When I bought Tandem’s shares (LSE:TND) at £1.59 in April 2019 I figured the average historical owner earnings to be £1.282m over seven years, which gave an estimated intrinsic value of £16.0m or 320p per share (see newsletter posted 10th April 2019). Now that the shares are over £3.70 I thought I’d update the numbers.
We look at historical owner earnings to get a feel for likely future earnings power and therefore future owner earnings. All future owner earnings after discounting at the required rate of return for equity risk capital (I use 8%) are totalled to estimate intrinsic value. With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available. Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend. Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future. Despite this imprecision it remains an important method for thinking through valuations. Owner earnings analysis is about future cash available for shareholders to take out of the business. But the only evidence we have available is past data. We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking. In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L. What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects. To start with we make the bold assumption that what was spent by the managers was also the necessary amount. When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future. The historical analysis helps us make that judgment. £000s YEAR 2012 2013 2014 2015 Profit after interest and tax deduction 611 1,053 1,317 1,086 Add back non-cash items such as depreciation, goodwill and other amortisation 85 211 200 209 Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items and working capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects. 696 1,264………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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I bought into Tandem (LSE:TND), a bicycle, outdoor toy and furniture company, in April 2019 at 159p – see previous newsletters 3rd – 11th April 2019, 1st – 2nd July 2019. After receiving 9.49p in dividends over the 16 months I’ve now sold at 370.7p for an overall return of 139%
Normally I would not have sold given that the shares have only just crept up to a fair value range. In calmer times I might have held for a few years to receive the increased flow of dividends and share prices rises. But that attitude is only justified in a steady business environment. My current reading of general business prospects is that we have not yet seen the worst of the impact of the coronavirus recession. Therefore, to hold Tandem shares would be to take on the considerable downside risk of the business going awry. I know there are many people pointing to considerable growth in demand for bicycles and outdoor equipment such as gazebos, trampolines and slides that Tandem is currently experiencing. And they say that consumer demand will keep going up, so there will be good profits to come in the next few months. While that is probably true, the share price has risen so much that a lot of that expectation is likely to be in the price already. I could be wrong, and this share will go on to multi-bag from here. But right now, I feel easier turning yet more of my portfolio over to cash (now roughly half). Then I can search for and buy deep value shares when the business troubles really get going. This is how the earnings, dividend and revenue history looked when I bought. Tandem back in early 2019 Basic earnings per share (p) Dividend per share (p) Revenue (£m) 2018 estimated April 2019 32.00 4.20 32.5 2017 35.00 4.10 36.8 2016 16.00 3.90 38.4 2015 21.31 3.75 34.4 2014 34.82 3.60 31.3 2013 7.63 3.45 28.3 2012 13.22 3.30 29.0 2011 13.37 3.15 29.0 2010 19.60 3.00 35.7 2009 5.34 0.00 35.2 Average (10 years) 19.83 The 10-year cyclically adjusted price earnings ratio in April 2019 was 159p/19.83p = 8, almost half that of the UK stock market. The dividend yield was 2.64%. In the last year matters have improved considerably. Even before the boost to bicycle sales in the coronavirus crisis the company stepped up its performance. In the year to December 2019 it reported earnings per share of 40.5p, considerably above the long-term average (profit after tax of £2m on turnover of £38.8m). And that was after an expectation-matching EPS in 2018 of 32.3p Thus, for the ten years 2010-19 the average EPS is 23.4p. At 370.7p Tandem’s shares are on a CAPE of 370.7p/23.4p = 15.8, slightly above the UK market average and no longer a value bargain as defined by proven earnings power. Of course, if 40.5p is now the base for future growth I’m going to look foolish selling at £3.70. But, being a more cautious soul, I prefer to look at the long-term earnings record rather than pick out the best year, even if it is the most recent. Good luck to anyone who takes this risk and wins – I will not resent it, I promise. But remember that in normal times the bicycle division was rarely profitable. This was because the UK retailers could play one bicycle importer and distributer against another to achieve low prices, especially in the mass market where Tandem plays. Indeed, because of this Tandem drastically cut its adult bicycle volume and increased the emphasis on children’s outdoor play items such as scooters, tricycles, etc. This summer’s boost has increased demand for bikes so much that Tandem has not been able to satisfy demand. This is likely to lead to increased margins this year. At least, that is a reasonably assumption. But today’s trading update was more circumspect regarding sales and profits. The directors said that while “it has been a strong year for bicycles and outdoor products” and that turnover and profit for the 6 months to 30 June 2020 “are expected to be ahead of the prior year” they are not exactly brimming with confidence. They point to two problems gumming up the works:
