TAA Vol. 1 Iss. 2 - Earnings Power, Margin of Safety and Asset Value

8/7/2019 TAA Vol. 1 Iss. 2 - Earnings Power, Margin of Safety and Asset Value

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The Aspiring Analyst Vol. 1 Iss. 2

Earnings Power, Margin Of Safety And Asset Value [email protected]

1

Happy Chinese New Year from Toronto, where the temperature has fluctuated between a balmy +11C

(52F) and a frigid -19C (-2F). As part of our real job, we had the opportunity to sit down with the

famous value investor Prem Watsa (Disclosure: Fairfax Financial Holdings Inc. is part of our research

coverage). While we cannot divulge the details of our conversations with Prem, we can confirm that

Prem continues to be very cautious regarding the current market rally, citing risks such as a Chinese

housing bubble, the European debt crisis and high unemployment in the U.S. At the end of the third

quarter, Fairfax had approximately 90% of its equity exposure hedged through index swaps and have

also hedged the entire business against deflation! Kind of makes you wonder if the current rally is

sustainable?

Speaking of the weather, is it not strange that the U.S. Northeast has suffered 5 major snow storms this

season and it is only February? Not to mention the wild swings in weather across the globe, from floods

in Australia and Pakistan to droughts in the American Midwest. In our opinion, this may be only a

preview of more weather volatility to come as a result of global warming; an increase in global

temperatures increases the energy in the system which causes greater volatility.

For disbelievers of global warming, you may want to ask yourself whether you can claim, with 100%

certainty, that global warming does not exist? Even IF the probability of global warming is only one in a

trillion billion, the fact that if global warming IS true, the eventual loss to society would be INFINITE

(since it would lead to our extinction) implies the expected loss to be INFINITE. Are we willing to make

that bet?

But we digress. This letter is not an appropriate forum to discuss global warming. In this months letter,

we wish to discuss earnings power and margin of safety in the context of U.S. tobacco stocks. We will

also discuss our thoughts on inflation and a recent addition to our portfolio, Hilltop Holdings Inc. (HTH-

NYSE).

Let us dive in!

Jason Chen

The Aspiring Analyst


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2

Earnings Power And Margin Of Safety; Time For A Smoke?

In the last couple of months, U.S. tobacco stocks have taken a hard drubbing as the investors worry

about the fallout from the ongoing FDA Tobacco Products Scientific Advisory Committee (TPSAC) public

hearings on the impact of menthol in cigarettes on public health and other tobacco-related topics. Of

most concern to tobacco stocks is the hearings and recommendations on menthol in cigarettes, asmenthol have been one of the few growth areas in a shrinking industry. The basic charge is that the

cool sensation of menthol helps mask the bitterness of cigarettes and thus encourages smokers to

breathe more deeply, inhaling more cancer-laden smoke. There is also concern that menthol cigarettes

seem to disproportionately target minorities. The committees full report and recommendations are

expected by March 23, and in a worst-case scenario, TPSAC may recommend to the FDA to ban the use

of menthol in cigarettes.

One company that has been hit particularly hard is Lorillard Inc. (LO-NYSE). Lorillard, the 3rd

largest

tobacco company in the U.S., is somewhat of a one-trick pony as its Newport brand of menthol

cigarettes account for over 90% of the Companys revenues. From a high of almost $90 per share, it hasfallen by 15% to the $75 level. It attracted our attention because at its current price, it sports an

estimated 6% dividend yield. Is now a good time to buy tobacco stocks, in particular Lorillard?

Putting aside the moral issue of whether buying tobacco stocks is akin to condoning the act of smoking,

it appears cigarette manufacturing has rewarded shareholders well. Did you know that Altria (MO-

NYSE), Philip Morris (PM-NYSE), Reynolds America (RAI-NYSE) and Lorillard all have extremely high gross

margins (45%+), even after accounting for excise taxes? That collectively, these four companies have

paid $42 BB in dividends and bought back almost $14 BB in stock in the five years to 2009? That Ben

Bernankes only stock holding was Altria?

