MasterCard has an impressive global brand.

by Michael Kon, CFA

On Friday, Visa V and MasterCard MA announced that they have reached a settlement with U.S. retailers in two separate legal battles over credit and debit interchange fees. Visa agreed to pay $4.4 billion to the plaintiffs while MasterCard's share will stand at $790 million. MasterCard will have to add $20 million to an allowance the firm set earlier this year to cover the costs of the settlement while Visa will have to book $4.1 billion charge in the quarter.

In addition to the monetary compensation, the card companies agree to give a 10-basis-point reduction in credit interchange rates for eight months, allow merchants to impose surcharge for card transactions, and to negotiate with merchant buying groups future interchange rates collectively.

Despite the lofty price tag of this settlement, we think the economic implications it will have on Visa and MasterCard in the short term aren't material. Although both companies will report lower earnings in the coming quarter, Visa will recoup the lost earnings by diluting the holdings of its bank owners. MasterCard will have to foot the bill to this settlement but the amount it will pay to retailers won't impact our projections for the payments firm.

In the long run, we think the settlement opens the door for retailers to have a seat at the table when bank interchange fees are being determined. Although merchants' influence on rates could initially hurt issuers more than networks, in the long run, this dynamic could further create a more competitive environment in the network space. We accounted for a more intense competitive landscape in our projections and at this point we are keeping our fair value estimates for both firms unchanged.

Thesis 05/15/12

MasterCard operates the second-largest, open-loop card network in the world. Its clients are financial institutions that issue MasterCard cards to their clients and process card transactions. When a cardholder swipes a MasterCard card, the merchant transfers the card information with the transaction details to an acquisitor--a transaction processor such as First Data, which services merchants by connecting them to the card network. MasterCard then facilitates the authorization, clearing, and settlement of the transaction and charges different fees for each processed transaction. In addition, MasterCard charges card issuers assessments for the right to issue its cards.

We think that connecting thousands of financial institutions through a card network garners MasterCard a wide economic moat. MasterCard has contracts with thousands of issuers around the world that offer its cards to their customers. For issuers, switching from one card network to another is costly, and the incentives aren't that high. On the merchant's side, merchant acquisitors have an interest in acquiring as many transactions as possible and have no incentives to stop acquiring MasterCard's cards. Merchants cannot afford to reject MasterCard because of the potential loss of sales.

MasterCard invests heavily in its brand to ensure that spending on its cards continues. With its "Priceless" marketing campaign, the brand is now better recognized globally and cardholders all over the world know they can shop with it anywhere.

With all these competitive advantages, we think MasterCard is one of the few companies set to benefit from the global trend of moving away from cash and checks toward electronic forms of payment, including cards. We believe this shift, along with increased acceptance of cards for almost any type of payment, is a very fertile field of long-term growth for MasterCard. MasterCard isn't immune to economic headwinds, but in the long run the secular trend of moving away from cash and checks toward electronic forms of payment is likely to remain intact despite any economic challenges. That said, we are carefully watching the actions of competitors as the rivalry in payments is on the rise. In addition, we're paying close attention to new technology such as mobile payments, which could over the long run fundamentally change the competitive dynamics in the payment industry.

Valuation

Our fair value estimate is $394 per share to account for higher growth rates and wider operating margins during the next five years. MasterCard benefits from global growth in the use of credit and debit cards. Despite the tough economic conditions in many markets, MasterCard benefits from strong secular trend of moving toward electronic payments. We model revenue to grow 15% in 2012 and 2013, and to average 10% through 2019. We expect the firm to keep expenses in check, but we doubt that the current operating margin is sustainable. We model operating margins around 47% in the long run, mainly due to higher marketing expenses.

Risk

MasterCard's biggest risk is regulation. New rules on interchange might derail the firm's business model. If governments interfere with the way the network operates, the downside can be substantial. We also think that competitive pressures are mounting and the changing market might bode poorly for MasterCard's future. Several lawsuits allege that MasterCard engaged in anti-competitive and anti-consumer practices. It's very hard to estimate the costs of these lawsuits, but the bill could mount to several billion dollars.

Management & Stewardship

Before joining MasterCard, CEO Ajay Banga served as CEO of Citigroup's C Asia-Pacific businesses and was a member of the bank's senior management team. Banga, despite his limited experience in the card business, has all the qualifications to head MasterCard. Nevertheless, we doubt that his appointment will materially change MasterCard's already attractive growth prospects in foreign markets. What concerns us the most is that management, old and new, has been very willing to open shareholders' wallets when it comes to acquisitions. Although MasterCard's deal-making record isn't that long, management paid lofty prices for all of its recent acquisition targets, which we think could become detrimental to shareholders' returns if these deals grow in size.

Overview

Financial Health: 

The balance sheet looks pristine, although in the future there could be large liabilities related to litigation. MasterCard is flush with cash and has almost no long-term debt.

Profile: 

MasterCard manages a group of global payment card brands, including MasterCard, Maestro, and Cirrus, which it licenses to financial institutions that issue cards to their customers. The firm acts as the payment processor by facilitating the authorization, clearing, and settlement of transactions on its proprietary networks.

Visa is set to benefit from the growth in electronic payments.

by Michael Kon, CFA

On Friday, Visa V and MasterCard MA announced that they have reached a settlement with U.S. retailers in two separate legal battles over credit and debit interchange fees. Visa agreed to pay $4.4 billion to the plaintiffs while MasterCard's share will stand at $790 million. MasterCard will have to add $20 million to an allowance the firm set earlier this year to cover the costs of the settlement while Visa will have to book $4.1 billion charge in the quarter.

In addition to the monetary compensation, the card companies agree to give a 10-basis-point reduction in credit interchange rates for eight months, allow merchants to impose surcharge for card transactions, and to negotiate with merchant buying groups future interchange rates collectively.

Despite the lofty price tag of this settlement, we think the economic implications it will have on Visa and MasterCard in the short term aren't material. Although both companies will report lower earnings in the coming quarter, Visa will recoup the lost earnings by diluting the holdings of its bank owners. MasterCard will have to foot the bill to this settlement but the amount it will pay to retailers won't impact our projections for the payments firm.

