Did the restaurant business just get harder?

The Food and Drug Administration (FDA) announced new rules today that will require chain restaurants with twenty or more locations to post calorie information on their menus. The guidelines also cover establishments such as movie theaters, convenience stores and even individual items at grocery stores. Food establishments in cities such as New York and Seattle have already been displaying calorie counts on their menus for some time. But so far study results on the impact of such an effort mixed. So is this likely to have any impact on the restaurant business and its customers?

Restaurants such as Panera, McDonald’s and Starbucks have the led the way in this regard by voluntarily disclosing calorie information on their menus. While all have maintained that the change did not hurt their business (and in fact, pleased customers), Panera actually reported that they have witnessed some shift from higher to lower calorie items on their menu. Different studies have indicated varying degrees of change in food choices based on available calorie information. According to some reports only about 30% of customers notice calories listed on a menu. And how many of those actually change their original choice for a healthier one is open to further debate. Data on total sales, and sales by menu item, from restaurants would be a better gauge of the impact compared to surveys – since what consumers actually do is more important that what they might say.

While in many cases listing calorie information may not cause much change in the total sales of food establishments, it does add to their regulatory burden and compliance costs. Also if customers resort to decreasing the size of their orders rather than substituting it with lower-calorie options available at the same restaurant, then it could be a setback for the business. But such a short term pull-back would be more harmful for smaller businesses. For large restaurant chains, it would be a sign to update their menus according to customer preferences for better growth in the future.

From the point of view of a customer having calorie information on the menu card (whether or not one decides to use it) is a welcome option to have. It is unlikely to matter to those who may eat out only when wanting to indulge, or those who are driven by price considerations, or have very specific food choices, etc. But it could help those who may be picking a higher-calorie salad over a lower-calorie burger only based on the name. Also it is a signal to restaurant owners of growing attention on wellness – something that could lead them to offer more lower-calorie choices to customers. A study by an associate professor at Johns Hopkins indicates a similar trend.

What impact this particular measure will have remains to be seen, but a greater commitment to healthy food habits is good for both customers and businesses.

 

Allied Motion Technologies Inc. – An Under Appreciated stock with growth potential

Allied Motion Technologies Inc. (AMOT) is a manufacturer of motors and motion control products to commercial, industrial, aerospace and defense markets. It is headquartered in Amherst, New York with operations in North America, Europe as well as Asia.  I think that Alliance is a company that is positioned to outperform the market but remains mostly unnoticed by investors. In the following article I will discuss how its strong financial position, growth drivers and reasonable valuation makes it a good investment opportunity.

Business: Founded in 1962 as Hathaway Corp in Colorado the company was in the power and process market until 2002. Since then it has rebranded and focused operations solely in the motion control business. It has also been making strategic acquisitions globally to solidify its position in the industry. As of December 2013 it had 942 employees including design, manufacturing and sales teams in the United States and overseas.

Some of the products and solutions it manufactures are used in alternative fuel vehicles, unmanned vehicles, weapons systems, prosthetics, chemotherapy pumps and testing of gaming equipment to name a few. So it has a fairly diversified customer base ranging from automotive to defense and medical industries. A positive extension of this fact is that the company has not relied on any one customer for over 10 percent of total revenue in the last 2 years.

The company holds several patents and trademarks, with many more pending, that are expected to create more value in the future.

Recent Financial Performance

In August the company reported strong second quarter 2014 results[i] largely on account of the acquisition of Globe Motors in late 2013. The new, larger entity led to a doubling of the company’s revenue, with a 145% growth over prior year in the second quarter. Most of this growth was concentrated in the defense, aerospace and automobile sector. Net income per diluted share grew 229% in the same period, from $0.09 to $0.29. Additionally bookings and backlog, which are good indicators of future income streams, also posted robust growth.

Business grew both domestically and abroad with a 191% increase in sales to U.S. customers and a 91% increase in sales to international customers. Currently the company’s revenue is split in approximately a 60 to 40 ratio between domestic and international customers respectively.

Overall the strong earnings results validated management claims of revenue and earnings improvements from the synergistic acquisition of Globe Motors.

