Shrinking Orange (HD)

The management at Home Depot (HD) continues to cut expenses so that shareholders do not experience the pains of "deleveraging" - a normally positive term which describes paying off debt, but used here to describe the negative effects of expenses becoming disproportionately large as revenues drop. In an earlier post (March 2008), I complimented the management's sanity in their "reversion to the mean" graph which indicated that markets were overreacting. Well, the markets weren't; instead, management was simply hoping. This graph indicates what others have often said - that markets overshoot before they revert to the mean:




As is evident from the pronouncement at the bottom: "worst of correction behind us," the management has not learned the perils of unqualified pronouncements. A political "may" or "might" could be a good tool for their toolbox.

HD has undoubtedly been moving through a horrendous environment, but in a case similar to the Biblical Joseph and the Pharoah, HD has had nearly 15 fat years of growth before these two lean ones. But after pioneering the "big box" retailer in home building products, HD let a huge lead become an equal race with Lowe's (LOW). Now, HD and LOW have commoditized each other's businesses so that what remains is a real estate play.

HD has over 2,200 stores. These stores are primarily in the U.S., but are also in Canada, Mexico and, incredibly, China. (Think of the distribution advantages with all those empty containers going to China!) These stores are costly - with sizeable pieces of land, additional sitework and paving, topped by a 100,000 sq.ft. building that is filled with furniture, fixtures and equipment. Total costs exceed $20 million. As long as returns on these stores are high, which is the job of the operations, then it's no problem. But commoditizing competition and a difficult environment have combined to create mediocre returns.

In 1978, Warren Buffett wrote the following about BRK's textile mills: "As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed." While HD has not moved pricing to direct operating costs, the decline in profitability to average real estate returns demonstrates that the prospects for superior returns on capital employed are, at best, cyclical and, at worst, historical. Perhaps HD could declare itself a REIT, drop its taxes and increase the dividend to shareholders.

How To Measure Danaher (DHR)

Danaher (DHR) is an extraordinarily well-run instrumentation and tool business. Its stock has outrun Berkshire Hathaway's (BRK), while operating on similar principles. Just as Warren Buffett seeks to acquire companies in order to grow, so does the management of DHR. Year by year, very little growth is organic. Instead, the vast majority is acquisition-driven.

So what makes this method work? To make acquisitions work accretively (meaning adding to earnings) over time, one must either have access to cheap capital - such as low interest rates or high priced stock issuance - or be a better owner. BRK has long trumpeted the fact that its management cannot add value - they simply purchase home run hitters and let them hit home runs. DHR, on the other hand, has a rigorous business system to which all acquisitions are held.

The proof is in the pudding. DHR has successfully made acquisitions pay for themselves when made on a cash basis - a rarity. By focusing the business and cutting excessive expenses, DHR is able to make the increased profitability repay the use of cash. The Danaher Business System creates about a 16% "free" cash flow margin. These excellent margins provide the funds fueling future acquisitions. I put the word free in quotations because interest and taxes must be paid.

Closer scrutiny shows that DHR's "free" cash has been getting freer. While the markets have accorded consistent and high multiples on earnings and book value to the stock for at least 15 years, the multiple paid on revenues has been increasing. When I sought to understand the reason, DHR has moved from 40% tax rates to lower than 25% rates currently - something to be careful about.

International Oil Companies (IOCs)

International Oil Companies (IOCs) are also known as Integrated Oil Companies because these companies combine the activities of Exploration and Production (E&P) and Refining and Marketing (R&M).

Before the days of OPEC, price increases on oil were difficult to get. Oil is a commodity and without a price setting (or fixing) mechanism, like OPEC (and the Texas Railroad Commission before that), prices tend downward. This graph illustrates the point:

Trying to avoid price competition, the oil companies tried to create the perception of value. Not only were there ads to "put a tiger in your tank," but businesses were vertically integrated so that brands and supply control could be developed.

No longer do the companies need to be integrated. Although none of the IOCs have dis-integrated, there are E&P only companies, such as Anadarko Petroleum (APC) and R&M only companies, such as Valero Energy (VLO) for analysis. By studying the characteristics of each, some of the IOCs might be understood by a component valuation approach.

Counter-cyclical? TIPs vs. IOCs

Treasury Inflation Protected Securities (TIPs) are U.S. Government bonds which adjust the coupon payments for inflation. The bonds make explicit the two typical sources of return in a bond: the "real" return and the "inflation" return. The two together combine for the total or "nominal" return.

Assuming the U.S. Government pays its debt, then the real risk of TIPs bond is in the "real" return component. If the economy's rate of growth exceeds the rate priced into the bond, then the purchaser will suffer low returns. However, if the economy is slower than anticipated by the rate priced into the bond, then the purchaser will enjoy superior returns.

Expectations are the key here. In 1999, the economy was buzzing and TIPs bonds priced in real returns that far exceeded those historically experienced. As it turned out, those expectations were unrealistic. The result was that TIPs bonds purchasers did very well. 2009's environment is moving towards the opposite. TIPs bonds are pricing in real returns that are significantly under those experienced. Caveat emptor.

Is there a way to make a counter purchase? One candidate to consider is the International Oil Company (IOC). IOCs have profitability dominated by the price of crude oil. Crude oil prices tend to rise at times of expansion and/or dollar declines. So, intuitively, it is logical to think that at times of rising growth expectations, IOCs would be high while TIPs returns would be low. Conversely, at times of declining growth expectations, IOCs would be low while TIPs returns would be high. The following chart looks at this:

Berkshire Hathaway: International Oil Companies (IOCs)

Warren Buffett's Berkshire Hathaway (BRK) has periodically owned shares of International Oil Companies(IOCs). He made a 2% purchase in 1979 of Hess, followed by the profitable sale of those shares in 1980. He then made a sizeable 15% purchase in 1984 of Exxon, followed by the profitable sale of those shares in 1985. Then, more than twenty years later, he made a 2% purchase of Conoco in 2006. He then pushed this purchase up to over 20% of the equity portfolio in 2008, admitting he made a "major mistake." Since that time, he has sold about one-third of the shares at a loss.

Was there a common thread of reasoning in these purchases? Based on reviewing the annual reports written for the years of purchase, I would conclude that inflation was a significant factor. 1979 and 1984's BRK annual reports have extensive discussions about the impact of inflation. However, the annual reports of 2006 and 2008 do not discuss inflation. Of course, 2008 is not under consideration as the environment turned into a deflationary rout. However, 2006's annual report has an extensive discussion of a weakening currency based on a widening trade deficit - a typically inflationary factor.