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Some Wiggle Room, Please

publication date: Feb 5, 2015
author/source: Brian Nelson, CFA

Let’s go around the horn.

Staples (SPLS) and Office Depot (ODP) will, in fact, join forces. The duo announced February 4th that Staples will pay $6.3 billion for its rival, valuing Office Depot at $11 per share, a nice premium to its previous day close and relative to our fair value estimate. Management expects to generate at least $1 billion in annualized cost savings. Removing redundant overhead, streamlining distribution and carving out other efficiencies will be par for the course. We also think pricing will ease up a bit, though competition from Walmart (WMT) and Amazon (AMZN) will always be present.

We wouldn’t expect Office Depot’s equity to converge to the take-out price until the regulatory review is completed, likely before year’s end. Investors can’t forget, however, that regulators axed this deal in 1997, but that was a long time ago, and the competitive environment was much different. Shares of Office Depot are trading at less than $10 at the moment. We value them at $8 on an individual basis under relatively optimistic assumptions. The market is factoring in a meaningful probability of regulatory road blocks, at least at this time.

In other dealings, Pfizer (PFE) announced that it would acquire Hospira (HSP) for $17 billion, or $90 per share in cash. Hospira closed in the mid-$60s the day prior, so the target’s management negotiated a rather nice deal, in our view, especially in light of our estimate of its standalone value. Hospira is a leader of injectable drugs, infusion technologies, and biosimilars – large and growing categories. Pfizer estimates that the global market value for generic sterile injectables and biosimilars will be $70 billion and $20 billion, respectively, by 2020.

Pfizer’s management had been on the acquisition trail for a while, having been rebuffed numerous times from AstraZeneca (AZN). Pfizer would have paid up for AstraZeneca if the deal had been completed, and we think it has paid up for Hospira as well. Remember, whether an acquisition is accretive or dilutive to accounting earnings per share matters little. In assessing whether a deal is value-creative to the acquirer, one must compare the target’s standalone intrinsic value + the discounted value of future deal synergies with what the suitor paid.

Though Hospira’s growth markets are large and synergies can be had, Pfizer paid well over our estimate of Hospira’s standalone value. The deal price values Hospira at 35+ times 2014’s adjusted earnings of $2.40-$2.50 per share. That’s expensive for a firm growing the top line less than 10%! Should Pfizer’s board be shaken up? Are they being too lax with shareholder capital? The market seems to disagree with us. Pfizer’s shares are up on the announcement.

I like to pay close attention to the building materials firms as they provide insight into a great many other areas of the industrial economy. The #1 maker of gypsum wallboard in the US, USG (USG) reported mediocre fourth-quarter results, with net sales advancing 4% and adjusted net income advancing to $32 million from $22 million in the prior-year’s quarter. Management noted that all of its businesses are heading in the right direction, which we view as a positive data point for much of the commercial and residential construction arenas. USG has tremendous operating leverage in its model, and we think it’s worth paying close attention to. Shares are trading off on the report.

The largest producer of construction aggregates (sand, gravel, crushed stone and the like) in the US, Vulcan Materials (VMC) announced a rather robust fourth quarter. Total revenues advanced 11% thanks to a 15% increase in same-store shipments, to 4.3 million tons. The company’s average sales price increased 2%, despite an unfavorable mix, and its segment gross profit surged 40% in the period. Adjusted EBITDA of $172 was 30%+ higher than last year’s mark. Vulcan’s performance continues to indicate a construction activity recovery, though its shares are quite pricey at ~50 times trailing 12-month earnings. Let’s just say the market is expecting a continued strong recovery at Vulcan to assign it that multiple.

Let’s move on to the reports of a couple high-beta stocks: Michael Kors (KORS) and Under Armour (UA). Both continue to grow like weeds. Though fast-growing operations are certainly positive attributes, such dynamics create an added layer of complexity to the valuation analysis. What is the correct normalized revenue growth number for Michael Kors to use in Year 5 of the valuation process, for example? Is the firm’s correct normalized growth rate 30%, or is it 20%, or perhaps 15% is correct?

