Bhp Bhilliton (BHP), Whole Foods (WFMI), Microsoft (MSFT), Google (GOOG), Water (PHO) & Bonds

By Yaser Anwar, CSC of Equity Investment Advisors and Others

With every new year the various newsletters and "experts" tout various asset classes, be it: stocks, currencies, commodities, bonds, that they see doing well.

While the student panel doesn’t contain any experts, we do have a smart and young team with diverse educational backgrounds that can add significant value to readers with their eloquent analysis. Without further ado I present:

Arjun Pai presents BHP, Joe Citarrella analyzing WFMI, Mark Lin delves into MSFT & GOOG, Ross Greenspan talks Water (PHO) & Yours truly is going to talk about Bonds.

Arjun Pai, Ph.D at Queens University of Belfast

BHP Bhilliton

• BHP Billiton is an Australian based diversified resources company with global operations in resource rich countries like Chile, South Africa and Australian. It has the reputation of being the world’s second largest producer of copper and energy coal.
• It is also currently the third largest producer of nickel and the fourth largest producer of nuclear fuel Uranium in the world. The company also has exploration interests in petroleum, natural gas and precious metals like gold, silver and titanium.

Broad macro environment and catalysts driving the future outlook of this mining giant:

• A diversified global asset base with a stable and strong cash flow.
• Commodity markets remain strong underpinned by supply restrictions and a constructive global economy.
• Robust growth potential meeting the challenges of the Chinese import demand for energy and industrial metals.
• India has remained one of the largest import markets in Asia for the base metals in 2006 with its infrastructural and realty story unfolding. Import of coal and fossil fuels are going to grow driven by the strong power demand and GDP growth.
• Global energy demand especially for civilian nuclear energy could be a big revenue generator being a raw material supplier.
• As per the most recent reports BHP Billiton one of the world’s largest mining groups is on the acquisition trail which will unlock the value for its shareholders.

Joe Citarrella, BA Economics at Yale University

Whole Foods (WFMI) & Homebuilders

It was the S&P500’s worst stock for 2006. Wall Street beat up its share price last year as expectations met the reality. Believe it or not, same-store sales can’t grow to the sky.

Whole Foods’ CEO John Mackey has also taken a beating, going from hailed industry titan and organic food guru to one of BusinessWeek’s “Worst Leaders of 2006” and the subject of ridicule for the size of his paycheck (though he’s now paid just a $1 token salary).

But

’s fickleness is sometimes cause for investor celebration as great companies get hammered, providing bargain purchases for the contrarians. So that brings me to the point of this Whole Thing: is Whole Foods a bargain?

I’ll approach the risks and rewards in list format as best I can before delving into the valuation. Here goes:

PROMISE

• Great business with strong management, lots of room to grow, enjoying an expanding market for its industry.
• Perfect example of “People, People, People” article (management pay improved, one of the most respected leaders in the business in John Mackey, strong attention paid to the customer and shareholder, ranked as one of greatest places to work, most of the executive team has been with the company for over 10-15 years)
• Stores profitable from day one, 88+ stores in the works (with leases signed). Only ~180 now, operating in just 34 states, D.C., the

  U.K.

  , and

  Canada

  . Lots of room to grow.
• Is increasing its brand awareness very successfully. The company is the largest and most well-known of its kind, and customers are willing to pay a little extra for service and experience.
• As they expand in size and brand loyalty, they can benefit from both economies of scale and pricing power, taking advantage of covering costs through higher volume of fresh foods while leveraging their brand and incessant focus on the customer’s experience to charge a premium. This is a competition killing two-punch combo, leading to both higher returns with wider margins over time.
• Their management has been very good at building a competitive moat – with an obsessive focus on the customer, the employees, and the shareholders, along with strong and increasingly growing brand awareness, the company is investing successfully in marketshare of mind, creating a culture that many will benefit from and many will be loyal to. Oh, and did I mention cost savings from economies of scale?
• As Charlie Munger has said, taking a competitive advantage to the extreme often benefits the company and insulates it from competitive pressures. Just as Costco took cost-savings to the extreme, Whole Foods takes its culture and people-friendliness to the extreme. That is their advantage.
• Many compare it to Starbucks in that company’s early days (check out Yaser Anwar’s article).