In the long run, we think the settlement opens the door for retailers to have a seat at the table when bank interchange fees are being determined. Although merchants' influence on rates could initially hurt issuers more than networks, in the long run, this dynamic could further create a more competitive environment in the network space. We accounted for a more intense competitive landscape in our projections and at this point we are keeping our fair value estimates for both firms unchanged.

Thesis 05/15/12

Visa is a global card Goliath that operates an open-loop card network and owns one of the most recognized and respected brands in the world. The firm's clients are thousands of financial institutions around the world that issue its cards. When a cardholder swipes a Visa card, the card information and the transaction details are received by Visa, which facilitates the authorization, clearing, and settlement of the transaction. The firm then charges its clients different fees based on the dollar volume and the number of transactions.

We think Visa enjoys one of the widest economic moats that a company can desire--a network that connects thousands of financial institutions. It is very hard to build any network, but duplicating Visa's is almost impossible. Visa has contracts with thousands of issuers around the world that push Visa cards to their customers. Switching from one card network to another is a costly process, and we think issuers don't have a lot of incentives to do so. On the other side of the network, acquirers have interest in acquiring as many transactions as possible and have no incentives whatsoever to stop acquiring Visa-branded cards. As a result, merchants can keep accepting Visa.

Even with an army of banks on its side, Visa has to ensure that cardholders actually use their Visa cards and that merchants accept them. To make this happen, the company has invested and keeps investing in its brand, which we view as another competitive advantage. The Visa brand stands for trust, reliability, and convenience. Cardholders all over the world know that they can use Visa anywhere and shop without the need to carry any cash or checks.

Merchants, in general, have love-hate relationships with Visa, as well as with other card networks. Although they like the benefits, merchants usually end up footing the lion's share of the bill when customers pay with cards. The bill comes in the form of a discount fee that each merchant pays to its acquisitor. The bulk of this fee--the interchange fee--is set by Visa and is transferred to the card issuer. Despite these costs, the power of the Visa brand leaves merchants with no choice but to accept the card. The alternative is to risk sales, which most aren't willing to do.

Visa is one of the best-positioned firms to benefit from the growth in paper-free payment methods. The Nilson Report projects that the share of such payments will reach 65% of total payments by 2014, and the share of card sales will expand to 50% from the current level in the mid-40s. While Visa isn't immune to tepid consumer spending, in the long run, the secular trend of moving away from cash and checks and toward electronic forms of payment is likely to remain intact, despite any hiccups on the economic front.

Aside from these positive tailwinds, the level of competition in the payment market is on the rise as American Express AXP and Discover Financial DFS try to steal share from Visa and MasterCard MA. In addition, we pay attention to new technology, such as mobile payments, which over the long run could fundamentally change the competitive dynamics in the payment market.

Valuation

Our fair value estimate is $105 per share. We expect revenue growth to average 14% during the next two years. We think this growth will come from credit and debit card purchase volume and the number of transactions processed by Visa. We model total purchase volume to increase 13% in 2012, despite the new limits on interchange fees in the U.S. We model higher operating expenses over the next few years but we expect the firm to maintain positive operating leverage through 2013. We project Visa will be able to keep its operating margin above 60%.

Risk

Several lawsuits allege that Visa engaged in anticompetitive and anticonsumer practices. It's very hard to estimate the costs of these lawsuits, but the bill could mount to several billion dollars. Regulation is another risk that could derail this business model. If governments interfere in the way the network operates, the downside can be substantial. We also think that competitive pressures are mounting. MasterCard's initial public offering, Discover's spin-off, and a court ruling from a few years ago in favor of American Express might change the competitive dynamics of the card networks. Another risk is pressure from five top clients (that contribute more than 20% of revenue) to lower prices.

Management & Stewardship

We think management's performance clock began ticking after the IPO. The top brass have to prove to shareholders that they can work together, respond to Visa's challenges, and deliver the results expected from them as leaders of a public company. The management team was assembled during the process of reorganizing the predecessor entities of Visa, the regional associations, and merging them into one entity to sell shares to the public. Some of the senior managers never worked in the card industry before and have little experience running a services company like Visa. In addition, top managers are strangers to one another, and their ability to work together in harmony was never seriously tested. The good news is that CEO Joseph Saunders is a card industry veteran who successfully led the card issuer Providian until it was sold to Washington Mutual. We think that his experience at Providian and Washington Mutual's credit card unit will serve him well in running Visa.

Overview

Financial Health: 

Visa's balance sheet looks pristine, and the firm's cash flows are stable, recurring, and growing. Given its financial strengths, the firm is returning capital to shareholders though share buybacks and dividends.

Profile: 

Visa manages a group of global payment card brands, which it licenses to financial institutions that issue cards to their customers. The firm acts as the payment processor by facilitating the authorization, clearing, and settlement of transactions on its proprietary networks. Visa maintains the largest card scheme in the world.

The Bond Market Bubble Is Finally Ready to Pop

 
By Jeff Clark
No matter what happens with the Fed next week, bond prices are set up to fall.

Lately, I've been spending a lot of time watching the action in the Treasury bond market and shaking my head in disbelief. It is baffling to me that anybody would be willing to lend the U.S. government money for 10 years at 1.5% or for 30 years at 2.6%. Heck, the average welfare recipient has better financial statements than the U.S. government.

Think I'm exaggerating? The U.S. government routinely spends 50% more every year than what it takes in. For example… this year, the government plans to spend $3.7 trillion. But it only expects to receive about $2.4 trillion in tax revenue. It makes up the difference by borrowing the money.

That would be like you taking a cash advance for 50% of your salary on your credit card every year… and never paying it down. You couldn't get away with doing that for very long before your creditors cut you off. (Welfare recipients can't do that.)

But the U.S. government can – which is why Congress has to constantly raise the debt ceiling and why the U.S. now owes nearly $16 trillion in debt. That's more than 100% of our total gross domestic product. And we haven't even addressed the $50 trillion or so in unfunded liabilities and the upcoming expenses of the new Obamacare program.

Think about this for a moment… Imagine walking into a bank and asking for a loan. You explain to the friendly banker that you make $100,000 per year but you spend $150,000. You already owe $700,000 in debt and that amount is increasing every year at an accelerated pace. You also have $2.1 million in other obligations and are planning to increase that debt by at least $50,000 every year.