Revenue and Returns

The following chart shows the 10-year trend in total revenue and gross margins for the company. The impact of the Globe Motors acquisition is reflected in the uptick in the 2013 revenue figure.

revenue

The company has achieved an overall positive trend in revenue as well as margins in this period with room for growth in the future. However growth in gross margins was flat between 2012 and 2013. Also in the first six months of 2014 gross margins remained at 29%. While Allied and Globe as separate companies had similar gross margins, the combined entity creates opportunity for margin expansion as synergies of engineering knowledge, technical know-how and operations are realized. Opportunities for cross sell are also likely to arise as the integration process proceeds.

Additionally the company has room to improve operating margins from current levels by improving operating efficiencies. There are likely to be positive impacts from Globe, which has a better track record than the legacy company with operating expenses and margins due to its structure.

OpMargin

On a different performance gauge, return on capital, the company does not impress at first. I used a simplified formula using Net Income and Total Current and Fixed Assets from the company’s financial statements to arrive at the following figures.

ROC

While 2012 was a lackluster year for the company’s financial performance due to economic weakness; acquisition and relocation expenses impacted 2013. Data from the most recent quarter yields a return on capital of 9.6% that exhibits a shift in that trend and indicates opportunities for better returns in the future.

Key Acquisitions

In 2013 Allied acquired Globe Motors from Safran, Inc. for approximately $90 million. Globe not only nearly doubled the company’s revenue, but the impact on earnings was also accretive. Additionally it brings intangible assets such as a more concentrated base of larger customers, trade name and engineering knowledge. While the acquisition increased the debt and interest burden for Allied (a potential risk to the company) it was achieved without much dilution of shareholder’s equity.

In the past acquisitions such as Ostergrens and Premotec have expanded the company’s international footprint and grown its product portfolio. While the global presence exposes the company to the risk of economic slowdown in other parts of the world, it also opens up new markets and opportunities. Most of the company’s manufacturing facilities (both domestic and international) are currently operating below capacity. So it is well positioned to ramp up production as demand rises.

Diversified Customer Base

A safety cushion that the company has is the wide range of industries it serves with its products. The variety of sectors it serves ranges from automotive to appliances, semi-conductors and defense systems.  For example, its technology is used in the medical field in pumps, prosthetics and other equipment.  Typically demand for such products tends to be a little more resilient to business cycles, which is useful for Allied in times of weakened activity among its other customer groups.

Another example is the use of Allied’s products in unmanned vehicles. While these are primarily used in the defense sector right now, eventually the application of such technology could be more diversified. In that case Allied could benefit from growing demand of its products from new sources.

Price and Multiples

The company had a trailing 12-month P/E ratio[ii] of 17.38 that is in a similar range as many competitors in the industrial equipment production industry. This value is close to the lower end of the average monthly P/E ratios observed for the company since January 2014. It is also below the comparable S&P 500 multiple of 19.3[iii].

The trailing 12-month Price to Sales[iv] ratio for the company is 0.63 which is close to the 12 month low of 0.56. Additionally the trailing 12-month Enterprise Value to EBITDA multiple of 8.91 is comparable to others in the industry.

At the time of writing the company’s stock was trading at $13.52 which is lower than its 200-day moving average and presents a good entry point. In the past 52-weeks the stock price has risen approximately 69% compared to the S&P 500’s gain of about 15%. Despite the gain, I think there is still more upside remaining to the stock based on my analysis outlined above.

 

 

 

 

 

 

 

 

 

Is Apple Pay the next big thing in mobile?

In January 2014 I wrote about Apple Inc.’s (AAPL) possible future entry into the mobile payments world. I outlined the terrain and the rivals it would face in this uncertain space. But recently when Apple CEO Tim Cook introduced Apple Pay, their brand new mobile payments system along with the iPhone 6, it raised two major questions that I will try to answer below.

  1. What is different about Apple Pay to make it more successful than its predecessors?
  2. Is Apple Pay the next big thing, or is it setting the stage for the next big thing by Apple?

