ValuePlays

“The definition of insanity is doing the same thing over and over and expecting different results”. Benjamin Franklin

“Deutsche Bank has hiked its price target on Coca-Cola Co. (KO) shares to $57 from $50, representing upside of roughly 19% from the stock’s current trading level. The firm noted that Coca-Cola’s operating profit has risen 24% since July 23, 2004 to an estimated $7.1-billion this year. While its dividends are also 33% higher, the shares are trading $1.50, or 2.5% lower, versus a 32% gain for the S&P 500 during the same period. “Against this, we see Coke today as better positioned to address the core strategic challenge – managing a wider portfolio while lowering distribution and input costs,” the firm said, changing its recommendation to “buy” from “hold.”

Not to be outdone, Morgan Stanley on 2/23 raised its rating on Coca-Cola to “overweight” from “equal-weight,” citing attractive valuation and improving operations fueled by strong performance in emerging markets.The investment bank, in a research note, said valuation was attractive with potential gains of 18 percent to its $56 price target on the stock

Because two is not a number that officially qualifies a group as “lemmings”, Goldman Sach’s Judy Hong joined them when she wrote in a note to investors. “Weak US demand in core categories and rising raw material costs set the stage for tepid domestic beverage profits in 2007, while emerging market growth remains robust.” She then raised Coke to a buy form neutral, “as its turnaround begins to get some traction”. She continued, “recent results demonstrate Coke’s ability to weather challenges in key developed profit centers and still deliver strong global profit. Improvement in developed markets, joined with continued robust growth in emerging markets, should help sustain solid results and help close the [price/earnings] multiple gap versus other high-quality global consumer staples stocks.” She at least was smart enough to not put a price tag on shares. If we go to the earnings conference call on 2/14 we can see Ms. Hong savagely grilled management with questions like this: “One segment where you didn’t gain share globally last year was ready-to-drink coffee and tea, and I guess some of that is because of the weakness in Georgia Coffee in Japan. Can you also talk about just broadly what you’re doing to improve your performance in that segment especially in markets like North America where you have been lagging competition?” “Talk broadly” ?? Are you kidding me? Here is the translation: “My boss might be listening so I have to ask a question, just give the corporate PR line on this and we’ll call it a day, besides, it is almost lunch time.” How can you actually “analyze” something by only getting “broad” information and then making a decision to tell people to buy the stock the following day with no additional details?

On its face you might read the reports and say “Hey 19% and three buy recommendations? Let’s jump in and buy shares!!” But before you do, lets take a closer look at July 2004 because after all, how can we know where we are going if we do not know where we have been?

July 2004 Coke Share Priced at $50
2004 Earnings Per Share $2.14
2004 PE ratio 23.3
2003 EPS $1.95
EPS Growth 9.7%

What is one of my most fundamental rules of investing? Never pay twice the growth rate for a stock. Especially one growing at a blistering 9% (see previous Coke post for my evisceration of management for this “goal”). In 2004 investors buying Coke paid 2.4 times the growth rate for shares. That is the reason shares have not gone anywhere, period, end of sentence, case closed, go home & turn out the lights the party is over and Colonel Mustard killed Mrs. Plum in the library with the candlestick. Now, the “analysts” want us to think Coke is in store for 19% share price appreciation? It must be that Coke’s situation has changed? Let’s do a little home work and look at some more numbers:

Current share price $47.5
2006 EPS $2.22
2006 PE Ratio 21.3
2005 EPS $2.05
EPS Growth 8.2%

So the lemmings want us to believe that paying 2.5 times earnings growth in 2007 will result in a 19% gain in the stock when for the past 3 years these same numbers have lead to a stagnant share price? How can they think this especially when you consider that Coke’s own executives have no goals or desires to grow more than 7% to 9% annually so it isn’t like we are in store for 15% EPS growth this year? For some inexplicable reason they must think the rules of investing will change? But wait, let’s look closer at Coke’s history. It is possible that the current situation is just an aberration and that is the reason for the blindly optimistic outlook. Maybe, just maybe when Coke has experienced similar financial metrics in the past, shares have appreciated. Let’s go back to even farther to 2001 to see how we got here.

2001-2006 Annual EPS Growth 8.2%
Average PE Ratio 26
PE to Earnings Growth Average 3.1 times

These numbers show us that Coke’s current numbers are essentially the same as its historical averages since 2001. We can now say with some degree of confidence that whatever has happened to the price of the shares in the last 6 years, we can reasonably expect that trend to continue. Why? The market has been presented with these numbers for Coke on a regular basis in the past and put a price on Coke shares based on them. So here are the results:

Jan, 2001 Share Price: $60
Current: $47

Uh Oh…. When faced with similar financial metrics since 2001, shares of Coke have lost about 21%, yet the “analysts” are calling for shares to rise 19% now! It is beyond my ability to comprehend how they can look at the results from 2004 to 2007 in their reports and based on the history above conclude anything but more of the same for Coke’s share price. Maybe they have never heard of Ben Franklin?

Don’t these people have a duty to do a legitimate job analyzing companies before they recommend them? How can you look at the above numbers, come to the obvious conclusion that the current situation at Coke is virtually identical to what it was in 2001, 2002, 2003, 2004, 2005 and 2006 and conclude, “things will be different this time”? Some things in life you can count on: Popeye will always find his spinach and inflict a “Rodney King” on Bluto, the coyote will never catch the road runner, peeing into the wind is always a bad idea, wiping your butt with poison ivy is an even worse one and stocks of huge companies that only grow 8% and sell for over 2.5 times that do not go anywhere.

Oh yeah… and Ben Franklin was right…….

