Four Factors of value creation

Dean Oliver (the Bill James of basketball), describes the Four Factors of Basketball Success. They are shooting, taking care of the ball, offensive rebounding, and getting to to foul line. There are hundreds of other statistics that are of interest, but unless they measure aspects of these factors, they aren't all that important to actual basketball success. Think of the Four Factors as a framework for interpretation.

I believe that there are Four Factors for value creation as well. Obviously there are even more statistics that may be important to understanding a company, but these four represent a complete path from customer to shareholder. I'm going to use my new favorite investment, First Marblehead, to illustrate the concepts.

Most public companies derive their value from sales. (The exception are companies like biotechnology firms that hope to turn ideas or other assets into sales at a later date.) But not all sales are created equal. Companies need to charge more than the goods and services cost to produce. And there are other costs such as overhead and taxes that need to be considered. From a shareholders perspective, those costs add little to the value of the company. So the first factor is Net Profit Margin:

Earnings 
-------- = Net Profit Margin
Sales   

In it's most recent 10-K, from June 2006, First Marblehead reported revenue of $563.572 million and, after subtracting costs, earnings of $235.960 million. Divide earnings by sales and the profit margin works out to 41.87%. In other words, 42¢ of each dollar in sales is profit to First Marblehead owners. Compared to the Consumer Financial Services industry average of 13.77%¹, FMD must be doing something right.

Specifically, what companies with high profit margins have done is a combination of raising prices and lowering costs. The risk is that customers don't like higher prices and that lower costs might mean lower quality products, which also don't go over well with customers. So if you've got two companies and one has a higher profit margin than the other, you would also expect it to have lower sales. But just as we compared earnings to sales, we need to compare sales to something else. If one company has two stores, you'd expect it to sell twice as much as a company with just one store. A company that sells to customers all over the world probably has more sales than a similar company that just operates in one city. So you have to compare sales to the company's size or potential.

Asset Turnover is the second factor:

Sales
------ = Asset Turnover
Assets

Every company has assets such as offices, factories, stores, patent portfolios, and so on, which it can use to generate sales. First Marblehead had $770.346 million worth of assets as of June, 2006. The bulk of those assets are residuals in its securitization trusts, which have the potential to contribute to future income as the underlying loans are paid off. For fiscal 2006, every dollar of assets produced 73¢ of sales. Since the industry average is about 21¢, First Marblehead looks even better.

How much better? Well if you multiply the first two factors, you get another ratio called Return on Assets:

Earnings   Sales
-------- X ------ = Return on Assets
Sales      Assets

This number measures how well management has balanced price, costs, quality and demand. Higher prices tend to depress demand, and lower costs tend to lower quality which lowers demand. But First Marblehead seems to be able to defy those tendencies since it has a ROA of 30.63% compared to the industry at 2.91%.² Given the first two factors, you might wonder how other financial service companies could compete with First Marblehead. There are several answers including some peculiarities in the way GAAP requires it to report earnings that affect the ratios. But the biggest difference is the third factor, which is Leverage:

Assets
------ = Leverage
Equity

Companies, especially financial companies, use debt an other liabilities to buy more assets that can in turn be used to generate sales. If you have one store and you've maximized its ROA, you can borrow money to open a second store. The result on the balance sheet is that you've increased you assets, but your equity has stayed the same. One the second store is operating as efficiently as the first, you will be generating twice as many sales and twice the earnings as well. As an equity investor, I don't really care how much debt a company takes on as long as there is a reasonable chance the company can pay it off with out hurting earnings.

