Archive for the ‘Sector Analysis’ Category

In the last post, I took a look at 3 companies in the healthcare industry to determine if they are the kind of business I would consider investing in. All three passed my initial screen, suggesting that they have wide moats and should continue to increase cash flow and generate high returns on equity into the future. This week I will use a discounted cash flow (DCF) analysis to determine a fair price for these businesses.

A DCF analysis requires the following 4 parameters:

Free Cash Flow (FCF) Growth Rate: an estimate of the rate at which free cash flow will grow over the next 5 years

Discount Rate:  the rate used to discount future cash flows

Long Run Growth Rate: the rate at which cash flows are expected to grow in the very long-term

Margin of Safety: rate at which the projected fair value is discounted

For a more detailed description of the DCF process refer to The Five Rules for Successful Stock Investing.

Given the difficulty of forecasting and the inherent error that forecasts are subject to, a DCF analysis is really only useful for firms that operate a stable business where there can be some confidence that past performance will be an indication of future results. This explains why Warren Buffet applies it to wide moat companies with a long operating history. As discussed in the previous article, BDX, JNJ and SYK have impressive operating histories and pass Dorsey’s tests for ROE, and FCF/Sales indicating that these businesses have wide defensible moats.

Let’s start with the FCF growth rate, I will use the 5 year consensus analysis earnings forecast published on msnmoney for my calculation:

5 year projected earnings growth rate as of (13/2/2010)

Symbol 5 year growth rate
BDX 11.40%
JNJ 7.60%
SYK 11.70%

When considering the discount rate, Dorsey typically assigns a discount rate of 9% for stable companies that represent very low risk, 10.5% for an average company and 13-15% for riskier firms. I have assigned a discount rate of 9% for JNJ and BDX to reflect the stable, non-cyclical nature of their business and 9.5% to Stryker to account for the fact that this business specializes in devices and instruments associated with more elective surgeries and therefore may be more influenced by the business cycle. All the companies have been assigned a low discount rate to reflect the stable nature of their businesses and their past history of consistent returns.

With respect to the long run growth rate, I will use a value of 3%. Dorsey uses this value since it mirrors the long run US GDP growth rate. I considered using a value of 4% to reflect my belief that developed world demographics and the developing world’s desire to increase healthcare expenditures means that the healthcare sector will outperform other sectors of the economy over the long-term. I will provide DCF analysis using both values.

Finally, I will use a margin of safety rate of 30% to discount my fair value. According to Dorsey, Morningstar uses a margin of safety of 20% for stable companies, and 30-40% for less stable companies with inconsistent earnings history or which operate within a cyclical industry. It would be reasonable to use a 20% discount rate for these companies given their previously mentioned characteristics, however I have chosen to use 30% to offset the fact that I am using analyst consensus growth estimates which tend to be overly optimistic. Below, the parameters necessary for a DCF calculation are summarized:

Discount Rate 9.00% 9.00% 9.50%
FCF Annual Increase 11.40% 7.60% 11.70%
Perpetuity Growth Rate 3.00%/4.00% 3.00%/4.00% 3.00%/4.00%
Current FCF 1125.70 12636.00 1204.20
Next Year FCF 1254.03 13596.34 1345.09
Shares Outstanding 246.00 2754.34 396.40
Margin of Safety 30% 30% 30%

Table 4 illustrates the 10 year FCF growth forecasts for the DCF analysis. I use a 5 year forecast to calculate the perpetuity values, rather than the 10 year forecast used in The Five Rules for Successful Stock Investing. Ultimately, this should render a more conservative estimate.   The results are as follows:

5 year FCF Forecast $1,733.66 $18,163.94 $2,093.94
Perpetuity Value 3% $29,761.13 $311,814.35 $33,180.91
Perpetuity Value 4% $36,060.09 $379,083 $39,594.50
Discounted 3% $19,342.69 $202,657.93 $21,077.44
Discounter 4% $23,436.58 $246,377.90 $25,151.50
Total Equity Value 3% $24,738.91 $263,323.29 $27,471.21
Total Equity Value 4% $28,832.80 $307,164.80 $31,545.30
Per share value 3% $100.56 $95.60 $69.30
Per share value 4% $117.21 $111.52 $79.58
Margin of Safety Price 3% $70.40 $66.92 $48.51
Margin of Safety Price 4% $82.04 $78.06 $55.71