Everybody just relax…... A 3.4% decline is nothing . It all started when Alan Greenspan , who I can only assume was well into a bottle of Makers Mark and is rapidly become the most irritating former public official since Jimmy Carter incoherently mumbled something on a conference call about the current conditions in the US leading us into a recession, despite all economic indicators to the contrary. Then, the Chinese market dropped 9% overnight and set off a scare. These events would be unnerving to me except when you consider the Chinese market had been UP 13% the previous week and Greenspan, to be honest kids, doesn’t have the best track record in my eyes. Look at his reign, he was too slow to get a grip on the bubble of 1999- 2000 (by raising rates behind, not ahead of it) that lead to it “popping” rather than “deflating” and then he was asleep at the wheel on the back end to ease rates and lead us like General Custard into the recession that followed. Personally I am a huge Bernanke both for his plain spoken testimony and his refusal to let those on “The Hill” frame his comments for their own agendas. I will follow Ben’s lead here when he says the economy is strong a settling into a “sustainable growth” phase vs. a guy who was too late to recognize what was going on when he was at the helm and hid it by talking in riddles .

Back to today. Events like this while scary are good for a couple of reasons.

-They allow you to test your portfolio
-Allow you to pick up shares you had been wishing you bought “when they were cheaper”.

How do you “test” your portfolio? Warren Buffet has a quote he equates to stocks “A rising tide lifts all boats…. and vice versa“. What does that mean? During big rallies, most stock advance no matter what the underlying fundamentals. The same is true of sell-offs like today. You would be hard pressed to find many stocks up today. That means almost everybody’s portfolio took a hit. Here is the test: What you want to happen on a day like today is for your portfolio to drop less than the market. If you are a value investor this is a true test of it. Since we are buying “cheap” stocks, if they truly are, there will not be as much pain during sell-offs. The opposite is true also. During rallies, we should see percentage growth in excess of the market because our shares are so cheap others will rush to pick them up. That is how we should beat the S&P. Drop less during sell-off and jump more during rallies. Also, as a test of how we are valuing companies, the stocks on the “Avoid” list ought to drop more than the S&P because if they are truly overvalued, sell-offs like these should really hurt them. So, then how did the ValuePlays Portfolio do today?

The proof in in the pudding…(4 pm prices)

ValuePlays Portfolio= -3% (up 2% to date)
S&P = -3.47% (-2.2% to date)
“Avoid” = -3.8% (-9.5% to date)

Down today? Yup.. who wasn’t? The key takeaway is we picked up another 1/2% against our benchmark, the S&P extending our lead over it to 4.2% and unlike the major averages remain in positive territory for the year. This also positions us to extend those gains even further once things turn around.

Now, what is cheaper that we may want to buy again? Keep an eye on the watch list, there are certain names that are getting closer as of today to our target prices. Another drop like this and we may get to go shopping. Please do not pull the trigger too soon though. Some of them may still drift lower over the next couple of days. Be disciplined and patient. Remember, “great” prices not “good” ones.

Those of you who are subscribers to the Premium Portfolio Service will know what I pull the trigger on and buy before I actually do it.

It appears I may have been a bit to rash with Mr. Frank Blake, the new CEO at HD. After reading the transcript from today’s conference call it appears that he may not be the shareholder patsy I initially thought he was. This turn of events also has me now looking much closer at shares of HD. Let’s get to the call before we run out buy any though. In it Blake said of the very supply business that only last week the rumor mill had on the block to be sold:

“The business exceeded expectations for the year, despite softness in the residential construction market. It also clearly gained market share in the fourth quarter and throughout the entire year.

Why then would we even consider selling Supply? We are past, present, and future, a retail business. To get the most value for Home Depot as a whole we would need, I believe, to integrate Supply with our retail business. While that integration effort might not be a complete hairball, it is sufficiently difficult to warrant checking — before we begin — on whether we can create more shareholder value through other alternatives, such as a sale. Once we integrate the businesses, a subsequent sale is much more difficult. If we can create more shareholder value now, through a sale or other alternative, then that’s what we will do. If not, we won’t.”

I know what you are thinking, “Is this Frank Blake or Bill Clinton?”. “We will, we won’t, it depends on what the definition of sell is”. There does appear to be a whole bunch of taking both sides here and Blake is hedging statements to keep both sides happy. I believe Blake is just holding off those calling for the sale until they get the details of the Supply integration together for presentation. In order for us to better decipher what may actually happen, we need to dig deeper in the call.

For me, the relevant details were provide by Joe DeAngelo,COO & EVP. This is a little long but important.

“Now let’s turn to Supply. 2006 was a great year for Supply, as we exceeded our financial targets, accelerated our Hughes integration plan, and built a strong foundation for future growth. For the fourth quarter, Supply sales grew by 64% and operating earnings grew by 20%. For the fiscal year 2006, Supply delivered sales growth of 162%, and operating earnings growth of 151%.

Supply’s fourth quarter 2006 operating profit was $143 million, with an operating margin of 4.9%. The fourth and first quarters are typically lower operating margin quarters, due to the seasonality of the construction business. For fiscal year 2006, Supply’s operating profit was $800 million, delivering an operating margin of 6.6%.”

What does this mean? The best performing segment at HD is the supply business! To continue:

“Additionally, we are extremely pleased with the integration of Hughes Supply over the last ten months. The Hughes businesses have been fully integrated into Supply. The Supply team committed to $0.01 of earnings per share accretion in fiscal 2006. As a result of the team’s focus and execution, we are well ahead of the integration schedule, and have also outperformed the operating plans, delivering $0.04 per share of earnings accretion.”

In summary, you have a company that is basically two parts, a huge retail business that grew at 2.9% last year and a smaller supply segment that is growing at 164%. The US retail business is mature and to expect anything other than pedestrian growth in the future barring any huge acquisition isn’t realistic. The real growth in HD is in their China and Mexico retail operations and Supply.