First Marblehead's leverage is 1.34, which is wimpy compared to the industry average of 7.54. Sally Mae, a competitor, is leveraged at $26.6 of assets for each dollar of equity. This is serious leverage which can lead to serious returns. At this point, there is a possibility FMD is leaving money on the table by not taking on debt to increase leverage. In order to decide, we can calculate Return on Equity:

Earnings   Sales    Assets
-------- X ------ X ------ = Return on Equity
Sales      Assets   Equity

First Marblehead's ROE is 40.95% compared to 22.01% for its industry. Imagine a rich uncle offered to give you a fixed amount of equity in any company in the world. You pick the company and your uncle will give you enough shares so that the equity you own equals the fixed amount. It's obvious that you'd look for a company that has the best ROE and seems likely to continue to do well in the future. If you were limited to student loan companies First Marblehead looks a lot better than My Rich Uncle which has a ROE of -253.53%³. If this were the way you acquired shares, we could stop the analysis right here. But normally you have to buy them on the stock market. The final factor doesn't have a standard name, but I'm going to call it Equity Valuation:

Equity
------ = Equity Valuation
Price

In theory, if a company closed shop, sold off all its assets, paid off all its creditors, and distributed the proceeds to investors, shareholder equity would be the value of the company. But some assets (such as newly purchased manufacturing equipment) are overvalued on the books and other assets (such as goodwill from profitable acquisitions) are undervalued. Further, some assets like brand names don't show up on the books at all. So Equity Valuation is rarely equal to one. For First Marblehead on June 30, 2006 the market paid one dollar for just 16¢ of shareholder equity. The industry average is 28¢, so the market rightly considers First Marblehead to be a better than average company.

When you put together all of the factors, you get a familiar measure:

Earnings   Sales    Assets   Equity
-------- X ------ X ------ X ------ = Earnings Yield
Sales      Assets   Equity   Price

Earnings Yield is P/E ratio inverted. First Marblehead's earnings yield was 6.46% compared to 6.88% for the industry. Now you might argue the relative quality of FMD to industry earnings or the relative growth rates or relative risks that make the final numbers better or worse than they appear, but that's missing the point. When I really need to find a companies value, I'm better off running a discount cash flow model. This exercise is more about the way earning yields can be composed and what companies can do to increase their value.

Footnotes:

1. Reuters uses a different method to calculate these ratios, so we have to take these numbers with a grain of salt.
2. Remember, other methods of calculation give different results. The important thing to understand is what the ratios mean and to try to be consistent. In this case, the 5-year average assets that Reuters uses overstates First Marblehead's ROA, since it is growing so quickly.
3. MRU holdings seems an unbelievably bad investment. I suppose the thesis is that eventually it will grow its way into profitability.

The case for Select Comfort

I think the crowd is wrong about Select Comfort because market participants are focusing on short-term, rather than long-term prospects. It seems to be the usual reason the market undervalues companies. In this case, Select Comfort has swung from a hot, growth stock to a company with troubles on several fronts. They had to take a big one-time expense because of an abandoned computer system. New fire-retardant regulations reduced company earnings to an extent. But the big news is the housing slump that slowed mattress sales. Also, Select Comfort's new ad campaign failed to bring in costumers. As a result, EPS for the last quarter was down 69.41% YoY and for the last 12-months EPS is down 19.48%. Sales last quarter were down 4.84% and for the last 12-months, sales are only up 5.06%—a far cry from management's 15% goal.

But the further back you go, the harder it is to see a problem. Over the last 5 years, sales have grown 25.23% and EPS has gone from -66¢ in 2001 to 85¢ last year. Gross and operating margins have improved dramatically. Management has predicted more margin improvements this year too. The company has a negative cash conversion cycle and new stores pay for themselves within a few months. The Four Factors are moving in the right direction, so earnings yield is higher than a year ago. So the question comes down to has Select Comfort's business changed so that the next five years will be much slower than the last five.

To be certain, growth in the last five years came on the back of fixing a broken sales and marketing system, expanding into new markets and controlling costs. Those low-hanging fruit are long gone. But the market is pricing in about 8.4% growth, which is nowhere close to the 14% projected by the most pessimistic analyst. I think the disconnect is that the market is looking out only one or two years. Because of the current macro-economy, the next two quarters look like they will be flat earnings-wise. But over the next five to ten years, Select Comfort has tremendous operational advantages.

