Saturday, January 21, 2012

Hasbro (HAS): Part Three - Circles Competence

Whatever your impressions of Mark Cuban, owner of the Dallas Mavericks among other business ventures,  you should read what he has to say at blog maverick. Several years ago he posted an entry called "How to Get Rich." When a billionaire offers that brand of advice, my ears tend to perk up. His advice did not disappoint. I'll quote liberally...

"The 2nd rule for getting rich is getting smart. Investing your time in yourself and becoming knowledgeable about the business of something you really love to do...Before or after work and on weekends, every single day, read everything there is to read about the business. Go to trade shows, read the trade magazines, spend a lot of time talking to the people you do business with about their business and the people they buy from. This is not a short term project. We aren't talking days. We aren't talking months. We are talking years. Lots of years and maybe decades. I didn't say this was a get rich quick scheme. This is a get rich path.
Now you wait for times of uncertainty and change in your business. The time will come. It may come quickly, it may take years and years. But it will come. The nature of our country's business infrastructure is that it is destined to be boom and bust. Booms are when the smart people sell. Busts are when the rich people started on their path to wealth. You will know when that time is here for you because you will know your business inside and out. You will be ready because you will have been saving up for this moment in time...
...Booms and busts happen in every industry. The question is whether you have the discipline to be ready when it happens for you? If you do, you will find out what it feels like to get lucky."
He speaks of developing deep competence in an industry by coming to know it intimately...understanding its rhythms, its cycles, its strengths, and its weaknesses. It supersedes number crunching and other forms of strictly quantitative analysis, so it's the sort of knowledge that tends to evade Wall Street pros.  It's  awareness that bolsters your confidence to push your chips in when others are folding and heading for the exits. Because you've studied this industry. You recognize what customers want and when customers buy. You have learned when a dip in earnings is signal of actual trouble for the business and when it's just a temporary blip...just part of the cycle. 

Investors are well-served getting to know particular industries as Cuban describes and making bets when they know the odds are stacked heavily in their favor. And while most of us don't have the luxury of being quite so parsimonious with our investments, the spirit of this as a mental model can be applied to our own disciplined approaches. 

Two things come to mind as I think through the Hasbro opportunity. First, can I sift through the avalanche of input that represents my research on the company and tease from it the few relevant pieces of information that give me the best shot at understanding its future? These are the business drivers...the variables that have an outsized impact. Second, can I buy it cheap enough that the low price - in and of itself - reduces my downside risk? This I need in case I didn't identify the right drivers or somehow convinced myself I was operating in an area I could comprehend when in fact it was beyond my abilities.

My Hasbro research will take me through several years worth of annual reports, financial statements, investor presentations, quarterly earnings update transcripts, and media features on the executive team. In my experience, if you dive into all this data without a goal of what you're trying to understand, it will confuse you, confound you, and otherwise leave your head spinning in all directions. 

To develop a baseline of competence on Hasbro and the toy industry in a reasonable amount of time, I must start with some questions or themes to frame my research. That's where we go next...

Friday, January 20, 2012

Hasbro (HAS): Part Two - Quick & Dirty Stab at Valuation

So I'm attracted to Hasbro because it appears relatively cheap at around 11x price-to-net earnings, has a respectable 10-year track record (per Morningstar's collection of its financial data), and has stable of toy brands that look strong, many of which I remember loving as a child.

We start off by listening to a Mattel presentation on the merits of the toy industry. It suggests good growth opportunities and stability through the roughest times. The past is no guarantee of future performance, but it's a pretty good place to start. I'm much more at ease extrapolating a long history of good performance into expectations for the future than I am looking at track record of bad results and expecting the business to change. So we invest a little more time to see where our research takes us.

In mid-2010 I created a humble model, a stress test of sorts, through which I would run prospective investment opportunities to see if they present a comfortable margin of safety. In simplified manner, it works something like this:

First, I look at the business's growth rates over the past seven to ten years, paying particular attention to owner earnings it generates (more or less operating income plus depreciation minus taxes minus interest minus my estimates for cash needed for maintenance capex and maintenance working capital growth) and what it does with those earnings  (i.e., does it let it accumulate as cash reserves? plow it back into the business? use it for acquisitions? pay it out as dividends? buy back shares?). Most importantly, I want to see whether owner earnings are growing at a healthy clip, staircasing in an up and to-the-right trajectory, and being used in shareholder friendly ways. 

Then I calculate the compounded annual growth rate of the owner earnings AND CUT IT IN HALF to build a margin of safety into my assumptions as early as possible. I apply that growth rate to the last full year numbers from the business. If it were to grow at my calculated rate, I want to know what its overall owner earnings will be five years from my initial investment. 

Let's just go ahead and use Hasbro as an example. Using fiscal year 2010 numbers, I calculate its owner earnings to be $360 million. Its compounded annual growth rate since 2003 has been 10.1 percent, so I'm going to use 5.05 percent in my conservative estimates. Meaning, at the end of 2015, its owner earnings would be $460 million. 

I assume that after paying dividends and reinvesting back into the business, excess cash will go to share repurchases. Without getting into all of those details now, my calculation is that Hasbro's outstanding shares would drop from 129 million today to 108 million at end of 2015. A quick bit of division and I see that Hasbro would generate 4.24 in owner earnings per share at the end of five years. 