The argument for the selling of the supply unit is that it’s purchase has distracted management from the retail operations and caused them to suffer. I asked the question is a previous post and it bears asking again, if Church & Dwight can make selling baking soda and condoms work and Proctor & Gamble can sell toothpaste and hair care products successfully, why can’t Home Depot succeed at selling electrical outlets and umm… electrical outlets? It doesn’t make any sense! We are in the middle of a housing slowdown which is hurting both the retail and supply segments yet despite this, supply has exceeded (crushed?) all expectations. Can you imagine how well they would have done had housing turned around? Retail is not suffering because of the supply purchase, it is suffering because former CEO Bob Nardeli while excelling at organizing HD left a lot to be desired in the people department.

The integration of Hughes into HD Supply was seen as too tough but it has been done and the results to date have been fantastic. It would be hard at this point to justify it’s sale unless of course you are not it this for the long haul. Relational Investors who own owns just over 1% of HD stock has been screaming for the Supply sale. Relational generally holds it’s positions for a couple years and I believe what they are looking for is a quick payoff and then an exit. The sale of Supply would accomplish a short term excess return to shareholder at the expense of long term results. Bad idea.

This whole scenario has me recollecting the HP / Compaq merger that was the genesis for the ouster of Carly Fiorina. Carly was forced out by the board after the merger proved difficult to integrate and did not produce the immediate results shareholders wanted. In addition, investors felt her management style was not “warm and fuzzy” enough. Talk swirled that HP need to break itself up into three pieces to realize full shareholder value. Stop me if any of this sounds familiar. What happened? HP did not break up, Fiorina’s vision of the value of the merger was realized and the stock has more than doubled from $20 to $43 in two years. Just because something is difficult does not mean it isn’t worth doing.

The last two years HD has generated about $6.5 billion in cash flow from operations annually and bought back $2.5 billion in stock each year. There is plenty of room to juice this amount up and make significant progress this year. A $4 billion buyback would reduce shares outstanding by almost 5% next year and still leave room to bump up the dividend again. In lieu of that, a big one time dividend ought to quiet the heard and make the short term folks happy enough to squash the Supply sales caterwauling.

HD grew eps 20%, trades at a pe of 14 (pe/eg of .7, great), has huge cash flows from operations, a growing the dividend, is buying back stock has and a total return yield (my calculation) of 7.8%. There is nothing not to like, I just will not own this company without the supply business. It is too valuable long term. Now, the stock ran up in anticipation of the sale and I expect it might fall should they decide not to do it. It would then be a good buying opportunity.

February 28th is the big day. HD will announce more details at it’s investors conference. Then we will see if Blake has any stones or not. We can assume from what he said earlier that once the integration of supply into retail begins, he would be unlikely to undo it. That leaves us in a “*hit or get off the pot scenario”. Blake needs to either start the integration or start the sale, choose a path. Here’s hoping he recognizes what he has. I said before I would want to own HD shares if they kept the supply business and will gladly apologize for my unfortunate characterization of Mr. Blake as “Bendover Blake” in my previous post, if he makes the right choice.

I would like to thank a couple of sites that have picked up my posts, give them some publicity and also ask you to check them out as I like to work they are doing.

The Stock Masters: These guys are great. They take a real irreverent look at investing and companies and their site is filled with “blasts from the past” from TV and movies. Some investing sites can be painfully dry but this is definitely not one of them. Here you can get good quality advice mixed with a chuckle or two. It is easy to navigate and best of all the advice covers a wide variety of stocks and industries.

Seeking Alpha: An aggregated site, Seeking Alpha takes articles from contributors (like yours truly) and re-posts them. It is a great site for research. Simply type in the name or the symbol of the company you are interested in and you can read all the posts from contributors on it. This is a great feature as it will give you both the pros and cons of company. Several of the contributors are regulars on CNBC so their thoughts are worth considering if for no other reason they will be widely disseminated. If you are interested in just the views of a particular contributor you can find those also. Their email alerts let you know when a post concerning either a company, contributor or sector is available. They also post earnings calls transcripts that you can access for details.

Value Investing News: This is a community driven site in which users “vote” for the top stories. It has a lot of in depth analysis focused on value themes. If you look through the site you will find posting that look familiar.

News:

ADM: Announced a $377 million dollar stock buyback on 2/14. This will repurchase about 10.8 million shares based on today’s price. I just love these things…

DOW: Announced a quarterly dividend of 37.5 cents per share payable on 4/30 to holders of record on 3/30. This means if you want the dividend you must own the stock before 3/30.

OC: Something looks to be happening here. OC normally trades about 380,000 shares a day. On Thursday, shares jumped over 6% on 7 times its normal number of shares traded (2.8 million). What does that mean? It means somebody(s) with big bucks was in the market buying up shares. Now, OC reports earnings on Wednesday 2/21 so word may be getting out on the stock (Or they are maybe reading ValuePlays?). Here is hoping you bought weeks ago when I recommended it.

I was looking for something to relax and read today so I picked up a copy of the CocaCola earnings call transcript from 2/14. As I was reading through it I got to a line that stopped me cold. CFO Gary Fayard said “EPS growth was 9%…. at the top end of our long term earning targets”. Just to drive the point home he reiterated “Our benchmark for success is high single digit eps growth”. Not to be outdone, CEO Neville Idsell claimed “Our strategies are working.” Way to push it boys, 9%, let’s back off that throttle just a bit, we are burning up here. It needs to be noted that the 9% includes a 2% gain from stock buy backs. Yet more proof that buy backs help earnings per share but, that means operations only delivered a 7% earnings gain. To repeat Idsell “Our strategies are working.”

