First Quarter 2006 Update and Company Reports
Linens
‘n Things was acquired on
February 15, 2006 for $28 cash per share by Apollo Management, L.P. We originally purchased this inexpensive
household products retailer over its then expensive direct competitor Bed,
Bath & Beyond (BBBY $38) in hopes that a management change in late
2004 would lead to an improvement in the productivity of its stores, driving
earnings growth. Numerous metrics of
management and store productivity confirm the vast performance superiority of
Bed, Bath & Beyond. A narrowing of
the performance spread between these two otherwise similar companies would have
made Linens a rewarding long-term investment.
Instead, Apollo made it a rewarding short-term investment. Meanwhile, Bed, Bath & Beyond dipped from
the mid-40’s to high 30’s, thus creating a purchasing opportunity that one
should not miss for such a beautifully managed company.
Revenues and earnings have increased every
year without fail for the past ten years at Bed, Bath & Beyond, averaging
30% annual growth. Metrics of store
performance, such as sales per square foot, sales per store, profit margin, and
return on investment have grown with incredible consistency over the 34 year
life of this company. Consistency is a
sign of great management. Because of the
size of the company, annual growth over the coming ten years will be slower –
revenues at 12% and earnings per share at 15% annually compounded would be
quite satisfactory. The company has
several growth drivers. First, it builds
new stores, cookie cutter fashion. An
additional 80 stores are planned for 2006, growth of 11% over the existing base
of 742 stores. The company projects it
can eventually build 1,300 total stores.
Second, it can increase same store sales, and a range of 3 to 5% is
targeted in 2006. Finally, the company
also owns two smaller store chains.
Christmas Tree Shops, with 29 stores, and Harmon Stores, with 38 stores,
can grow from their small bases much faster than Bed, Bath & Beyond.
Bed, Bath &
Beyond’s business depends on a robust consumer.
Certain factors, such as rising mortgage rates, high energy costs, and
slowing home sales weigh on the consumer and the stock price. These factors are at least partially offset
by employment gains and growth in real household earnings. Only time will tell if the stock price, down from
$45, has sufficiently discounted these factors.
However, two less
cyclical drivers for household products businesses, the rates of household
formation and home ownership, are quite positive. Two major demographic factors, the maturing
of “Generation Y” (the 72 million Americans born since 1978) and immigration,
portend long-term strength for household sector. Clearly, we believe that purchases in the
mid- to high-30’s are very attractive for the long-term investor.
Bed, Bath &
Beyond generates significant levels of free cash flow. Last year, the company allocated $600 million
for the repurchase of 16.4 million shares at an average price of $36.60 per
share, reducing the share count by 3.5%.
Analyst consensus earnings per share estimates for the next five years
are $2.18 in 2006, followed by $2.51, $2.88, $3.32, and $3.75,
respectively. Cash earnings drive
intrinsic value, so an intrinsic value estimate based on consensus earnings is
currently in the mid-40’s and grows to the mid-80’s in 2011.
Wm.
Wrigley Jr. Company (WWY $47) is one of the highest quality companies one can own. Founded in 1893, the company spent its first
82 years selling only four gum products.
The decision to expand the number of individual gum brands in 1975 led
to a 30 year period of double-digit revenue and earnings growth, characterized
by exceptional consistency. Management
still owns over 30% of the stock, helping to keep the company focused on the
creation of shareholder value. It has
been years since the stock has traded at or below our estimate of intrinsic
value. Due to acquisitions made last
year, 2006 will see a failure to break the double-digit earnings growth
hurdle. The stock has responded
accordingly. Similar past episodes of
Wrigley stock price weakness have proven to be great buying opportunities. Note that the company just split its stock
5:4, which also served to reduce the apparent price.
Wrigley is the
world’s largest chewing gum company.
It’s brand names include Doublemint, Spearmint, Juicy Fruit, Big Red,
WinterFresh, Extra, Orbit, Freedent, Bubble Tape, Big League Chew, and Hubba
Bubba. Growing this business is the
company’s top priority. Expansion into
confectionery brands is part of a long-term growth strategy, focused, in
particular, on
Management
decisions at Wrigley are made for the long-term benefit of shareholders. Brands are built to last for generations, and
the world-wide supply chain has been built with the goal of permanent global
positioning. Investment in innovation
has led to an unprecedented increase in the percentage of sales that come from
new products. A manifestation of
management’s increased attention to innovation is the new
First quarter 2006
revenues grew 13% over the same period in 2005, reflecting the addition of
Altoids and Lifesavers revenues. Another
contributor was 26% revenue growth in
Analyst consensus
earnings projections for the next five years, starting with 2006, are presently
$2.04, $2.24, $2.49, $2.76, and $3.06. I
consider the estimates for 2006 and 2007 to be optimistic. However, this is still excellent growth,
leading to an intrinsic value estimate in the high 40’s now and mid-$70’s in
five years. The dividend is raised every
year and currently yields 2.7%.
Risks include: 1)
Wrigley’s success in integrating the Altoids and Lifesavers acquisitions, which
will improve profit margins and, 2) competition from Cadbury-Schweppes, which
acquired the
Pfizer
(PFE $25) just reported first quarter 2006 earnings per share growth of
13% (61 cents compared to 54 cents.)
Pfizer has done a great job of controlling expenses. However, revenues were down 3%. The issue facing the world’s largest
pharmaceutical company is revenue growth.
Lipitor’s growth may flatten due, among other factors, to competing
Zocor losing patent protection. Generic
Zocor will be priced at a fraction of Lipitor, and works nearly as well. Also, billion dollar drugs Zoloft, Norvasc,
Neurontin, Zithromax, and Diflucan have recently or will soon face patent
expiration. Meanwhile, revenues from
recently approved drugs grew, including Sutent (anti-cancer,) Exubera (inhaled
insulin,) Eraxis (antifungal,) Lyrica (neuropathic pain and anti-epileptic,)
Macugen (wet macular degeneration,) and Geodon (antipsychotic.) The pipeline of drugs in various stages of
the approval process is very impressive, including potential blockbusters
Varenicline for smoking cessation, Torcetrapib for cholesterol management, and
Ticilimumab for cancer. Operating cash
flow of $16 billion creates enormous financial flexibility, funding a recent
25% increase in the dividend, a projected $4 billion stock repurchase, and 2006
research and development spending of $8 billion.
Computers and spreadsheets have given financial analysts the ability to swiftly run scenario analyses. So, we have valued Pfizer using three different five year revenue growth assumptions. First assuming analyst consensus 5% growth, intrinsic value is estimated at $35. More conservative estimates of 3% and 0% revenue growth lead to intrinsic values of $30 and $25, respectively. Our best guess is zero revenue growth for 2006 and 2007 followed by 5% revenue growth, yielding an intrinsic value estimate of $31.
Steven L. Ré, CFA April
26, 2006
This report
contains the current opinions of the author and such opinions are subject to
change without notice. It has been
distributed for information purposes only and is not to be construed as a
recommendation to purchase or sell securities.
The information contained herein is from sources deemed reliable but is
not guaranteed. It should not be assumed
that investments in any of the above-mentioned securities will be profitable,
and past performance is no guarantee of future results. Earnings projections often miss and markets
go up and down. The employees and
families of Quality Growth Management, Inc. may own the above-mentioned
securities in their own accounts, and may trade them at any time without
notice.