Berkshire Ruminations

Wednesday, April 26, 2006

Budweiser gets some recognition and triggers a thought

The stock that Buffett has been buying for over a year now (and I started buying before him) finally looks to breaking out of the basement that it has been in for the last couple years. Of course, it took a blockbuster earnings announcement from AB to get it to move, but this is the type of thing patient investors have to wait for. In the short run, the market is a voting machine, in the long run it is a weighing machine. In my opinion, BUD is clearly a good investment, but it will take positive sentiment from the masses in order for the stock if any large cap to move. Hopefully, today's announcement and flattering front-page WSJ article do just that.

All this got me very interested in another stock I have been watching lately and which took a big hit yesterday. Wrigley's is a Buffett stock if I have ever seen one, and is similar to AB in a remarkable number of ways. Family-owned and run for nearly a century, a comparable dividend yield, consistent growth for decades, easily-understood consumer product, an impenetrable moat and ubiquitous brand. I finally broke down and bought some shares today at $46.75, the lowest the stock has been in over two years.

The stock took a big hit yesterday after the company announced its first quarter earnings were down sharply, due first to the costs of its newly-acquired brands and second to its expensing of stock options. With the latter clearly being irrelevant, we can focus on the expenses associated with the former. Last summer was big for the company. It issued debt for the first time in recent memory to finance the acquisition of the Kraft confectionary group, which includes such products as Altoids and Lifesavers.

With its stellar credit rating, the company was able to finance this purchase for less than 5%. After the purchase, the company began advertising its new brands heavily and attributes these costs to the reduction in profitability – gross margins fell from 56% a year ago to 51%. So despite record sales, net income was off. I see this as a very short-term problem, and one that has appropriately been priced in to the stock. With these costs behind it, now is an excellent time to buy.

Time will tell, of course, but it wouldn’t surprise me a bit to see this stock behave the same way BUD has for the past couple years. Give the market time and it will realize how strong this company is. WWY is a bargain, I think, at $47 and worth a place on everyone’s watch list if not in a portfolio.

Monday, April 17, 2006

Should we try to play ethanol?

Yes. But be careful. Once it becomes widely known how easily this nation can switch away from gasoline and toward ethanol, plenty of traders will be eager to snatch up every small supplier or research firm with any connection to the fuel. This approach is a crap shoot and very unwise. The best approach, I feel, is to invest in an established, profitable company that is currently trading at a reasonable price. And I’ll be darned if there isn’t one sitting right in front of us. It’s called Archer Daniels Midland.

What prompted this post of mine is an article a friend of mine told me about by know-it-all trend maven Jim Cramer. Apparently Cramer’s rant of choice this morning was how foolish buying anything and everything ethanol can be. Seems like a legitimate take, but then he goes on to dismiss ADM as becoming “such a momentum play it makes a mockery of the fundamentals.” Mockery of fundamentals? Seems like a little bit of a stretch for a company selling at 23 times ttm earnings and less than three times book value. So, as if you need any convincing that Cramer hasn’t fully thought an idea through, let me explain why this is not true.

Ethanol is, admittedly, not what ADM has traditionally produced. It would be a huge overhaul of the current business model were the company to rely solely on ethanol sales. But at present, this is not the case and this makes the company stable and reliable. ADM has grown in to the premier food supplier in the country and consistently grown for many years. But ethanol is enormously more profitable to the company than its food products - whereby it contributes only 5% to the company’s total sales, according to Fortune magazine, ethanol contributes nearly 23% of total income.

The reason I think ADM is a reasonable investment is because even in the absence of any growth as the result of ethanol the company is selling at a reasonable price. The type of basic discounted cash flow valuations I have run on ADM’s numbers using assumptions based on no increased benefit from new ethanol sales, produce values roughly equal to the current price. To be specific, I assume free cash flow grows at 5% indefinitely and I assume a discount rate of 10% (approximately ADM’s cost of capital). Therefore what I am assuming is that current government ethanol subsidies will persist and that sales and capital expenditures will continue to grow at historic rates. This will not prove to be the case, however, as the company has announced plans to nearly double its rate of capital expenditures by 2008 in an effort to expand ethanol capacity.

What we are left with is a company that is appropriately priced given its current operations but with a speculative component that seems to have been given little added value. So long as the ethanol expansion produces a positive return on investment, the stock is a good buy at the current price of $35. However, if ethanol proves to produce nothing or negative returns, the stock is not a good buy, although no one stands to lose his shirt on it either because of the strength of the company’s traditional operations. Is this a good roll of the dice? I would say so. Moreover, ADM is the only prudent attempt to play the ethanol phenomenon, which I have been convinced is real, occurring and will continue to occur. Most other investment alternatives are entirely speculative.

Wednesday, April 05, 2006

Permanent Holding - Part 1

Today one of my personal permanent holdings, Walgreens, released its quarterly results. As shareholders have come to expect, sales increased 9.2% over the year-ago period. Better yet, same store sales rose 4.3% -- but the shares barely budged. No surprise though, the stock of this “boring company” has gone nowhere in the last twelve months and another buying opportunity is quickly approaching. I originally bought Walgreens on a dip three years ago in March and April of 2003. As expected, the stock quickly rebounded. I could expect this because I was confident in the future performance of the company.

Buffett likes stocks with consistent growth. In my experience very few companies beat Walgreens in this regard. The company has grown its earnings and sales every year for the last thirty-one years, with earnings averaging around 15% growth over this time period. How many other companies can say that? I would be willing to bet you could count them on one hand (but I am not a betting man.)

The company has no debt. And it is growing by leaps and bounds – 432 new stores opened last year to bring the total to 4953. That it can do this solely with equity financing is remarkable, and indicative of the strength of the firm.

I feel Walgreens is doing to the pharmacy industry what Wal-Mart did to retail. I don’t like what this does to a small town spiritually any more than the next guy, but like it or not, mom-and-pop stores are inefficient and will eventually go by the wayside. The independent pharmacy will not be able to compete with Walgreens any more than the old-fashioned dry goods store can compete with Wal-Mart.

Which is an interesting comparison since Wal-Mart competes with Walgreens for pharmacy services. First off, make no mistake about what is Walgreens’ core business. It is prescriptions. The “front-end” sales that might seem more significant are not at all – they comprise only 36% of total revenue. What the photo shop, convenience mart etc do for the company is keep customers regularly visiting the store and much more likely to rely on it for their prescriptions. Walgreens stores are ordinarily located on the corners of major roads in predominately residential areas. Most also have drive-thru service. It should be obvious that Wal-Mart will never be able to offer this type of convenience.

Moreover, the company currently only has 15% market share and thus tremendous room for growth. This is one stock I think will definitely outperform the market over the next 10-20 years.

More on Walgreens later…