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An opportunity in platinum

15 Apr 2013 by Jim Fickett.

Last December I posted a rather lengthy analysis of the platinum market, and came to the conclusion that the price then, in the neighborhood of $1600, was probably on the low side, given that mining costs have increased significantly in recent years (Platinum mining costs are likely to drive the long-term price moderately higher).

Over the last three years platinum has traded in the range from about $1400 to about $1800. So the $1600 price last December was about in the middle of the range. I made up my mind at that time that if platinum went back down to the bottom of the range, I would buy. Today the price went to $1395.

With the price staying mostly below the long-term cost of production lately, one would expect mine closures. This is, in fact, exactly what is happening. From Bloomberg in February:

Platinum supplies are falling to a 13-year low as mines in South Africa, the world’s biggest producer, close and automobile sales reach new highs.

Production will drop 2.7 percent to 5.68 million ounces, the least since 2000, according to Barclays Plc, which raised its 2013 shortage estimate sixfold last month after Johannesburg-based Anglo American Platinum Ltd. (AMS) said it plans to idle shafts. At the same time, demand from carmakers, the biggest consumer of the metal, will increase 0.5 percent in 2013, Barclays says. …

Global production of the metal will fall as South African output drops 3.4 percent to a 12-year low of 4.11 million ounces, Barclays estimates. There was a 394,000-ounce shortage last year as Impala Platinum Holdings Ltd. (IMP) shut its Rustenburg mine, the world’s biggest, and police killed workers striking over pay at Lonmin Plc (LMI)’s Marikana complex.

South African producers closed nine platinum-mine shafts and dismissed 3,332 workers in the second half of 2012, the Department of Mineral Resources says. Amplats, as the top producer is known, said Jan. 15 it would idle four shafts and cut 400,000 ounces of platinum output a year, about 7 percent of global production, to restore profitability.

I don't think one should take any precise predictions of shortages too seriously – no one can predict the course of the recession in Europe or growth in China. The main point I want to make by quoting this analysis is that, as expected, mining companies cannot make money at the current price. Therefore, in the long run, the price is very likely to rise.

If the opening price on Tuesday is still in the neighborhood of $1400, I will put another 2% of the portfolio in platinum. Since commodities are, in my overall strategy, in part protection against possible high inflation, I will make the purchase within an IRA (so as not to be taxed on illusory nominal gains), using the ETF ETFS Physical Platinum Shares, with symbol PPLT. Shares in this ETF are backed by 600 thousand ounces of physical platinum stored in vaults.

Writing about this ETF, Zacks Equity Research said in March,

heading into 2013, the outlook for platinum prices appears much better. The reason is that the metal is going through a supply deficit attributable to the labor dispute in South Africa and other factors in this important producing nation which makes running many mines unprofitable …

investors looking to capitalize on the outperformance of the metal can consider investing in Zacks top ranked ETFS Physical Platinum Shares ETF (PPLT). …

PPLT is the only ETF which is backed by the physical metal and holds the metal in the form of bullion or ingots. The metal is securely stored in London and Zürich on behalf of the custodian, JP Morgan Chase Bank.

Investing in platinum through PPLT represents a cost-effective and suitable mode for investors. It is expected that the transaction costs for buying and selling the shares will be lower than purchasing, storing and insuring physical platinum for most investors …

PPLT is by far the most liquid option available in the platinum ETF investing world, trading with volumes of 75,100 a day. The fund trades with assets under management of $842.6 million.

The expense ratio of 0.60 basis points also appears to be much lower than other ETFs in the space despite the relatively greater costs associated with physically storing the metal.

Holding on to Exelon

31 Mar 2013 by Jim Fickett.

Government subsidies for wind are causing a problem for some Exelon power plants, but the problem is not a major one for the company as a whole. Checking up on a previous concern, the retirement plan is expensive but also not a major problem. Valuation overall is reasonable at the current price, and I still expect a recovery in gas prices to help the company, and the mood of investors, so I will continue to hold.

