Tuesday, March 30, 2010

Pantry Gets a Heads-Up from the Globe

The Pantry just received a mention in a blog that is part of Toronto's Globe and Mail, essentially Canada's version of the Wall Street Journal.

The article, On the Hunt for 'the king of value factors' highlights price to sale ratios. At the top of the list is The Pantry.

Just a word about price to sales ratios. Be careful in using them. A company with very poor profitability but big time sales will appear attractive on these screens. If they can develop some operating margins that are respectable, then these companies can be huge winners. But if they can't, they merely churn through sales dollars without adding much value for shareholders.

Monday, March 29, 2010

Is "The Pantry" Bare?-Piotroski Says No

"You can't buy what is popular and do well" is one of the great Warren Buffett quotes. Though over time, I have learned to be far more comfortable investing in quality businesses that throw off lots of free cash flow and earn superior returns on invested capital, many value investors start their search for cheap stocks with the new low list and those that are making news headlines that portray disappointment. Contrarianism does work, as Buffett says, there are many ways to get to "financial" heaven. As is obvious, the real challenge for us as investors is separating those businesses that have been unfairly beaten down because of Street overreaction from those that truly deserve to be disregarded and ignored. "Moribund and poorly run businesses deserve to languish" as the great mutual fund investor, John Neff once described.

So how do you separate these businesses? For many years, academics focused on low price to book value companies (or put another way, high book to market companies) as a place to seek superior returns. As it turns out, these companies demonstrated an anomaly to the prevailing capital assets pricing theory. Subsequent analysis showed that a low price to book value ratio implies that prices contain expectations of low ROE expectations. Such companies, at current prices are generally expected by the consensus to be poor performers and therefore considered risky.

In a Seeking Alpha article earlier this year, John Reese of Validea highlighted an enhancement of this value investing screening technique developed by Joseph Piotroski of the University of Chicago. These refinements focused on generation of operating cash flow (as opposed to earnings), improvements in liquidity or leverage, as well as some signs of improving profitability and turnover. As John described it earlier:

Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. I've listed the 10 criteria below.

  • Book/market ratio
  • Return on assets
  • Change in return on assets
  • Cash flow from operations
  • Cash compared to net income
  • Change in long-term debt/assets
  • Change in current ratio
  • Change in shares outstanding
  • Change in gross margin
  • Change in asset turnover

In essence, this is contrarian investing with a wrinkle, some sign of internal improvement, cheap but with some light at the end of the tunnel. Rather than seeking excellence, Piotroski looks for encouragement. Most investors tend to "over-extrapolate" past performance trends, as I like to say, extrapolate short term trends into the hereafter. Overly pessimistic extrapolations do tend to reverse as the reality of changing actual earnings hit the tape. Ditto for those companies with a positive bandwagon…overly optimistic extrapolations reverse as well.

Having done some recent work on retailing (Tiffany's Valuation Looks Too Rich), I thought it may be of interest to look at a retailer at the other end of the spectrum, one that was bumping its bottom in the new low list, and with apparently few friends, The Pantry Inc (PTRY) .

The Pantry operates a convenience store chain in the southeastern United States. Its merchandise products include tobacco products, packaged beverages, beer and wine, general merchandise, health and beauty care products, self-service fast foods and the usual snack and grocery items. As of December 2009, it operated 1,668 convenience stores in 11 states primarily under the banner, "Kangaroo Express."

Like most convenience chains, gasoline and fuel sales drive overall sales but contribute significantly less to gross profits (data per Gridstone Research)

Pantry Inc







Gasoline Sales







COGS Gasoline






Gross Profit -Gasoline













Merch Sales













Gross Profit-Merch













Gasoline as % of Total Sales






Gasoline as % of Total Gross Profits






In terms of some ratio analysis (again, per Gridstone), here is how the business has developed:

FYE Sep-05

FYE Sep-06

FYE Sep-07

FYE Sep-08

FYE Sep-09

[ST] Gross margin






[ST] Operating margin












[ST] EBIT margin












[ST] EBITDA margin












[ST] EBITDA margin (TTM)






[ST] Pretax margin






[ST] Net margin






[ST] Effective tax rate






[ST] Return on equity






[ST] Return on assets






[ST] Return on invested capital






[ST] Net operating profit after tax






[ST] Cash flow from operations to Sales






Obviously, this is a business whose metrics are far less appealing at first brush to most investors having just salivated at the metrics of high end retailing.

Yet, there is some evidence of improvement in operating margins, in returns on assets and equity, and invested capital.