It does give me a certain amount of comfort though. I now know that if my children ever bring home a report card filled with C’s on it and are completely satisfied, they are then qualified to run a $112 billion dollar multinational company.

To be fair we need to compare this to their only competitor, Pepsi. Maybe it is the business they are in? Maybe to expect more is unreasonable of me. For the answer we need to turn to Pepsi’s call on 2/8. CEO Indra Nooyi said of 2006 results “We are making good progress on key initiatives” a rather subdued synopsis of the year. CFO Richard Goodman gave the outlook for 2007, “consistent with our long-term guidance, we anticipate…. EPS growth of at least 10%”. Oh, and what did Pepsi do for 2006? Eps increased 13%, and they call that “good progress”.

What to make of this? Easy, the floor for success in the eyes of Pepsi is Coke’s ceiling. This is staggering and also explains why 5 years ago you would have paid $47 a share for Coke and you could sell it today for, well, $47. For Pepsi on the other hand, you would have shelled out $40 for share you could sell today for $64.

Now I need to dig for more here. In the past 5 years at Coke they annually averaged:

Eps Growth of 8%
Dividend growth of 13%
Shares Outstanding decreased .8%
Cash From Operations increased 8%
Debt decreased 2.3%
Revenues increased 8%

Is it any wonder why the stock is worth the same today as it was 5 years ago? They have not done anything! They are flat lined.

Now for Pepsi (annual amounts):

EPS growth 25%
Dividend growth 20%
Shares Outstanding decreased 1.1%
Cash From Operations increased 11.5%
Debt Decreased 1.3%
Revenue increased 8.6%

Anyone surprised the shares have behaved so differently? The people at Pepsi seem to realize that managing is actually a verb, not a noun. With almost identical revenue growth they have managed to triple the profits, double the dividend growth and exceeded the share reduction and cash flow increase rates of Coke. You also have to consider that Pepsi is a larger company than Coke, (45% more revenue) which inherently makes percentage growth more difficult.

I need to go back to the Coke call to give you more perspective on their mindset because this stuff is really out there. Now this really is a quote from CEO Idsell:

“Third on our agenda is leading the franchise. From my first day back I have stressed that the Coca-Cola Company, in order to excel, needs our whole system to be healthy and to be aligned. This is more than just a financial metric. It’s about changing the mind-set of our people to take a total system focus and understand the value chain all the way from consumer to manufacturer.

But it’s also about making the hard decisions, and we have done that time and again. In Germany, we have made significant progress on the creation of a one bottle system …”

That’s it? Picking one bottle is a “hard decision”? For Christ’s sake get a circus monkey in there and let them pick it out. Better yet, film the stupid monkey jumping around a room full of bottles searching for the perfect one and use it for a commercial, it will be better than the mind numbing drivel you subjected me too during the Super Bowl. I felt like Malcolm McDowell in “A Clockwork Orange” watching those things. Memo to Coke: Nobody cares about a damn bottle!!

He continued “No matter which market you examine the basics are clear. When an issue arose we quickly identified the root causes, developed and communicated our action plan, and delivered results”. Yeah, okay, we got it, Coco the chimp picked the new bottle. Way to execute that “action plan”. Nice job, now maybe we can stop patting ourselves on the back and try to make a little money?

Another one from Idsell:

“Additionally, during the year we highlighted Japan, as weakness in our core brands, particularly Georgia Coffee, impacted our results”…. Georgia Coffee???? What, do they think the Japanese will drink anything? What’s next, natural spring water called “New Orleans”? A fruit juice called “Newark”? If I want peanuts I think Georgia, if I want coffee Georgia will never come to mind. Apparently it doesn’t in Japan either.

Now we again must contrast this to the Frappuccino coffee offering from Pepsi. No contest, it actually doesn’t illicit a gag reflex and it sounds drinkable. Pepsi also recently bought a company called Naked Juice, make you curious? Me too so I bought some. This stuff is unbelievably good and is quite possibly the healthiest thing you could drink daily,100% pure fruit juice, nothing else added. Coke is countering this with a new Minute Maid product . When I think of Minute Maid I think of powdered lemonade, not a health drink and I bet you do also. What is this going to be, powdered strawberries? Yum Yum. If I was a betting person, I would bet millions of American’s think the same way. This will fall by the wayside just like Vanilla Coke & New Coke.

Yet despite all this, not one of the “analysts” that cover Coke challenged Idsell. This is why blogs like this and websites who are not trying to get investment banking business from those companies they cover are so important. We do not care who we piss off. You cannot make an investment decision based on what these folk tell you to do. On Wall St. there is almost no money in analysis but, there are billions of dollars in investment banking. All of these “analysts” companies covet Coke’s banking business, do you really think they are going to anger the decision makers at Coke by holding their feet to the fire on a conference call? Me neither. How could anyone who is legitimately trying to “analyze” Coke not mention that their “goal” of single digit earnings growth is pathetic or ask why Pepsi is trouncing them on almost every metric? Here is the “analyst” line up for you:

Mark Swartzberg – Stifel Nicolaus
Bryan Spillane – Banc of America
Bill Pecoriello – Morgan Stanley
Lauren Torres – HSBC
John Faucher – JP Morgan
Christine Farkas – Merrill Lynch
Carlos Laboy – Bear Stearns
Robert van Brugge – Sanford Bernstein
Kaumil Gajrawala – UBS
Judy Hong – Goldman Sachs
Matt Riley – Morningstar

Finally let look at what is rapidly becoming my single most important metric for success. Six years ago if you bought shares of both Coke and Pepsi here is what you did. In Coke shares you paid 29 times earnings for a company that was then growing at 2%, so you paid 14 times it’s growth rate for shares. For Pepsi you paid 27 times earnings for a company growing then at 19% or roughly 1.6 times it’s growth rate. Based on my mantra of trying to always pay as close to or below a companies earning growth rate, is it any wonder Coke shares are flat while Pepsi’s have advanced? The real surprise for me here is that Coke shares have not collapsed. You cannot pay over twice a company’s earning growth rate and expect success. I have yet to find an example where this tool has let investors down. I am sure there is one out there and somebody will dig it up but, look at it this way, if we have 50 examples of when it worked and 1 where it didn’t, do you like those odds? Those who subscribe to our Enhance Portfolio Service will get their updates on Saturday morning. This is a key metric in the portfolio and they will be very pleased with our results so far.