Consider they way mattresses are traditionally bought and sold. Since people rarely buy more than once every decade or so, they don't have any reason to spend a lot of time thinking about how to do it. Unlike buying a car, mattress shopping seems boring and unimportant. Consumers look for things like brand, an in-home trial, manufacturer's warranty, and price. These are shortcuts that people use so that they can get a mattress they are comfortable with and get on with their lives. It's relatively easy to manipulate people using these shortcuts. For instance, there's a mattress store here in Southern California that advertises very heavily with the slogan, "We’ll beat any advertised price, or your mattress is FREEEE!" At first glance, one would assume the store is losing money (which is the way the commercials spin it) or is working on razor thin margins to avoid giving away the store. But the fact is each chain carries slightly different models with different names so that each store can claim to offer the lowest price. The low price message must be drilled into the consumer's consciousness because you never know when they might in the market for a mattress.

Since Select Comfort offers a unique style of mattress and controls the retail experience for the most part, it can differentiate itself without resorting to product name shenanigans. The key will be a long-term, consistent focus on the unique attributes of the product. Just having a storefront in the mall that people walk past year after year improves the odds that they will buy a Sleep Number bed. When combined with advertising (especially on the radio), it should be possible to encourage most people in a market to at least consider it. Management hasn't moved into non-US markets so far because they see plenty of potential in US markets they haven't tapped so far.

Sealy cut prices in the face of slow sales, but ended with a bad quarter in terms of earnings. Tempur-Pedic, on the other hand, recently raised prices yet sales increased. The purchase cycle is very long for mattresses, so its hard to read too much into a few quarters, but it seems foam has become a legitimate substitute for traditional innerspring models. Select Comfort might benefit since newer models come with improved foam toppers.

First Marblehead gets cheaper and I couldn't be happier

First Marblehead has lost 23.67% since I bought it in March (-98.36% annualized). Obviously, I would be happier if I had waited to buy, but getting cheaper is a good thing overall. Consider the Four Factors. The only one that has really changed since I bought is equity valuation, which has improved to 24¢ of equity per dollar of price. Other investors might have lowered their estimates of asset value and future earnings based on potential defaults or the potential acquisition of Sallie Mae. But I don't think those fears are warranted and I haven't changed my estimates.

Having already bought shares, how can the lower price help me? For one thing, I could buy more shares (double down). But as I'm short of investable cash, that isn't an option. If the price doesn't recover before First Marblehead distributes its next dividend, I'll be able to reinvest it at a lower cost. A more likely scenario is that First Marblehead will repurchase on the open market over the next few days.

There are potential disadvantages to a lower prices. For instance, if I needed to sell today, I would realize a substantial loss. Or a third party might attempt to takeover First Marblehead. Or if First Marblehead were to issue shares (perhaps as a part of executive compensation), it will get less value per share than it would have a few months ago. But as long as those things don't occur, lower prices can only be good for shareholders.

As for the "news" that has been driving down FMD's price, I'm not too worried. The default scare seems totally bogus. First Marblehead's estimate of residual value seems very solid.

The issue with the SLM buyout seems to be that two potential purchasers, JP Morgan Chase and Bank of America, are also two of First Marblehead's clients and might direct private student loan business to Sallie Mae. FMD's CEO has said that there will be no impact on his company. I don't see how there could be an immediate impact since neither company would control SLM. Two private equity investment companies, J.C. Flowers & Co. and Friedman Fleischer & Lowe LLC, hold majority stakes and I doubt they would be willing to give away Sallie Mae's competitive advantages to the giant banks. A scenario that seems more probably is that the banks will outsource their student loans to SLM over time. But they could have done that even before this buyout was proposed, so I don't see what the big deal is.

Select Comfort levering up

Select Comfort released their 2^nd quarter results and there isn't anything too surprising there. We already knew sales would be down and they were. Same-store sales dropped 14% from last year, which isn't good any way you look at it. But we've know it was coming for a month now, so that shouldn't be the focus today.

The first thing I notice is that gross profit margin has not suffered. It improved from 60.4% to 61.2% which indicates management has not panicked and slashed prices. Operating margin on the other hand has plummeted because of lower sales and increases in sales, marketing, and R&D. So looking at the Four Factors, profit margin is lower over the last twelve months (4.78%) than in 2006 (5.85%). David Kretzmann points out that the effect is "sacrificing short-term results for the long-term strength of the business." If those ad and research dollars are well spent, Select Comfort ought to reap a good return on investment over the next few quarters.