Do you think the banker is going to lend you money for 10 years at 1.5%?

Of course, the government gets away with it because it has the power to print money. But that only further highlights the stupidity behind buying Treasury bonds at such low interest rates. The official inflation rate is running at 2%. That means buyers of 10-year notes are already losing purchasing power every year. But just imagine the potential for higher inflation as the government attempts to print itself into a better financial condition.

Buying Treasury bonds right now – at historic low yields – just doesn't make any sense.

So why on Earth is everybody piling into the Treasury market?

Well… the argument you hear most often is that Treasurys are a "risk-off" trade. Investors are so concerned about the potential for a financial collapse, they're willing to accept a miniscule return in exchange for the safety of being backed by the full faith and credit and the money-printing ability of the U.S. Treasury.

At first glance, this sort of makes sense. After all, it's hard to find another time in history where there was more potential for financial market disruption. Europe is on the verge of imploding… and many of the largest European banks are teetering on the edge of the abyss. California's municipalities are declaring bankruptcy one by one. Agricultural commodity prices are skyrocketing higher. Corporate earnings are falling. Commodity trading firms, like MF Global and PFG Best, are stealing customers' money. Multinational banks are openly colluding to "fix" key interest rate levels. The U.S. government's deficit spending is spiraling out of control. China is failing. The U.S. economy is drifting into a recession. And tax rates are set to ratchet higher.

So sure… we can argue investors are buying Treasury bonds because they're scared to death of buying anything else. But that's simply not true. Investors aren't worried at all. Despite all the previously mentioned concerns, the U.S. stock market is still up on the year. Gold and other precious metals have been selling off. And the Volatility Index – a widely followed measure of fear – is barely up off its 52-week low.

Investors aren't fearful at all. In fact, they seem downright complacent.

Buying Treasury bonds doesn't look to me at all like a "risk-off" trade. It's actually a giant "risk-on" trade ready to explode. Let me explain…

In November 2008 – as Lehman Brothers was going bankrupt, the mortgage market was disintegrating, and the financial world was on the brink of collapse – the Federal Reserve Board made the unprecedented announcement that it would use its money-printing abilities to prop up the price of Treasury bonds and mortgage-backed securities through what it called quantitative easing (QE).

Bond prices rocketed higher and interest rates plummeted as investors realized the Fed would provide a backstop against any adverse move in the bond market. This was the first time the Fed had ever done such a thing. The market was not expecting the move, so it had not discounted that possibility.

Since then, however, the market has done an admirable job of discounting the Fed's willingness to manipulate bond prices. In March 2009, when the Fed announced an increase in the size of its QE program, Treasury bonds actually sold off on the news. Investors were expecting the action and had bought positions in advance of the event. So it was time to "sell on the news." Bond prices fell 15% over the following two months, and they stayed down until June 2010 when the Fed hinted at the possibility of a second QE program.

Once again, investors rushed into the bond market – secure in the knowledge the Fed would prop up prices. Bond prices rose and interest rates fell as the market discounted the future QE2.

By the time the Fed announced QE2 in November 2010, it was time once again to "sell on the news." Bond prices fell 15% over the following four months.

Ever since QE2 ended in July 2011, investors have been betting on QE3. It has to happen. The Fed has to keep up the charade. So folks have been piling into the bond market at record-high prices and record-low rates because they're discounting QE3.

Long-term bond prices are up nearly 40% since QE2 ended last July. They're up almost 20% in just the past three months.

This is a remarkable move. It's the epitome of a "risk-on" trade. Investors are speculating the Fed will announce another QE program, and they're bidding up bond prices to insane levels ahead of the event.

This is going to end badly. And I'm willing to bet it ends next week – after Fed Chairman Ben Bernanke's scheduled Congressional testimony on Wednesday.

You see, it seems just about everybody is expecting more QE this year. The past two monthly employment reports have been disappointing. Other economic indicators are weakening. And there's a presidential election coming up in November, so now is the ideal time to try to goose the stock market higher with a QE announcement.

If it doesn't happen on Wednesday, investors are likely to be disappointed and the bond market is going to sell off.

If we do get a QE announcement next week, we'll likely have another "sell on the news" event.

Either way, it seems no matter what happens with the Fed, next week should mark at least a short-term top in the bond market – if not something even more significant.

Take a look at this chart of the iShares Barclays 20+ Year Treasury Bond Fund (TLT)…


 
The near-20% rise from April to June has the look of a parabolic top. These moves are unsustainable and usually end with a sharp drop following a retest of the parabolic high point.

To get an idea of what I mean, take a look at this chart of gold from last year…


Gold rallied more than 20% from July to September last year. That's an unsustainable parabolic rise, and the metal dropped $150 per ounce almost overnight after it hit its $1,900-per-ounce high point. The retest of the $1,900 level followed immediately and was accompanied by negative divergence on the MACD indicator.

The setup is similar right now in the bond market.

We took a risk and went against conventional wisdom last year by shorting the gold market into its parabolic move. That was one of the fastest and most profitable trade recommendations we made in 2011.

We need to do the same thing right now with the Treasury bond market.

The Corruption of Politics

 
By Porter Stansberry
Let me show you the numbers – the hard facts – behind what's happened to our country…
I'll start with one of the biggest factors in the decline of our civilization – the link between welfare, education, crime, and politics.
It is routinely alleged in national political debates that something is fundamentally unfair and un-American about the huge "wealth gap" between the poorest Americans and the wealthiest. Some politicians like to argue that the poor never have a real shot at the American dream… And as a nation, we owe them more and more of our resources to correct this injustice. Most important, it is alleged that only the government has the resources to correct this inequality.
This is a dangerous notion…
First, it promotes the idea of entitlement. Entitlement is a fairly new idea in the American political lexicon – perhaps because most of our nation's wealth is still fairly new. The American idea of entitlement argues that because you were born into a rich society, other people owe you something. The idea has become pervasive in our culture. It underlies the basic assumptions behind the idea of a "wealth gap." Implicit is the assumption that successful Americans haven't rightfully earned their wealth… that in one way or another, they've taken advantage of society and have an obligation to give back most of what they've "taken."
I believe the idea of entitlement lies at the root of many of our most serious cultural problems.
The more obvious problem is the idea that the government is responsible for fixing the "wealth gap." But the government has proved wholly ineffective at dealing with poverty in America. The data is nearly conclusive that government efforts are far more likely to be the cause of the wealth gap than the solution.
The simple fact is, the government has to take resources from someone before it can dole them out to others. And this act of taking is economically destructive. It reduces the market's incentives for entrepreneurs. The more you take from the productive members of society, the less productive they become. That's the primary lesson of the history of socialism. Yet… many of our political leaders seem oblivious to this iron law of human nature.
Consider a simple analysis that compares the unemployment rate with the size of the federal government's spending, as measured against GDP. (We created this chart after reading a similar analysis at Mark Perry's excellent financial blog, Carpe Diem.)