What? Isn’t this supposed to be the make hay-while-the-sun-shines time for………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Profits from the Berkshire Hathaway's Shoe Group jumped from $28.8m in 1993 to $55.8m in 1994 with about nine-tenths of the increase down to Dexter coming into the fold. And Buffett and Munger were looking forward to 1995, “Management was pleased with Dexter's 1994 performance and better results are anticipated during 1995. This optimism results from the fact that recent wholesale price adjustments should help mitigate the effects of prior years' increases in Dexter's costs. Additionally, operating efficiencies are anticipated in connection with the start-up of Dexter's new computerized distribution center and from advanced manufacturing technologies.” (1994 Letter)
But rather than profits moving up another notch they fell, down to $37.5m. Buffett put a brave face on it, pointing to the even worse performance of other US manufacturers. “Our shoe business operated in an industry that suffered depressed earnings throughout last year, and many of our competitors made only marginal profits or worse. That means we at least maintained, and in some instances widened, our competitive superiority.” (1995 Letter) And he looked forward to a “climb back to top-grade earnings” in 1996 as the managers capitalised on opportunities resulting from loss-making competitors closing and lowered production and administration costs. He asked Berkshire shareholders to view the 1995 result as a “cyclical” problem – just a bad year in a cycle of good and bad - and not as a “secular” one, a long term trend. He was right, to some extent, as profit crawled up to $41m in in 1996; the managers exploited a slightly improved marketing environment and had indeed cut costs. Buffett anticipated further operating profit increases during 1997. But it wasn’t to be, the trend was very much secular for Dexter, after all. Profits fell to $32.2m in 1997 and operating profit margin to 7.4% on revenues down by $18.9m to $542m. Dexter was now clearly identified by Buffett in the annual report as the problem area. Its sales were down about 12% in one year. But, nevertheless, Dexter’s management were “repositioning its brand to be more competitive in a highly discount oriented retail environment.” (1997 Letter). Berkshire’s shareholders were told that Dexter’s managers anticipate a recovery of a substantial portion of the lost volume in 1998. After waiting another year shareholders were shocked to discover shoe profits to be down yet again. They were now less than half those of 1994, at $23m from sales of only $500m “The unfavorable results represent a continuation of a trend which began three years ago. Manufacturers such as Brown, Lowell and Dexter are facing reduced demand for their products. Additionally, major retailers are offering promotions to generate sales which is resulting in an ongoing margin squeeze.” (1998 Letter) Still Buffett gave the benefit of doubt to the people running these operations, saying they are working to align production activity to the reduced sales level. Hopefully their genius at an operational level will cause profits will rise to a satisfactory level. Despite their efforts, 1999 was dreadful. Profits halved again, to £11m on turnover down another $2m. Buffett noted that all businesses in the Berkshire stable had “excellent results in 1999” except Dexter. He identified the problem not as one of managerial capability. Dexter’s managers were every bit the equal of the other Berkshire’s managers in terms of “skills, energy and devotion”. No, the core of the issue was that “we manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low-cost labor is the rule.” (1999 Letter) Thus, the issue was strategic; Dexter lacked competitive advantage to contest overseas producers. Belatedly, the reluctance of The Shoe Group to manufacture a significant proportion of output in low-cost countries dissolved. “We have loyal, highly-skilled workers in our U.S. plants, and we want to retain every job here that we can. Nevertheless, in order to remain viable, we are sourcing more of our output internationally” Buffett wrote in his 1999 letter. Some US plants were closed in 1999 and the Group had to bear the costs of severance and relocation. Buffett is not perfect In 2000 all the remaining goodwill attributable to Dexter was written off and more factories were closed, with others scheduled to close in 2001. Buffett took the blame on himself for the tragedy. His mea culpa drew attention to mistakes across his career, “We try…to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.” (2000 Letter) He was being far too hard on himself. While there were errors in these areas, we know, firstly, that successes elsewhere far out-weigh those mistakes. Second, resources from Blue Chip Stamps, Berkshire’s textile business and Diversified Retailing were taken from unproductive areas and reallocated to highly profitable investments in other industries such as candy (See’s Candy), insurance (e.g. National Indemnity) and in stock market listed shares such as Capital Cities and Coca-Cola which went on to multiply 6- or 20-fold. What Buffett was doing in dwelling on mistakes was impressing on himself and others the need to remember the logic.……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Today I'll describe how Warren Buffett got into his worst investing mistake, and tomorrow I'll cover the tragedy that started to unfold almost immediately after buying.
