2018-Second Quarter Review
PLEASE BE ADVISED THE FULL REVIEW IS SENT TO CT CAPITAL CLIENTS INCLUDES IN DEPTH FIRM REVIEW WITH ADJUSTMENTS TO THE PUBLISHED FINANCIAL STATEMENTS
The account continued to outpace the Russell 1000 (TR) Value by a very wide margin over the last 5 years, while the so-called tech-based FANG stocks have again propelled the S&P 500 this quarter. The long-term very high correlation between the S&P 500 and Russell Value broke apart in 2015. One would certainly expect they will again converge at which time our performance can be expected to surpass that benchmark as well.
For the portfolio, the Tax Reform Reconciliation Act fundamentally altered the way multi-nationals are taxed, and yet we have found many have not altered their international financial structures which were set to take advantage of a now antiquated tax system. Our firms stand in a relatively stronger position from which the account should benefit in the years ahead.
A US shareholder of one or more controlled foreign corporations must include in gross income its GILTI (Global Intangible Low-Taxed Income). This rule generally subjects a US shareholder to tax on the combined net income of its controlled foreign corporations that is not otherwise taxed in the United States, thus giving many of our holdings a nice domestic advantage, especially when combined with the new 21% statutory rate vis-a vis foreign entities so subject. Much of this will be felt as the years roll by.
Many companies will find they will be subject to the base erosion (BEAT) tax it did not expect.
COMMENTARY
Consumer tech eventually meets its match and for Apple it may come about from sovereign interference or plain old competition[1] as 5G comes to pass next year or perhaps a residue of its litigation with Qualcomm. As shown in Table 1 Apple’s economic profits as a percentage its market value, using proprietary CT Capital worksheets, has declined the past two years, its first consecutive such decline over the past decade. Economic profits, not return on capital, is the appropriate benchmark for Apple due to declining equity, assets, plant and equipment. Should this trend continue, its shares will very likely drop as well.
[1] See https://www.cnet.com/reviews/xiaomi-mi-8/preview/
Many companies will find they will be subject to the base erosion (BEAT) tax it did not expect.
In the 1990’s investors also drove technology shares to unfathomable heights. Yet, no sector undergoes market share alternations more rapidly, with each generation seeing firms thought bullet-proof fold. Anyone know where I can buy Kodak film? A Wang word processor, or a Magnavox TV? Nokia was thought invincible not too long ago as were Lehman and Bear Stearns. We are not suggesting Apple or Google will meet similar fate, yet they too will meet their match.
Restrictive trade policies and actions to be established under CFIUS could bear on free cash flows, employment, and government policy. There is no guessing the extent at this point; sensitivity analysis helps estimate any potential impact on existing and potential investment related to supply chain, segment sales (cash flows) and other expense, including asset relocation if necessary. The discount rate could be impacted as well if expected free cash flows are to become increasingly uncertain.
To be sure, the crystallization of the BEAT (base erosion tax) provides additional expense to non-US firms, in a way forcing Europe’s hand, yet it is prudent not to over-react at this point.
AN UNDENIABLE LONG-TERM TREND GOING OUR WAY DESPITE AMAZON
When those FANG investors move on we believe many will indeed gravitate, despite this week’s Amazon announcement, toward our investments in CVS and Walgreens, which have all the characteristic of becoming the next McDonalds or Starbucks.
Upon Amazon’s announcement it would acquire Pillpack, a firm which has been for sale quite a while and has slightly more than $100M in sales (vs CVS almost $200B), the combined market values of CVS and Walgreens market values fell $12B. We have seen Amazon scares too many times to count and remain doubtful they will be able to make large inroads against the physical locations.
The future of health care is “closeness to the consumer” —CVS and Walgreens employ over 600,000 with over 20,000 locations. Amazon has zero locations. Amazon does not enjoy similar advantage in health they have in general retail, such as pricing, delivery, and technology.
Importantly, consumer health hubs—dental to urgent care—is taxiing on the runway and a space where they needn’t worry about Amazon, and both CVS and Walgreens are active and gearing. CVS currently has over 1100 such clinics in 33 states while it is estimated both companies control between 50%-75% of the drugstore market.[1]
| Example: Clinics offer a quick means to combat the spread of disease or illness as was seen this month in Ohio where an outbreak of hepatitis A took place. CVS’ MinuteClinics offered Hepatitis A Vaccines statewide following the outbreak of the virus.
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And with its expected merger with Aetna, we are confident CVS is primed to become a large winner for the portfolio, ensuring superior return on capital and economic profits for years. Aetna’s insurance is a product Amazon does not offer, bringing additional large cash flows into the firm.
CVS and Walgreens have vast experience in best practices—including real estate management, billing, Medicaid and psychological services— making this indisputable movement of health hubs ferrying considerably lower risk with strong prospective growth. While the hubs could very well be sad news for hospitals and even for Amazon’s health unit, CVS and Walgreen’s are well-primed to benefit while selling at high normalized expected cash yields.
The implications of the Tax Reform and Reconciliation Act will also prove a catalyst to these firms—CVS’ cash rate of 38.6% and Walgreen 26.5%. Amazon is facing large tax bills in Europe. As written last quarter, the compounded effect of the Budget Act has yet to be fully digested by investors, and especially for those firms which make value-adding decisions with regard to said cash. Real return on capital and economic profit/market value is quite likely to remain at least 4 percentage points above their weighted average cost of capital for all our healthcare holdings.
INVESTORS MOST OFTEN EXAGGERATE SINGLE PERIOD IMPACT ON FAIR VALUE
Large share price movements following earnings announcements are typical as investors overstate a single period’s importance to fair value. Investors and firm executives who extrapolate recent events are quite prone to error.