As you can see in this chart, the larger the government grows as a percentage of our economy, the higher unemployment rises. The more government, the less opportunity. These figures are similar when studied comparatively across many different countries.
We also know from decades of experience that little of the government's funding for the poor will ever reach those who are actually in need. Instead, these kinds of socialist policies end up sending billions of dollars into the hands of unions, "community organizers," and other sponsors of the Democratic Party. This tightens their political control of America's inner cities, which have become the source of our country's most intractable social problems.
Believe me, I have reams of data and decades of case studies for these conclusions. But before we get to my proof, I want you to simply assume that what I'm saying is 100% correct. Assume most of the government's social spending ends up corrupting the politics of the inner city. Assume these efforts actually make the "wealth gap" larger. Assume these policies and the politicians who sponsor them are actually creating a society of complete dependence, where the spread of ignorance has created entire generations of people who aren't educated enough to know they've been enslaved by their own leaders.
If these things are true, if my conclusions are exactly right, what would America's poorest communities look like today?
 
It has now been almost 50 years since the start of the War on Poverty, President Lyndon Johnson's program to radically increase domestic welfare spending. These programs and their various spinoffs have been at the center of Democratic politics ever since. In fact, if you compare speeches about these programs from the mid-1960s until today, you will find the verbiage never changes. Obama is merely echoing the same calls for "social justice" that Robert Kennedy used in his ill-fated 1968 campaign for president.
But besides the soaring rhetoric – besides the promise of a "chicken in every pot" – what have these programs actually achieved? The wholesale destruction of urban communities across America… communities that are overwhelmingly African American. If the intention of these programs had been to destroy black communities, you could have hardly done more damage than the last 50 years of Democratic policy.
I don't think most Americans realize how dangerous these communities have become or the toll they take on our country as a whole. That's primarily because talking about this problem is seen as racist. That's complete nonsense. The victims of these policies are primarily black people. Trying to help them restore dignity and independence to their communities isn't a racist goal. It's humanitarian.
And let me offer a prediction… Sooner or later, the people in these communities are going to finally point their finger at the politicians who've lied and pandered to them for decades, all while stealing from them at every turn. When that moment comes, having a track record of correctly speaking out about the real nature of these problems will be a valuable political asset…
Let me give you some of the numbers that define the enormous scope of these problems.
According to the NAACP, Texas taxpayers spent $175 million in 2009 to imprison residents from a small part of Houston – only 10 zip codes out of 75. Thus, people from neighborhoods that are home to only about 10% of the city's population account for more than 33% of the state's entire $500 million annual prison spending. These neighborhoods are overwhelmingly poor and African American.
In Pennsylvania, taxpayers spent $290 million in 2009 to imprison residents from just 11 of Philadelphia's neighborhoods, representing about 25% of the city's population. On this relatively small urban area, the state spent roughly half its $500 million prison budget. These neighborhoods are overwhelmingly poor and African American.
In New York, taxpayers spent $539 million to imprison residents from only 24 of New York City's 200 different neighborhoods. Only 16% of the city's population lives in these areas, but they account for nearly half of the state's $1.1 billion prison budget. These neighborhoods are overwhelmingly poor and African American.
America has many problems… but these neighborhoods represent more than a society in decline. Life in these places reflects a complete collapse of Western civilization. What's happening in these communities? A breakdown of the family and the resulting collapse of the school system. What you have left is crime – violent and political.
In Detroit, only 27% of the black male students in the school system graduate from high school. This is not a racial problem: Only 19% of the white male students graduate from those same schools. What's causing this problem? A complete breakdown of society. When communities can no longer teach their children the most basic academic skills, such as reading, math, history, literature, and economics… what future can we expect? And what kind of society do you expect after several generations of total ignorance?
What opportunities are available in America to people without even a basic education? The New York Times reports almost 70% of black males without a high school diploma are unemployed in the United States.
In many predominantly black, urban communities, the actual unemployment rate is close to 100% for young dropouts. Given these figures, it isn't surprising that many of these people end up in jail.
According to various studies, black males who dropped out of school by age 16 are four times more likely to end up in jail than those who remained in school. Crime is literally all they know. Likewise, a black youth whose mother was a high school dropout is 88% more likely to end up in jail. These are the two primary reasons nearly one in 11 adult black men are either in jail or on parole.
How did this all happen? How did we end up with expensive schools that can't teach? How did we end up with young mothers who aren't married? How did we end up with entire generations of people who won't – and probably can't – work in the labor force? How did we end up with a skyrocketing prison population? The prison population in America has soared from less than half a million people in 1980 to more than 2.5 million people today. More than seven million adults are in prison or on parole in the United States. We have an incarceration rate that's seven times higher than any other industrialized nation.
The land of the free?
Let's ask the most basic question: What has the gigantic increase in welfare spending and education spending done for the underclass of America? It seems apparent that growth in federal spending has caused far more harm than good. When you study these neighborhoods, what you find is a horrifying story that's been repeated, generation after generation since the early 1960s. It's a story of families who have been destroyed by their dependency on the state.