Now I apply a multiple that those earnings. Most value investors would be aghast at this practice. After all, you should never try to guess the mind of Mr. Market! I find it no more arbitrary than trying to calculate business performance out to infinity by running a formal discounted cash flow analysis. Hasbro's current multiple is about 12. A quick look at its historic owner earnings multiple shows that it has ranged - on the low side - from 11.8x to 36.9x over the past nine years. That makes me feel comfortable that 12x is plenty conservative for my margin of safety needs. I'll use it.

So 12 times 4.24 gives me a conservative share value of 50.90. Now I add back accumulated dividends, assuming that Hasbro will continue paying out at its recent rate of 36 percent of owner earnings. I think that's pretty conservative since it means the five year dividend growth rate will only be about five percent (the same as owner earning growth rate for obvious reasons) instead of its historical 26 percent compounded rate. 

The dividends are 6.41 plus the share value of 50.90 gives me a total value of 57.31. Starting at about 33 per share today, that means the value will appreciate a total of 73.7 percent or on a compounded annual basis of 11.7 percent.

Now, where should we start quibbling about the errors in calculation or thought process? They are plenty. The point, however, is to make a quick and dirty stab at valuing the business five years hence using conservative assumptions. Each step of my process is meant to lead to an easy way to screen out investment candidates that don't merit more of my research time. Hasbro passed the early tests, meaning I thought it worthy of investing an hour to push it through this margin of safety stress test.

What do I want to discover from this stress test? That the conservative inputs suggest the likelihood of a satisfactory return for my investment. I'm not looking to thread the needle with businesses promising only  marginal upside after making ambitious assumptions of their performance. I'm looking for meaningful compounded growth after chopping their growth prospects down to earth.  As a prominent investor once said (and I paraphrase), it should be so obvious you could drive a truck through it.

Rough calculations suit my needs at this stage.

Hasbro shows promise of about 12 percent compounded growth in this test. Since the business has modest needs for reinvested capital, the bulk of the benefit comes from using owner earnings to payout investors via dividends and share repurchases. I prefer to see a clear and easy path to 15 percent compounded returns, but my impression is that Hasbro is of high enough quality that I can invest my time and take it to the next stage of research.

Thursday, January 19, 2012

Hasbro (HAS): Part One - My Intro to the Toy Industry

Flipping through some 52-week low stock screens I run across Hasbro (HAS), see its relatively low P/E at 11, its comfortable dividend yield at 3.6 percent, and decide to dig in for a closer look. Here's a first blush check list that tells me its worthy of investing some time...

1. 10-year historical information at Morningstar shows decent performance in revenue growth and operating income while maintaining a respectable return on invested capital and a much better return on equity.

2. A glance at its balance sheet shows growing debt levels but the cash flows show no problem covering interest payments. 

3. Its statement of cash flows demonstrates a commitment to returning cash to investors in the form of consistent and growing dividend payments along with plenty of share repurchases over the past several years. Its need for capex is pretty low when compared to its cash generating abilities.

4. And finally, its website shows that it owns and/or licenses some real franchise brands like Transformers, G.I. Joe, Star Wars, Nerf, Monopoly, etc. I like strong brands. 

This looks promising, but I know almost nothing about the toy industry. I need to educate myself. Strangely enough, one of the first places I end up spending time is the investor relations page of arch rival Mattel where I start reading its Analyst Day presentation from October 2011 which attempts to answer these three questions: Why toys? Why Mattel? and Why now?

Seems a good place to start.

Mattel management presents a reasonable thesis that appears grounded in facts. Here are the key points:

  • The global toy market is growing, sporting a respectable 2.1 percent CAGR since 2007 despite strikes, recessions and epidemics and showing no reason it would slow down soon.
  • There are more kids today then ever before, and mothers keep popping 'em out.
  • Grandparents are growing as a demographic, and they spend $52 billion a year on their grandkids in the U.S. alone. As true a fact as you'll ever read...Grandparents are the biggest suckers the toy industry could ever hope for!
  • The middle class is growing like crazy in developing countries and more disposable income creates the desire to spoil your kids with brand-named toys.
  • The toy industry is largely recession resistant, actually growing during the 2001-2003 recession and doing five percent better than the rest of the S&P 500 during the 2008-2009 recession. Not to mention toys outperformed most other forms of discretionary consumer spending when things got tight for shoppers.

The gist of the rest...Mattel is very shareholder friendly with its cash, has incredible toy brands along with strong licensing partners, and it's poised to knock the proverbial ball out of the proverbial park as consumer wallets start opening up again.

Few senior executives make it to their high-salaried positions without honing some sales skills along the way. And as I finished listening to the Mattel presentation, I was ready to speed-dial my broker and grab me a slice of that pie. I like good brands! I like demographic tailwinds! I like global growth! I like shareholder friendly management!

Alas, it was trading at a premium to Hasbro (14x to 11x) and was much nearer to a 52-week high than Hasbro's low. Plus, I have a hard and fast rule about making impulsive investment decisions. I set out to evaluate Hasbro and the toy industry. Let's just digest this information for a night and see where our efforts lead us tomorrow.