Home Depot's Capital Allocation

As I wrote in a post (1/3/2007), Home Depot (HD) has been attempting to make two wrongs equal a right for sometime. The first wrong, a poorly structured (at least from a shareholder perspective) employment contract, facilitated bad relations all around. The second wrong, a reactive removal of Nardelli as the CEO left HD with difficulty executing the complex business model Nardelli had constructed.

Now, HD has struggled with refashioning itself. The basic business platform generates a likely return on capital of 12%, creating adequate cash flows to build new stores, refurbish old ones and pursue business initiatives. Left to its own devices, this would indicate a growth rate of 7% plus inflation on an unlevered basis. Not bad.

But HD is trying to refocus on this business model. It is disposing of HD Supply for about what it paid, given that HD is getting cash back of $8.5 billion, keeping a 12.5% equity stake and guaranteeing $1 billion of debt. Overall, this is not a bad outcome. The purchasers will ultimately take the stock public and HD will cash out at that time without the business having been a management distraction. Thank you, Jamie Dimon.

The aggressive area seems to be the increase of debt in order to repurchase $22.5 billion of stock. HD has been extremely fortunate to have a market downturn, reducing by at least $1.2 billion the cost of its repurchase. The total is almost 290 million shares at $37 per share for a total cost of $10.73 billion. This is roughly 14% of the shares outstanding. Most of this cost will be covered by the $8 billion of sales proceeds from HD Supply. In addition, HD will be borrowing about another $12 billion to repurchase more shares. A downturn in the stock would be welcome as it would allow HD to dramatically shrink share count.

Another Saga of "Synergy"

A great business story is starting to unravel. In 1969, George Valassis opened a small home sales business that sold printing around Detroit. He had enough growth to purchase a printing press in 1971. However, he didn't have enough work for the press. So what did he do? To the dismay of paperboys since, he invented the coupon-insert-in-newspaper business, or in industry terms FSI (free-standing insert). Valassis grew rapidly and dominated the FSI business, until recently.

Over the time, Valassis has continued to search for other ways to get advertising dollars. This has accelerated over the years and recently culminated in the purchase of Advo - another great business story. Started in Hartford, Connecticut in 1929 by Paul Siegel, Advo specialized in delivering fliers door-to-door from retailers. Moving by fits and starts, Advo continued its growth into mailers for the large insurance companies. The growth reached a milestone when the United States Census Bureau purchased its mailing list for American households.

Both companies, Valassis and Advo have struggled with newspaper competition, changing technology and the search for better, more measureable results for their advertisers. Valassis made an acquisition of Advo in 2006, commenting on the multiple "synergies" that would be generated. As I have commented before in this blog, synergies seem to fail either because of illegal monopolies or an overpayment for an acquisition. This case seems to be the latter. But here is some truly destructive potential because of a huge (to me) amount of debt loading up the entire purchase price of $1.1 billion with an annual free cash of only about $100 million.

The stock (VCI) could be a real bargain, but the debtload looks too heavy. Here is a telling graph depicting the core weakness of the business which is servicing that debt:



It looks like Mama ain't using coupons as much these days!

I've Been Workin' on the Railroad

As the song title indicates, I too have been working on the railroad. My motivation has been understanding the interest of investors with good history: Warren Buffett and Carl Icahn.

The railroad industry is the most capital intensive of all industries. Capital intensivity is so unattractive that I refer to the characteristic as being a "capital pig." Railroads are capital hogs, consuming over 20% of their revenues with track maintenance. Trucking companies, in contrast, pay a much lower percentage of revenues in taxes for support of road maintenance.

So what's to like? Warren Buffett commented "As oil prices go up, higher diesel fuel raises costs for rails, but it raises costs for its competitors — truckers — roughly by a factor of four." This is a powerful metric in a rising fuel cost environment. In addition, there has been consolidation to the point that the industry has more pricing power than in the past with very few new tracks being built. This is important, because a typical cylical stock (as in commodity cycles) generates more capacity just as profits get strong. In the railroad business, such a cycle is unlikely.

John Amos, Founder of AFLAC

AFLAC is an amazing company. When I first studied the company over ten years ago, I was certain that the information was wrong. It was inconceivable that a company from south Georgia dominated the insurance market in Japan. But I learned it was true. So much for the fabled inability of U.S. companies to do well in the Japanese market.