A preliminary strategic analysis (using Porters 5 Forces) would suggest cigarette manufacturing is as

good a business as they come. Nicotine addiction makes buyers insensitive to price; the main

ingredients to a cigarette is just paper and tobacco leaves (both commodities that can be bought and

sold with relative ease); and there is no real substitute for cigarettes. This creates an almost perfect

environment for maximum value creation (see Figure 1). Despite what industry participants say, there

cannot be true rivalry and competition when the industry participants earn in excess of 20% net

margins. The threat of government regulations and potential fines means also act as a strong barrier to

entry, leading to a perfect environment for maximum value extraction also.

Moving on from the industry analysis, lets consider LOs stock valuation. As value investors, we prefer

to look at a companys earnings power, or what we believe the companys earnings are worth (Lookingat the asset values may also be appropriate for tobacco companies, particularly for a company like Altria

which owns almost 29% of SABMiller).


3/9

Earnings Power, Margin Of Safety

For example, let us consider Lorilla

Figure 2: Lor

We can see that the Company has

that LO can earn an operating inc

(see Figure 3) into perpetuity. (We

for 3, 5, 7 years into the future,

perpetual cash flows worth? (As a

business, as Lorillard has practicall

in North Carolina).

Income Statement

For the Fis cal Pe riod Ending 12 m on

Dec-31-2

Total Revenue 2,69

Gross Profit 1,3

Operating Income 1,0

Net Interest Exp. 1

EBT Incl. Unusual Items 1,0

Income Tax Expense 3

Net Income 6

Diluted EPS $

The Aspiring A

nd Asset Value theaspiringa

3

Figure 1: Porter's Five Forces.

ds simplified income statement:

illard Simplified Income Statement. Source: Capital IQ

been a fairly consistent earner, recession-proof, e

me of $1.8 BB or generate approximately $1.1 B

can also build a full financial model and estimate

ut that would be overkill for this example). Wha

side note, figure 3 also demonstrates the econom

no capital expenditure needs it only has one ma

ths

004

12 months

Dec-31-2005

12 months

Dec-31-2006

12 months

Dec-31-2007

12 months

Dec-31-2008

1

De

0.0 2,892.0 3,056.0 3,281.0 3,492.0

2.0 1,454.0 1,595.0 1,656.0 1,770.0

1.0 1,167.0 1,318.0 1,395.0 1,513.0

9.0 54.0 78.0 109.0 19.0

9.0 1,151.0 1,344.0 1,383.0 1,434.0

7.0 445.0 518.0 485.0 547.0

2.0 706.0 826.0 898.0 887.0

.69 $4.059 $4.75 $5.16 $5.15

nalyst Vol. 1 Iss. 2

[email protected]

en. Let us assume

in free cash flow

the free cash flow

t is the stream of

ics of the tobacco

ufacturing facility

months

-31-2009

LTM

Sep-30-2010

3,686.0 3,965.0

1,906.0 2,066.0

1,639.0 1,788.0

(22.0) (71.0)

1,519.0 1,619.0

571.0 607.0

948.0 1,012.0

$5.76 $6.559


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Figure 3: Normalized FCF Calculation.

To find the earnings power of Lorillards business, we discount the normalized free cash flow by an

appropriate cost of capital (For those not familiar Discounted Cash Flow Valuations, Professor Aswath

Damodaran from NYU has a great website devoted to finance and valuations:

http://pages.stern.nyu.edu/~adamodar/). Note that if we were to use the standard investment banking

formula to calculate Lorillards weighted average cost of capital (WACC), we would come up with a

discount rate of approximately 6.0% ( of 0.49, Rf of 3.3%, MRP of 6%, 4.75% after-tax cost of debt, 14%

debt/equity). We believe this is far too low, given the risk embedded in Lorillards business (the risk of

class action lawsuits and additional government regulations come to mind). Instead of discounting witha suspect discount rate, we prefer to look at the valuation over a range of discount rates (see Figure 4).

As can be seen from the table, if Lorillard were able to earn $1.1 BB in free cash flow into perpetuity, we

would consider Lorillard attractively valued at discount rates below 10%.

Figure 4: Calculation of Enterprise Value & Stock Value.