And so, earnings reflex often reverses as events normalize for firms with strong market penetration and growing markets. A shortfall to a single quarter effects fair value to only a minor degree, as a firm is worth the present value of the entirety of its free cash flows plus a terminal value. For instance, at a 7.5% discount rate and free cash flow growth of 15% per year for 10 years, moderating to 2% thereafter, the current year free cash flows can often constitute just 2.6% of its total fair value[2]. For lower initial growth the impact is even smaller. So, when we see a holding’s market value react inappropriately, we exercise patience, all else equal. Such pessimism is most often unwarranted and why shares in fact shrug off the short-term nonsense given sufficient time.
This brings us to Fluor, which dropped this quarter on its announcement. As you know we prefer to write of firms which did not meet their normalized metrics as the winners speak for themselves.
Fluor, a construction and engineering firm, which could have as many as a thousand jobs going in various stages, mis-bid a gas-fired project, the consequence being a write-off and always-present possibility of additional cash outlays. Such action does not reflect well on their bidding teams as fixed price contracts always carry risk. Over the decades such “wins” too often have resulted in losses, yet for shareholders it has paid to stick around. Other times a single job can sink a company, as was the case with Morrison-Knudson due to its then subway manufacturing division.
Meanwhile, Fluor’s backlog remains satisfactory though subject to many factors, including energy prices and political events. The firm is supported by strong credit and liquidity of $7.5B. As with many firms, they erred in its use of capital, re: share repurchases, for which we penalized its cost of equity.
Given firms like Fluor have a strong tendency towards normality, in this case a rather consistent normalized 15.65% (Table 1) adjusted return on equity, we remain with the position.
Figure 1-Fluor Adjusted Return on Equity-NOT SHOWN, SENT TO CLIENTS DUE TO PROPRIETARY NATURE
IMPORTANT DISTINCTION BETWEEN EQUITY AND FIXED INCOME INVESTING
As the default rate on high-yield instruments drops, yield spreads collapse, and bonds priced near bankruptcy offer superior returns relative to investment grade. Approaching a default rate nears zero, a firm’s credit rating—for bond investors—become less weighty and the appropriate fixed-income investment strategy is to allocate a higher percentage of the portfolio within firms paying the highest rates of interest. For this reason, CCC rated firms have outperformed investment grades over the recent past.
The same investing logic does not apply to investors in equities.
Yet, have those investors throwing a record volume of capital into lower quality debt again laid the seeds for a credit “event”? Leverage loans (LIBOR 125+) are now greater than the high yield market, exceeding $1.2 trillion according to Fitch, and while maturities have in many cases been stretched out, investors look over the hill in decision-making.
Because funds for acquisitions are abundant and yield spreads tight, we have become increasingly mistrustful of those large-scale technology deals [3] . We would not touch AT&T with a ten-foot pole. And unfortunately, we have seen credit agencies giving acquirors abundant headroom and become too rating-lenient, abundantly trustful of management puff instead of penalizing for the credit build.
As interest rates rise the great corporate debt build will begin to have consequence as rollover time nears. Over the past decade, according to McKinsey, corporate debt issuance has nearly equaled the rise in government debt.
And furthermore, as refinancing’s become due for roll, it would not be unusual for key metrics to be below peak.
The Tax Reform and Reconciliation Act limits the deduction of interest expense in the US to the sum of business interest income plus 30-percent of adjustable taxable income. Many firms who may now seem far away from the ceiling will certainly run thru it, having an absolute impact on valuation.
Higher rates of interest are more easily tolerated for firms with high return on capital (or economic profit), while for other firms becomes more difficult to grow or even maintain its spread with cost of capital.
Importantly, with interest rates moving up piecemeal, our firms enjoy strong credit rankings by our higher standards. Investees have little to zero exposure to floating rates and about 13% of their debt due the coming 3 years. They enjoy strong flexibility with more than adequate credit facilities.
VALUATIONS– NEVER EVALUATE ON A SINGLE METRIC
When comedian Henny Youngman’s was asked: How’s your wife? He responded, “Compared to what?” The same applies to valuations.
Someone should tell analysts at Factset—a firm I was an original client and helped one of the co-founders set up some proprietary financial software—as well as investors and other data providers, single metrics should never be viewed in isolation. Valuations (Figure 2) must be viewed relative to inflation, credit, prospects, consistency of metrics, lawsuits, taxation, etc. and not relative to itself as a measure of value. What good is a free cash flow yield of 12% (8 multiple) if inflation is 15%?
Figure 2 Valuations Must be Viewed Relative to Other Metrics-FIGURE NOT SHOWN
Same is true advice for the St. Louis Fed researcher in making a case between recession and unemployment. High employment is not, in and it itself, a motive for recession but may be a function of imbalances (inventory), excesses (dot -com) or government action (Vietnam War). In 2008, the lower unemployment rate was a function of large scale hiring in real estate and related sectors.
CONCLUSION
While the high-yield default rate is expected to stay low for the time being allowing valuation multiples to remain lofty, sector and firm-specific valuations can be expected to undergo platonic shifts due to alterations in risk—from trade, location of suppliers and cusitmers, to credit— topics we believe CT Capital has a large competitive advantage.
We do not pretend to have a crystal ball, only our financial statement adjustments and definitions bear a closer reflection of economic reality and have worked well over multiple cycles.
Kenneth S. Hackel, CFA
Eli C. Hackel, CFA
[1] http://fortune.com/2017/12/04/why-did-cvs-tical buy-aetna/
[2] Assumes typical CT Capital credit, return on capital and economic profit and cost of capital.
[3] AT&T will have over $180B in debt post its Time Warner acquisition.