 

1. Apple’s mantra tends to be “Do it right” over “Do it first”. However it means that others like PayPal, Google Wallet, etc., have a head start in this market. But so far no one has been able to deliver on the promise of replacing people’s wallets with their phones.

Adoption of a new technology, especially involving personal, financial information, can make consumers nervous. Security and convenience are top priorities for most. A platform like PayPal handles the data security issue satisfactorily by not revealing the shopper’s credit card or bank information to merchants. But it is lacking on the convenience front. You can use PayPal to make online purchases easily but the same cannot be said about brick and mortar stores where a larger number of customers still shop.  So even if using credit cards may expose people to a greater risk of fraud, the lack of universal acceptance of mobile payment systems at major retail outlets limits their adoption and active use.

But I think the following factors distinguish Apple from its competitors in the mobile payments space.

i) Hardware: Unlike Google or eBay, Apple has the advantage of producing its own devices that work seamlessly with its software. This gives the company more control over the transaction to ensure a smoother money exchange, better user experience and repeat customers. The integrated hardware and software ecosystem is also a great cross-sell platform for all things Apple.

ii) Data Security: Near Field Communication or NFC[1] technology that the company is using for Apple Pay enables a user to wave their iPhone before an enabled terminal to make a connection. Another chip called the secure element completes the transaction by generating a random, unique number instead of using the actual credit card number for each transaction. While a random number generator is available with traditional credit cards as well, it can only be used online. But with this technology it can be used by customers in stores. An additional layer of security comes from Apple leveraging its existing Touch ID technology for fingerprint authentication before payment.

iii) Brick and Mortar: Apple has taken the next step by making mobile payments about using your mobile device to make a payment wherever you are shopping and not limiting it to just shopping on the mobile device. It has engaged popular retailers like Starbucks, Target and McDonalds to accept Apple Pay at their outlets, improving its odds for mass appeal. Customers will be able to use this payments system at over 200,000[2] merchants.

And the best thing is that it has MasterCard, Visa and American Express on its team. This payment support network is critical because one of biggest hurdles to widespread adoption is convincing merchants to install the required terminals. Having major payment processors with high customer penetration aligned with Apple makes it a more lucrative and credible step in the eyes of the merchants. Conversely the typical customer is likely to have a credit card enabled by one of those providers and is more likely to adopt Apple Pay if it can be used in most major stores; rather than only a select few. Additionally people can still earn their rewards, miles, etc. on the credit cards while all they do is wave their phone near a terminal to pay.

iv) Customer Loyalty: The Company tends to have something of a fan following among its core customer base. It reportedly has over 800 million registered iTunes accounts which is a large potential customer base for its mobile payments system. If the iPhone6 (and maybe even the smartwatch) sales exhibit strong growth then this benefit can become more tangible.

 

  1. 2.      So is Apple Pay the next big thing in the mobile world? It may be. But even if it does not make the regular wallet redundant, it paves the way for the next wave of mobile integration for the likes of Apple.

i) NFC Tags: A sizeable new revenue stream is an obvious reward if the company proves successful in this latest endeavor. But the NFC technology that it is using for payments can also be a testing ground for becoming a more pervasive part of a customer’s everyday life. The use of one’s mobile phone as something of a universal remote that controls appliances, thermostats, security systems and so on can be accomplished with near field communication. In fact appliances that can be synced with smartphones are already available today. But for Apple this could be the beginning of building an increasingly integrated system where its customers rely on the company for many aspects of their routine. This could open up exciting new avenues of growth for the company.

 

 

 

 

 

 

 

 

theValueSurfer Investment Channel launched on Youtube!!

I am excited to launched a Youtube channel extending the information and ideas from theValueSurfer website. The first “How to” video series will be for beginners who are starting to think about investing in stocks and want to learn the ABCs. The first video is now available here How to Invest in Stocks? Step 1 – Opening a Brokerage Account Online  Please watch and subscribe for more upcoming videos. Thank you!!