So where are we today? If you are looking at shares of Coke, do just that, look but do not touch. Currently they trade at 22 times earnings and are ecstatic to be growing at 9%. Do not pay over 2 times earning growth for a company who has no desire to do any better. It is one thing to have a mediocre year and look to the future with plans to improve, it is another to have a mediocre year and stand up and take a bow. This is what Coke did.

You are thinking about buying shares in the following company in January 2001. Sept. 11th is 9 months away, the recession that followed is almost a year away and the current events in Iraq and Afghanistan are not on anyone radar screens. Looking at the financial picture of this company, you decide to pick up some shares. Now fast forward 5 years and this is what has transpired:

Revenues have grown 80%
Earnings grew 147%
The dividend has grown 150%
Cash flow from operations grew 137%
Shares outstanding decreased 8%
Assets increased 109%

You are probably thinking you are sitting on the porch of your new ocean front house reading this. How could the stock of this company not have doubled or even tripled? Life must be good.

Reality check. Not only has your stock not double or tripled but you have actually lost money! How much? As of today you are down about 20% but, don’t feel bad as this is far better than the almost 60% you were down in 2003. “Who is to blame?” you shriek. “Heads must roll!! Fire the CEO, hang the Board of Directors and bring me the head of Alfredo Garcia!!” Do you want to know who is to blame? I will tell you. Please get up from your computer screen, go over to a mirror and stare in it. Who do you see? That’s right..You!! You are to blame. “Why me,” you ask?

Because, for some inexplicable reason you paid over 50 times earnings for a company that sells screwdrivers and lawn mowers and was growing at a rate of less than half that. The company? Home Depot (HD). I have said it before and it bears repeating, timing in life is everything. Now former CEO Bob Nardeli took the job when the stock was at an irrational all time high and because he was not able to re-write the number one law of investing, overpriced stocks always fall, (see SBUX & Google) he is out of a job. Here is the timing part, had he taken the over in Jan. 2003 when HD stock was at its lows, and delivered the same financial performance, his reign would be marked by a stock price increase of 95% and we would writing articles about how he “Rescued Home Depot”. Irony…

The HD Board of Directors caved to pressure from delusional investors who thought there was a “new paradigm” and plowed money into shares of HD at the turn of the century only to be shocked when there wasn’t, and ousted Nardeli. I know “technically” he left over a pay dispute but if I am in charge and want you to leave, I will refuse to give you what you want hoping you get mad and do just that. That is what happened here. It is clear the Board of Directors no longer wanted him around. Now, Nardeli did not help his cause with his management style and made himself an easy target. A GE product from the Jack Welch days, he attempted to bring that same hard charging persona to the HD ranks. He failed to realize that an up and coming manager at GE who has aspirations of greatness will accept that pressure and try to perform. But, the retired plumber or electrician who works nights and weekends at HD for a little extra cash will tell him to stick it (and they did in droves). He then decided to stop giving “analyst” earnings and sales guidance and Wall St. freaked (he later changed his mind). Continuing to dig the grave, he was less than graceful (to be polite about it) to shareholders at the annual meeting. In short, he did put the bull’s eye on his back.

Shrill investors were not satisfied just with his ouster though. They demanded board representation and new CEO Frank Blake did hid best impersonation of a French soldier and instantly surrendered before the battle began. His reasoning must have been “hey, these guys were shrewd enough to pay 80% too much for the stock when they bought it, surely they are qualified to make decisions for the future of the company” Okayyyy.

He then sent two key executives close to Nardeli packing probably thinking, “24% earnings growth per year? These clowns got to go”. I can only assume he was listening the same investor group he gave the keys to the boardroom to.

Now, “Bend Over Blake” has decided that the Hughes Supply Division that Nardeli purchased for $3.8 billion dollars (including assumed debt) less than a year ago might need to be sold (again listening to these same investors). The claim is that Nardeli overpaid for Hughes and it is a drag on the company. Opponents of the acquisition claim in has distracted HD from its core business of retail sales. This is ridiculous, they are still selling the same items, just to different people, it isn’t like they decided to go into the shoe business. I mean if Church & Dwight can make selling baking soda and condoms work (who doesn’t think of those two in the same sentence?) why can’t HD make selling screwdrivers and uh screwdrivers work?!? Estimates today have the division going for $8 to $13 billion. Let’s do the math, Nardeli paid $3.8 billion and less than a year later estimates are that HD could realize a return of 110% to 240% on that investment. He overpaid? This too is foolish. If you look at HD retail operations, is there a town in the US that does not have one? Where is the future growth for HD? The answer? Currently it is in the very supply business they are considering selling!

This summer I picked up some HD when it was trading at $34 a share. I sold it in December at $39 (it currently sits at $41) when the Nardeli ouster hysteria was hitting a crescendo. My thinking was “the devil I know is better than the devil I don’t”. I decided to get out and wait to see how things shook out. I also would not be a buyer of it at this time.