The wind subsidy

In a recent post (Negative electricity prices) I described how government subsidies allow wind farms to operate at a profit even when there is no demand, leading at times to negative wholesale prices for electricity. Naturally, baseload generators like Exelon are not happy with this situation. Since one cannot easily shut down and restart a nuclear power plant in short order, Exelon ends up paying the grid to accept its electricity, at least at some times and in some places:

[Exelon]'s Byron nuclear plant in Illinois, [Exelon Corp. Chief Executive Christopher Crane] said, is in a negative pricing scenario 16 percent of the time.

How widespread is this problem? It is hard to tell, as Exelon does not provide any more detail than is in brief quotes in news articles. However there are good reasons to think that cheap natural gas, rather than wind, remains Exelon's central problem. Although in a few locations wind power is a substantial fraction of the market, in the country overall wind only provides 3% of the power, while natural gas provides about 30%. And since Exelon sells power in 31 states, it seems likely that their market overall resembles the national market fairly closely.

This view is supported by the tenor of the 2012 annual report, recent presentations, and the transcript of the most recent earnings call, which all emphasize cheap natural gas as the main challenge, and which project gradually rising electricity prices over the next few years.

Overall I think that in the next couple years, as the natural gas market hopefully normalizes, Exelon will be helped. Over the next decade or two, the wind subsidies are an issue that could grow, and should be watched closely.

Of course all utilities, not just Exelon, are strongly affected by regulation and environmental law, and a major part of the business is managing regulatory/legal risk, and keeping a good relationship with lawmakers. Exelon has so far done this job dependably well, and is currently fighting to prevent uncompetitive bidding in wholesale markets.

The retirement plan

When I bought Exelon stock in 2010 (Exelon: a dividend stock with some risk but likely capital appreciation), I argued that the company needed to be contributing more to the retirement plans. In 2010 and 2011 the company did some catching up, making contributions of over $3 billion. The unfunded obligation (i.e. the current actuarial obligation minus the current value of assets), measured as a fraction of revenue (to account for the company growing), is now back to almost exactly its long-term average. Exelon, unlike most governments and some companies, is dealing with this obligation, and not allowing it to get out of hand.

Valuation

It is never completely straightforward to calculate a realistic price/earnings ratio. Here I look at three variations, looking at both net income and free cash flow.

  1. The most pessimistic variant is to look at the most inclusive free cash flow calculation, including all acquisitions in capital expenditures. With this calculation, the average free cash flow over the last 12 years is $1.45 bn. With a market capitalization of $29.48bn, this gives a P/FCF of about 20.
  2. Average net income over the last 12 years is $1.88bn. This gives a P/E of about 16.
  3. In attempting to calculate a value for P/FCF, one should really only look at capital expenditures that maintain the operating condition of the company. This is hard to do; one approximation is to add back to free cash flow any increases in the book value of the company. Over the last 12 years, book value increased, on average, $1.21bn/yr. Using, then, $1.45bn + $1.21bn for an estimate of maintenance-level free cash flow gives a P/FCF of about 11.

Given that significant investment did go to growing the company, the very conservative P/FCF of 20 is definitely too high. Given the extent to which either net income or book value can fail to reflect reality, it is hard to tell whether the P/E of 16 or the P/FCF of 11 is closer to the truth. Overall I would say that Exelon is probably not far from fair value currently. This is in contrast to most dividend stocks, which are currently popular and somewhat overvalued.

Dividend

If you look at some general resources for stock information, you will see a very high, and misleading, dividend yield for Exelon. The company has announced that the dividend will be reduced to conserve cash. The yield with the current stock price and the new dividend is 3.6% – still quite healthy.

The average “true” (counting only required capex) free cash flow over the last twelve years was, as outlined above, somewhere in the range $1.45bn to $2.66bn. The average dividend over the last 12 years was $1.09bn. So historically the company has kept the dividend to a sustainable level (sometimes by lowering it). Reducing the dividend is quite unpopular, of course, and Exelon went to considerable trouble to try to make sure the new dividend is low enough that it will not have to be lowered again – a number of very negative scenarios were projected forward, and a dividend level chosen that was affordable in all of them. Probably the current dividend is quite safe.

Conclusion

Over the next few years, I think the natural gas price will rise before financial repression ends, implying that Exelon is more likely to become overvalued, medium-term, than undervalued. So I will continue to hold. And, in case I'm wrong, on the whole I think Exelon is a well run company, and one I wouldn't mind holding long term.