VCA Inc. – Take a Second Look at this Veterinary Stock

Approximately a year ago in August 2013 I wrote an article about the veterinary care company then called VCA Antech (WOOF) outlining the opportunities and risks facing it. Since June 2014 the company is known as VCA Inc. in an effort at rebranding. It operates over 600 veterinary hospitals as well as a network of laboratories in the United States and Canada.  In this article today I will refresh that analysis and attempt to re-evaluate the company based on updated information.

 

Recent Financial Performance

The company released its second quarter financial results last month. It reports its financials in three major segments; Animal Hospital, Laboratory and All Other. It beat consensus estimates on earnings with an EPS growth of over 10% in Q2 2014 versus prior year. Revenue missed analyst expectations but still expanded by 5.2% over the previous year.

The last time I reviewed VCA Inc., I was concerned about the lack of revenue growth in their largest segment, that is, Animal Hospital, which accounts for about 76% of total revenue. For the six months ended June 30th 2014 revenue in this segment expanded by 4.6% year-over-year. In Q2 the same figure was 5.9% out of which 2.2% was organic growth whereas the rest came from acquisitions. While this growth is not impressive, it is a good start to improving the top line. Another positive development was expansion in gross margins both at a total and same store level. Management has indicated that there is still room for margin expansion in the future. The company has also continued with acquisitions, adding 6 new hospitals so far with more in the pipeline for the remainder of the year.

Revenue growth in the Laboratory segment was 3.3% over prior year for the six months ended June 30th, 2014. Separately organic revenue growth in the second quarter over previous year in labs was over 5%. This category reported improved profitability as well with expanded gross margins. While the number of requisitions was down, it was the smallest decline in recent history.  Also the company added 2 new labs to its network.

The All Other segment reported an approximate 7% decline in revenue year over year but it was due to a onetime hit from the destruction of the Sound Eklin facility in Carlsbad from wildfire.

 

Price and Valuation

Since I wrote about WOOF one year ago its price has risen approximately 42% from $27.29 to $38.98. For reference the S&P 500 has risen 21.7% in the same referenced period. The following chart shows the movements in the closing share price of the company along with the highest and lowest closing price in this approximately one year period.

Interestingly when I wrote my last article about VCA Inc., its trailing twelve month (ttm) P/E ratio was very high at over 50, even though the forward P/E was expected to be at a much more reasonable level around 16. With improved earnings performance in past quarters the company is trading today at about half of that ttm P/E of about 24 which is closer to historical levels.

 

Growth Potential                

Universal Appeal: As I outlined in my last article, there is a high proportion of pet owning households in the United States. Estimates range between 70–83 million pet dogs and 74-95 million pet cats. I think that the universal appeal of pets to different demographic groups is likely to continue whether the population has a mix of the elderly with companion animals, families with children and family pets, or young, single professionals in apartments with smaller pets.

Pet Care Expenditure: Additionally the general sensibility in the United States of treating pets as members of the household also increases the likelihood that pet owners will continue to spend money on the health and well-being of their animals. In my last article I quoted the American Pet Products Association (APPA) which forecasted total expenditure on pets in the United States would be upwards of $55 billion in 2013, that is an increase of 4% over 2012. Actual figures for 2013 available now on the website show that $55.72 billion was actually spent on pets in the United States. The current forecast for 2014 is $58.51 billion with $15.25 billion being on Vet Care. This implies acceleration in total expenditure growth to 5% in 2013-2014 compared with 4.5% in 2012-2013. In fact expenditure on Vet Care is expected to grow slightly faster at 6.1% between 2013 and 2014.

Pet Insurance: According to statistics provided by the North American Pet Health Insurance Association (NAPHIA) the pet insurance industry has been growing over 13% annually since 2009 and the North American market is estimated to be about $595 million. It estimates that there are over I million insured pets in North America which suggests that there is still room for a lot of expansion in this field which would benefit a company like VCA , Inc.