Does this mean Lorillard is undervalued, given the market WACC is 6%, which would imply a value of

$126 on the stock? Not exactly. Recall above, we assumed that free cash flows would be $1.1 BB in

perpetuity. In reality, tobacco is a business in terminal decline. Even if Lorillard is able to gain market

share via its Newport brand of menthol cigarettes, the whole industry is shrinking. For a perpetuity with

negative growth rates, the valuation formula is =

, which effectively increases the discount

rate. Let us assume a terminal growth rate of -2%, this would imply Lorillards value is closer to $95 and

not $126. Moreover, we do not know the impact of the TPSACs recommendations to the FDA. At the

very least, we might expect the FDA to impose tougher regulations on marketing or packaging of

menthol cigarettes. More draconian measures may include changing the formulation (and hence taste)

of menthol cigarettes or an outright ban. Figure 5 looks at the impact to valuation of a 10%, 25% and

75% reduction in the free cash flow.

EBIT 1,788

Tax Rate 37.50%

EBIT (1-T) 1,118

+Depreciation 39

-CapEX (42)

NWC -

Unlevered FCF 1,114

FCF 1,114 WACC Sensitivity

WACC 8% 6% 7% 8% 9% 10%

EV ($MM) 13,926 18,568 15,915 13,926 12,379 11,141

Less: Net Debt (296)

Equity Value 14,222

Shares O/S 149.6

Price 95.06 126.09 108.36 95.06 84.72 76.44


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Figure 5: Sensitivity Of Implied Value To Reduction In Business.

What is the probability of those scenarios? We do not know, but we do know they are not zero. If we

venture forth the probabilities shown in Figure 6, then the expected value falls to approximately $80 for

a miniscule 8% margin of safety. Notice all the adjustments we have made so far have been negative to

value. In fact, we think of Lorillard as having upside of approximately 27% or $95 but with significant

downside that can come from a multitude of factors, ranging from a miscalculation of the discount rate,

a faster decline in the smoking population or tougher than expected government regulations.

Figure 6: Expected Value & Margin Of Safety.

In conclusion, we do not think Lorillard is a good investment despite the attractive 6% dividend yield and

recession-proof business model. In general, we prefer investments in securities with large margins of

safety and more upside risk than downside surprises. We think the relatively small margin of safety does

not adequately compensate us for the large risks that we are taking. (On the other hand, if on March 23,

the TPSAC recommends a complete ban on menthol cigarettes and Lorillards stock price plummets to

$25, we may reconsider our position since at that point, there would be more upside surprises such as a

potentially drawn out implementation process to the complete ban.)

Inflation Does Not Matter...If You Do Not Drive, Eat Or Heat Your Home

We recently read Ben Bernankes speech on economic outlook and macroeconomic policy

(http://www.federalreserve.gov/newsevents/speech/bernanke20110203a.htm ) where he once again

reiterated that overall inflation remains quite low, despite the rapid rise in the price of gasoline and food

prices globally. Central bankers in general like to focus on core inflation, an inflation rate that ignores

90% 70% 25%

EBIT 1,788 1,609 1,252 447

Tax Rate 37.50% 37.50% 37.50% 37.50%

EBIT (1-T) 1,118 1,006 782 279

+Depreciation 39 39 39 39

-CapEX (42) (42) (42) (42)

NWC - - - -Unlevered FCF 1,114 1,002 779 276

FCF 1,114 1,002 779 276

WACC 8% 8% 8% 8%

EV ($MM) 13,926 12,529 9,735 3,449

Less: Net Debt (296) (296) (296) (296)

Equity Value 14,222 12,825 10,031 3,745

Shares O/S 149.6 149.6 149.6 149.6

Price 95.06 85.72 67.05 25.03

Price 95.06 85.72 67.05 25.03

Probability 25% 50% 20% 5%

Expected Value 81.29

Margin of Safety 8%

Current Price 75.00


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volatile items such as food and energy prices. We would like to invite central bankers to return to the

real world where people have to eat, drive and heat their homes.