Holding on to Best Buy

20 Mar 2013 by Jim Fickett.

I bought Best Buy at an average price of about $16/share. Today the stock closed at about $23. It is tempting to sell, but I think the stock is still very likely undervalued, and I will hold.

I first bought stock in Best Buy (BBY) on 9 Oct 2012, at $17.84 (Best Buy is very likely undervalued), and then again on 30 Oct 2012, at $15.21 (Best Buy got even cheaper last week). Today BBY closed at $23.07, giving me a paper gain of almost 40%. It is certainly tempting to realize that gain, but I will make two arguments that the stock remains undervalued.

First look at the long-term history of free cash flow, updated to reflect fiscal 2013:

Free cash flow is highly variable, and we need to take a long-term average to get some idea of a sustainable rate. The company grew pretty steadily over the period shown, and early dates are not representative because revenues were so much lower. It was nine years ago that the company first reached revenues one half of today's, so at least on the same scale. The average free cash flow over the last nine years was about $830 million, which at today's market cap of $7,800 million gives a price/fcf of about 9, which is cheap, or, equivalently, a free cash flow yield of 10.6%, which is impressively high.

Of course one has to ask whether the company can maintain its long-term average free cash flow. Both revenue and market share have been fairly steady over the last few years, so there is no reason to expect the company to shrink. It is possible that the bricks and mortar business will shrink, but Best Buy has hired new leadership that understands on-line sales, which are growing rapidly.

The big question is margins. Could it be that competition in the on-line world will drive down margins and reduce profits? Here is the history of free cash flow as a percentage of revenue:

Again, this number is highly variable, but looking at the variable numbers in relation to the long-term average rate (2.15%), there is no evidence that the rate is in a declining trend. The company is undergoing big changes right now, and no one can predict with any certainty how it will all turn out. But Best Buy has a long history of adapting to a changing world and producing healthy profits. It seems quite likely that their overwhelming advantage of scale over most competitors, together with a smart strategy of undoing recent mistakes (too many stores, not enough work on the web site) will pull the company through again. If so, then 2.15% of current revenues, which works out to $1067 million, might be a reasonable guide to free cash flow going forward. That gives a price/fcf of only about 7.

Of course if you think Amazon is going to kill all physical stores, none of this analysis matters. I've given my arguments before (see links in the posts already mentioned); I doubt very much that Amazon is going to significantly reduce Best Buy's market share. So I think Best Buy is a strong business and that future free cash flows will be generous to those buying at the current price.

Incidentally, at the current price the dividend yield is 3.1%.

J&J is now too expensive

9 Mar 2013 by Jim Fickett.

J&J is priced for continued high growth, but a long trend in rising profits has been broken, and there is little evidence that strong growth will come soon. I will probably sell on Monday, with a capital gain of about 30%.

There was more news today about J&J's defective products (Damages awarded in J&J's DePuy hip implant case), which caused me to do a quick checkup. The long trend of increasing earnings was broken in 2011, and 2012 does not look much better:

The big dip in free cash flow in 2006 was due to the acquisition of Pfizer consumer healthcare; otherwise free cash flow confirms the net income numbers. Over the last 6 years, after the large acquisition, net income averaged $11.6bn, and free cash flow averaged $10.2bn. That gives a P/E of about 19 and a P/FCF of about 21.

That is quite expensive, and the current price only makes sense if you believe the company will continue to grow strongly in the future. Maybe it will, maybe it won't. Considering that (1) Europe is in recession, the US might or might not be in a stall, and China and Brazil are running on fumes, and (2) the company is paying now for the poor quality control of past years, I don't think strong growth in the next few years is even likely, much less a good bet.

So the price looks very high to me and, unless something surprising happens in the interim, I will sell on Monday. I bought at about $60, and the closing price on Friday was $78. So in addition to the healthy dividend, I am currently sitting on a capital gain of about 30%. Maybe I'm missing out on a further rise, but that is an ok profit to my way of thinking.