There are certainly some issues here that are disturbing, a lot of debt, for example, with $1.67 billion in total liabilities versus $440 million in equity. Interest coverage is about 2.7 times. Leverage has often been high in this consolidating industry, and in particular at PTRY where some heavy acquisition years of 2006-2007 impacted the balance sheet. Given the significant assets here and the relatively low equity base, the hunter may well turn into the "hunted."

Standard and Poors recently affirmed its corporate credit rating announcement of The Pantry as a "B+" and noted:

"Credit measures deteriorated, with total debt to EBITDA at 6.6x compared with 4.9x one year ago. Although we expect some improvement in fuel and merchandise margin through 2010, credit measures are not likely to improve to levels needed to support a higher rating. We revised our rating outlook to stable from positive, and affirmed our 'B+' corporate credit rating on Pantry Inc."

Of note, there is $180 million in cash on hand as compared to a market cap of only $278 million as well as availability of an additional $142 million through its revolver. The next tranche of debt that comes due is convertible debt due in November of 2012.

Book value is about $19.50, most of which consists of goodwill, hence, at current market prices, PTRY trades at about 60% of book, certainly "qualifying" it for Piotroski's scrutiny. Five years ago, this stock sold at almost four times book value at a time when ROE was near 30% and ROA was about 6%. These metrics seem impossible now.

Taking a somewhat more recent perspective, consensus earnings are now around the $1.27 area having dropped down from $1.66 some nine months ago. Certainly this represents a different trajectory for expectations than most retailers have had in the same period. Sales per share is enormous at over $300 per share…there is tremendous operating leverage…both ways primarily because of gasoline sales. Even looking at just the non-gasoline sales, these represent over $80 per share in sales.

Though not a perfect demonstration of Piotroski's criteria, (shares outstanding have increased YOY and asset turnover has yet to show improvement) most of the other parameters have been met.

Though not a name I would want to stake my retirement assets in, I think The Pantry is a worthwhile speculation at current levels. High risk but potentially high reward.

Please find an investor presentation by The Pantry management at the Bank of America Merril Lynch Consumer Conference of March 10th, 2010.

Disclaimer: I, my family and clients do not currently own a position in PTRY.

Tuesday, March 23, 2010

Tiffany & Co-Valuation Seems Generous to Me

On Monday, Tiffany & Co reported what seemed to be somewhat disappointing earnings of $1.09 versus a street consensus of $1.13. TIF actually has had a fairly good history of positive earnings surprises in recent quarters (data courtesy of Reuters):

Quarter Ending

Percentage Surprise


- 3.63%






+ 0.42


+ 6.61








+ 5.09

As you can see, the negative surprise was not hugely negative either. What went right and what went wrong?

The fourth quarter was actually surprisingly strong on a sales basis. The breakdown by geographic segment looks strong across the board for the fourth quarter:

For the Americas:

+14% versus a drop of 29% the previous year

For the US+12% versus a drop of 33% the previous year

For Asia Pacific:

Sales were also strong throughout with exception of Japan, rising 14% in dollar terms. Outside Japan, sales were robust at +38% in constant currency. Japanese sales in the fourth quarter were down 9% in constant currency.

For Europe:

Particularly strong sales here +18% on a constant currency basis.

Tiffany was quite defensive through 2009, reducing headcount by 900 people and opening only 10 stores, taking capex down to $75 million from a more normal level of about $200 million. Ex one time items, it appears that SG&A positively leveraged by 140 basis points in the quarter to 35.7%. However, the dollar amount of SG&A was increased by 12.7%, as the company indicated, largely tied to incentive compensation. Strong cuts through through the year seem to have come somewhat unglued in the fourth quarter due to incentive payments.

Given a fairly aggressive plan for new store additions (adding 17 stores) and increased marketing spend, management is guiding for 10% SG&A growth in 2010. With marketing growing faster than sales, TIF is going for market share, perhaps not an unwise strategy when small independent competitors may be having difficulty securing financing for their expensive inventory.

Nevertheless, incentive compensation seems to be driving SG&A growth at Tiffany and I wonder about how well this will leverage into earnings per share. Consensus earnings per share estimates for Jan 2011 are already at $2.47 up 21.0 % from this year's $2.04. It is interesting to note that earnings estimates for the upcoming year were $2.01 just six months ago.

I have provided a spreadsheet compiled from Gridstone Research analysis at the following link:


As the analysis indicates, return on equity has gone up to 15.3% from 13.5% in 2007 largely due to the use of higher financial leverage. Tiffany has purchased over $1 billion in common stock in the last three years (generally at higher prices than current.) About $400 million in new long term debt was issued last year. Asset turnover and operating margins worsened over this period.