 

Overall

VCA Inc. has an expanding network of hospitals and labs that position it to take advantage of these industry trends. Management plans to continue to use capital for a combination of share buybacks as well as acquisitions. Also since I reviewed it last the company has kept up its good margin performance while slowly improving its revenue growth. There has been a focus on increasing overall wellness visits that generate higher priced orders and reducing lower priced orders. The company has also continued to introduce new programs such as CareClub for wellness and Cattitude for care of pet cats. It recently acquired pet daycare and overnight board franchise Camp BowWow. Although there is still more to be desired on that the revenue growth front, but there has been an effort to improve it. Overall, I think that WOOF could be a good addition to a long term investment portfolio. 

Prada with Peanut Butter

What do Costco and Carrie Bradshaw have in common? Fendi.

High end designer merchandise has been popping up in the unlikeliest of places. In the past one had to go treasure hunting in discount retailers such as TJ Maxx and Ross for a great luxury find that did not break the bank. These would mainly be discounted items from previous seasons. But now you can find high end merchandise alongside your groceries and cleaning supplies. Target has been collaborating with designers such as Isaac Mizrahi, Prabal Gurung and Missoni. Similarly you can run into Prada and Fendi at Costco. Kohl’s has been selling Vera Wang and Juicy Couture for a while. But is this really a good strategy for these brands? Or is luxury for less, less luxury?

What Works? A sales platform like Costco for instance, gives a designer brand exposure to the company’s 71.2 million cardholders. The average household income of a Costco customer is approximately $96000[1]. For Target customers the median household income is $64,000. Some of these people may not have purchased a full priced high end item from a designer or department store, but may be willing to try it at a lower price point during their usual shopping trip at a mass retailer. So these stores are a gateway to a large, untapped market of higher volumes (although usually lower price points) for the luxury brand. Also for some shoppers exposure to an accessible version of a luxury brand may be the initial hook that pulls them into the world of high end merchandise.

What Hurts? There are two ways in which the move to reach the masses could backfire for some makers of luxury merchandise and lead to a dilution of their brand. Firstly, if they produce lower quality versions (to match the lower price) of their full line merchandise specifically for sale at mass retailers it could hurt the overall reputation of the brand and actually lead customers away.

Secondly, for many people buying a high end item is not just about paying a higher price for great quality. It is also about acquiring a status symbol. If Prada was sold at the same store as peanut butter, that may dampen the “posh factor” for some loyal customers of the brand.

Is it worth it? Among many other factors the success of this strategy depends upon the price and income elasticity of the product being sold. And that depends on the type of product in question.

Luxury goods like high end designer merchandise are defined as products whose demand increases more than proportionately as income increases. But their relationship to movements in price can be interesting.

Usually luxury goods are price elastic, so a change in price leads to a more than proportionate change in demand for the product. Price elasticity can be defined as the percentage change in the volume of a good demanded with a one percentage change in its price, everything else equal. Let’s assume that a luxury handbag is highly price elastic. So for example, a one percentage price cut leads to a ten percentage increase in its sales. In such a case selling more handbags for a reduced price may lead to higher total revenue for the seller. Taking their merchandise to the mass market at a lower price point may be a good bet.

Alternatively, if sales of an item do not respond as greatly to price changes, then selling fewer but more expensive units would generate greater revenue and could be the better way to go. This price indifference could occur in instances where there is a great degree of brand loyalty, or the price of the item is a tiny proportion of the buyer’s budget.

This is just a small piece of a much larger cost benefit analysis that any luxury brand would need to do before making the decision. In the meantime, there are more options in the market for shoppers!

Costco: Is it in your shopping cart?

The over sized shopping carts and super sized merchandise of Costco (COST) is familiar to most Americans and even some customers overseas. As a members only warehouse it provides a diverse selection of merchandise to its customers at a discounted price. While the loaded shopping carts and long checkout lines at the warehouses suggest that people have bought into Costco’s idea of quality at a reasonable price, but does the bargain end inside the store?  Or are the company’s shares a good value for money for the long term investor? The following is my view of Costco’s growth potential and valuation.