The reasoning for using a fair value range in valuation analysis is clear when it comes to high-beta, fast-growers. We can’t possibly peg the company’s normalized growth rate with absolute precision (nobody can), no more than we can predict the future with absolute certainty. We also don’t want to truncate upside potential, no more than we want to ignore downside risks. Thinking about valuation as a range of probable fair value outcomes, or a fair value range, is one of the most valuable approaches you can ever adopt. Being approximately correct in the identification of valuation outliers is the goal of any valuation process, not being precisely wrong.

With all of that said, the Street appears to be overreacting to Michael Kors’ conservative top and bottom-line guidance for the balance of its fiscal 2015. Market observers know that the future outlook always trumps the most recently-reported quarterly results (which are now history), but it’s difficult to truly be disappointed in a firm that is growing the top line at a ~30% clip, the pace of growth achieved during its calendar fourth quarter. Kors’ torrid pace of new store openings (114 net new ones in the quarter), strong e-commerce expansion (+70%) and 8%+ comparable store sales growth are driving such expansion.

The firm’s European growth story, however, is perhaps most impressive. Adjusting for currency, revenue generated in Europe grew more than 85% versus last year’s quarter thanks in part to comparable store sales increases of ~30%+. Very few, if any, firms in our coverage are growing their European operations that quickly. Diluted earnings per share is expected to be in the range of $4.27-$4.30, implying a ~16 times multiple on trailing earnings. For a company that is growing as fast as Michael Kors, a below-market multiple makes very little sense, even with its heightened risk profile. The company’s shares are trading below the low end of the fair value range, and we’re watching them closely.

Under Armour is growing at a similar clip. Net revenues advanced 31% in the fourth quarter, and the firm leveraged such expansion into 37% net income growth. The company’s apparel operations were helped by new offerings across training and hunting, and its footwear offerings continue to gain traction, up more than 50% on a year-over-year basis in the quarter. This is quite a feat given the dominance of Nike (NKE) in this area. Under Armour’s international net sales more than doubled and now account for nearly 10% of the business. Diluted earnings per share for 2014 came in at $0.95, and the firm is targeting operating income growth of 12%-15% in 2015. Consensus is looking for earnings per share just north of $1.20 in 2015, putting Under Armour’s earnings multiple at 60+ times. That’s way too pricey for our taste!

Similar fickle customer bases, similar growth products, and similar intense competition, yet the market assigns Under Armour a multiple (60x) that is ~4 times that of Michael Kors (16x). I think you can see why we think Under Armour is overvalued while Micheal Kors is undervalued. Take a look at their 16-page reports. The market sometimes has a difficult time reconciling such discrepancies. This is one of the key advantages of Valuentum’s birds-eye view. We can call out mis-pricings as we see them. You’ll find the market is not as smart as academia says it is – sorry advocates of EMH.

As for Best Ideas portfolio holdings, Teva’s (TEVA) and PPL’s (PPL) quarterly reports were business as usual. I didn’t see anything wrong with PPL’s quarter and was quite encouraged by management’s confidence in its ability to drive mid-single-digit earnings per share growth through 2017. We’ll re-evaluate our position in shares in the Dividend Growth portfolio as the spinoff of Talen Energy approaches.

I still remember when I received an email from a member a few weeks or so after we added Teva to the Best Ideas portfolio. I think the stock had dropped from $40 to $36 per share over that time – a completely immaterial move – but he felt something was terribly wrong. Shares of Teva, one of the best performers in all of 2014, are now approaching $60 per share, up significantly from the July 24, 2013 “add” price! Our fair value estimate of shares is in the mid-$60s.

Give us some wiggle room, please.

I preach: “Perspective. Perspective. Perspective.” And then I preach: “Patience. Patience. Patience.” And remember the critical formula: materiality + context = experience. Those that are following our investment seminars know what I am talking about. For those that don't know, I'm always available. I want you to succeed!

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