Considering other benchmarks for management's performance, the return on invested capital remains lackluster despite what seemed to be a reasonable year. ROIC was 12.2% up from last year's 10.7% but not up to the 2008 and 2009 levels of 12.7% and 15.9%.

EBITDA margins have fallen to 16.3% in 2010 down significantly from last year. Surprising! Capital intensity (the amount of capital it takes to generate sales) has also moved up slightly from prior years. As well, one of the most important missions for a retailer is working capital management. In the quarter, strong inventory controls were very evident with inventory falling 10.8% versus last year relative to the 17% revenue gain. Yet, working capital management turnover was 1.65 times for 2010 down from levels generally better than 2 times in the past.

Tiffany at 19.3 times forward estimates which presume 21% growth seems expensive to me.

Disclaimer: Neither I, my family or clients have a current position in Tiffany.

Sunday, March 21, 2010

Traits of the Successful Investor and the Changing Nature of Brand Loyalty

The year 2010 seems to be progressing as a positive experience following the shaky start in January. The subsequent rally that has transpired since that time has caught many people flat-footed, but that is the price of erratic trading. Most of us are bombarded with an onslaught of noise portraying itself as information. We are encouraged to make massive shifts from sector to sector, from stock to stock, even from currency to currency. Our exposure to information and communication technology in real time has advanced well beyond the advancement in our human judgment for most of us.

I think successful investors accept the rapid pace of trading with a great deal of humility. Many of our worst problems in investing stem from the hubris of imagining, if not actually believing that we are that super-brain that can predict short term fluctuations in the market. Most successful investors approach the market with a great deal of humility and a fundamental understanding that the short term is incredibly random. How many six sigma events do we need to endure in a decade to understand that the market can fluctuate completely unexpectedly? Expecting to catch every short term ripple can only lead to frustration and discouragement.

In order to profit from the market, we simply must be there at those times when the probabilities of success are on our side. Though having an eye for value is a key attribute of success, there are many places where investors gain an edge.

Cheapness, in and of itself is not a sufficient condition for investing. Think of the disastrous results of many value investors in the last couple of years who bought book value “bargains” in the financial services sector. I think great investors are extremely conscious of the quality of balance sheets, both from the quality of the asset side as well as the nature of the liabilities and especially the off-balance sheet liabilities. How often have I been approached by a young analyst who insisted that some retailer was debt-free without regard for its heavy schedule of operating leases? How often do we forget the impact of assumptions in the pension plan liability or the retirement health care benefits? How little attention or regard did some analysts have for the obligations of banks as issuers of securitized assets? The truly great investors recognize "iceberg" risk, that is, those risks that are not obvious to initial scrutiny but lie beneath the surface. Understanding these sorts of obligations, such as the domino impact of a drop in credit rating on securitization differentiated the most successful investors in financial services from the book value bargain shoppers.

Great investors have a strange capacity to suffer. And the best returns develop from those times when you suffer the most. There is rarely a bell-ringing moment that tells you are looking at a bottom. Fight the complacency that we succumb to in bear markets, that feeling of why bothering to do anything, because next month the price will probably be cheaper. Whether it is dollar-cost averaging in getting a lower basis cost for a position, or just a commitment to maintain equity weighting at a higher than average level when bargains seem to abound, great investors have an ability to drage their guts through the gravel and maintain commitment to an investment plan regardless of the popular "wisdom."

In strong markets, stay disciplined and don’t try to be too creative. Unusual takeover activity in a sector should encourage you to sell investments in that sector rather than seek “the next target.” We were fortunate to have a position in Pall Corp (PLL) which reacted strongly to the announcement of the Millipore (MIL) takeover. Pall hit our target price and in our determination was fully valued unless some strategic buyer chose to pay the same sort of multiple as Millipore enjoyed. Possible, but I choose not to roll the dice and play a game of hope. Pall is sold and gone from our portfolios. Maybe I’ll look stupid in the coming weeks, a chance I am willing to take. A corollary of risk control is always leaving something on the table, both at the bottom and the top.

Taking a bit of a 30,000 foot view, what is the source of a successful investor’s edge? Can this apply to the average “home-gamer” as Cramer refers to the retail investor? I divide edges into four types:

Informational Edge- Do you have information that nobody else has? As a rule of thumb, having insider information and acting on it will get you into prison. Rule FD leveled the playing field so that analysts with long standing relationships (but not ethics abiding CFAs) could not receive special insight. Information had to be disseminated democratically.

