepsiCo, the company would trade at $87.72. This would be 40 percent higher than its current price.

    The third way to value PepsiCo is by discounting future free cash flows back to the present. Using a 10 percent discount rate and assuming the company grows at six percent per year, the estimated fair value for PepsiCo is $95.05.

    Regardless of how you look at PepsiCo, I think it is an attractive stock that offers a very good return/risk proposition. Patient investors should be rewarded.

    Disclosure: I am long PEP.

    Additional disclosure: All clients of Granite Value Capital are long PEP.

    Mar 03 10:05 PM | Link | Comment!
  • What Does the SEC Fraud Filing Against Goldman Mean for the Financial Sector?
    Will the SEC’s fraud filing against Goldman Sachs be the first of many shots expected to be fired upon the big financial companies or a punch that won’t even be a glancing blow? You could not have asked for a better script. The two companies involved at the epicenter of the lawsuit and financial crisis are Goldman Sachs, a company that according to its CEO, Lloyd Blankstein, ‘Does God’s Work’ and John Paulson’s company, best known for profiting from the financial crisis. (Note: The SEC has stated Paulson & Company will not be charged because they did not make false representations to investors.)
    From what I have read in regards to the SEC’s filing and an analysis of historical fraud filings, I view the chances of the charges sticking against Goldman and the other large financial institutions unlikely. However, even if the charges do not stick, there is plenty of potential collateral damage that can be done to the five financial behemoths (Goldman, Bank of America, Citigroup, J.P. Morgan and Wells Fargo).
    First, my guess is there will be dozens of additional lawsuits brought by other foreign governments, individuals and companies. These lawsuits are inexpensive to file given the fact that the lawyers work on a contingency basis. However, they can be very expensive for the defendants in terms of money and time.
    Second, even if the charges do not stick, the accusations and perception of the events that unfolded during the financial crisis adds more ammunition to the call for greater financial regulation. This is a cost that will lower profits and returns on equity for these companies.
    Third, reputation risk increases as more lawsuits are filed and the image of these firms are tarnished. A lot of customers were irate at the companies before news of the SEC fraud charges became public. In talking to customers of these financial behemoths over the past 18 months and what I have read in the media, there has been a movement by customers from the big banks to smaller financial institutions and independent financial advisors. Why would anyone do business with a company where you may be the ‘sucker’ at the poker table? My guess is this will further increase the rate of customer attrition for these large financial companies.
    The fourth risk is bailout risk. I seriously doubt these companies will be given the same support 18 months ago when they were bailed out by the U.S. government. I think the Goldman lawsuit increases the chances these companies could fail but the government would step in to make sure the customers of these institutions are made whole. I think the ‘Too Big to Fail’ safety net is gone.
    As of Friday, the financial sector was up 165% from its March 6, 2009 bottom. The Goldman lawsuit starts another chapter of the financial crisis. I think this uncertainty are not reflected in the current prices of these financial institutions and exposes them to further downside risk.


    Disclosure: The author and its clients do not have any positions in the stocks mentioned in this article.
    Tags: BAC, WFC, JPM, C, GS
    Apr 18 8:35 PM | Link | Comment!
  • Avoid the ‘Too Big To Fail, Too Difficult To Understand’ Banks and Look at a ‘Low Risk, Easy to Understand’ Insurance Stock.

    The three biggest bank stocks in the S&P 500 Index, Bank of America, J.P. Morgan and Wells Fargo, have posted nice gains over the past 12 months. Bank of America’s stock is up 162%. Wells Fargo is up 119%. J.P. Morgan is up 68%. The average 143% gain in the three stocks has significantly outpaced the 49% increase in the S&P 500 Index.

    Wayne Gretzky was once asked, “What makes you such a great hockey player.” He politely said, “I don’t skate to where the puck has been, I skate to where the puck is going.” I think this quote is reflective of the recent performance of the Big Banks. The performance over the next 12 months is going to come from somewhere outside of the Big Banks. (The stock that I mention at the end of the article has only increased by 21 percent over the past 12 months.)

    Each of the three banks, with the help of the U.S. Government, have played ‘Moby Dick’ during the financial crisis by swallowing many troubled competitors. Bank of America bought Merrill Lynch. J.P. Morgan acquired Bear Stearns and Washington Mutual. Wells Fargo bought Wachovia. I recently looked at each of the bank’s latest 10Ks. Do most investors who own these companies intelligently discern their financial statements? I would be willing to bet that the CEOs don’t even understand half of what is in these statements? As these companies have gotten bigger, I think they have become more difficult to understand.
     
    I look to purchase companies that meet the principles of my investment philosophy which focuses on minimizing business risk, balance sheet risk and valuation risk. I think minimizing losses is one of the keys to investment success. While the big three banks have performed very well over the past year, I think these companies have significant risk at these prices.
     
    First, their success is linked to a continuation of the strengthening of the economy and the stabilization of the housing market. Much of the strength in the economy is being driven by government stimulus programs. I see unemployment remaining at above average levels for a number of years and continued problems with an overleveraged consumer.
     
    Second, I cannot determine these company’s balance sheet risks. After looking at the 10-Ks, I scratch my head and wonder how much risk is embedded in their balance sheets.
     
    Third, an important element of investing is valuation a company. I prefer to value financial companies by comparing their stock price to their tangible book value per share. I have very little confidence in my ability to value these companies’ balance sheets. If you can’t properly value the companies’ balance sheets, I do not believe you can properly value the companies.
     