Nestle should navigate macro headwinds with its diverse product portfolio and geographic reach.

by Erin Lash, CFA

Nestle NESN/NSRGY announced its intentions to acquire Pfizer's PFE infant nutrition business for $11.85 billion in an all-cash deal valued at 5 times fiscal 2012 sales and 19.8 times fiscal 2012 EBITDA. While the deal makes strategic sense for both parties, the price seems rich to us at first blush. However, the acquisition does not affect our fair value estimate for Nestle, given that the target segment's annual revenue of about $2.4 billion represents just 3% of packaged food firm's top line. We had initially estimated that the ultimate price for the Pfizer unit would be about $9 billion to $10 billion, but we expect that the higher price reflects the fact that Nestle wanted to keep this valuable asset out of its competitors' hands (namely Danone BN and Mead Johnson MJN). From Pfizer's perspective, while Pfizer sold the nutrition unit for a slightly higher than expected price, we don't expect to change the fair value for the company. However, we believe Pfizer will likely use the proceeds to repurchase shares, which will likely increase its 2013 earnings per -share growth by 300 basis points.

We aren't surprised that Nestle would look to scoop up this attractive asset. The infant nutrition business is high growth (with Pfizer's unit generating about 85% of sales from faster growing emerging markets like China) and high margin (with EBITDA margins in the mid-20s). This follows on Nestle's purchase of a 60% stake in Chinese confectionery manufacturer Hsu Fu Chi, the producer of the popular breakfast bar Sachima, last summer. China--along with other growing Asian economies--is an attractive market for Western manufacturers, whose domestic markets offer very few growth opportunities, and this growth opportunity is reflected in the rich multiple Nestle is paying for the investment. When Nestle sold its stake in Alcon to Novartis NVS for $28 billion pretax, we argued that it should invest the cash in extending its footprint in emerging markets. In addition, the packaged food firm has repeatedly expressed its interest in building out its health and wellness offerings, and this acquisition fits that initiative. We continue to expect Nestle to make bolt-on acquisitions of health and wellness brands, as well as to look to further build out its presence in faster growing emerging and developing markets. From our perspective, the firm's balance sheet would support further leverage for a large acquisition.

Thesis 12/15/11

Despite its position as a leading global consumer product firm, Nestle is not without its share of challenges, namely soft consumer spending and persistent input cost inflation. However, with an expansive global distribution network and well-known brands, Nestle has garnered a narrow economic moat, and we expect that the firm will continue generating solid cash flows and returns for shareholders over the longer term.

As the largest packaged food and beverages firm in the world by revenue, Nestle is one of the leading players in several categories, including beverages, dairy products, confectionery, and pet care. The breadth of the firm's product portfolio, which spans packaged food, beverages, pet care, and nutritional and pharmaceutical products, makes Nestle a core supplier to grocery stores across the world, and its distribution network is extensive. More than 20 of Nestle's brands each generate in excess of CHF 1 billion in annual sales, and the firm is particularly dominant in the bottled water category, fending off competition from beverage behemoths Coca-Cola KO and PepsiCo PEP. As a result, Nestle is in a relatively strong position to negotiate with retailers for primary shelf space in stores.

However, competitive pressures (from both other branded players as well as private-label products) remain intense. Amid an environment of elevated unemployment, consumers are still price-sensitive in grocery stores. The frozen foods category in particular, has been a fierce battleground. The quality of lower-priced products has improved in the last 10 years, and this could erode the premium that consumers are willing to pay for branded food products. Nestle's growth could slow because consumers who are switching to private-label products during the downturn may not revert to leading brands when the economy recovers.

Similar to other consumer product firms, we anticipate that Nestle's presence in faster-growing emerging markets will ultimately offset more sluggish developed market growth. In these regions, consumers' wealth and spending power continues to grow, leading to increased per capita consumption of some of Nestle's discretionary products, such as confectionery. While some investment in manufacturing and distribution infrastructure will be necessary (management expects to spend CHF 2.5 billion in emerging markets capital expenditure in 2011, which seems reasonable to us), we think Nestle can create more meaningful economies of scale by growing its emerging market unit volumes. Nestle can also utilize its impressive balance sheet, in our view, to make bolt-on acquisitions to build out its presence in these regions. By 2020, Nestle expects to generate 45% of consolidated sales from developing markets, up from just 36% in fiscal 2010.

While we recognize that opportunities for additional growth and margin expansion exist, we are skeptical that the company can meet management's goal of 5%-6% internal annual growth and generate margins comparable with its smaller peers, given the sheer size of the firm and its decentralized operating structure. That said, Nestle offers broad exposure to the consumer staples industry, and we recommend the shares to investors who wish to rotate some assets into a defensive sector amid the current market volatility. Despite this, we don't believe the shares represent a compelling risk/reward proposition at current market prices.

Valuation

After reviewing Nestle's results through the first nine months of 2011 and transferring coverage to a new analyst, we are lowering our fair value estimate to $57 per ADR from $59, which implies forward 2012 price/earnings of 17 times, enterprise value/EBITDA of 11 times, and a free cash flow yield of 4.7%. Our updated outlooks incorporates a more conservative view of the firm's sales growth potential in fiscal 2011 in light of the strength of the Swiss franc and persistent macro pressures in both the U.S. and Western Europe. We value the firm's stake in L'Oreal (30%) separately from its core food and beverage business, and estimate the value of the investment to be $6 per ADR, based on our fair value estimate for L'Oreal. We value Nestle's core food and beverage business at $51 per ADR.

We now forecast revenue to decline 10% in fiscal 2011, compared with our previous forecast of nearly 2% growth. Between fiscal 2012 and 2015 we expect sales to increase nearly 4% on average annually, down from 5% in our prior forecast. Over the near term, we anticipate that the strong Swiss franc will hinder reported sales, and we suspect that competition from other branded products and private label will restrict revenue growth to inflationary levels over the longer term. Because of the firm's decentralized structure, and the pressure to continue investing behind product innovation and marketing core brands, we think that margin expansion will be limited. We forecast operating margins to average 13% over the next five years which is about 100 basis points above the average margin of the past two years. We project Nestle to generate returns on invested capital including goodwill of around 14% during our five-year forecast period, comfortably ahead of our 8.8% estimate of the firm's cost of capital. Our valuation does not take into account potential acquisitions, which may cause future results to deviate materially from our estimates. We use an exchange rate of CHF 0.8878 per $1 to calculate our fair value estimate, which is the one-year average spot rate as of Dec. 14. However, the CHF/USD rate is very volatile at present as assets flow into the Swiss franc, which is seen as a safe haven in uncertain economic times. Changes in the CHF/USD exchange rate could cause our fair value estimate to differ materially from the prevailing market price.

