3 Highest Rated Economic Castles

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Includes: DPZ, NVDA, XLNX
by: Valuentum
Summary

The sustainability and duration of a firm’s economic value creation tells us little about its economic castle, or the magnitude of the value creation that it is expected to deliver.

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC).

Let’s take a look at three companies boasting highest rated Economic Castles: Nvidia (NVDA), Xilinx (XLNX), and Domino’s Pizza (DPZ).

By Valuentum Analysts

The Economic Castle – Keeping the Horse Before the Cart

The concept of an economic moat – or sustainable competitive advantages – generally focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat generally does not consider the cumulative sum of a firm’s potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.

The sustainability and duration of a firm’s economic value creation – or its competitive advantage period – tells us little about a company’s economic castle, or the magnitude of the value creation that it is expected to deliver to shareholders. Though a focus on economic moats is important to Warren Buffett’s process, identifying “economic castles,” or those that will deliver the most value to shareholders may be equally, if not, more important to an investor’s process. We are keeping the horse before the cart.

Valuentum’s Economic Castle™ rating assumes that ‘economic profit’ (as measured by ROIC less WACC) is the primary factor in assessing the value that a company generates for shareholders. Whereas an economic moat assessment evaluates a firm on the basis of the sustainability and durability of its economic value creation stream, Valuentum’s Economic Castle™ rating evaluates a firm on the basis of the magnitude of the economic profit that it will deliver to shareholders (as measured by its ROIC-less-WACC spread). Firms with the best Valuentum Economic Castle™ ratings are poised to generate the most economic value for shareholders, regardless of their competitive positions.

Let’s take a look at three companies boasting highest rated Economic Castles: Nvidia (NVDA), Xilinx (XLNX), and Domino’s Pizza (DPZ).

Nvidia (NVDA)

Nvidia is a computer graphics company. Its business is based on two technologies: the GPU and the Tegra processor. GPUs are the engine of visual computing. Tegra processors incorporate multi-core GPUs and CPUs together with audio and video capabilities. The company was founded in 1993 and is headquartered in Santa Clara, California.

Investment Highlights

• We're big fans of Nvidia's balance sheet health. Cash, cash equivalents and marketable securities were just over $7.1 billion as of the end of fiscal 2018. Though it does have ~$2 billion in total debt, a strong balance sheet supports dividend potential and provides a cushion in a rapidly developing market.

• Though it does not expect its long-term fundamentals to be materially impacted, Nvidia is anticipating near-term headwinds as a result of excess inventory in gaming related to the sharp decline in cryptocurrency mining demand. Gaming card prices declined materially and have stabilized, but a previously anticipated increase in volume for Nvidia has yet to materialize.

• Nvidia expects to be a significant player in autonomous driving. As of the end of fiscal 2018, 320 companies were using its Nvidia Drive platform, a 50% increase from a year earlier, and the list includes many of the top names in next-gen car and truck manufacturing. Nvidia tabs autonomous vehicles as a $60 billion opportunity by 2035.

• Gaming has been a strong point for Nvidia of late, and rapid demand growth in deep learning has been pushing GPU revenue higher. Gaming remains a key driver, and virtual reality continues to create new opportunities for innovation, with which Nvidia has become synonymous

Economic Profit Analysis

Image Source: Valuentum

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Nvidia's 3-year historical return on invested capital (without goodwill) is 146%, which is above the estimate of its cost of capital of 9.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image Source: Valuentum

Xilinx (XLNX)

Xilinx makes FPGAs, SoCs and 3D ICs. These devices are coupled with a next-generation design environment and IP to serve a broad range of customer needs, from programmable logic to programmable systems integration. The company was founded in 1984 and is headquartered in California.

Investment Highlights

• As with rival Altera, which was acquired by Intel, Xilinx's strategy centers on the displacement of ASICs and ASSPs in the development of next-generation electronic systems. The company strives to drive down cost and power consumption at each manufacturing process node.

• Investors in technology pay close attention to a firm's gross margin to get a read for product pricing pressures. We like Xilinx's focus on growing earnings and its cash-rich balance sheet. The firm's shares have benefited from reports that it may be a takeover candidate, and robust estimates of potential markets including autonomous vehicles and artificial intelligence for chipmakers have been welcome news.

• The company is experiencing solid momentum in the 28nm market. Xilinx's quarterly revenue run-rate is growing, and demand for its 16nm, 20nm, and 28nm products is expanding thanks to end markets such as data center, automotive, test and measurement, wired and wireless communications, and even space.

• The company is heavily dependent on distributor Avnet for the majority of sales revenue and order fulfillment. Resale of product through Avnet accounts for 40%+ of worldwide revenue and for roughly 60% of total net accounts receivable as of 2017.

Economic Profit Analysis

Image Source: Valuentum

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Xilinx's 3-year historical return on invested capital (without goodwill) is 144.4%, which is above the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image Source: Valuentum

Domino’s Pizza (DPZ)

Domino’s Pizza is the number one pizza delivery company in the US, based on reported consumer spending. The firm also has a leading international presence and ranks as the second-largest pizza company in the world, based on number of units and sales. It has an enterprise of more than 15,000 units with ~60% outside of the US market.

Investment Highlights

• All investors should become familiar with the success of Domino's. Profits are driven primarily by franchise royalties, which account for more than 90% of international operating income. 2017 marked the 21st consecutive year of positive international same-store sales growth.

• Domino's is an impressive company. Its US annual same-store sales growth has averaged +3.8% since 1997, with particular strength coming during the past few years (+12% in 2015, +10.5% in 2016, and +7.7% in 2017). The firm's average annual international same-store sales expansion has been even more impressive over this time horizon (+5.7% average).

• The firm's franchise model generates sustainable returns for franchisees ($133k-$136k in annual EBITDA in the US in 2017), revealing healthy internals. It is targeting a mid-range outlook of 6%-8% net unit growth, domestic same store sales growth of 3%-6%, international same store sales growth of 3%-6%, and global retail sales growth of 8%-12%.

• Domino's return on invested capital is simply a sight to see. If it is not the greatest value-generator in our coverage universe, it certainly is within the restaurant space. However, its debt load should not be ignored. Debt-to-EBITDA was near the upper bound of its 3x-6x target at the end of the third quarter of 2018.

Economic Profit Analysis

Image Source: Valuentum

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Domino's Pizza's 3-year historical return on invested capital (without goodwill) is 217.5%, which is above the estimate of its cost of capital of 9.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image Source: Valuentum

Wrapping Things Up

We think the Economic Castle rating is a valuable tool for investors, and we use it as a core component of our equity research methodology. However, it is important to note that it is but one part of the bigger picture, and highly-rated Economic Castles can be undervalued, fairly-valued, or overvalued. though the economic value framework and discounted cash-flow framework are interdependent, the Economic Castle is independent on a firm's price-to-fair value assessment. This dynamic can be seen in the examples provided in this article. While we view Nvidia, Xilinx, and Domino's Pizza to all have highly-rated Economic Castles, each stock is trading within our respective fair value range, and Xilinx and Domino's currently sit in the upper half of their fair value ranges.

Additionally, what we view as one of the most attractive characteristics of the Economic Castle rating, as well as discounted cash flow based price-to-fair value assessments, is the forward-looking nature of the assessment. This forward looking-nature helps avoid potential problems that might arise if one focuses only on companies that have (or have had) economic moats, or sustainable and durable competitive advantages, and overlooks those with shorter-duration, high-magnitude economic profit spreads by using historical data alone as a driver of future expectations.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.