Dexter Shoes Harold Alfond, the son of blue-collar Russian-Jewish immigrants, worked his way up from 25c an hour shop floor work making shoes in the Depression to factory superintendent. Then, aged 25, in 1939, he picked up a hitchhiker when driving to the county fair in Maine. In passing, the hitchhiker mentioned an idle shoe factory in nearby Norridgewock. Intrigued, Alfond skipped the fair to look over the factory. He wanted it but didn’t have the $1,000 asking price. However, a year later he sold his car and partnered with his father to buy it. That $1,000 was turned into $1.1m when in 1944 the Norrwock Shoe Company was sold to rival for $1.1m. In 1956 Alfond put down a bet ten times as large as the one when he was 26 by creating another shoe company and spending $10,000 buying an abandoned wool factory in his hometown of Dexter, Maine. His right-hand man was to become his nephew Peter Lunder, who joined in 1958. At first, The Dexter Shoe Company concentrated on making own-label shoes for department stores such as Sears, JC Penny and Montgomery Ward. But in 1962 Alfond, Lunder and the team developed the Dexter brand, signifying “reasonably priced” shoes for men and women but with some style. Dexter was aiming at the volume market. With the help of crack sales and marketing team these shoes were sold to independent stores all over the US. The innovation of the 1980s was the purchase of malls along highways in New England. Dexter turned these into factory outlet malls selling seconds and discontinued lines. The company would take some space for their own shoes - the units looked like log-cabins - and rent out units to other manufacturers. By 1990 Dexter owned more than 80 factory outlets, employed 4,000 employees and annually turned over $250m selling 7.5m pairs of shoes. By then it had branched out into moccasins, boat, golf and athletic shoes. The deal to buy Dexter In early 1993 Buffett was excited by the way Frank Rooney and Jim Issler were managing “superbly-run” H. H. Brown (bought for Berkshire in 1991), “a real winner…expectations have been considerably exceeded” (Buffett's 1993 letter to shareholders) Confidence was boosted further when Rooney and Issler deftly did some “fixing” at Lowell shoes (bought 1992) and again surpassed Buffett’s hopes. So, when Rooney suggested to Buffett that Dexter would fit well in The Shoe Group and that he should meet his old friends Alfond and Lunder to discuss buying it Buffett jumped at the chance. An airport in West Palm Beach, Florida was the chosen location. “We went to some little restaura………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 (From the third volume of The Deals of Warren Buffett - to be published next year (I've only written 4 of the 11 chapters so far)) Lowell Shoe Inc. was the second firm to go into Berkshire Hathaway's Shoe Group. Warren Buffett was encouraged to buy it because he had witnessed the first shoe company bought, H. H. Brown, performing well in the the six months after purchase on July 1, 1991. Turnover was $104m and after-tax earnings $8.6m. Then in its first full year under Berkshire’s ownership it earned $17.3m on revenue of $215m, a nice steady increase and a decent income on the $161m laid out. Rooney and Buffett made their move to create The Shoe Group on the penultimate day of 1992 by acquiring Lowell Shoe Company for $46.2m.