Risk

Nestle's greatest operational risk is the threat of rising commodity costs, which could squeeze margins. Although the rate of input cost inflation has moderated, the prices for several raw materials continue to trend higher and remain considerably above the level of just two years ago. If the firm seeks to raise prices to offset margin pressure, volumes could weaken, as consumers might switch to cheaper private-label alternatives. Nestle operates in some competitive categories and faces stiff competition from companies such as Coca-Cola and Pepsi in bottled water, Kellogg K in breakfast cereal, and Kraft KFT in confectionery.

Management & Stewardship

Although we have some concerns about the strength of the firm's corporate governance structure, capital allocation at Nestle has been solid from where we sit as returns on invested capital exceed our cost of capital estimate. We applaud Nestle's separation of the roles of chairman and CEO, but CEO Paul Bulcke has had a 30-year career at Nestle and rose through the ranks while former CEO and current chairman Peter Brabeck-Letmathe was at the helm. We are concerned that the two may have formed a close professional relationship that may jeopardize the independence of the board from management. Furthermore, we would prefer if Nestle held annual elections for all directors, rather than the current three-year staggered structure. In addition, more disclosure regarding management compensation would be highly valued on our end so that we could better assess whether the financial incentives of the executives are truly aligned with shareholders' interests. Having said that, we think that the board includes a number of directors with impressive executive, financial, and legal experience, and we like that 12 of the 14 members are independent.

Overview

Financial Health: 

Nestle is in solid financial health. The company received an aftertax cash windfall of around CHF 22 billion following the sale of its Alcon stake to Novartis NVS, which it has used to pay down debt, repurchase shares, and pursue small bolt-on acquisitions. With so much cash at its disposal, we do not anticipate any liquidity issues in the short term. We forecast Nestle to generate free cash flow at around 9% of revenue on average during the next five years, and its debt/EBITDA ratio should amount to 1.3 times (in line with fiscal 2010). With debt maturities quite well dispersed during the next five years, the firm should comfortably be able to meet its repayment schedule. We expect Nestle to make bolt-on acquisitions of health and wellness brands, as well as to look to further build out its presence in faster-growing emerging and developing markets. The firm's balance sheet would support further leverage for a large acquisition, but with the shares currently fairly valued, we would not be in favor of additional leverage for share repurchases.

Profile: 

With a history that dates back more than 150 years, Nestle has grown to be the largest food and beverage company in the world. The firm generates sales of around CHF 100 billion through its diverse product portfolio, which includes brands such as Nestle, Nescafe, Jenny Craig, Perrier, and Pure Life. Nestle also owns just more than 30% of French cosmetics firm L'Oreal. In January 2010, the firm sold its 52% stake of Swiss eye-care company Alcon to Novartis in a $28 billion deal.

Pepsi's dominant snack food operations are underappreciated by the market.

by Thomas Mullarkey, CFA

PepsiCo has built a wide economic moat, thanks to its economies of scale, dominance in the snack category, and efficient distribution network. The direct store delivery system allows the firm to leverage its portfolio of brands, and should ensure that PepsiCo maintains its strong returns on invested capital over the long haul.

Although Coca-Cola KO is the global cola leader, PepsiCo is the dominant force in the global snack market. Pepsi controls around 64% of the U.S. salty snack market, 60% of the market in Brazil, and 46% of the U.K. market. The North American snack business is Pepsi's most profitable segment, generating 24% of the firm's total revenue in 2011, but 41% of its operating profits.

Additionally, PepsiCo has an impressive record of creating or acquiring products that are aligned with emerging consumer trends. Over the past decade, Pepsi's Good-For-You portfolio has grown to $13 billion in annual sales from $2.2 billion, as consumers increasingly demand tasty and nutritional foods and drinks. We expect that future growth in the health and wellness segment will primarily be organic (via increased focus on the firm's Tropicana, Quaker and Gatorade brands) but will be supplemented through select acquisitions, such as the firm's 2011 acquisition of Wimm-Bill-Dann for $4 billion, which helped PepsiCo to enter the Russian dairy market.

From our perspective, PepsiCo's direct store delivery system is one of the key attributes driving the firm’s wide economic moat, given that replicating such a system would be prohibitively expensive for an upstart competitor. Pepsi's distribution system allows the firm to deliver merchandise and stock the company's beverages and snacks to retailers across the globe, and garner market share from the firm's smaller peers.

Pepsi's relationships with retailers have become even more direct since the firm took control of its two anchor bottlers, Pepsi Bottling Group and Pepsi Americas, Inc. The transactions, which closed in 2010, have already delivered over $550 million of annual synergies, and have allowed Pepsi to more nimbly experiment with packaging formats and to incubate niche products. It is important to note that the bottling operations are much more asset-intensive than the beverage concentrate business, and Pepsi's asset-base has swelled to $73 billion at year-end 2011 from $40 billion at year-end 2009 as a result. This surge in assets is the primary reason why we forecast that Pepsi's return on invested capital will pull back to the upper-teens percentage range over the next five years, versus the loftier mid-30% range the company enjoyed during the last decade.

Given Pepsi's competitive advantages, we think the company's stock should trade at a high-teens multiple. Currently, the market appears fixated on problems in the company's beverage business, and is ignoring its dominant position in snacks.  Overall, while we believe that Coke should trade at a richer multiple--given that it dominates the on-premise channel, and is outspending Pepsi in emerging markets--we believe that the valuation gap between these beverage and snack giants has grown too wide.

Valuation

We are reducing our fair value estimate for PepsiCo to $72 per share from $76, largely as a result of reduced outlook for the company's 2012 performance. We expect in 2012, Pepsi's core EPS will drop by about 8% versus what it earned in 2011 as its efficiency programs are more than offset by higher marketing costs, increased raw material costs, and a strengthening U.S. dollar. Longer term, we expect Pepsi's top line and EPS to grow around 5% and 7% per year, respectively. Our new fair value estimate implies an 11 times EV/EBITDA valuation, 5% free cash flow yield, and a 2.8% dividend yield.