Analytical Edge- I view this as coming to a different conclusion than the consensus viewpoint based on the information that is there. For example, John A. Paulson made a fortune in betting against residential real estate and the mortgage markets based on his understanding of the sub-prime markets and the exposure of various banks to this market. Sometimes an analytical edge can be garnered by using the same inputs everyone else has but weighting them differently. For example, a great business run by capable managers may extend its franchise to other geographies where markets are under-penetrated. This incremental growth might not be priced into the current price of the stock. A problem subdivision which represents a sideshow or a distraction, at worst a short term problem can become an overwhelming distraction for Wall Street and hence, most investors.

Behavioral Edge- As Buffett described it, be fearful when others are greedy and greedy when others are fearful. This is an incredibly difficult attribute to develop because for most of us, we are falsely comforted by a consensus viewpoint. We often ask for advice from people who will affirm our own views. The frenetic investment in bond funds last year seemed to be more of a movement to avoid the pain of stocks rather than an endorsement of the fixed income markets. Another example, Administaff (ASF) announced a dreadful fourth quarter on February 11 which clocked the stock from $23 to $16 and change in the next two days. It appears at least superficially to be based on a non-recurring one-time issue. In decent times this has been a mid 20’s return on invested capital, but in two days, almost 30% of the company’s shares outstanding traded hands, dismissing the past entirely. Currently, the stock is back to level of $21 plus once again. An important part of the behavioral edge is the ability to actually execute, not merely to theorize and wait. When the "fat pitch" crosses the plate, be sure you are ready to swing for it. If it ain’t on the tape, it ain’t in the portfolio and no one has gotten rich on paper profits.

Time Horizon Edge- Having the ability to take a longer term perspective, having the comfort of waiting for the fat pitch, having the ability to avoid the misinformation is another important edge that some value investors enjoy. Great ideas deserve a disproportionate part of your capital, but make sure you are safe. Too short a time horizon and you’re in danger of not letting your thesis unfold. But look at and stress test your portfolio all the time. Being married to too big a view can be dangerous however. Being too dogmatic and inflexible can be dangerous. For example, one of my former partners was married to a view that the S&P 500 could not possibly trade at more than twice book value because historically this represented dangerous ground. Needless to say, as share buybacks became prevalent, and write-downs eroded the value of equity, his dogma became nonsensical.

Though it is difficult for the average retail investor to develop an informational edge, I believe that it is certainly feasible for this person to develop and utilize any of the others. It is vital to develop this edge in my view. If you approach the markets without a model or a philosophy, your odds of being doomed are very high. If you don’t have a framework anchored on objective measurements (in other words not just a gut feel) you will be ground down by the uncertainty of markets. As individuals, it is tough but not impossible…we are neurologically not wired to make rational decisions, with emotional decisions anchored in animalistic “fight or flight” wiring. If you think like an owner, you will remember that the investment is locked up in the business rather than the stock price.

Someone once said that successful portfolio management was a little like taking friends and family out on a fishing boat. The paramount responsibility is everyone’s safety. Cluttering and overloading the boat is a dangerous practice in boating just as it is in portfolio management. Heading out into an oncoming storm can be disastrous for the boater and investor alike but storms pass and smooth sailing will follow.

I have been giving a lot of thought to Berkshire Hathaway as the annual meeting approaches. Buffett’s annual letter reads like a value investing primer, much of which is knowledge that has already been presented in prior letters. Buffett's investment approach over these many years has evolved from Graham and Dodd net working capital exercises to the purchase of incontrovertible brand name franchises that have long periods of competitive advantage. I think the last few years of investment involve some new thinking and a different perspective: especially the regulated utilities and Burlington Northern investments , and how it seems that Buffett is showing less and less interest in brands. I sense some changes in brand loyalty are occurring. Is this driving Buffett's seeming lack of interest in buying additional brands? Why is this?

The common ground for consumer brands and his forays into the railroad and utility worlds is recurring revenue. Though cyclicality is present in every aspect of business, it strikes me that over the long run, all of these chosen industries enjoy a competitive advantage. Certainly rails and utilities are unlikely to be displaced by substitutes and the amount of capital for a new entrant to achieve share is enormous. But are brands becoming less valuable over time?