Encana checkup

28 Dec 2012 by Jim Fickett.

Encana scraped through 2011, keeping reserves and production approximately constant while also keeping free cash flow (barely) positive. This was accomplished by a (continuing) strategy of selling some assets and partly funding development through joint ventures. It remains the case that the market values Encana's proved reserves at just the value of the sunk capital costs, and values the resources beyond that, which include much that is of comparable quality to proved reserves, as worth nothing. The wait has already been long, but this undervaluation will change.

This post brings some past analysis up to date with more recent data, and addresses some general concerns about the gas industry. All data not otherwise attributed in this post is from the company website.

Strategic adjustment to current conditions has been reasonable

The slump hit Encana at a bad time. They were in the process of ramping up production when it became unprofitable to produce at all. And they let all the oil assets go to Cenovus in a company split, just before all the gas companies began to emphasize liquids production to keep revenues going. But their balance sheet was reasonably strong, and they have adjusted their strategy in a reasonable way.

Their current strategy (based in part on the latest earnings call) is:

  • Keep the machine going so as to be ready for better times. Reserves and production were more or less level from 2010 to 2011. In 2012 they shut in production for part of the summer, but started it up again when demand began to pick up in the fall.
  • Fund capital expenditures from cash flow, not new borrowing. This has been possible by doing some joint ventures and selling some assets.
  • Ramp up liquids. This is difficult for Encana because of the Cenovus split, but they are making progress. In 2012 liquids are estimated to be about 7% of production (by heat value; more by revenue), and they may come close to doubling that in 2013.

Despite some criticism of the sector, Encana's reserve estimates are solid

Arthur Berman, an engineering consultant and general skeptic of the shale gas revolution, suggested in a 2011 presentation that many gas companies had taken advantage of a 2009 rule change by the SEC to increase their reliance on undeveloped reserves. That is, their reserve quality had gone down, starting in 2010, because they were relying less on reserves associated with producing wells, and more on reserves interpolated between wells, based on geology.

Here are Encana's proved reserves over the last decade, broken down into developed and undeveloped.

All of Encana's reserves went down in 2009, because of the spin-off of Cenovus. However the roughly even split between developed and undeveloped has persisted since 2005, and there is no evidence of a decline in reserves quality.

Backing off from this particular issue, note that Encana goes to great lengths to ensure that their annual reserves estimate is carried out in a fully independent manner, by outside experts; their reserves estimates are quite solid.

Profit and free cash flow were positive in 2011

Recall that free cash flow is cash flow from operations less capital expenditures. Since, in this industry, a major capital expenditure is the purchase of new land, I have included all the effects of acquisitions and dispositions in capex.

In 2011 Encana spent more than its available cash flow on exploration and development, replacing production by 180%, but then sold several assets, with the net effect that free cash flow remained positive (just), and reserves about level. This was a reasonable way to take advantage of plentiful, undervalued, resources.

Overall I think it is accurate to say that at 2011 gas prices, with half their sales hedged at higher-than-market prices, they were just breaking even. 2012 production was also about half hedged at well above market prices, so perhaps results will be similar.

No problem servicing debt

Some companies, for example Chesapeake, have run into serious problems with debt during the natural gas slump. This does not appear to be the case with Encana. Long-term debt has not increased in the last few years. Over the last decade Encana has maintained a cash reserve of about 1.9 times annual interest costs, on average. At the end of 2011 that ratio was 1.6, which still leaves a comfortable margin. And operating cash flow for 2011 was about 9 times interest cost. So it seems very unlikely that Encana will have any problem servicing its debt.

To keep the cash flow positive while the gas price is low, they are continuing to divest some assets.

Quality of management

On the plus side, Encana's management

  • foresaw the importance of shale gas, and bought up assets when they were cheap
  • has a reasonable, straightforward strategy now, and has successfully kept cash flow positive and kept the balance sheet out of trouble through a difficult time
  • is generally careful with money; for example, the employee stock plans and retirement plans have modest liabilities
  • has enough respect within the industry to succeed with a number of joint ventures in which they provide less than their share of the capital, in exchange for providing more than their share of the expertise

On the minus side, the timing on the Cenovus split, and the push to ramp production up strongly just before the gas bust, is disappointing. Still, I don't know of any management team that did succeed in preparing beforehand for the gas bubble and bust.