Business Model:  The Company operates over 550 warehouses in the United States and Canada. It also has a smaller, but growing, footprint in the United Kingdom, Mexico, Japan, Korea, Taiwan, Australia and Spain.  While targeted towards small business owners, the warehouses also meet the needs of households with their selection of groceries, home supplies, furniture, furnishings, pharmacy and even gasoline. The business is built on the principle of providing cost savings to customers by sourcing merchandise directly from manufacturers and shortening the distribution channel. In addition the warehouses have shorter hours, minimal aesthetic displays and limited number of active SKUs to reduce labor costs and increase efficiencies.

Growth:  Costco’s two main sources of revenue are sales and membership fees. Since 2009 both have expanded over 10% annually on a compounded annual growth rate basis. Food and sundries (such as candy, alcohol, cleaning supplies, etc.) contribute the largest share in revenue. The company operates with tight margins and needs to maintain its fast inventory turnover along with growing its membership base. Its in-house brand, Kirkland Signature, generates a higher margin and could be a useful income source if it continues to grow as a proportion of sales. 

When it comes to sales it is important for the company to grow organically, as well as add new warehouse locations. Same store sales of the company were in negative territory in the aftermath of the financial crisis in 2009, but have recovered admirably since. In comparison to its major direct competitor Walmart’s Sam’s Club, Costco’s comparable store sales performance has been stronger.

Change in Comparable Store Sales*

2013

2012

2011

2010

2009

Sam’s Club

0.4%

3.9%

8.4%

3.7%

-0.8%

Costco

6%

7%

10%

7%

-4%

* Sam’s Club and Costco fiscal years are different.

The company has also been expanding through new stores both domestically (an average of 11 new stores per year in the United States since 2009) as well as internationally. In fact by the end of this month, the company expects to open 3 new warehouses. There is more room for growth in the international markets where the company’s presence is still not as large. Same store sales performance of warehouses overseas has been at par with the United States in the last couple of years, but international markets are more profitable than the domestic market. So there are opportunities to grow both sales and margins in those markets as well.

Treasure Hunt:  An approximation of revenue per square foot also shows that Costco’s generates over $1100 per square foot racing ahead of Sam’s Club over $674 figure. The company has been maintaining this strong performance through large sales volumes and quick inventory turnover supported by its limited yet high quality and fast moving selection of merchandise. Since the company is on the lookout for the best deals, it does not consistently carry the same products that it may have sold before. Anecdotally, while this can be frustrating for some shoppers it also leads many to stock up whenever their favorite product is being sold in the stores. Additionally there can be an element of curiosity pulling people into the stores to discover what new product lines are being sold each time. Similarly the practice of moving products around within the warehouse also may help with putting customers face to face with new items they may not have bought otherwise.

Keeping it Simple:  Another point in favor of Costco is that management understands its market and target customer. The focus is on offering low prices without compromising quality and so it has stayed true to simple warehouse style stocking of items and shorter hours that save on labor costs.

In terms of e commerce, there has not been an overly zealous approach in that area. Online sales are only 3% of total revenue and could be a potential growth area in the future. While management is cognizant of future opportunities/challenges in the ecommerce channel, I think it has wisely kept its focus on the warehouses which are the core of the business at present. Similarly marketing via its newsletter Costco Connection and other activities is limited but targeted.

Employee Satisfaction:  One of the business ethics that Costco follows is that a happy employee leads to a happy customer. It is well known that the company pays an average of $21 per hour to its employees, much higher than its direct competitor Walmart. The company also does well in offering career growth opportunities to its employees since it follows a model of promoting people within the organization, from warehouses to corporate offices. Unsurprisingly, employee turnover rate is low and sales per employee are strong.

 Brand Value:  A harder to monetize yet important metric is what I like to call “brand value”.  In this case I looked at the loyalty that the Costco brand enjoys reflected in its total membership renewal rate which has continued to strengthen, reaching above 90% for U.S. and Canada and above 87% internationally in the last quarter. Among business members the renewal rate is even higher, that is, above 94%. This implies that the company has a stable, growing base of customers that are loyal to the brand as long as it maintains its product quality and pricing.

Valuation:  The shares of the company were trading at $118.64 at the time of writing. This price is above the company’s 100, 50 and 20 day moving averages and just below its resistance ceiling calculated with recent price data. Additionally the peak closing price in the last three months was $119.59, close to the current level at which the stock is trading.  