This act is an example of a Berkshire Hathaway principle: subsidiaries are encouraged to make small “add-on” acquisitions if at least a dollar of value is created for each dollar spent. Such actions could be used to extend product offerings or distribution capabilities. “In this manner, we enlarge the domain of managers we already know to be outstanding - and that's a low-risk and high-return proposition.” (1992 Letter) Lowell, also located in New England but with one of its manufacturing plant in Puerto Rico, had a niche business supplying nurses (and some doctors) with shoes. “Nurse Mates” are anti-slip, light-weight and comfortable with their broad heel. With a reputation established over many decades most US nurses today wear Nurse Mates or shoes from their rival Dansko. Turnover in 1992 was $90m. This was boosted by the sale of other kinds of women’s shoes, but the reputational competitive advantage lay with nurses’ shoes (Lowell was later renamed Söfft Shoe Company). Buffett joked about a limitation on potential candidates for acquisition: “a trend has emerged that may make further acquisitions difficult. The parent company made one purchase in 1991, buying H. H. Brown, ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 When the creator of the specialist boots and shoes company H. H. Brown died in December 1990 aged 92 his family concluded that it was best if the company were sold. Frank Rooney, CEO and son-in-law, took up the task of finding a buyer with the help of Goldman Sachs and their pack of material to give to potential buyers.
But real progress began on the golf course. A long-time friend of Buffett, John Loomis, was out on the links in Florida in Spring 1991 playing against Frank Rooney. The conversation turned to the sale of H. H. Brown. Immediately Loomis thought the company a good fit for Berkshire Hathaway, “John told Frank that the company should be right up Berkshire's alley, and Frank promptly gave me a call”, Buffett recounts in his 1991 letter. The conversation went well. According to Rooney, “Warren said ‘Well, that sounds interesting. Don’t send me any of that stuff from Goldman Sachs, just send me the audited numbers for the last couple of years.’” (Frank Rooney interviewed by Robert P. Miles for “The Warren Buffett CEO; Secrets from the Berkshire Hathaway Managers”). Buffett came away from the call thinking “that they would make a deal”. Rooney sent the accounts and they agreed to meet in New York. At lunch, Buffett asked Rooney and his brother-in-law whether, if Berkshire agreed to their asking price, they would stop talking to other potential buyers. “I said ‘Yes’ and he said, ‘Okay, we got a deal.’ So my brother-in-law and I took a walk around the block and came back and said, ‘Okay, that’s it.’” (Book: The Warren Buffett CEO) Rooney was astonished that Buffett had agreed without having yet seen a factory or met any of the H. H. Brown people. “Why the hell did he buy a shoe company? I asked him later, and he said…‘because of you’”. Berkshire paid $161m cash for 100% of H. H. Brown shares July 1, 1991. Why buy? Apart from the proven earnings (around $25m before tax, $15m after tax) there were three key reasons why Buffett wanted H. H. Brown, each linked directly to the likelihood of the profits continuing to rise:
This story covers what Buffett himself declared as his “most gruesome error”. Within a few short years the value of $433m paid for the third company bought to build Berkshire Hathaway's Shoe Group, Dexter, had evaporated completely. It wouldn’t be quite so painfully seared on Buffett’s mind if he had paid cash. Okay, that’s $433m lost, but in the context of a company with a market capitalisation of $10bn (in 1993) it would be bearable.