On the whole Encana's management seems reasonably competent, careful with money, and, as far as I can tell, quite honest.

The stock is a bargain

I'll repeat, with current data, what I think is the strongest argument making clear that the stock price is unreasonably low.

Reserve replacement cost is the cost for adding to reserves, expressed in dollars per thousand cubic feet of gas ($/Mcfe). It is calculated as capital spending per Mcfe added to reserves. Taking all capital expenditures (including net acquisitions), and all additions to reserves, for the years 2003-2011 (leaving out 2009 because the split with Cenovus muddies the accounting) gives a long-term average of $1.70/Mcfe. This is close to the industry average for the last three years, estimated from Ernst & Young data, of $1.60/Mcfe. Let's split the difference, at $1.65.

With proved reserves, at the end of 2011, of 14.2 trillion cubic feet (Tcfe), that means Encana's proved reserves represent a sunk capital cost of roughly 14.2 * 1.65 = $23 bn.

At the end of 2011 enterprise value, what you would spend to buy out all stock holders and debt holders, and own the company's assets free and clear, was $21 bn. It is in the same neighborhood now; perhaps a bit higher.

So according to the current market valuation of Encana, a reasonable outlook is this: current reserves will bring in only enough to cover sunk capital costs, with no profit, and all the resources that are not yet proved reserves are worth essentially nothing.

This is particularly astonishing in view of what Encana calls “economic contingent resources”. These resources are supported by roughly the same level of evidence as reserves, and are expected to be produced profitably, just as reserves, but are not yet proved reserves because some part of the infrastructure is missing are the plan is to produce more than 5 years in the future. Those economic contingent resources that are known with 90% certainty are larger in volume than current proved reserves, and are receiving a valuation of essentially zero from the market.

The three classifications of contingent resources have the same degree of technical certainty as the corresponding reserves category. For example, the 1C contingent resources meet most of the same criteria as proved reserves; most importantly, they have the same degree of technical certainty – a 90 percent probability that the quantities recovered will equal or exceed the estimated number. The major factor that prevents them from being included as proved reserves is time. Generally, 1C contingent resources exceed the five-year regulatory guideline for proved reserves development. By adding the qualifier that the contingent resources are “economic”, the resources are high-graded. Shareholders then understand that these resources are expected to be economically recoverable under the fiscal conditions that Encana expects to prevail.

1C contingent resources at end 2011 were 25.0 Tcfe, compared to proved reserves of 14.2 Tcfe.

The market is putting this valuation on the company because, it is true, gas being produced currently is NOT making a profit. In fact, to keep the cash flow positive, Encana (and other companies) have been selling assets. But it would be remarkably illogical to assume that gas companies will continue selling gas at a loss for the long term – they would all go out of business. When the gas price again rises to a level that results in profitable production, the market will suddenly attribute value to Encana's reserves and resources.

One final note on distressed assets

Encana is hardly the only gas company that is being forced to sell assets. It would seem that those with cash to buy such assets are probably getting excellent prices. This suggests that one should look into some of the MLPs that are currently buying gas assets, e.g. EV Energy Partners.

Best Buy got even cheaper last week

30 Oct 2012 by Jim Fickett.

Last week's announcement from Best Buy included some very encouraging strategic news. On the whole I remain optimistic that the company will bounce back. Since the future of Best Buy depends on convincing customers that it is worth paying a little more to take advantage of a network of physical stores, no one can predict sure success. I will increase my position a little and leave it at that.

Last week's announcement contained some very good news

Last week a press release from Best Buy caused rather a negative reaction from analysts and a fall in the stock price. Part of the press release is indeed bad news – a pre-announcement that for Q3 earnings will be down year over year and same-store sales will continue to decline:

The company is providing an update on its expected results for the fiscal third quarter ending November 3, 2012. Comparable store sales are expected to decline at a rate consistent with the range of results for the first two quarters of fiscal 2013 (-5.3% in the first quarter and -3.2% in the second quarter). Gross profit rate is expected to decline at a rate similar to that experienced in the fiscal second quarter of 2013, with a decline of more than 100 basis points compared to the prior-year period, due to the impact of product mix and product transitions in advance of several key new product launches. The company expects SG&A expense percentage growth to be in the low single digits over the prior-year period, due to investments related to the company's strategic focus on improved customer service (including increased training and higher compensation costs for sales associates). As a result, the company expects fiscal third quarter adjusted (non-GAAP) earnings per diluted share will be significantly below the prior-year period.