Why? Hall of Fame football coach Marv Levy, the only coach to ever lead a team to four consecutive Super Bowl’s once said “If you listen too much to the fans, you’ll soon find yourself sitting with them.” This is exactly what “Bend Over Blake” is doing. Yes I want management to listen to shareholders concerns and behave in a way that adds value for us, but management cannot let them run the company. Especially when it was not running poorly to begin with. Think about it, in the past 6 years HD went through 9/11, a recession and now a housing downturn. HD’s business is very sensitive to these events and through it all it has performed well. The phrase “if it ain’t broke, don’t fix it” has meaning for a reason. HD was not broken, it just needed tweaking. Maybe a little “warm and fuzzy” from management to employees and shareholders would have turned attitudes around. Had HD been losing money or had rapidly falling profits then shareholders and Bend Over would be justified in taking these drastic actions. But, giving the reigns to people who, let’s be honest, made a terribly indefensible buying decision themselves is insanity. I’ll get your seat ready Mr. Blake.

I would like to buy HD again but with what is happening, who knows what they are going to do. So I wait. I will not add it to the watch list because the conditions that would have me considering a buy at this point have nothing to do with price and everything to do with the direction. I cannot figure out a price to buy when I do not know what the company will look like. I am just wondering what will be left after these guys are done.

Don’t think I have forgotten about you either. Yes Nardeli made mistakes, and Blake appears to be making bigger ones but if you are holding this stock and are under water, the biggest mistake was made by you. “Wait a minute!” you scream. The stock of Lowes, HD’s only competitor is up 200% in the same time. “What do you think about that!” you ask indignantly. This one is real easy. Those Lowes investors in 2001? They only paid 20 times earnings for their shares for a company growing at 20%, therefore they received the full benefits of Lowes earnings growth. It should be noted here that all the stocks in the Value Plays Portfolio trade at about equal to or less than their earnings growth rates. When you pay a price commensurate to or less than a companies earning growth, you reap the rewards of that growth. You on the other hand paid over 2.5 times earnings growth for HD shares and are suffering despite the 147% earnings growth over that time. Lesson learned? The next time you want to pay 50 times earnings or over twice a companies growth rate for anything, email me and I will try to talk you off the ledge before you and your money fall. If you do not want to email me, take a hammer and smash your thumb with it rather than buy the stock. At least that pain will go away soon, the pain of the stock buy will linger for as long as you own it.

Intrigued? It is only a week until pitchers and catchers report to spring training boys and girls. This is great news, as it means winter will soon be over and there are more warm summer nights watching the Red Sox with my sons around the corner. It also has me thinking about investing. I know, stay with me though, it will all make sense soon enough.

When a batter has two strikes on them, it is called a pitchers count. The reason? The batter must swing at any pitch close to the strike zone for fear if they let it go, the umpire will call it a strike and they will be out. Sit down, do not pass go and do not collect your $200. Pitchers know this and throw pitches that are just out of the strike zone knowing the batters will swing. The reason batters in the major leagues have lower batting averages when they have two strikes on them? They are not usually swinging at good pitches. Even if that pitch is the perfect hitters pitch, a fast ball, if it is not in the right location, batting averages fall. The ultimate example of this is in the Baseball Hall of Fame in Cooperstown, NY, next to a statue of Boston Red Sox great Ted Williams, the greatest hitter in the history of the sport. Yes Yankee fans, Ted Williams was the greatest. Had he not spent two tours in the military (5 years) serving his country while in his prime, Barry Bonds would be chasing his HR and walk records today. It should be noted here Williams never once regretted this decision and spent his time in Korea as a fighter pilot, almost being shot down several times. In baseball, he posted a .344 lifetime average, a .488 on base percentage and is the last player to hit .400 for a season. But I digress, sorry, the juices are starting to flow. The display (pictured to the right) is from the Hall of Fame. It illustrates the average Williams believed he would hit for if he swung at pitches in a certain location. The better the location, the better his results. Now, all the pitches are strikes but depending on their location, the outcome for the greatest hitter of all time was dramatically different.

Last summer I started watching Church & Dwight and no, they aren’t cousins of Brooks & Dunn or even Montgomery Gentry and I am relatively sure they cannot carry a tune. CHD is the maker of Arm & Hammer Baking Soda, Trojan condoms, Nair hair removal, First Response Pregnancy test and a host of other consumer products you can find here.

The stock had been bouncing around from $35 to $37 a share for a while and given its past track record, I was interested to say the least. Earnings had grown from 76 cents a share in 2001 to $1.84 in 2005 (140%), the dividend had grown 26% in the same time frame (not great but still growing), cash on hand grew from $50 million to $125 million (this is good when you consider annual profits in 2005 of $637 million) and total debt only grew 56% to $735 million (this too is okay as it is only 1/3 the growth in profits and was used for the acquisitions that helped grow them). But, their products are boring (I know there is a Trojan and First Response joke there but I am going to leave it alone) and how much growth is there in baking soda? Besides, they were trading at about 21 times earnings, expensive and not a true valueplay . I said to myself “If I buy it and it drops I have broken my cardinal rule by buying a stock that is not really undervalued”. I decide to wait.

Then in August, they announce they were raising earnings guidance for 2006 2 cents to about $1.95 or 11% higher than 2005. I want to jump but the stock reacts immediately and begins a march from $37 to $39. Strike One. “But”, I say to myself again “they only raised the guidance by 2 cents a share, it is too much of a run for 2 pennies so I will wait for it to come back down and consider it again”. What happens next? In November they raise guidance again by 5 cents this time and the stock begins its accent to $42. Strike Two. “Still trading at a price to earnings in the low 20’s and growing at 12%, a bit too pricey” I remind myself. Again, how much growth is there in baking soda?

