Quarterly Letter – Q1 2011 – Part 1

I’d like to share excerpts from our quarterly letter we send to our clients. I’m not sharing the full letter, we are still accumulating shares in some stocks.

Quarterly Letter – Q1 2011 – Part 1

I’d like to share excerpts from our quarterly letter we send to our clients (this is Part 1; I’ll send out Part 2 in a few weeks).  I’m not sharing the full letter for a simple reason: we are still accumulating shares in some stocks mentioned in the letter.

Purchase of Big Lots

Big Lots (BIG) is a closeout retailer with about 1,400 stores in the US.  If you visit one of their stores, you’ll probably be less than excited about this purchase.  But don’t be discouraged – you are not BIG’s target customer, as it caters to lower-income, cash-strapped consumers who are looking for ultimate bargains in household items and care little about ambiance.  In fact, soon after we made this purchase, a client mentioned that his wife would never shop at Big Lots.  Our “clever” response was, we bought BIG so she would not have to.  As investors we have to realize that, though it is easier to buy stocks of companies whose products and services we use, that is not always going to be the case.

BIG’s stores were poorly managed until arrival of new CEO Steven Fishman about six years ago.  He completely transformed the company.  Every single operating metric from margins to inventory turnover to return on capital improved substantially.  Mr. Fishman refused to open new stores, he argued real estate prices were too high (instead he focused on improving existing stores).  This is exactly what we want to hear from a CEO: he is not focused on growth for growth’s sake, but wants only profitable growth with return on capital well in excess of its cost.  Today, after a severe recession and a few high-profile bankruptcies – Circuit City, Borders, Linens ’n Things – BIG is able to find real estate at prices that make economic sense.  It will open about 90 stores this year.

BIG has a debt-free balance sheet.  It doesn’t have to do much to achieve reasonable low-double-digit earnings growth: about 3% will come from opening new stores and another 1-3% from same-store sales; their profit margins are still below their competitors’, so they have some room to expand, contributing a few percentage points to earnings growth a year; and finally, management was not shy about buying back stock with its ample cash flows.  At the time we purchased the stock in the majority of our accounts it was trading at about 10 times earnings.

In early March, to our surprise, rumors circulated that BIG put itself up for sale and hired Goldman Sachs as an advisor.  The company would not comment on rumors, a common practice.  The company’s stable and growing cash flows and debt-free balance sheet make it a likely candidate for a private-equity buyout.  In our estimate, if the company is taken private it will be done at about $55-60 a share.

Purchase of Abbott Labs (ABT)

We owned ABT in the past, and were patiently waiting for the opportunity to own it again.  Think of ABT as a smaller version of Johnson & Johnson  (without weekly product recalls – we’ll touch on that issue later in the letter) – a diversified healthcare company that makes pharmaceuticals, children’s formula, stents, diagnostic products, etc.  ABT is very similar to other super-high-quality companies in our portfolio (we own plenty of that kind): it is being OVER-penalized for its overvaluation in the late ’90s (see attached article on Cisco where Vitaliy expands on this).  At the time of the purchase ABT was trading at a little bit less than 10x times earnings (in the late ‘90s it was sporting a P/E close to 30x).  ABT has high return on capital, terrific management, reasonable amount of debt (especially considering the stable nature of its cash flows) it can pay off its debt within two years if it decides to do so, and it has almost 4% dividend yield.  Over the last decade ABT’s earnings per share have almost tripled, and though we don’t expect that to happen, we still think it can comfortably grow earnings in high single digits.

Purchase of BP

The Japanese tragedy has made global society question the safety of nuclear energy.  Already, Germany is “temporarily” suspending nuclear reactors, will likely shut down older ones, and is stress testing new ones for earthquakes and terrorist attacks.  China has suspended approval of new nuclear power plants.  Nuclear energy is not going away anytime soon; however, getting approval for new reactors will become a more difficult and time-consuming process.  We believe this will increase demand for other sources of energy, natural gas in particular.

We looked at energy names and found BP to be the most logical choice.  Though we still have the vivid images of the sunken Deep Horizon rig and gushing oil from the Macondo well in the Gulf of Mexico, the well is capped and the impact on nature appears to be a lot less than everyone feared.  We did not buy BP in the midst of the crisis, because it was very hard to estimate the longevity of the problem and the impact it would have on the environment and thus on BP.  We bought Total instead, at the time.  It had declined as much as BP and had no significant exposure to the Gulf of Mexico.  A year later, though BP stock is up from lows it hit at the height of the crisis; it is still down substantially from its highs.

BP will continue to pay for losses, but these expenses appear to be very manageable, running a few billion a year (you have to take this statement in the context that BP has revenues of over $300 billion and profits in excess of $20 billion).

Over the last few months BP reinstated the dividend it suspended last year, and the yield today is slightly less than 4%.  The stock trades at about 7 times earnings.  BP’s leverage is not alarming (it can pay off its debt in one year), but management has announced they want to reduce it further.  Today BP’s stock is still tainted by the Macondo spill – its significant discount to its competitors clearly reflects that (Exxon, for instance, trades at a 70% premium to BP), but as time goes by and memories of the spill fade, the discount to peers will shrink.

Johnson & Johnson – why we still own it

J&J is probably one of the most respected companies in the United States, thus it is the last company you’d expect to recall a product every other week – it has recalled 22 products since September 2009. On the surface it appears that J&J lost control over its manufacturing, doesn’t care about its customers, and that the old white-glove J&J is gone.  At least that is what the headlines would have you believe.  But if you carefully look at the nature of the recalls you’ll see that quite the opposite is true.  The majority of  recalls came from the US consumer division McNeil, the one that manufactures Tylenol, Motrin, and some other well-known drugs.  J&J had manufacturing issues at that plant that ranged from (nontoxic) chemicals used to clean wooden pallets leaking into the bottles and creating nauseating odors, to metal and wood particles found in packaging.  J&J closed the McNeil plant a year ago, and went back and inspected products it manufactured at the plant over the previous year or so.  In typical J&J fashion, it erred on the paranoid side (as it should) and recalled almost everything under the sun that this plant manufactured.  So the recalls we are hearing about in the news are of products that were manufactured quite a while back.  It is important to understand that even after the McLean manufacturing problem has been put to rest, J&J will still have an occasional recall.  J&J is a giant healthcare conglomerate, making  everything from Band-Aids to stents to medical equipment to artificial hips.  Though it would be ideal if it had zero recalls, humans will make mistakes, and the more products you make, the higher the likelihood of mistakes.

The recalls have hurt J&J, as revenues in the US consumer business have experienced double-digit declines; however, this segment represents only 8% of total revenues.  J&J is not a broken company; its brand is so strong that it is unlikely to be tarnished by these recalls – aside from discomfort, the faulty products issued caused few problems, and certainly no fatalities.  J&J has a pristine, cash-rich balance sheet, double-digit return on capital, dividend yield of 3.6%, and is trading at about 12 times earnings.  We believe our patience will be rewarded.

Please read the following important disclosure here.

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