Although this is not happy news, it is not unexpected. The company is making changes, like closing stores, retraining employees, and strongly building up its web capabilities, and these changes cost money and take time. So things will not get better right away.

The other major part of the announcement, on strategy and personnel changes, also produced negative reactions from analysts but in fact it holds very positive news. The new CEO, Hubert Joly, is taking more direct control, moving those responsible for the current stagnation out of the way, promoting people who have gotten good results, and increasing the prominence of internet sales (newly reporting to Joly).

Effective January 1, 2013, Best Buy's operations in the U.S. will be structured around the following groups:

  • Two Channels - Online and Retail: While online continues to be overseen by Stephen Gillett, president of Digital and Marketing, Shawn Score is appointed to lead the U.S. retail channel.
  • Three Business Groups - Connectivity, Home and Services: Jude Buckley is promoted to head the Connectivity Business Group, succeeding Shawn Score, while Home and Services will continue to be led respectively by Mike Mohan and George Sherman.
  • Support functions, including Human Resources, Finance, Legal and Marketing, where there are no leadership changes.

In this phase of Best Buy's transformation, these groups will report directly to Joly. The current president of Best Buy's U.S. business, Mike Vitelli, will retire from the company at the end of the fiscal year. He will work closely with Joly to ensure a smooth transition. Executive Vice President of U.S. Operations Tim Sheehan will leave the company at the end of the month.

“Shawn Score and Jude Buckley have done a great job growing Best Buy Mobile and then leading the Connectivity Business Group. I look forward to working with them and the rest of our team as we re-invigorate and rejuvenate Best Buy,” said Joly. “Mike Vitelli and I will work closely together during the next few months to ensure a smooth transition. I am very grateful to him for everything he has done for the company and for his terrific support.”

So Joly is getting started on some important big changes right away, but is not going to make the changes effective until after the key holiday season. In the meantime, a promise to match Amazon prices evidences a strategy of holding on to market share now, and then working to compete more effectively at more realistic margins starting next year.

Critics are right that there is some risk in getting rid of Vitelli and Sheehan. These two know how to make the business run in its current form. However that is also exactly the reason to get rid of them. If Vitelli and Sheehan really appreciated the importance of the internet, Best Buy would not have given online sales such minimal attention over the last few years. And the only way to make big strategic shifts is to move the powerful people who have resisted the new direction out of the way.

A bio of Vitelli and a video interview with Sheehan are both long on generalities and short on ideas for producing satisfied customers. On the other hand, a five-part interview with Shawn Score, who will now be in charge of the physical stores in the US, discusses specific customer needs and specific Best Buy responses to meet those needs.

So all in all, I think the reaction to this press release was in the wrong direction – it contains more good news than bad.

Summary of the situation

At this point, I'd like to make a summary of the main points for and against Best Buy as a value play.

The big positives

1. The long-term track record is impressive

When evaluating a company, it is good to look not only at recent events, but at the long-term record. Best Buy has done extremely well, growing from nothing to become the single largest US player in consumer electronics. And even after investing strongly in growing the business, it has produced remarkably high free cash flows over time.

Is that changing? There is no evidence yet that it is. Since capital expenditures are so volatile, let's look at operating cash flow. This should not be confused with free cash flow, of course; the two differ, in the long run, by the average of capital expenditures. But if the business is really becoming unprofitable, as so many think, then we should see operating cash flows trending down.

The low value in Q2 could indeed be the beginning of the end, as many think. It is certainly cause for concern and vigilance. But it is not that different from other low points in the past, and so does not really indicate any serious downward trend just yet.

