Wednesday, May 23, 2007

Canon's dividend valuation

Until recently, I've seen Canon's dividend as a nice, but not vital piece of the valuation puzzle. But in the last few years, Canon has raised its dividend to a point where the company can be valued on actual payments to shareholders rather than cash flows which might never reach investors. Here is a chart of dividend information for the last 10 years:

                2007    2006    2005    2004   2003   2002   2001   2000   1999   1998   1997  
Dividend        ¥150.00 ¥125.00 ¥100.00 ¥65.00 ¥50.00 ¥30.00 ¥25.00 ¥21.00 ¥17.00 ¥17.00 ¥17.00
Dividend growth 20.00%  25.00%  53.85%  30.00% 66.67% 20.00% 19.05% 23.53% 0.00%  0.00%  -
Expected growth 11.00%  11.75%  12.28%  13.14% 13.25% 10.49% 10.11% 9.18%  4.61%  8.13%  9.47%
DDM for 5 years ¥7,867  ¥6,813  ¥5,597  ¥3,800 ¥2,939 ¥1,533 ¥1,253 ¥1,003 ¥638   ¥769   ¥824
Price           ¥7,131  ¥7,050  ¥6,710  ¥5,560 ¥5,090 ¥4,580 ¥4,660 ¥4,250 ¥4,160 ¥2,320 ¥3,040

"Expected growth" is the mathematical maximum growth that can be sustained based on a Canon's financial information. It is composed of retained earnings rate multiplied by return on equity. Only earnings that are retained (about 75% of income) may be reinvested to fund future dividend growth and the return on equity over the next five years is likely to be about the same as it is this year (15% or so). Multiply those rates and you get a growth rate of about 11% a year. Notice that actual dividend growth has been somewhat better than that since 1999 in order to make up for some flat years in the late 1990s.

I discount that growth at 5% for the next 5 years. This rate seems appropriate for the low return on Japanese risk-free investment. At the end of 5 years, I assume Canon's dividend will grow at 2% compared to a discount rate of 5%. As you can see above, 2007 will be the first year in which the Dividend Discount Model values Canon higher than its market price. Since the dividend-only model is as conservative as you get in valuation, there's no particular reason to construct a more elaborate model when the value exceeds the current price. Converted to dollars, the DDM values Canon at about $64. Meanwhile, the Quicken model I've used in the past puts the value at $77. The current price is $58.59, so by either measure, Canon is still a good buy after doubling over the last 5 years.

Since this estimate is based on what Canon is already doing, I see at least two free options offered by the stock. First, SED TVs could add substantially to Canon's bottom line. Second, consumers in emerging markets such as China, India, Russia, Brazil, and Mexico may soon afford lower-end digital cameras and printers to replace traditional film cameras. Canon has pretty much eliminated the PC as a necessary part of the digital imagery work-flow and the upfront costs are within an order of magnitude of film costs. Over the long-term, digital pictures are vastly cheaper to process and far more convenient for most consumers than film, so I expect the switch-over will happen over the next five years or so. Kodak and Fujifilm sell billions of dollars of film equipment and services around the world and Canon has a shot at nearly all of that business now.

Monday, May 14, 2007

Cost of complexity

I've been listening to Aswath Damodaran's valuation class online, which has been very informative. Near the end of Lecture 10, Professor Damodaran suggests an interesting adjustment to "punish" companies for having complex structures that are hard to understand and analyze. The argument goes the more complex a company is, the more places it can hide information about itself and the more likely some of those details will turn out to be bad news. The professor suggests counting the number of pages in a companies 10-K as a simple way to measure complexity.

I sort of assume my companies are more transparent than their peers, but I didn't have any way of measuring that. Now I do. Here are my core holdings with the first competitor I thought of for reference:

Company        Pages
-------        -----
Oracle         103
Canon (20-F)   122
Select Comfort  72
Berkshire       84
Alberto         99   
Sally           99
Marblehead      71+38F

SAP (20-F)     121+70F+1S
HP             152
Tempur-Pedic    48+30F
Citigroup      180
P&G             23
Regis          117
Sallie Mae     118+84F+12A

I don't know how to treat the extra pages (F-38, A-12 and so on), but my sense is that these are a sign of even more complexity than regular pages. Proctor & Gamble walk away with the prize in this group, but overall, the companies I own are objectively less complicated than the ones I don't. I had actually picked Citigroup as a foil to Berkshire because I expected it to have over a thousand pages. Perhaps that number includes all the supplementary documents that I don't plan on even opening. I only included the main 10-K.

One other reason to use this sort of test is that if a company's filings are too long or complicated, chances are you won't read it. My Alberto-Culver investment relied on that principle, since I hoped as few people as possible would have worked though the sum-of-the-parts valuation and I could buy in at a low price. Now that I've bought, I hope the Sally reports at least are going to become more clear and simple so that other investors can begin to appreciate the company's true worth. And since insiders have had these same goals, I'm pretty sure my wish will be granted.

Thursday, May 10, 2007

First Quarter results

All of my companies have reported earnings for the first quarter of 2007 (though some of them call it Q2 or Q3). With a single exception, I'm quite happy with the results. Here are the earnings per share adjusted for splits and spin-offs:

1st Quarter EPS      2007  2006  Change
                     ----  ----  ------
Oracle                .20   .14  42.86%
Canon                 .84   .69  21.74%
Select Comfort        .21   .21 -00.66%
Berkshire Hathaway  56.07 50.03  12.07% 
Alberto-Culver        .23   .16  43.75%
Sally Beauty          .06   .17 -64.71%
First Marblehead      .75   .62  20.97%

One quarter isn't really enough to give a clear picture of a company. But with the exception of Select Comfort and Sally Beauty, these companies are performing well on a multi-year basis. I've talked about Select Comfort's issues, so I won't go into them too much more. This Sunday, they ran a clever ad in Parade magazine that gets delivered with many paper in the US, which confirms my basically good opinion of the new campaign.

Sally Beauty is a more interesting story. Remember that I bought it before the split with Alberto-Culver. After the split, I owned one share of Sally, one share of New Alberto, and $25 for each share of Old Alberto. The $25 special dividend was paid for by borrowing huge amounts—in essence prepaying future earnings of Sally. I haven't seen the latest cash flow statement or balance sheet, but you can get a pretty good idea of the effect of the transaction from this portion of the income statement:

3 months ending March 30     2007    2006
                             ----    ---- 
Operating earnings         60,771  51,313
Interest expense           44,947     321
Interest income               300     300
Market interest rate swaps  1,700       -
Net interest expense       42,947      21
Earnings before taxes      17,824  51,292
Provision for income taxes  6,785  20,117

Net earnings               11,039  31,175

Operating earnings are up because of growth in the business and cost savings from no longer being part of Alberto-Culver. Interest expenses are up dramatically even after income from interest rate swaps because of the massive debt load. Sally shareholders owe roughly $12.45 a share to Sally bondholders after the special dividend. Fortunately, there is plenty of cash flow to cover the payments and plenty of growth to grow out from under the debt. You'd be forgiven for thinking the whole thing is a pointless exercise if I hadn't included the impact of taxes. Since interest payments are tax-deductible to Sally, net earnings are not as small as you might imagine. Over the life of the debt, this will amount to significant tax savings.

Although the market value of my companies have increased at a healthy rate, I'm not currently interested in selling any of them because I believe their potential has increased even more. That's the reward for buying good companies at a cheap price.

Update May 14

Sally released the balance sheet with their 10-Q and the debt is closer to $10 a share. Book value is about -$5 a share, which makes life a bit tough from a relative valuation perspective.