In fact, we are beginning to think another key risk to the world economy is runaway inflation caused by

the commodity asset bubble inflated by cheap credit. Anecdotal evidence supports our view that

inflation is much higher than the 0.7% core inflation cited by Mr. Bernanke and is a far bigger problemthan many realize:

McDonalds recently announced price increases to some menu items to offset rising input costs

(http://articles.latimes.com/2011/jan/24/business/la-fi-0125-mcdonalds-20110124)

Appliance manufacturers Whirlpool and Electrolux recently announced they would be raising

prices significantly in an effort to offset the rising cost of steel and other inputs

(http://www.reuters.com/article/2011/02/02/us-whirlpool-idUSTRE7112UR20110202 )

The doubling in price of onions in India (a staple in Indian cooking) leading to an onion crisis

(http://www.ft.com/cms/s/0/5ae4ddb0-0dca-11e0-8b53-00144feabdc0.html#axzz1CwUFfddL )

A similar chili crisis in Indonesia (http://www.bloomberg.com/news/2011-02-02/chili-peppers-indicate-inflation-heating-up-commentary-by-william-pesek.html)

And many more...

We think there are serious implications to commodity bubbles and runaway for investors. First of all,

there will be a short-term squeeze on profit margins, as there is usually a lag before businesses can pass

on additional costs to customers. Moreover, rising prices can put a serious crimp on consumer spending

(and hence GDP growth), as consumers are forced to allocate a greater share of their wallet to food and

energy. Finally, in the medium to long-term, there is significant risk from political unrest in emerging

markets (think food riots) and from governments trying to do too much to stamp out inflation (such as

the recently enacted laws in China where retailers must get approval from the government before they

can introduce price increases). Investors beware!

Hilltop Holdings Inc. (HTH-NYSE)

Hilltop Holdings (Disclosure: we own HTH) is a holding company whose main operating asset is NLASCO,

a P&C (property and casualty) insurance holding company. NLASCO is comprised of two insurance

subsidiaries, National Lloyds Insurance Company (NLIC) which primarily underwrites fire and

homeowners insurance to low-value dwellings, and American Summit Insurance Company (ASIC) which

underwrites insurance on manufactured homes.

Prior to entering the insurance business, Hilltop Holdings was formerly known as Affordable Residential

Communities Inc. and primarily engaged in the manufacture, sale and financing of manufactured homes.

In early 2007, Hilltop Holdings, under the direction of newly appoint Chairman Gerald Ford, sold off its

real estate business to hedge fund Farallon Capital Management for $1.8 BB (netting approximately

$550 MM in cash after taxes and debt) to focus on NLASCO, its newly acquired insurance business.

Hilltop also wanted to make further acquisitions with the proceeds of the sale.


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Before we discuss further on why we like Hilltop, we should really make a detour and talk about three

important and related topics:

1. Gerald Ford Gerald J. Ford (not the former President of the United States, Gerald R. Ford), is a

successful billionaire from Texas who made his fortune from buying distressed banking assets,

fixing them up and selling them for substantial profits. He purchased his first bank in 1975 for$1.2 MM and later sold it for an $80 MM profit. He is most famous for acquiring First National

Bank of San Francisco in 1994, merging it with Golden State Bancorp in 1998 and selling it to

Citigroup in 2002 for $5.3 BB, making Gerald Ford a billionaire in the process.

2. P&C Insurance From studying the successes of Warren Buffett and Prem Watsa, we believe

we have a good understanding of the P&C insurance business. Broadly speaking, P&C insurance

companies can be separated into 2 groups: those that focus on market share and those that

focus on profitability. Insurers focusing on market share will aggressively pursue premium

volumes at the expense of underwriting standards, even in soft markets, when pricing is

generally inadequate. While in the short term, they may appear quite profitable (as rising

premium volumes can hide bad underwriting), in the long-run, they usually suffer heavy losses

from negative claims developments. Things to look for include combined ratios consistently

above 100% (meaning their policies are not priced adequately), a history of negative claims

developments (meaning when the claim was initially recorded, the insurer under-reserved for

the claim) and consistently high leverage (measured as premiums written / capital; 2 to 1 is

usually considered the limit, but this metric varies, especially for different kinds of insurance,

i.e., mortgage insurance typically have much lower premiums to capital because the risks are

longer-tailed and potentially larger).

On the other hand, insurers focused on profitability will typically see their premium volumes

stagnate or shrink in a soft market, as they would only underwrite profitable business. For these

insurers, the insurance business is really there to provide an investment float; if the insurer can

underwrite at breakeven or better, then the benefit of the investment portfolio accrue to the

shareholders. The power of this investment float could be quite significant, especially if the

investment portfolio is controlled by a good investor (think Fairfax and Berkshire Hathaway).