2. Current changes in strategy look smart

I am very impressed with Joly so far. It looks to me as if he is tackling exactly the right issues:

  • Improvement of the online “channel” is receiving top priority
  • Personnel changes at the top indicate a focus on the customer experience
  • He has highlighted the difference in performance between stores, probably indicating a willingness to change management at underperforming stores
  • Some of the big stores are being closed, and the successful small mobile device stores are expanding

The big negatives

1. Consumer electronics is a tough business to be in

Many people compare Best Buy to Amazon, Target, and Walmart, its three biggest competitors. But the comparison is not very helpful, as none of these three concentrates exclusively on consumer electronics. Perhaps a better comparison is to Dixons, a European retailer whose stores look very much like those of Best Buy.

Dixons reported a net loss in four of the past five years. This certainly means it is a tough business, and it might even mean that we should give up on Best Buy. Note, though, that the euro zone problems mean Europe's recovery from the great recession has been even rougher than that in the US. The euro zone problems are evident in Dixons performance – for the most recent quarter, same store sales were up 5% year-over-year overall, but were down 10% in Italy, Greece and Turkey. Incidentally, Dixons' turnaround plan looks very much like Best Buy's – closing excess stores, improving customer service, and putting a greater emphasis on “multi-channel” sales (buy on web and pick up in store; up 39% YOY).

2. Falling margins are scary

The fact that margins have fallen significantly in the last couple quarters certainly is not good for an investor's peace of mind. But it is to be expected in a situation where the company has to spend money, and take losses on previous bad decisions, in order to switch strategic direction.

It is extremely important for Best Buy to maintain its dominant market share. Think of the biggest challenge you would face if trying to build up a competitor from scratch. That challenge would be scale. A key reason that consumers are still attracted to Best Buy is that there is always a store nearby, and the selection available is very broad. That advantage must be maintained. So it makes perfect sense to put the first priority on holding onto customers, and let margins fall temporarily while improving the customer experience, and then to attempt to charge more fairly for what is provided.

3. Falling same-store sales are not a good thing

The bad news that is most often mentioned in the news is the falling same-store sales and, indeed, this is not a good thing. Many of the costs at any particular store are fixed, and so falling volume means reducing revenue while expenses fail to fall as much. This problem must be fixed. But the good news is that overall revenue and market share have not fallen significantly, and the problem is probably one of too many stores, and of some badly managed stores. That is fixable.

Myths

1. Best Buy is about to go under

Only a few very uninformed people are writing such things, but it contributes to the pessimistic mood. In fact free cash flow set a record in fiscal 2012, working capital (current assets minus current liabilities) at the end of fiscal 2012 was $1.4 billion, and free cash flow in fiscal 2013 is again expected to be healthy.

2. The costs for supporting retails stores is so much higher than the costs of an online business that Best Buy cannot possibly compete with Amazon

In fact the bulk of Amazon's advantage comes from not collecting sales tax, and this advantage is going away.

3. Showrooming is killing Best Buy

Although showrooming, in which people go to see the item at a retail location but then buy it online for less, might or might not really be a problem. But there is no evidence that it is a major one, and investors worry so much about it only because the idea seems plausible and the fear is often restated. As for evidence, Deloitte has shown that people who refer to their mobile devices while shopping in a physical store are actually more likely to buy. And in a recent Google survey of shoppers, half of respondents said their strategies include the opposite of showrooming – to research online and then go to the store to buy.

Conclusion

Soon after I began my career as a manager I was in a position to hire. As I prepared interview questions, a good friend looked over my list, which included many questions designed to probe knowledge, philosophical approach to the job, past relationships with colleagues, etc. His response shocked me. “Forget all that. Hire someone who has done the work you want done, and has done it well before. Then you know he/she can do it again.” It was good advice, and extends in a natural way to investing. Buy the shares of companies that have shown over the long haul that they can make money and grow a business. So I put a great deal of weight on Best Buy's long record of excellent free cash flow. Yes, they have some big challenges right now, but they have done very well in the past, and their strategic direction seems right.

The negatives most often mentioned in the news are myths, but there are real negatives, the most important being falling margins. On balance I think the evidence suggests that they have real competitive advantages, and can bring margins back up in a year or so. But they have to make some significant changes to show customers that they are really a top choice for shopping, and no one, certainly not I, can know for certain that they will carry this off.