The current price puts the trailing twelve months price to earnings ratio at 26.55, which at first glance is not inexpensive in my book. Alternatively, the forward P/E is estimated to be around 23.04, which is more reasonable.  Also the trailing 12 month price to sales ratio for Costco is 0.48 which is lower than that of its direct competitors.

Another good forward looking measure to consider would be the price to earnings growth or PEG ratio. Given that the company has seen EPS growth of 9.88% per year compounded annually for the last 5 years we can make some assumptions about future growth. Assuming this growth will continue in the near future and adjusting for dividend yield (since that is another consideration for investors besides earnings growth) the result is a PEG ratio of approximately 2.4. This is on the higher side compared to its direct competitors in the industry.

A point to note is that the company has been continuously adding new warehouses domestically and internationally. Since profitability is higher overseas and major U.S. competitors have a limited presence there, it is a possibility that earnings growth may improve in those markets. Also if the company can continue to increase sales of its higher margin Kirkland Signature brand then that would be another impetus for better earnings.

Overall: Costco is an example of a company that has proven to be a sound business idea combined with good execution.  It has potential to expand its footprint in the United States and overseas and I would look for a price level near the 100-day moving average ($115 – $116) to pick up some stock in the company.

Walgreens: Not Leaving on a Jet Plane

The price of Walgreens (WAG) shares plummeted after the company announced that it had no plans to shift its headquarters overseas as part of its acquisition of Allianz Boots and take advantage of the “inversion loophole”. The company’s management cited reasons like the burden of IRS scrutiny as well as public and media backlash as drivers of the decision. The move may be considered patriotic by some, but did not get the stamp of approval from disappointed shareholders. Wall Street expectation was that Walgreens would follow the footsteps of several other corporations that have acquired companies located in countries with lower corporate tax rates primarily for the benefit of slashing their U.S. tax burden. But Walgreens was not alone in forgoing the overseas tax advantage and retaining its headquarters in the homeland. Agricultural giant Archer Daniels Midland (ADM) also decided to move its headquarters to the Chicago area despite rumors of a possible move overseas associated with its recent purchase of Swiss food ingredient producer Wild Flavors.

While these companies refrained from this lucrative but ethically ambiguous option, there are many others who have leveraged it. A recent article in the Wall Street Journal reports that this has been the chief motivation for approximately 66% of international deals announced this year. Corporations such as pharmaceutical company AbbVie have initiated mergers with foreign counterparts in the recent past that could result in large tax dollar savings. So I have been wondering if this was a smart move or a missed opportunity for Walgreens.

Anyone reading the news will see that this topic is heating up in Washington. President Obama has expressed his resolve to tackle this loophole and prevent U.S. companies from “gaming the system”. Although any substantial executive action may be easier said than done in the near term, the issue is definitely on the radar. So for a business that is estimated to earn a sizeable chunk of its revenue from Medicare and Medicaid program prescription sales, picking a fight with Washington may not be the greatest idea. Since Walgreens is such a universally recognizable brand, there is greater awareness and somewhat higher exposure to backlash from the government and general public compared to other companies that may not have as much direct consumer recognition. So in the case of a possible inversion investigation, large PR costs would likely be piled on top of legal costs.

Additionally inversion deals could lead to greater burden of corporate gains tax on shareholders even without selling any shares when they receive shares of the new corporation. There are ways to mitigate this impact, but it is another case in point that this route may not be an obvious win for shareholders as it appears to be initially.

The debate over whether it is justified for companies to evaluate the option of inversion deals or not, and what would be the optimal way to dissuade them from it, is not likely to be resolved easily. In the case of Walgreens, while the initial shareholder response to the decision was negative as manifest in its stock price decline, for the long term investor the focus should remain on fundamentals and growth.

Going Organic

Walmart recently announced that it was partnering with Wild Oats to sell organic foods in their stores at prices 25% below other organic food brands. If successful this could be a game changer in the organic foods world, typically understood to be a niche market for a premium paying customer. In this regard Walmart has a potential goldmine of untapped customers who shop on a budget and have been keeping away from organic foods due to the cost factor.