December 15 rolls around and they announce they are entering India next year and the stock begins its climb from $42 to $44. Now I am really pissed at myself because I have waited and watched almost 25% in profits not materialize in only 6 months. Strike three, but I am still at the plate batting.

January comes and CHD shares begin to falter. After hitting an all time high on Jan, 31st they drift lower over the next 5 days. “Here we go” I think, “let’s give up a few dollars and I will pick some up”. Of course CHD reports earnings on the 6th and they grew profits 47% in 4th quarter and they guide higher (again) for 2007. Strike four and I am still at the plate. The stock now sits at $46.42 and still trades at 22 times 2006 earnings.

CHD is a story about the power of brands and being in lines of business that are consistent earners. No matter what the economy does, people will clean, have sex, get pregnant, brush their teeth and hopefully get rid of unpleasant body hair (not necessarily in that order I assume). CHD is in all these business with industry leading products. They have been able to leverage the image of quality in the Arm & Hammer brand into laundry soap, toothpaste and cleaning supplies with great success. When you think of condoms you think of? Trojan. When you think of the results of not using them you think of? First Response. The strength of these brands has allowed them to successfully pass on price increases and because of this CHD is projecting 13% to 14% growth for next year. In short, this is a great company that is running very smoothly and yes by leveraging the Arm & Hammer brand there is growth in baking soda. As for their other segments, sex and pregnancy are certainties in life and world population growth will lead to continued strength for CHD.

Back to baseball, CHD is a high fastball, the perfect hitters pitch but its location, like its price is too high and not a good one to swing at. Our chances and the level of success we would expect at this level, like Ted Williams’ would be diminished. So I wait.

For the past 5 years the performance at CHD has been nothing short of outstanding. They haven’t missed earnings estimates and when the topic does come up they are typically guiding higher. This has lead investors to have total confidence in their them and they have been rewarded, with shares up about 170% in that period. This confidence is illustrated by investors being willing to pay a higher premium for shares (price earnings ratio). At its current ratio (22), CHD trades at almost twice next year’s earnings growth rate. Compare this to our current portfolio picks like Dow, MO, SHW that trade at premium’s that barely exceed their current growth rates and picks like ADM, SHLD and OC that trade below their current growth rates and you’ll see why I think it is expensive.

Why does this matter? The high multiple investors are paying on CHD shares has them priced for management’s flawless execution. Should they falter, shares will be punished. You have heard it before, everybody makes mistakes, nobody is perfect, well the same can be said of the management of a business. For 5 years CHD has been, eventually they will falter. India may be that event. It may be more expensive to break into the market than they believe, there may not be the market for condoms and pregnancy tests they hope there is. Any of these would cause earnings to stumble and at this price level, the shares would fall fast as doubts now enter the picture for the first time in 5 years.

Now you may ask, what about Friday’s post on the Gap? If you bought it now you would be paying 21 times this years earnings and they are actually growing at a negative rate! Hypocrisy? No. Let me explain. Gap is broken. CHD is not. Gap, if they take my prescribed fix can grow earnings next year 12% just through share buybacks and if they close the unprofitable locations another 6% to 7% earnings growth from the savings is easily attainable. You then have 18% to 20% earnings growth at Gap next year. That is the reason I have advised we not buy Gap shares now until we hear what the new CEO has to say. Should they not buy back shares and close unprofitable stores then the shares are too expensive at their current levels and I will not be a buyer. At CHD there is nothing obvious to do to improve performance. They are leveraging brands, raising prices and entering new markets. No problems.

Just like I have been advising against buying shares of Google at its current levels, so too must I advise against CHD. Unlike Google I will add it to our watch list because it is in markets and businesses that give me a high degree of predictability when it come to earnings, Google is not. Also, its brand strength does give it a durable competitive advantage in several of its businesses. I just need as little less risk to the downside on it before I swing (I want this fastball lower in the strike zone). In order to consider shares in CHD I need to be able to get them around $40, that has me paying about 17 times 2007 earnings for a great company growing at about 14%, I can live with that ($40 is about 15% less than its current price).

If the price comes down to my $40 I will swing. If not, I will just keep letting pitches go buy. The beauty of investing over baseball is I cannot be called out, no matter how many strikes I watch go by. I only have a bad result if I swing at a bad pitch.

In memorium:

“Ted’s (Williams) passing signals a sad day, not only for baseball fans, but for every American. He was a cultural icon, a larger-than-life personality. He was great enough to become a Hall of Fame player. He was caring enough to be the first Hall of Famer to call for the inclusion of Negro Leagues stars in Cooperstown. He was brave enough to serve our country as a Marine in not one but two global conflicts. Ted Williams is a hero for all generations.” – Dale Petroskey (President of the Baseball Hall of Fame)

ps. Baking soda. Did you know that it can replace almost all of your household cleaners? The beauty of it is that it is cheaper, works better than most of them and if your children get into it, they will not get poisoned, go blind or suffer burns. For all its household uses please click here

So how do we know when a stock has bottomed? Thursday morning retailers reported January same stores sales. This is “the” metric most people follow to determine the health of a retailer. While I fall into “profits are more important than sales” camp as espoused by Eddie Lampert at SHLD (read it here) and Julian Day, formerly of SHLD and currently CEO of Radio Shack , it is important to understand the effect this metric has on a stock.