On the whole it seems to me the burden of proof should be on those who say a successful business will be successful no longer, and I do think Best Buy will bounce back. So if the price tomorrow, when the markets reopen, remains in the neighborhood of Friday's closing, I will add to my position. But given the uncertainties, I will probably stop there.

Finally, on a lighter note

Previously on Best Buy

Taking a short-term profit on hard-to-value Peabody Energy

22 Oct 2012 by Jim Fickett.

Recently I took a small position in Peabody Energy, as a way of betting that the market for coal had been unfairly beaten down by excessive pessimism. As of this morning, that position was up 41%. Since my continuing study of Peabody shows that an objective valuation is very difficult, I took my short-term profits and will look for a more transparent company for future investment.

Take Peabody's reports with a grain of salt

In Peabody's 2011 annual report one finds the following impressive graph:

That looks somewhat less striking when one includes one more year and compares to the price of coal:

So most of the impressive performance is due to the period covered being one of a strongly increasing coal price. (Concerning the period covered: the company has existed in a number of different forms for more than a century; the latest incarnation began with an IPO in 2001, so 2002 is the first full-year result.)

Here is a long-term view of the real price of bituminous coal:

Clearly there is a large cyclical component to coal prices, and the recent runup is not necessarily going to continue.

The above is just one example of the company reports being too much under the control of the PR folks, and not really geared to the needs of a rational investor. There are many other examples: reserves, basic to any mining company, are not given in the annual reports at all; you have to go dig through the SEC filings to find them. And “tons [of coal] sold”, which figure prominently in the annual reports and 10-K's, turn out to include trading; the number of tons produced is much more modest.

Where is the cash going?

But the main point I want to concentrate on in this post is cash flow produced and what is done with it – a key measure of the successful operation of any business.

Over the period 2002-2011, Peabody has had average free cash flow of -$173 million. Negative free cash flow is not necessarily a problem, if the money is being used to grow the business. Indeed, capital expenditures and acquisitions have been high, and shareholder's equity has grown from $1.1 billion in 2002 to $5.5 billion in 2011. So it would seem the company has grown significantly.

In what way has it grown? Most often, when one analyzes a growing resource company, one finds purchases of new land, exploration and development, and the growth of both reserves and production over time. But while equity grew 400%, reserves shrank slightly, and production grew only 30%:

It could be, of course, that the quality of reserves and production has increased, or that the reserve of unexplored land has been built up.

For example, Peabody has worked hard to increase its business in Asia. 2% of Peabody's reserves were in Australia in 2002, but 13% were Australian by 2011. In particular, this year Peabody bought MacArthur, an Australian coal miner, for $2.8 billion. Since Australia is close to China, the increased emphasis on Australia was good for business over the last few years (though much less so this year, as the slowdown in China has hit mines in Australia very hard). On the whole a shift to move part of the company's business from the US to Asia is a good one, even if future Chinese growth is generally over-rated.

Metallurgical coal might provide another example of improving asset mix. Metallurgical coal, used as both a heat source and a chemical reactant in the production of steel, has fewer impurities and fetches a higher price than thermal coal, used in power plants. Peabody often brags about its metallurgical coal, and occasionally offers data. Part of the reason for acquiring properties in Australia was probably that the deposits are rich in metallurgical coal. While only about 4% of production was metallurgical coal in 2011, Peabody's Australian reserves are about 32% metallurgical, allowing for increased future production.

Unfortunately, although these examples provide some qualitative evidence that the company really is using cash to increase value, it is impossible to make a quantitative case. For example, since mine acquisitions are listed on the books at cost, there is some suspicion that the Peabody has bought mines at peak prices and that, therefore, assets are overstated on the balance sheet. More generally, there is simply not enough information in the company filings to tell

  • whether this year's reserves, in toto, are more valuable than last year's
  • whether capital expenditures on mines overall can provide increased production over time, or are simply maintenance
  • what the company's overall strategy is in which deposits to keep, which to dispose of, and which to acquire

All in all, looking simply at P/E and the historical share price, I suspect Peabody is reasonably valued. However without being able to do a serious free cash flow analysis or reserve valuation, I not willing to make Peabody a long-term holding. So today I will took the short-term profit of 41% and began looking for a more transparent company.

Other past commentary on coal

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