Changing the Perpetuity Growth Rate by 1% has a significant effect on the Margin of Safety Price  Only JNJ is currently trading below its margin of safety price calculated with a 3% Perpetuity Growth Rate, however all 3 companies are currently trading below their Margin of Safety Price calculated at a 4% Perpetuity Growth Rate.  Not surprisingly, the performance of these companies has not gone unnoticed by a famous investor who also likes to concentrate on cash flow and ROE.  Warren Buffet has been a long time holder of JNJ with recent purchases between $50.47 – $56.60 and has also recently taken a position in BDX purchasing it between $60.88 – 70.94 (see GuruFocus).

Full disclosure – long JNJ, SYK.

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Previously I took a look at the Canadian Telco and cable sector to determine whether the largest operators in that space met my requirements for investment. My analysis pointed to an inconsistent 10 year record that precludes investment for now.

This week I will take a look at the healthcare space by analyzing 3 of my favourite companies: Becton Dickinson and Company (BDX), Johnson & Johnson (JNJ), and Stryker (SYK). BDX is the world’s largest manufacturer and supplier of needles and syringes. JNJ is a giant in the health care space with diverse operations ranging from pharmaceuticals, medical devices and consumer staples. SYK is a manufacturer of devices and equipment for orthopaedic surgeries.

Table 1 and 2 illustrate the 10 year history of free cash flow and return on equity for all 3 companies. Applying Dorsey’s screen of a consistent 10 year history of FCF/Sales ratio of 5% or better and ROE above 15% illustrates the quality of these companies.

FCF/Sales Ratio and ROE

Symbol 5 year FCF/Sales average 10 year FCF/Sales


5 year ROE average 10 year ROE average
BDX 8.96% 11.79% 23.19% 21.46%
JNJ 19.94% 19.38% 28.17% 28.08%
SYK 14.32% 12.99% 20.73% 23.14%

These numbers handily exceed Dorsey’s requirements. Table 2 shows the financial leverage employed. The current leverage ratio for JNJ and SYK is 1.82, 1.31 respectively, both well below the 3 to 4 range that Dorsey considers a red flag. BDX has maintained a higher level of financial leverage (currently 3.6) which is a concern, however the non-cyclical nature of their business should ensure debt obligations are met.  BDX has a credit rating of AA- from S&P.

Lastly, let’s take a look at dividend history. Table 3 illustrates the 10 year dividend history of the companies. All 3 have a perfect record of increasing dividends yearly.  Indeed, JNJ and BDX are dividend aristocrats with a record of 46 and 36 consecutive years of dividend increases respectively. The payout ratio has remained in a steady range for all companies with JNJ the most generous, returning an average of 40% of its earnings to shareholders. Lastly, dividends have been increasing at a healthy rate for all companies with SYK specifically posting a very healthy 5 year increase rate of 49%.  As well, given that the company has close to 3 billion dollars in cash, it seems reasonable to expect further large dividend increases in the future.

The above analysis suggests that all 3 companies have wide economic moats that should protect their businesses long into the future. To paraphrase Buffett, these are great companies, the next question is, are they trading at a fair price? Next time I will try to answer that question by using the discounted cash flow method outlined by Dorsey in The Five Rules for Successful Stock Investing.

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When searching for great companies I want to find a company with a history of strong free cash flow generation, high return on equity and a history of consistent and growing dividend payments.   My philosophy is based on ideas taken from The Five Rules for Successful Stock Investing by Pat Dorsey, Director of Stock Analysis at Morningstar (see about me).

In this post I am going to examine the Canadian Telco and Cable sector by analyzing the quality of 4 of the largest companies in the space: Bell, TELUS, Rogers and Shaw. Phone, cable, and internet services are considered staples in most households and as such, should provide stable cash flows to companies providing those services. Additionally, the sector is dominated by large, well established firms and so it would be reasonable to believe that it is a good place to find companies with good return on equity and a history of consistent dividend payment.