The opportunity that lies open before Walmart is a market that currently makes up about 4% of total grocery sales in the United States and is expected to grow to 5% by 2019. The largest components of these sales are produce and dairy. In the case of dairy, the share of organic to total milk sales ratio in the United States has grown from 1.92 in 2006 to 4.38 by 2013. Interestingly during this period, except for the year 2009, there has been a decline each year in total milk sales while sales of organic milk have been increasing. Since around that time consumers were feeling the direct hit of the Great Recession on their personal finances, it may be possible that it led to a cutback in the purchase of higher priced organic milk. However the fact that every other year the consumption of organic dairy has increasing might suggest that the status of organic foods as “luxury” grocery may be changing. And Walmart could benefit by taking it even further in affordability to a growing number of customers who are willing to try it.  In fact Walmart’s own survey indicates that 91% of their customers would be willing to buy organic foods if they were available at more reasonable prices.

But the question is whether the reduction of this price premium by Walmart will pose a threat to the Natural foods stores that have so far been out of reach for a majority of customers. The typical customer who shops at such stores is already willingly paying a higher price not only for their grocery, but also for the ambiance, the healthy cuisine in-store restaurants, and so on. So natural food stores can probably keep this group of customers even if Walmart offers a more competitive price. However, it is the potential “converts” who are not buying organic foods at present but would try it at a more reasonable price that could open up a still largely untapped market with great growth potential.

 

Ceco Environmental: Three Takeaways from the Q4 Conference Call

Ceco Environmental (CECE) is a global air pollution control company that I have evaluated in the past as a potential investment opportunity. In its recent released Q4 2013 earnings report the company beat expectations with an EPS of $0.26, but missed revenue expectations. This was despite the fact that its revenue expanded over 100 percent year over year, mainly on account of acquisitions, and gross profit was up 50% from last year. But to me the highlights of earnings release were in the following three themes that indicate the future direction of the company.

Acquire and Integrate: In my last article on Ceco I had written in detail about the business and management’s strategy relating to acquisitions. Total revenue in 2013 was $197 million compared with $135 million primarily due to the acquisition of new businesses. In order for an acquisition to be successful it is crucial for the integration of the new asset with the existing operations to be seamless. In this regard the company has been successful so far in smoothly integrating the recent acquired MetPro and realizing $9 million of synergies from it. Management has consolidated 3 manufacturing facilities and office buildings, selling the Met Pro facility and moving ahead on the path of realizing synergistic value from the integration. Recent acquisitions have opened up new revenue sources, contributed to an increase in bookings as well as more recurring business opportunities. Another example of the effective management of the integration process has been that operating margins improved with MetPro under the Ceco umbrella, and the company was also able to achieve 19% SGA including MetPro, despite it having run on higher SGA before.

Grow Overseas: The Company currently has about $3 billion of installed capacity worldwide and there is an opportunity to grow recurring revenue from this source since currently it counts for only about a third of the business. It is looking to expand operations in China both as a market and manufacturing source. In fact, it was indicated that there could be a potential acquisition as part of a manufacturing expansion initiative in China in the near future. While the company has operations in countries like India, China, Canada and Latin America, a large proportion of the business is still in the United States. So there is still room for expansion of its business internationally. Moreover in developing countries environmental/pollution control regulations and laws are likely to grow and create opportunities for the company.

OneCeco Initiative: Most of the revenue growth reported in the quarter was from acquisitions and organic growth was not robust during the period. But one of the company’s initiatives highlighted in the earnings call could also be instrumental in moving the dial on this. The OneCeco sales initiative is a tool to consolidate all air pollution control products and technologies and use this powerhouse to gain more market share and grow margins. The company is tracking its sales performance closely under this OneCeco “segment” and management expects that only 50% of the gains from this initiative have been realized yet. The initiative has already resulted in the creation of over 150 new RFQs and led to over a dozen new air pollution control projects. I think this could be an astute way to blend, bundle and leverage economies of scale for the benefit of Ceco as well as its customers.