Friday, 16 October 2015

Bill Miller the "contrarian" on Amazon (and a comparison to Walmart)

Quick post on contrarian-ism (not sure if I just made a word up).

Probably due to my cynical nature, I've never considered Amazon.  A lot of people much smarter (and much richer) than me have.  Good for them.

It's no secret that Amazon has eaten Walmart's lunch in terms of $ volume of sales, and it's virtually a weekly occurence to see the two companies compared side by side.

Here's a graphical representation of stock price return since 1999:

Amazon has compounded at 15% per annum since 1999

Walmart is basically flat since 1999 (excluding dividends).

I think that sentiment is extremely important and should be noted and observed by investors in approaching any potential situation.

When I read headlines such as the following from CNBC, I make a mental note of the sentiment:

The imputed sentiment is that, despite Amazon rallying 85% over the last year, and despite Amazon returning close to 1,000% since 1999, it's terribly misunderstood, and as such, it's mispriced.  There's obviously another 1,000% to go over the next 15 years.

So here is real sentiment in action resulting in a "misconception put" supporting the stock.  And the more the paradigm of misconception exists among participants all trying to generate alpha on each other's coat-tails, the more the theory of misconception becomes widely accepted as real and true (for now).  I think this is a joke, and what we're observing in real time is the Nifty Fifty playing out all over again. Nothing changes (and will ever change).

On the subject of Walmart this week, here are few headlines from my favourite "objective" news sources, which almost seem to demonstrate the polar opposite extreme in sentiment:

First, from

Next, a quote from an Edward Jones analyst, article from NBC news:

I believe these are exactly the types of extremes in sentiment that value investors want to see.  We want to see participants continue to shun Walmart in favour of Amazon.  We want to see analysts doubt whether Walmart's current initiatives will ever lead to better sales.

I think of this in terms of discounting free cash flow.

Let’s be really conservative and assume 0 growth.  After all, as an investor, you want a margin of safety, right?  Well one way of building in a margin of safety is to assume worst case growth and then run your DCF.  If DCF’s at worst case exceed current market price, you may have a margin of safety.

Here’s Walmart:

2015 FCF = $14.6B
2014 FCF = $16.4B
2013 FCF = $10.1B

I want to be conservative, so I will take the average of the three FCF’s, so $13.7B.  I also know that they’ve spent about $1B this year on ecommerce transition, new systems, restructuring.  Let’s add this back in,  so let’s say $14.7B in FCF.  

Another way of building in a margin of safety is to use a high enough discount rate coupled with zero growth.  Their weighted avg cost of capital is around 7.5%.  Let’s price the DCF’s as a perpetuity at 7.5%, 10%, and 12%. 

At 7.5%, I get $196B, plus cash, minus debt = $196B -$42B = $154B vs. current market cap of $200B.  No margin of safety. Expected pps = $48

At 10%, I get $147B, plus cash, minus debt = $147B -$42B = $105B vs. current market cap of $200B.  No margin of safety.  Expected pps = $32

At 12%, I get $122B, plus cash, minus debt = $147B -$42B = $80B vs. current market cap of $200B.  No margin of safety. Expected pps = $25

Now, I don’t think it’s likely to get down to $25 per share, but sub $50 is possible.

Wednesday was a reaction day.  All the sheep who simply hold Walmart because Buffett does were puking.  But here’s where you have to put on your analytical hat.

They’ve guided down because a) they expect currency to hit sales, and b) they are taking more restructuring charges and/or spending more $ on aligning the ship.  This is exactly what you want to see.  You want Wall Street short term participants concentrating on the guidance through 2017 only. The seeds of doubt are now out there.

Here’s the guidance:

Fiscal year 2017 will represent our heaviest investment period. Operating income is expected to be impacted by approximately $1.5 billion from the second phase of our previously announced investments in wages and training as well as our commitment to further developing a seamless customer experience. As a result of these investments, we expect earnings per share to decline between 6 and 12 percent in fiscal year 2017, however by fiscal year 2019 we would expect earnings per share to increase by approximately 5 to 10 percent compared to the prior year.

Let’s assume Walmart management are not stupid.  They are spending $1B this year, and expect to spend $1.5B through 2017.  Let’s say they are going to spend $3B in total.  Well, they wouldn’t just arbitrarily spend $3B, they’d only do this if they expect positive NPV.  Their return on invested capital is around 14%, basically double their cost of capital.

If they spend $3B, they should expect this to translate into future incremental returns right?  What happens to forward FCF once they’ve gone through the program?

  1. They have an additional $1 to $1.5B in FCF
  2.  They earn incremental returns on $3B of say, 14% x $3B = $420M per year

So, my guess is that FCF will increase from $14.7B up to $15B at the low end and $16.2B at the high end.

DCF of $16.2B @ 7.5% cost of capital $216B less $42B = $174B.  If the stock gets down to $50 or less in between now and 2016/2017, you get $50 x (3.2B - .4M shares due to buyback) = $140B.  Margin of safety becomes 20% (I can see this scenario as possible given we're getting into tax loss selling season and we're trading $58's now).

If the stock gets down to $32, you get $32 x (3.2B - .4M shares due to buyback) = $90B.  Margin of safety becomes 52% (I highly doubt this scenario).

And in the meantime, Walmart pays you close to 3.3% to wait.  (PS, all of the above scenarios are at zero growth).

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