Volume and pricing are key drivers of our valuation model. We forecast Pepsi's top line to grow roughly 5% per year over the next decade, driven by roughly 3% to 4% volume growth and 1% to 2% pricing growth.  Additionally we believe that the company's operating margins should be around 15% to 16%. We believe that, in the coming years, EPS growth should outpace top-line growth as the firm utilizes the substantial free cash flow it generates to reduce debt and repurchase shares. For 2012, we expect Pepsi to earn roughly $4.08 per share on $68.5 billion in revenue.

Risk

Volatility in commodity prices, particularly for raw materials such as corn, juices, wheat, aluminum and plastic resins, could pinch PepsiCo's sales and profitability. PepsiCo is only able to hedge approximately three-quarters of its raw material costs, constantly leaving it somewhat exposed to commodities fluctuations. Approximately half of Pepsi's revenue is generated from international markets, exposing it to various currency and geopolitical risks. Finally, sales of PepsiCo's carbonated drinks and snacks are vulnerable to the impact of shifting consumer tastes that might favor healthier options, or by governments looking to tax sweets and snacks.

Management & Stewardship

PepsiCo has an above-average standard of corporate governance. Chairman and CEO Indra Nooyi, who has been at the helm since 2006, has been instrumental in shepherding some bold strategic moves, including the firm's increased focus on Good-For-You products and the acquisition of Pepsi's North American bottlers. While we would like to see the roles of chairman and CEO separated, we note that with Nooyi's ownership of over 1.5 million shares, combined with her incentive-heavy compensation package, her interests are likely aligned with those of shareholders. We further applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think allowing cumulative voting would further enhance the rights of the small shareholder.

Overview

Financial Health: 

Although the acquisition of Pepsi's North American bottlers measurably increased the company's debt (to $26.8 billion in 2011 from $8 billion in 2009), we view the firm as financially healthy, with the prospect of default remote. Even with its increased debt load, we expect the company's debt/EBITDA ratio to remain below 2, and EBITDA to cover interest expense by about 15 times on average during the next five years. We currently assign Pepsi an issuer rating of AA-, implying very low default risk.

Profile: 

PepsiCo manufactures, markets, and sells a variety of salty, convenient, sweet, and grain-based snacks, as well as carbonated and noncarbonated beverages. The company's broad portfolio of brands includes: Pepsi, Mountain Dew, Gatorade, Tropicana, Lay's, Doritos, and Quaker. Pepsi owns most of its bottling infrastructure in North America, but typically utilizes independent bottlers in international markets. Food accounts for approximately 50% of Pepsi's revenue. Additionally, 53% of Pepsi's top line comes from the United States.

Coke's thirst for emerging market expansion has yet to be quenched.

by Thomas Mullarkey, CFA

Coca-Cola KO and its local bottling partners plan on investing an additional $3 billion in India through 2020. This investment, combined with prior commitments, means that from 2012 to 2020, the Coca-Cola system will invest $5 billion in India. Much of the investment will go toward adding capacity, expanding its distribution network, and rolling out more cold-drink equipment. We believe that success in India is critical for Coca-Cola's desire to achieve its 2020 vision to roughly double its global volumes. While the details of this investment are new, the concept is not. In order to double systemwide sales by 2020, we have long believed that the company would need to significantly invest in emerging and developing countries. Consequently, we are maintaining our $73 fair value estimate on Coke shares.

While India is home to 1.2 billion people (17% of the world's population), its citizens consume far fewer Coca-Cola products than the rest of the world. While the average American consumes on average 400 Coca-Cola products per year, the average Brazilian drinks 230 servings, and the typical Chinese has 38 servings per year; the average Indian drinks only around 12 eight-ounce servings of Coca-Cola products annually. This is well below the global average of roughly 90 servings per person per year. Coca-Cola India has grown case volumes in the country for over 5 years. While the company's Thumbs Up and Sprite brands are India's top-selling soft drinks, the Coca-Cola brand is seeing healthy growth, with volumes up 27% during the most recent quarter. Additionally, Coca-Cola's Maaza brand is India's best-selling juice drink.

Thesis 04/17/12

Coca-Cola's wide economic moat is bolstered by its extensive distribution network, which enables the company to deliver its products to consumers in more than 200 countries, as well as its bevy of powerhouse brands. While declining consumption of carbonated beverages in North America will serve as a near-term headwind for Coke, we believe international markets will provide plenty of growth opportunities over the long term. Absent any strategic missteps, we view Coca-Cola as a safe haven in an uncertain economic environment given that the firm has one of the widest moats in our consumer coverage universe.

Even though Coke's existing distribution network spans the globe, the company continues to invest for international growth. The company and its bottling partners intend to invest billions over the next few years in countries such as China, Russia, and Brazil, where per capita consumption is increasing in light of the burgeoning middle class. For example, annual per capita consumption of Coca-Cola products in China is just 38 servings, versus eight servings in 1998, and versus 403 servings in the U.S. We think that these investments will build out the firm's manufacturing and distribution footprint to such an extent that it would be too costly for a new entrant to duplicate, further solidifying the sustainability of the firm's competitive advantages.

Over the last decade, tastes have changed in mature markets as consumers have shifted from purchasing carbonated soda to still beverages such as juices, ready-to-drink teas and coffees, and enhanced water. To mitigate this falling volume and maintain share, Coca-Cola has been forced to broaden its portfolio deeper into various still beverage categories, which has enabled the beverage giant to leverage its vast distribution system and marketing might to continue to grow its worldwide volumes.

The pressure on bottlers' margins and the demands of the syrup makers for distribution and production flexibility have been sources of conflict for many years. Consequently, Coke followed PepsiCo's PEP lead by acquiring the North American operations of Coca-Cola Enterprises CCE. This acquisition is intended to eliminate these conflicts and to make the firm more responsive to changing customer demands. Although Pepsi was the first to control its North American bottlers, Coke's copycat move less than a year later shows that there is little that one of these beverage juggernauts can do that cannot be duplicated by the other. We think that Coke's strategy will nullify some of the competitive advantage that Pepsi had hoped to achieve in its route to market.