    Take a look at the following table:

    Company
                Year End       Net Level 3 Exposure     Derivative Exposure
    Bank of America   2009                      15.7%                   $1.41 Trillion
                                 2008                      10.8%                   $1.47 Trillion
    J.P. Morgan          2009                      11.1%                   $1.49 Trillion
                                 2008                      13.3%                   $2.58 Trillion
    Wells Fargo          2009                      17.3%                   $65.9 Billion
                                 2008                      20.2%                   $168.9 Billion


    The two items that concern me most about these banks are Net Level 3 Asset Less Liability Exposure and Derivative Exposure.

    Financial institutions are required to classify their assets and liabilities based on whether they are Level 1, 2 or 3. Level 1 is the most transparent balance sheet items. Level 1 holdings are easy to value by the fact that prices are readily available. An example of a Level 1 security would be a Treasury Note. Pricing for Level 2 holdings are less transparent than Level 1 holdings. Level 2 holdings may require some estimation by the financial institution as to its fair value. An example would be a residential mortgage loan. Level 3 holdings are a potential problem for financial institutions due to the fact that they are very illiquid (difficult to buy or sell) and have little to no pricing availability. Look at the following definition of a Level 3 holding obtained from Bank of America’s 2009 10-K:
     
    Unobservable inputs that are supported by little or no market activity and that are significant to the overall fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments for which the determination of fair value requires significant management judgment or estimation. The fair value for such assets and liabilities is generally determined using pricing models, discounted cash flow methodologies or similar techniques that incorporate the assumptions a market participant would use in pricing the asset or liability. This category generally includes certain private equity investments and other principal investments, retained residual interests in securitizations, residential MSRs, asset-backed securities (ABS), highly structured, complex or long-dated derivative contracts, certain LHFS, IRLCs and certain collateralized debt obligations (CDOs) where independent pricing information cannot be obtained for a significant portion of the underlying assets.
    These are the so called ‘Toxic Assets’ that the press has latched onto during the financial crisis. I cannot understand these assets or whether the prices assigned to them are reflective of their true value. (I think almost nobody does.) The table above shows each company’s net exposure. The Net Level 3 Exposure consists of deducting each company’s Level 3 liabilities from their Level 3 assets and dividing the difference by the bank’s net equity. I still think each company’s Level 3 exposure is quite high. Also, Bank of America’s and J.P. Morgan’s derivative exposure of between $1.4 and $1.5 trillion concerns me.
     
    Given the three banks Level 3 exposure and derivative exposure, I cannot get my arms around each company’s balance sheet or business risk. If I cannot understand these risks associated with a company, I am not interested in owning it.

    I think if you are to own financial stocks, some companies in the insurance industry are attractive. The insurance industry is going through tough period for pricing. Insurance is a commodity business. However, if you look for an insurance company that is disciplined in its underwriting, has a solid balance sheet and sells at an attractive valuation, I think you can do well over the next 3 to 5 years when pricing power will probably return to the insurers.

    One company I like a lot is Safety Insurance Group (NASDAQ:SAFT). Safety Insurance Group is a Massachusetts based property and casualty company. They have posted an underwriting profit on their insurance operations for the past six years. The fact that they posted a combined ratio of 97.2 last year is impressive in a market that was experiencing softness in the pricing of insurance policies.
    85 percent of SAFT’s business is automobile insurance. Unlike insuring homes along the Gulf Coast, this is a predictable and low-risk business. All eight members of their management team have been with the company for at least 20 years. 6.3 percent of the shares are owned by insiders. While they have been writing less insurance in the deteriorating pricing environment, they have maintained profitability and management has been wise allocating capital. Instead of writing unprofitable business to maintain market share, management has decreased it share count by 3.5 percent over the past year and pays out a generous dividend as the shares yield 4.3 percent.

    The stock sells six percent below book value and 7.3 times five year average EPS. I think the downside is very limited given the fact that the company sells below book value, has no debt and pays a 4.3% dividend. (Note: Level 3 assets is 0.2% of total assets. This is illustrative that the company’s balance sheet is much less risky than the ‘Big Three’ Banks. Plus looking at Safety Insurance’s balance sheet by line item is much easier to understand than the ‘Big Three’ Banks.)

    Before the financial crisis, the average profitable property and casualty insurance company had been acquired at 2.9 times book value. Over the same time period, the average commercial bank had been acquired at 3.0 times book and the average brokerage firm had been acquired at 2.6 times book. Let’s split the difference and say the average high quality financial firm has been acquired at 2.8 times book. Now the past does not represent the future. Fair Market Valuations are probably going to be lower going forward. Let’s apply a 30 percent discount to our 2.8 number. That gets us a fair value estimate for financial firms of 2.0 times tangible book.

    The ‘Big Three’ banks are trading at 1.6 times tangible book. If we apply our 2.0 book to these stocks, at most they have 25% upside to fair value. It is possible these banks could trade to or below tangible book value. This implies downside potential of 38%. At the current valuations, the Big Three Banks are not attractive investments.

    If we look at Safety Insurance Group and apply at 2.0 book multiple, I get a price of $79.79. A 1.5 book multiple gets me a price of $59.80. Based on these two valuation levels, my appreciation potential with Safety Insurance Group is between 59% and 112%. I do not see the stock trading much below its current price. The company presents a very favorable risk and reward trade-off.

    Successful investing is all about positioning yourself where the odds are in your favor. With a rock solid balance sheet, dirt cheap valuation and management that understands shareholder value, I think the odds are high Safety Insurance Group will outperform the ‘Big Three Banks’ over the next three years.
     


    Disclosure: Tony Abbate and clients of Granite Value Capital are long SAFT; Tony Abbate and clients do not own BAC, WFC or JPM; Prior to starting Granite Value Capital, Tony Abbate worked at Bank of America and its predecessors for nine years.
    Tags: SAFT, BAC, WFC, JPM
    Apr 05 1:55 PM | Link | Comment!
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