Moving on to the balance sheet, it's striking how much smaller the asset base has become since the beginning of the year. Select Comfort has shed $77.5 million of cash and marketable securities in that time. As a result, the sales to assets ratio has actually improved from 3.52 to 4.82 despite lower absolute revenue. There didn't seem to be much need for the money on the balance sheet, so most of it was returned to shareholders via a repurchase program. Turning to the liabilities side, management borrowed $10 million to buy even more shares. Altogether, Select Comfort has bought back $94.3 million of shares at an average price of $17.46 a share. As a result, assets to equity has improved from 1.89 to 3.75 which further leverages the business.

Current and prospective investors need to understand what this is—this is a "bet the business" moment by management. If sales pick up over the rest of the year, the boost to Select Comfort's value will be dramatic. But if sales continue to fall, expect share prices plummet even further and there won't be a cash cushion or a buyout offer to ease the pain. So far there is enough cash flow and not enough debt to worry about the price going to zero, but Select Comfort is significantly riskier than it has been in several years.

Is management making a good gamble? There are several reasons to think so. When Select Comfort released their new TV ads, I had high hopes. But since they haven't worked, the company has reverted to the original Sleep Number campaign for most markets. The old ads have worked in the past and there's no reason they won't work again. Next, the bed maker is rolling out some product updates that seem to target customers tempted by foam beds. Finally, the company is close to finishing their SAP integration. I hadn't grasped the full significance of the system until today: it will make international expansion possible. Select Comfort already sells some mattresses in Canada through a partner, but if they can start opening stores in Europe and maybe Asia, the growth will be astronomical.

Why I bought Select Comfort

For our first bed, Joy and I bought a expanded queen Sleep Number mattress and foundation from Select Comfort. I think you can guess where I'm headed. Our bed has performed flawlessly. My sleep number is 55 (0 is the softest and 100 is the firmest) and Joy's is about 35, we never would have found a conventional mattress that would have worked for us. When Joy was pregnant, she could adjust so that she had good support, but still be comfortable. I sometimes have a sore neck, but it goes away if I make my side a bit more firm. (I set it softer if I have sore shoulder muscles.)

At the time, I looked into buying Select Comfort stock for my portfolio. Peter Lynch talks about how much effort people go to buying things like pantyhose, microwaves and cars, yet they throw money at companies they don't understand or research. He suggests people would be better off buying shares of the companies that make the products they buy. If I had followed that advice, I would have had a four-bagger or more. But I was worried about both our bed and the company. Now I feel pretty comfortable about both.

At the time, Select Comfort was a "penny stock", which hovered around $5. It also was owned in large part by a St. Paul Venture Capital that had bought the bed maker and turned it around. Eventually it would want to cash out, and I wasn't comfortable with what it might do to shareholder value. In fact, in May 2003 Select Comfort had a secondary offering at $13 a share which diluted shares significantly. (Oddly it didn't hurt the price of those shares. I suspect that I wasn't the only one waiting to see what the "exit strategy" would be.)

Meanwhile, I heard that one of my cousins had bought a Select Comfort bed that he replaced a little while later. I don't know the details, but it made me wonder if getting an air bed was really such a good idea. Traditional mattresses, whatever their weaknesses, just seem more "solid" than air-, water-, and foam-filled mattresses.

Time corrected my view of these factors. My bed works great and I don't see why other people won't have the same sort of experience. I think the VC has done most of its damage. (Though in fairness, it really did turn a failing company around.) At the same time, Select Comfort's remarkable advantages are becoming more clear. It control's most of its distribution channels, it avoids holding much finished inventory by direct shipping products to the customer, and it has a unique and growing brand name. Unlike its department store and showroom competitors, Select Comfort needs only a little mall storefront to demonstrate a handful of models. On average each locatation generates over a million dollars in revenue per year. I recently noticed their logo on the Extreme Home Makeover TV show.

I bought Select Comfort on Feb. 9, 2005 at $19.95 a share.