We believe that Coke's extensive distribution network and strong brands in almost every nonalcoholic beverage category should allow the firm to successfully generate excess returns on invested capital for years to come. We recommend buying the stock at about 15 times forward earnings, and thanks to its strong competitive advantages, we think that Coke should trade at a premium to other consumer staples firms.

Valuation

Following the company's healthy first-quarter results and continued solid execution on its 2020 vision, we are increasing our fair value estimate for Coca-Cola to $73 from $69. Our fair value estimate implies fiscal 2012 price/earnings of 18 times, enterprise value/EBITDA of 13 times, a free cash flow yield of 5%, and a dividend yield of 3%. We believe that Coca-Cola's wide economic moat and opportunities for continued growth merit above-average valuation multiples.

Volume and pricing are key drivers of our valuation model. We forecast Coca-Cola's top line to grow roughly 5.5% per year over the next decade, driven by roughly 3%-4% volume growth and 1%-2% pricing growth. Additionally, we believe that the company's operating margins should range between 25% and 27.5%, in line with Coke's average adjusted operating margin during the last five years. From our perspective, EPS growth should outpace top-line growth going forward as the firm utilizes the substantial free cash flow it generates to reduce debt and repurchase shares.

Our estimates for Coke's revenue growth and EPS growth are within the range of the company's long-term targets of 5%-6% CAGR for the top line and 7%-9% CAGR for long-term EPS growth. For 2012, we expect Coca-Cola to generate about $49 billion in revenue and $4.11 per share.

Risk

Coke's sales and profitability could be negatively affected beyond our forecasts by greater than expected increases in commodity prices, particularly for raw materials such as sugar, cocoa, and oranges. Ownership of the company's North American distribution platform will increase Coke's exposure to other commodities such as aluminum and plastic resins; the deal is also not without integration risk. With about 70% of revenue being generated outside the U.S., the firm is subject to currency and geopolitical risks in the overseas markets in which it operates. Sales of Coke's carbonated drinks could be hurt by negative publicity regarding the health concerns associated with drinks with high sugar content, and volumes of Coke's sugary drinks could be constrained should governments look to increase taxes on soda.

Management & Stewardship

Coca-Cola generally has a high standard of management stewardship. We attribute the firm's consistent execution during the difficult operating environment over the past several years to strong leadership from the top and a very deep bench. We are also impressed with management's focus on the company's 2020 vision, which emphasizes making the best decisions to grow the business over the long term, not just the next quarter.

Muhtar Kent is currently Coca-Cola's CEO and chairman. In general, we prefer to see these roles separated. Executive compensation is generous, but incentive-based pay does appear to be aligned with the long-term interests of shareholders. While six of Coca-Cola's 15 board members have sat on the board for more than two decades, the firm has recently added some high-profile new board members, including Howard Buffett (Warren Buffett's son), Evan Greenberg (CEO of ACE Limited ACE), and former Chicago mayor Richard Daley.

We applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think that allowing cumulative voting would further enhance the rights of the small shareholder.

Overview

Financial Health: 

Coca-Cola is financially healthy. Although the acquisition of CCE's North American bottling business measurably increased the firm's debt, interest expense, and pension expense, we believe that the firm's strong cash flows will enable the company to meet all of its financial obligations, invest for future growth, and grow its dividend. We forecast EBITDA to cover interest expense more than 40 times, on average, over the next decade, and forecast the firm to generate free cash flow of about 19% of revenue over our 10-year explicit forecast period. We currently assign Coke an issuer rating of AA-, implying very low default risk.

Profile: 

Coca-Cola is the world's largest nonalcoholic beverage company. The firm, which sells a variety of sparkling and still beverages, generates 70% of its revenue and about 80% of its operating profit from outside the United States. Coke's core brands include: Coca-Cola, Sprite, Dasani, Powerade, and Minute Maid. Following the asset swap with CCE, Coke now owns about 80% of its distribution in North America.

Here's the Answer: GERMANY, Not Greece, Should Exit the Euro

By Dr. Steve Sjuggerud

Monday, July 2, 2012

 

German taxpayers shouldn't bail out their neighbors…

Instead, Germany should consider leaving the euro.

Over the weekend, Germany's neighbors convinced Germany to sign on for even more help. The Europeans agreed on having a pan-European Banking Union. The idea is that all of Europe would bail out European banks when necessary. The reality is, Germany will be the one saving the others.

Instead of being forced into that position, Germany should consider stepping out of the euro itself.


It comes down to who is actually in the euro. Based on the size of their economies, Germany, France, and the five "PIIGS" nations (Portugal, Italy, Ireland, Greece, and Spain) make up over 80% of the euro.

All of these countries are in trouble, except Germany.

You already know about Greece and the other PIIGS… but France will soon be in trouble, too…

You see, France has a new President, François Hollande. Mr. Hollande was a key figure over the weekend in forcing Germany to help the weaker countries. Take a look at Mr. Hollande's plans (according to The Economist):

Mr. Hollande will start by cutting the retirement age for some workers to 60, putting the top marginal income-tax rate up to 75%, raising taxes on wealth, inheritance and dividends, increasing the minimum wage and making it much harder for employers to fire workers.

Far from curbing the size of the public sector, at 56% of GDP the biggest in the euro zone, he seems likely to expand it.

The thing is, if Mr. Hollande follows through with these plans, France could be a bigger mess than Greece and the rest of the PIIGS in no time… Heck, with French public debt at 90% of the country's GDP, it won't take long for France to catch up with the PIIGS.

So the big question is, why should German taxpayers work hard and eventually pay to bail out guys with plans like Mr. Hollande's? They shouldn't…

Again, as measured by the size of their economies, these seven countries make up over 80% of the euro. Only one of these countries – Germany – has its act together. It appears that the other countries are incapable of making the necessary changes.

So why should we prolong Europe's euro crisis indefinitely?

The answer to the problem is relatively simple: Germany, not Greece, should exit the euro…

I wish I had a nifty trade for you on all of this mess… like buying German government bonds, for example. But unfortunately, the land mines are too big whichever way you turn. (If you bought German government bonds denominated in euros, for example, and Germany left the euro, would those bonds stay in euros? I don't know.)

In sum, the quickest, simplest solution for Europe is right under their noses… It's for Germany, not Greece, to leave the euro.