I searched for the story and found it in a book titled "The Man From Enterprise: The Story of John Amos, Founder Of AFLAC." After reading about his entrepreneurial childhood, wonderful marriage, early law career, I found what I wanted. In Chapter 16, the author describes that John was on a round-the-world trip with an eighty-one year old friend of his.

On a cold, rainy April day in 1970, John saw something. "Many of the Japanese wore surgical masks to prevent other people from catching their colds. Most people would think...how quaint. John...thought of something else..these were a health conscious people, people who might buy cancer insurance if it could be made available."

Over the next four years, AFLAC worked to get approved. They were not only approved, but granted a monopoly on the writing of supplemental cancer insurance for a period of three years that was extended for eight. The first year was portentous. They expected to write about $3.5 million of premium and ended up writing $25 million. The rest, as they say, is history.

Most Fun Annual Report of 2006.

I have always said that Berkshire Hathaway's (BRK) annual report was the most fun read, but I may have found a contender - the 2006 Annual Report of Mercury General (MCY).

George Joseph and his excellent team at MCY have created a report under "flash movie" that summarizes the developments at MCY since 1962 decade by decade while highlighting some of the cultural changes in the U.S.

To view this, it requires a computer with certain software. It worked great on my computer. Make sure to run your cursor over the little images. Some of the sound effects are wonderful.

What Is Appropriate Exposure?

The financial guarantors, such as MBI, receive a premium from borrowers in order to lower their borrowing costs. For an example, consider a company which wants to borrow $10 million. Also, in this example, let's assume the company is considered investment grade. Such a company may find that by "wrapping" its bond with a financial guarantee provided by a guarantor, the interest rate may be reduced by more than than cost of the guarantee.

This "free lunch" is a result of asymmetry of information, that is, the financial guarantor may have a greater understanding of the risk than the investor. The principle here is similar to the father who cosigns an auto loan for a child. Not only does the lender receive the additional comfort of the father's financial statement, but the father also, ("theoretically" as my partner Joel says), knows better the likelihood of the child's repayment.

By providing a guarantee, the financial guarantor exposes a portion of its portfolio to risk. For example, the financial guarantor may have a multi-billion dollar capital base. By guaranteeing the bond of the company above, how much of the capital base of the guarantor should be "set aside" to fund the risk that the company may have a problem?

The first answer is $10 million. Intuitively, this simple answer seems too conservative. If the company is investment grade, then some rating agency discovered enough ability to repay its IOU so that a complete loss, while possible, would be highly unlikely.

The second answer would be to simply fund a "gap" number by understanding the difference between the current investment grade rating and a AAA rating. A AAA rating is a result of what's backing up the IOU. If Company XYZ has $10 million in cash backing up a $10 million IOU, then it wouldn't need the guarantor. But the company may have some real estate assets or receivables which could be used as collateral. The more collateral, the higher the rating.

If a company needs, for example, 12% overcollateralization to achieve AAA rating, then a $10 million loan would need $11.2 million in collateral. If the company has only put up a 5% overcollateralization to achieve the investment grade rating, then the "gap" number would be $700,000.

The third answer is a statistical modeling approach. This approach takes historical default rates of investment grade bonds and simply applies the loss rate as an average. So, for example, if investment grade bonds have failed 1% of the time, then $100,000 would be set aside as the appropriate exposure.

You can see a wide variety of choices. These model in a real way the challenges faced by the current situation for financial guarantors.

Cost of "Free" Choice

This Goldman Sachs graph illustrates the explosive growth of movement from Defined Benefit plans to Defined Contribution plans.

In my first post (IBM Freezes Pension Plan), I commented that employees have never understood the tremendous benefits that Defined Benefit plans provide. Just as a teenager underestimates the benefits of living at home, so too do employees underestimate their Defined Benefit plan. I would guess it to be a factor of three.

And just as parents are financially relieved to see these freedom-seeking teenagers go off on their own, so too are companies financially relieved to see employees get control of their money by moving from Defined Benefit plans to 401(k) Defined Contribution plans.

This movement illustrates a powerful force not accounted for in economic theories describing "rational" participants. "Freedom" is a powerful elixir. Individuals would rather control their own outcome to suit their own desires than take a prescribed outcome with generally higher benefits. Recently, Alan Greenspan himself had to intercede as Americans were clamoring to use their own retirement plans rather than the benefits of the Social Security system.

Another fascinating chapter in the story of this principle is about to shape the healthcare world as participants move towards the Consumer-Directed Health Plan approach.