It seems that a number of factors have proliferated which have governed brand loyalty are getting more difficult to attain. These new, and developing, challenges include:
  1. The recession has caused a significant and perhaps more than a temporary change in shoppers’ behavior. The consumer seems to be making her choices using different criteria than in the past. Though recently, we seem to be going through a period of frugality fatigue as shoppers have perhaps started to step up slightly from the bargain counter, it seems that for many of us, the need to cope with less discretionary spending is putting many brands through an ongoing review, scrutiny and re-evaluation.
  2. Consumers seem to be more willing than ever to try new brands. This movement toward experimentation seems to have diminished historical fierce brand loyalty and has encouraged switching between brands. Some people refer to this as brand promiscuity.
  3. Private labels are starting to emerge as brands in their own right, and offer a strong incentive to switch to a retailer’s products. Some years ago, President's Choice became a branded generic product (in Canada as well as migrating into the States) that achieved favor through offering consistently high quality than what consumers expected. The strategy for competing against a retailer controlled brand (especially with Wal-Mart and Target) is likely quite different from competing against other national brands. Target has been especially successful in developing identifiable women’s brands that offer style at a reasonable price.
  4. Are brand lives shortening? Is the consumer’s tolerance for quality mistakes dropping? It seems that consumer expectations of their branded products have risen. It is not just a matter of quality or value that today’s consumer expects; how does the brand resonate with the consumer in terms of its reputation? What is the corporate ethic of the company behind the brand? As we look at Toyota, some would argue that the brand has been diminished by the reduced quality perception of cars out of control. Yet, on the other hand, no other auto manufacturer has ever shut down production in order to search for an answer to an engineering problem. All these factors mean that it is easier for a brand not to deliver against consumer expectations. Our expectations are higher, and ergo so must the brand’s standards improve. Brands which do not continually improve their standards will be dropped. Consequently, brand lives may be shortening and importantly, the spending to support a brand may be increasing.
  5. Brand image is no longer passed around by word-of-mouth or by traditional advertising. Twitter, Facebook, and social media is changing the brand management landscape. Good experiences as well as bad experiences impact reputation quickly by virtue of social media.

Don’t get me wrong. Traditional brands still are worth a great deal. A look at Nike’s (NKE) results the other night are telling. Great numbers, better than expected, great brand, lots of momentum. But SG&A was 33.0% as compared to the previous year’s 30.4%. Sales were up 6.6%, so there was no leverage in the SG&A line. Nike is still a great brand, largely because it carries a lifestyle image to its consumers. In short, Nike is cool! Proctor and Gamble (PG), the quintessential consumer brand company reported in February that fourth quarter sales had grown 5% in line with revenues, but SG&A was up 170 basis points. Again, no sales leverage in SG&A. I suspect that care and feeding of brand companies will continue to require more upkeep (= dollars) and consume more margins over time.

Perhaps the paragon of today’s brand is Apple (AAPL). In early days of cell phones, brand loyalty was essentially non-existent. Before the iPhone, loyalty was low for both handset manufacturers and for network providers. In the past, consumers often switched handsets repeatedly, and often tried handsets from a variety of different manufacturers as a result. Before the iPhone, cell phones were very much commodity items, competing on price largely based on the number of functions that were offered. Reliability was not a particularly relevant consideration since phones came and went based on the length of the network’s contract. Nokia (NOK) had some edge and loyalty largely because of functionality considerations, not because Nokia was a “lifestyle brand” which helped consumers have more fun from their phones. Networks were a very secondary consideration for most of us who stayed within close geographic proximity. In fact, networks were often viewed negatively as the high cost, recurring part of cell phone ownership with not especially reliable functionality.

The tons of apps that are offered for the iPhone have changed everything. Consumers accessed a highly functional service which is both fun, allowing them to use the products in new ways (remote access to turning off the lights at home) and all sorts of practical and not so practical experiences. Powerful stuff!

Even more powerful is Apple has captured the heart and soul of its consumer by engaging with him/her. Ongoing development of apps (generally by someone other than Apple) increases its interaction with the consumer and modifies and improves the brand with every interaction. For most products, our interaction is established at time of purchase, but with Apple, the interaction is not limited to the retailer, the manufacturer can still build an ongoing relationship with the customer for more than simply providing information (or doing recalls!).

So it seems that brand loyalty in the future will be derived largely by the post-purchase interaction. This is quite different than the traditional consumer brand development of “new and improved.” Social media ensures that the consumers’ views and experiences will be monitored by all of us, and especially the owner of the brand. Online transparency will force brands to ensure that their credentials stand up to scrutiny.

Social media opens up a two-way communication with the consumer…the basis for post-purchase engagement. This means that transparency is a key watchword for brands when developing post-consumer engagement – by inviting consumers to be more involved with your brand they are likely to take a longer, deeper scrutiny of what the brand is doing and what it represents.

Brand loyalty is still something to look for in investments. However, both capturing it and maintaining it has become a new discipline. However, many brands with a long heritage and consumer trust have survived the recession better than middle brands, and have invested to ensure that they come out of this period in a stronger position to continue growing. But just as the consumer is constantly assessing and re-evaluating these brands, so must we as investors.

Disclaimer: I, my family, and or clients have equity or fixed income positions in Berkshire Hathaway, Apple, Nokia, and Toyota.

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