RISKS

• The question we have to ask is whether the company can really beat the burgeoning competitive landscape – Walmart, Wild Oats Markets, etc — and remain at the top of the industry to actually enjoy those competitive advantages for an extended period of time. Currently, Whole Foods is more successful than any competitor, and given the culture and lifestyle it is forming, I can foresee this being the case for a long time into the future.
• Another related, yet altogether different, question is whether the industry will continue growing given that there is some, though probably small, chance that it’s all a fad.
• Speaking of fads,

  America

  ’s blitzkrieg on trans-fats, the obesity epidemic, and mounting health issues continue to open new market potential as customers become more educated and grow in number. It is difficult to tell whether this is a lasting societal change or an extended trend that will either be temporarily lived or overcome by another. If the former, the chances are high that growth will continue at a rapid pace over the next ten to fifteen years plus for this outstanding company.
• Though I’m not confident enough to place much money on it (at least not yet), I believe that the industry and the company are in good shape and will stick around in full force for the foreseeable future.
• Despite the big pullback from the $80 per share days, the company still trades at a high PE around 32. We’ll talk about this further in the valuation section.

OTHER PROS/CONS

– Stock option plans

PRO – With its generous payouts, employees are digging it and staying happy, which trickles down to the customer

CON – Dilution. The size of the stock option plans mean current investors won’t have as big a claim on future income as otherwise possible.

• The company’s average returns on capital over 5 years are high relative to the grocery industry (around 12% versus the industry’s 9.6%). They do this with basically no debt, save for some small line items.
• Capital has historically been internally generated cash flow that is reinvested in the business along with equity from the issuance of shares to “team members.”
• These returns are not objectively very high, but for grocers it is.

VALUATION

• I’ll try to keep this as simple and short as possible. Let’s assume that the company’s free cash flow of $215 million in last FY (Net inc of $204 + Depreciation of $156 – Maintenance Capex of $145) will continue to grow at 15% over the next ten years. After that, the company will grow FCF at 5% per year. Assuming a WACC of around 10% (probably high), we get a value for the company of $9.8 billion (its current market cap is around $6.6 billion). That would represent a 33% discount from intrinsic value.
• But is this realistic? Well, again, that depends how you weigh the risks and likelihood that the company continues its growth trajectory as we know it.
• The company is ambitious in opening new stores and is aiming for sales of $12 billion by 2010. With a (simplistic) calculation that this would mean earnings of around $420 million (based on the company’s consistent net profit margin around 3.5% and not accounting for the possibility that this margin could improve based on economies of scale and pricing power, as mentioned above), which would, in turn, mean that the 15% growth rate may be low.
• But, on the other hand, if the competition, big and little, starts eroding market share and pressing margins and operating results, a value near $10 billion might well be as good as from thin air.
• While this may seem anticlimactic, this brings me to an important point. DCF, multiples analysis, or any other valuation method is pointless unless we first size up the business’s true long-term potential. Whole Foods is a promising enterprise, with great management, a solid business model, and strong financials. It seems reasonable (though not necessarily a no-brainer), that the company can justify its high PE and, in fact, still be a bargain.
• Because it doesn’t strike me (yet) as a no-brainer, I personally have no money in it. That said, I will be watching Whole Foods very closely in 2007, and if prices begin to leave investors with a wider margin of safety, you can rest assured I’ll be on it.

Mark Lin, Double Major in Accountancy and Banking & Finance at Nanyang Business School (Singapore)

Microsoft (outperform) & Google (underperform)

MSFT

•  Strong fundamentals have attracted a large legion of investors, both retail and institutional.
•  Microsoft is launching the broadest barrage of new products in its 30-year history, including

  Vista

  , the new version of the Windows operating system, and Office 2007, an upgrade of the popular software suite.

  Vista

  ‘s validation could improve Microsoft’s OS penetration.
•  Despite poor reviews, there is still demand in the market for a music player like Zune. Zune Marketplace also has potential of being a viable distribution model.
•  X-Box sales are doing better than expected, with more than ten million sold.
• Microsoft’s “Home of the Future” concept will create synergy between its current products and offer the platform for further growth,