Let’s begin with a look at free cash flow (FCF). Specifically, I’m looking for a consistent FCF to sales ratio of over 5% and an ability to maintain that ratio for 10 years or more.  This is indicative of a strong economic moat according to Dorsey.  Table 1 gives the 10 year history of free cash flow and illustrates that all four companies were unable to consistently produce positive free cash flow over this period.  FCF was negative at the turn of the century (2000-2002) due mainly to large capital expenditures incurred while building out high speed internet and cell phone networks. Indeed, large capital spending is an ongoing consideration in this sector given the necessity of maintaining up-to-date data delivery systems on an ongoing basis. The cost of doing this is prohibitive and acts as a major barrier to entry for new competitors, however it also makes consistent generation of free cash flow a challenge. None of the companies have been able to maintain a consistent FCF to sales ratio of over 5% for the last 10 years.  Failure to achieve this key indicator implies the companies being analyzed are less likely to have maintainable competitive advantages.  The returns of the last 5 years however, paint a more promising picture as all companies except Rogers have posted FCF/Sales ratios well above 5% (Rogers has a very good 4 year record but in 2005 only managed a FCF/Sales ratio of -1.69%). Shaw,in particular devotes a section of their annual report to a discussion of their focus on free cash flow generation, which is certainly an encouraging sign. Unfortunately, it is difficult to assume that the 5 year record is an indicator of future performance given the rapid pace of technological change in this industry.  At this point in the analysis, strict adherence to Dorsey’s method would suggest looking elsewhere for safer wide moat companies to invest in. Depending on your appetite for risk however, you may decide that the recent 5 year record will more accurately represent the future performance of these companies.   If this is the case, I would suggest that at the very least a greater margin of safety should be demanded when determining an appropriate purchase price given the uncertainty illustrated by the 10 year record.

A second key indicator is the ability of a company to generate a return on shareholder equity (ROE). According to Dorsey, a good indication of a defensible economic moat is maintenance of an ROE greater than 15% for 10 years or more.   Further, the quality of ROE should be evaluated with respect to the amount of financial leverage used.  In this regard, Dorsey considers any company with financial leverage of 3 or 4 as a red flag.  Table 2 displays the 10 year history of ROE as well as the financial leverage for each company over the same period. Again the 10 year and 5 year pictures tell two different stories. None of the companies have maintained an ROE of greater than 15% for the 10 years, although once again, the 5 year picture is improving. The question becomes whether the 5 year picture represents the future or whether some new event will occur (technological change, new regulatory environment etc) that returns these companies to negative returns on equity. The financial leverage for Bell, TELUS, Rogers and Shaw is 2.7, 2.6, 3.4, and 3.6 respectively.  The degree of leverage for both Rogers and Shaw represents a red flag according to principles set out by Dorsey. While it may be that the stability of the cable business justifies a higher leverage I would again consider a higher margin of safety when determining a purchase price to account for this uncertainty.

Although not a key Dorsey indicator, a record of growing dividend payments is something I look for in a company (see about me).  The record of dividend payment for these companies does not reflect the stable operating cash flow characteristic of the business. In fact, dividend payment is a relatively recent development for Rogers (paid regular dividend since 2003) and Shaw (paid regular dividend since 1998). TELUS cut its dividend in 2002 and did not raise it again until 2005 while Bell cut its dividend in 2000 and again in 2008. Table 3 illustrates the dividend record by giving the 10 year history of dividend payment, dividend increase and payout ratio. The current dividend yields for these companies appear attractive, however the seemingly inconsistent nature of free cash flow and the weak history of maintaining dividend payments make me skeptical of relying on their long-term dividend growth.

Dividend Share Price Yield
Shaw $0.79 $20.81 3.80%
Telus $1.90 $34.32 5.54%
Rogers $1.08 $31.37 3.44%
BCE $1.73 $27.84 6.21%

Note all data is as of 10/1/2010

In conclusion, despite the perception that the Canadian telco/cable sector contains solid companies with stable economic moats, my analysis suggests a number of caveats to consider before making an investment. Namely the requirement to take on large capital expenditures in the face of technological change jeopardizes free cash flow, return on equity and dividend payment. Given this point of view, I would require a significant margin of safety before being comfortable making an investment. In a future post I will take a closer look at the earnings of these companies and give my opinion on their future prospects.

Disclosure – no positions currently held in these companies.

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