Most retail analysts view this number as gospel. A good number is good and a bad number is bad, period. If your same store sales are increasing your health as a retailer is increasing and vice versa. Get the point? Back to Thursday. Industry results were released for January and the results were good, increases virtually across the board except for Gap (GPS). Here is the rub though, people were actually happy with Gap’s number because while negative, it was not as negative as they thought it would be. People were expecting a drop of over 7% and only got 6%. Because of this the stock traded up over 2.5%. We now have a situation were a company is performing worse than its peers and because it’s results were not as bad as expected, this is good. Can you imagine what would have happened if they actually reported good news? The question now begs us, “What would Gap have to do for the stock to drop much lower?” It would almost take an enormously negative event. This is intriguing and makes Gap worth a closer look.

What happened to Gap? In short, it is too easy to get their stuff. When Gap was becoming popular there was a certain cache or “trendiness”to their products. People clamored for their products and were willing to pay high prices for them and Gap obliged by building stores everywhere. Is there a mall anywhere that does not have a Gap in it? When your products become too easy to get and everyone has them, they cease to be trendy. When you try to sell those now non trendy clothes at trendy clothes prices, people will not buy them (and they haven’t). People drifted to their low price, low margin Old Navy brand. Reason? Same clothes better prices. Again in my situation, why would I go to Baby Gap or Gap Kids and pay $30 for pants I can get at Old Navy for $7? Answer? I won’t and obviously neither are most people when you consider Old Navy sales are about 20% higher than Gap brand’s are. Do my 4 year olds care if their clothes say Gap or Old Navy on them? If they do I am failing as a parent. (Disclaimer: If this conversation is Red Sox over Yankees then this must be important to them or I am obviously failing). Let’s put aside the parental duties argument. They do not care if the say Old Navy or Gap nor will they when they are 14 or even 24. That, in a nutshell is Gap’s problem. They have a value brand and a premium brand and in order to sell the latter they must price it like the former.

As a result, Gap’s stock has essentially been flat for the past 5 years bouncing around $20 after hitting a high of $50 in 2000. Recently fired CEO Paul Pressler’s reign is largely viewed as a failure. Lets take closer look at some numbers though. Under Pressler Gap grew earnings from 54 cents a share in 2003 to $1.27 last year before dropping to about 89 cents this year, causing his ouster. In what shape did he leave Gap? Not bad really. Total shares outstanding have decreased by 90 million in the last year and (this is a big one) debt went from $3.4 billion down to $500 million. He did this while maintaining the $2.5 billion Gap has in the bank. This means debt for Gap is now essentially irrelevant.

Numbers: We need to break everything down to per share amounts. Why? You pay your price for the company on a per share basis, we need to find out what you are getting for that money by the same metric. Currently Gap has 900 million shares outstanding and roughly $2.5 billion in cash (this amount has typically risen after the holiday season but we will use “what is” rather than “what could be”). That gives us $2.77 per share in cash. It’s property is valued at $7.2 billion or $8 a share (this is carried at an undervalued level, I will use it though so as not to be accused of fudging numbers to make a point, again, “what is”). Profits will be about 85 cents a share and the dividend is 32 cents a share. At this profit level, investors are paying 23 times 2007 earning (16 times the $1.25 they earned in 2006). The total value of the cash, property, earnings and dividends is $11.94. Sales look to be about $16 billion this year or about $17.80 a share.

Let’s say I have the cash to buy all of Gap (the market values it at $16 billion). For the $20 a share I would pay I would immediately receive $2.77 a share in cash (it’s in the bank, I own it now) plus the $1.17 in earnings and dividends for a total of $3.94. That gives me an immediate return of 19%. Not bad! Remember, this does not even consider the value of its assets which we conservatively valued at another $8 a share. This would be the reason you may have read rumors about people wanting to buy Gap. For comparison, if we did the same calculations for Target we would get a return of 7%.

Brands: Gap has strong brands (Gap, Old Navy, Banana Republic). They have no quality issues and there is no negative stigma attached to them. Currently they are watered down, not tarnished and that is a huge difference. By contrast, Kraft ruined its brand with its association to Phillip Morris (Marlboro). Gap just diluted it by making its product to common. This can be fixed.

What to do? This is really simple. Gap is overextended, time to shrink in the US. Follow the Lampert / Day model. Close / sell under performing stores now. Sales will fall, but profits will rise (isn’t that the name of the game?). Take the excess inventory and transfer it to other stores. This will decrease expenses this year, yup, more profits. Take the money in the bank and buy back shares. If you take $2 billion of it you could buy back another 100 million shares. Assuming all thing being equal (revenue and profits) that adds another 10 cents or 12% to 2008 eps and 12% to the dividend with no additional cash outlay for it over last year. Too much you say? Not really when you consider that cash flow from operations will add another $1.5 billion to the till. This also does not take into effect the extra cash from Christmas that will be reported soon. The decrease in expenses from store closures will add to that and make more cash available for? Yup, more buybacks. You could easily buy back $2 billion worth of shares this year and still have another $2 billion available at the end.

As for the brand, the less common it is, the better. Gap’s commercials portray it as a cool and hip brand and this contradicts reality in which there is a Gap in every mall. Hipness needs to be something you seek out, not trip over. For an easy example see its Banana Republic brand that is much less omnipresent and is performing quit well. Closings stores and reducing the brand dilution will accomplish this.

In review, we have a business that is fundamentally strong, has lots of cash, no debt, producing quality apparel, trading at a great value to its assets who watered down its brand and it’s stock is stagnant. This is an easy fix and the results could be very profitable and if they take the fix I prescribe, they produce gobs of cash to reward those who own shares.

I am not buying shares of Gap now nor do I currently own any. I want to hear what the new CEO says first. If they just continue the same path and try to jazz it up through more advertising, I do not see a resurrection of the Gap brand. In that scenario I believe they are in for another five years of mediocrity. But, any hint of them closing unprofitable locations and I am jumping in as I think we’ll have a ValuePlay.