GOOG

• Excellent company, bad investment. Google will have to maintain its current strong performance in terms of growth and profitability to keep its stock price afloat.
• The next big hit after its text ad business (98% of company’s revenues) is nowhere in sight. Its new experiments have not done well: Gmail (security flaws), Google Answers (shut down), Google Finance (not found on Nielsen ratings for the top financial sites) etc
• Google could also miss the advertising targets set by brokerages and banks as a result of Google’s advertisers cutting back on ads. The reasons are higher costs and low conversion rate of clicks to customers (and click fraud as well).
• Competitors pose the greatest threat to Google. Yahoo has an advantage in content and driving user traffic. Microsoft has the financial and strategic resources fight a long-term battle.
• Acquisition of YouTube in question as YouTube’s failure to complete a key piece of anti-piracy software as promised could pose a risk of possible legal action

Ross Greenspan, Major International Affairs at George Washington University

The PowerShares Water Resources ETF (PHO)

• The PowerShares Water Resources ETF (PHO) is based on the Palisades Water Index. PHO consists of companies that focus on the provision of potable water, the treatment of water, and the technology and services directly related to water consumption.
• The majority of fund holdings (54.44%) are industrial manufacturers, including some highly diversified multinational conglomerates such as General Electric (1.23%) and Danaher (3.03%). One quarter of the funds holdings are utility companies and which have a distinctly international bias with Brazilian, French, British and American corporations. The fund is heavily weighted towards small-caps (22.94% small-cap growth, 34.23% small-cap value).
• Many parts of the world continue to undergo rapid economic development. The supply of potable water is crucial to healthy and productive populations. The management of waste water is additionally crucial. In Brazil, only 55% of the population is connected to a public waste water collection system. Turkey has 59% connected and Mexico has 61%. (UN) "In East Asia and the Pacific (EAP), 24 percent of the population lacks access to improved water supply and 52 percent lacks access to sanitation, equal to 465 million and 705 million people, respectively" (World Bank).
• The developing world is rapidly urbanizing, and mostly in an unplanned settlements. The population of urban dwellers in East Asia and the Pacific will double to 1.2 billion by 2030 (World Bank).
• There is tremendous opportunity for the corporations held by the Water ETF to profit from countries that need to develop the capacity to distribute potable water and remove waste water from the new urban centers of the developing world.
• The World Bank and the United Nations portray a potential for a world water crisis. That very well may be the case. But international corporations held by the PowerShares Water Resources ETF (PHO) have tremendous opportunity to profit from the development of water services for the world’s urban populations.

Top Five Holdings:

1. Watts Water Technologies Inc. (Cl A) 4.15%
2. Companhia de Saneamento Basico do Estado de Sao Paulo (ADS) 3.63%
3. Layne Christensen Co. 3.50%
4. United Utilities PLC (ADS) 3.47%
5. Insituform Technologies Inc. (Cl A) 3.35%

Yaser Anwar & Bonds

As you can read, some excellent insights by my fellow bloggers and students. They all presented eloquently their side of the story about which stocks they see doing well in 07. I thought of presenting a stock too, but realized part of any diversified portfolio are- Bonds. Hence I’m going to be talking about how to go about positioning bonds in your portfolio.

• Investors add bonds exposure when economic data &/or Fed officials talk about economy slowing down. Usually a good time to start adding bond exposure is when economy is slowing down and now seems about the time.
• Start with 5-10% of total portfolio bond allocation because a head start doesn’t always guarantee perfect timing. Ex: It would have helped adding exposure to Treasurys & short-term bonds from May & when GDP was said to be 2.5%, before it was revised higher. Or before Bernanke’s testimony to Congress on July 19 2006. The vice versa applies when economy is coming out of a trough/recession. So when economy is coming out of a trough and growth in GDP is picking up alongside low interest rates, buy floaters!
• For example: Demand for floating-rate notes increased when the Fed began raising rates from a 45-year (2004) low of 1 percent two years ago. As a general rule, when you expect the Fed to cut rates (like in August 2006) you should buy two-year Treasuries to prepare for Fed rate cuts next year (referring to 07).
• As the housing market cools and the economic outlook dims, investors will come to the conclusion that inflation isn’t a worry, and they load up Treasury notes and bonds, pushing their, Tnotes & bonds, yield lower.
• Finally, use a laddering strategy. Bond ladders can help deduce reinvestment risk — If interest rates rise, you may be able to capitalize on higher rates by purchasing new bonds with money coming from expiring bonds. If rates fall, money reinvested would earn the prevailing (lower) yields but your ladder’s existing longer dated bonds would continue to be locked into the initial, presumably higher, yields.

Thanks for your patience during this lengthy post. We hope it adds value to your investing.

http://www.equityinvestmentideas.blogspot.com/