3. U.S. banking Although the U.S. banking system is currently in tatters, with banks failing left

right and center, we have to take a longer term view and recognize that this phase is going to

pass. Banks have failed before in the past; most recently in the Savings & Loans Crisis of the

early 1990s (see Figure 7). In a normalized world (Reinhart & Rogoffs research suggests the

average length of recovery from a debt-induced recession is 7 years and we are now in year 3),

banks should earn above 10% ROE (see Figures 7 and 8). At their peaks, banks can also trade

approximately 12 15x their earnings.


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Figure 7: Bank Failures Have Happened In The Past. Source: FDIC, The Aspiring Analyst.

Figure 8: U.S. Banking ROA & ROE. Source: FDIC.

This brings us back to Hilltop Holding and the reasons why we like it. First, we like the $500 MM in net

cash HTH has on its balance sheet (more than $8.80 per share) and the Companys stated goal to make

acquisitions or business combinations. Let us assume that HTH is able to acquire banking assets with a

book value of $500 MM. Further, assume when things normalize, these banking assets will be able to

earn 12% ROE, or $60 MM a year. Finally, assume that these earning will be valued at 12x by the market,

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1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Number of proble m institutions Return on equity (%)


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or $720 MM. That would translate into $12.75 per HTH share in value. This is likely a lower-bound

scenario, as HTH is probably trying to acquire assets below book value and generate above normal

returns on those assets. Given the involvement of Gerald Ford (he has motivation to create shareholder

value since he owns 26% of HTH), what if he can buy good assets at 0.8x book value (there are currently

almost 200 public banks in the US trading at less than 0.8x book value), achieve a 15% ROE and gets a

premium multiple of 15x P/E? That would translate into banking assets worth $1.4 BB, or $25 per share

in 4 to 5 years time.

Certainly, there is upside potential. But we must caution investors that HTH has not yet made an

acquisition. In fact, Hilltops shelf-charter from the U.S. Comptroller of Currency (the regulator)

obtained in 2008, was recently deemed to be outdated and hence HTH is in the process of updating and

re-filing a shelf-charter with no guarantee that the regulator will grant it. But I think the downside to

owning HTH at less than $10.00 per share is limited with $8.80 per share in net cash.

We also think the insurance business itself is undervalued. The current stock price implies that NLASCO

is worth approximately $1.00 - $1.20 per share, or $60 - $70 MM. This is an insurance company withstatutory capital (shareholders equity) of almost $120 MM, so the value ascribed to the insurer is 0.5

0.6x BV. Moreover, if you dig into the details, you would find that the insurance company has been

underwriting at a breakeven pace or better (97.6% combined ratio in 9 months to September and 96.8%

combined in 2010), with generally positive claims development in both NLIC and ASIC (look at claims

triangles in the 10-K). With premiums written to capital ratio of 1.1, the firm also has significant capacity

to write more business when P&C insurance markets eventually harden (when capital leaves the

industry and pricing improves). In a normalized cycle, insurance companies by themselves can trade up

to 1.5 1.75x BV, ($180 MM to $210 MM) or $3.20 to $3.70 per HTH share.

In summary, we like the fact that investors seem to fear the worst for HTH, ascribing book value to the

cash on hand and seriously discounting the value of the insurance business. We believe HTH has

significant asset value, with an undervalued insurance subsidiary worth up to $3.50 a share and the

potential to deploy its net cash into banking assets worth $12.75 to upwards of $20.00 a share. The

downside is that the insurance company remains profitable, but HTH experiences consolidated losses

from paying interest on its $130 MM in debt and fails to find a suitable acquisition. This would lead to

the stock being range-bound between $9.00 and $10.00. In our view, the risks are mostly to the upside,

for example, any progress on the acquisition front or improvements in insurance markets would boost

HTHs valuation significantly.

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your

own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management

of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for

any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its

accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about

the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct

or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial

advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and

strategies mentioned in this blog or its accompanying letters.

Documents

TAA Vol. 1 Iss. 2 - Earnings Power, Margin of Safety and Asset Value