But he agreed to pay with 25,203 Berkshire Hathaway shares, around 2.14% of the 1.177m shares in public issue. Thus, Berkshire shareholders swapped 2.14% of their company for something that would soon be slaughtered by the blows of competitors. The shares they sacrificed are today trading over $314,000 each. So effectively, Dexter has cost $8bn. The shoe adventure wasn’t all bad. The specialist manufacturers H. H. Brown and Lowell continued to be able to charge prices allowing a reasonable profit. Customers of these products, e.g. telegraph pole climbers, soldiers and nurses, needed good quality boots with steel toe caps or indoor comfortable shoes that they could wear all day. They were more than willing to pay a premium price to get the right fit and performance – going cheap would be an obvious false economy. And so it is that Berkshire Hathaway has enjoyed a flow a profits from shoes and boots selling in niche areas for over three decades. It is just a pity that two-thirds of the money laid down to create what Buffett named “The Shoe Group” turned out to be wasted. Still, we investors can learn much from errors, especially when made by a then very experienced 63-year old investor. Summary of the deal Deal The Shoe Group Time: 1991 - Present Price paid:H. H. Brown, July 1991: $161m Lowell, December 1992: $46m Dexter, November 1993: 2.14% of Berkshire’s shares, worth $433m Berkshire Hathaway in 1991 Share price $6,550 - $9,100 Book value $7,380m Per share book value $6,437 H. H. Brown Henry H. Brown opened his first shoe factory in 1883, adding to the 23 already in the town of Natick, Massachusetts. Two years later the company was employing 175 people producing 2,000 pairs daily. Thirty-seven years after that, in 1927, Henry H. Brown sold his company to 29-year-old Ray Heffernan for $10,000. He was to run the firm for 62 years during which time it earned a reputation for producing rugged boots. For example, the Corcoran boot was the original jump boot for paratroopers in WW2, and its combat boots have been used by infantry soldiers in many theatres. It collected other famous brands through takeovers such as the Double-H western boot. It’s not just the military who are willing to pay up to $300 for a pair of boots (average prices are $120 - $160): builders, farmers and lumberjacks need long-lasting strength, steel toe caps and all-day comfort, as do the police and firemen; miners, postal workers, bikers and search & rescue teams not only value resilience but the water resistance. Then there is the “built in America” cachet which meshes with the proclivity of US government organisations at all levels to favour goods perceived to be manufactured domestically. Also, many key customers require short lead times, and sometimes small batches, which means there is an advantage in manufacturing in America rather than in far-away Asia. These factors allowed H. H. Brown to both grow its market and achieve good margins. By 1991 operating profit was 12% of revenue of over $200m. Pre-tax profits were about $25m, and after-tax profit attributable to shareholders around $15m. Frank Rooney Ray Heffernan managed the four factories employing around 1800 employees and a direct sales force of over 100 brilliantly, supplying hundreds of small independent retailers and wholesalers who then sold to workers required to wear safety shoes or boots because of the nature of their work in say heavy manufacturing, construction or steel. Then there were the special relationships he built with the likes of the army, police forces or fire services. Over a lifetime of endeavour he created the leading domestic producer of .....………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1......... .....This story continues tomorrow with a look at the deal Buffett struck to buy H. H. Brown - it is part of a number of case studies to be published in the third book in the series of "The Deals of Warren Buffett" next year. It is important to examine Samuel Heath (LSE:HSM) with an income metric better than conventional profits after tax. Normal earnings fail to properly consider the annual cash outflows which end up being spent on more fixed assets and on working capital items (inventory and receivables in particular) just to support the current strategic market position, and therefore turnover and profits. I’ll use Warren Buffett's “owner earnings” approach.
The idea behind owner earnings With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available. Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend. Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future. Despite this imprecision it remains an important method for thinking through valuations. Using the past to guess the future Owner earnings analysis is about future cash available for shareholders to take out of the business. But the only evidence we have available is past data. We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking. In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L. What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects. To start with we make the bold assumption that what was spent by the managers was also the necessary amount. When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future. The historical analysis helps us make that judgment. “Owner earnings” in the past £ooos YEAR 2015 2016 2017 2018 2019 2020 Profit after interest and tax deduction 394 769 1,013 980 968 1,069 Add back non-cash items such as depreciation, goodwill and other amortisation 418 369 329 423 375 421 Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects. 812 1,138 1,342 1,403 1,343 1,487 Deduct fixed capital expenditure other than property. And deduct cash invested in working capital. (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.) -604 -282 -804 -313 +111 -585 Owner earnings 208 856 538 1,090 1,454 902Average owner earning over the last six years is £841,000. Will the future be like the past? Now, more than ever, we are uncertain, but we can think in terms of reasonable scenarios. Scenario 1: Recession and recovery Owner earnings fall to zero for two years. All yea………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
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