Dear Investors,
On October 11th, we at T&T Capital Management celebrated our 6-year anniversary. I feel incredibly blessed to say that the vast majority of our original clients are still with us, including quite a few that were with our prior enterprise, which we ran before we went off to create our own 100% family-owned company. It truly is an honor to be trusted to protect and grow your hard-earned capital and I can 100% guarantee that there is not a day that we take that for granted.
“It truly is an honor to be trusted to protect and grow your hard-earned capital and I can 100% guarantee that there is not a day that we take that for granted.”
As we are now in year-eight of a bull market; with volatility near all-time lows, and valuations at some of their highest levels in history, I spent some time thinking about the present, fit relates to our future.
Back in late 2012, Hewlett-Packard was being written off as a complete dinosaur and the stock had dropped from the mid-$30’s to the low-teens. It was clear to everyone that desktop computers and printers had entered into a secular decline. Past acquisitions had been incredibly destructive, stretching the balance sheet and destroying value.
At TTCM, we follow cash flows and HPQ was still generating them at a prodigious level. Meg Whitman had taken over and expressed clearly that the company was going to abstain from acquisitions, reduce costs, and pay down debt.
On November 20th, 2012, the stock was trading at $11.71 per share and had a market cap of $20.3 billion. The dividend yield was 4.3% and the business itself generated $7.5 billion in free cash flow over the previous 12 months. Think about that… would you pay $203,000 for a business that generated annual free cash flow of $75,000, or a yield of 37%? We didn’t need HPQ to suddenly invent the next iPod-like technology invention to make a ton of money. Instead, the company simply had to funnel its free cash flow to reduce debt. Then once the balance sheet was fixed, the company could take advantage of the disconnect between the stock price and intrinsic value by buying back stock.
“Would you pay $203,000 for a business that generated annual free cash flow of $75,000, or a yield of 37%?”
Ultimately, value can be its own catalyst when management is adept at capital management. Whitman executed this strategy to perfection and now HPQ and its spinoff HPE have a combined market cap of $60 billion, or 3 times the 2012 value, not including the millions in dividend payments that shareholders have received over those years. Here is a link to our research report on HPQ from back then:
Hewlett-Packard: Distressed Investing 101
Looking at today’s investments, I see quite a few similarities to HPQ back in 2012. Everyone knows that retail is forever changed and online sales are going to continue to grow as a percentage of total sales. This has led to a massive bear market in retail stocks. One stock that has gotten creamed is Macy’s, which traded above $60 just a few years ago, and now trades below $20.
When you look at Macy’s balance sheet and compare its real estate to comparable prices, you can see that the market cap plus debt (enterprise value) is less than its real estate value. Then you have a business that generates over $3.25 per share in earnings on top of the real estate. The company is selling non-core real estate and using proceeds to pay down debt. It is also investing in growing initiatives such as Blue Mercury and Backstage, which should set the stage for future same-store sales growth.
We don’t need revenue growth to win on this investment. I don’t believe Macy’s has as good of a CEO as Meg Whitman was for HPQ, but there does seem to be an understanding of what is necessary to increase the value of the enterprise. While we are waiting for the price to correct, we can collect an 8% dividend yield that is well-covered at this point. I’d like to see the company move more aggressively to sell real estate to reduce debt and ultimately buy back stock.
Teva pharmaceutical is another example of a stock that has gotten annihilated due to a terrible acquisition, in this case Allergan’s generic business. In addition, there is pressure on generic drug pricing and its leading drug Copaxone is facing competition. The stock trades around $15 per share, when it was trading near $70 two years ago. With Teva, you have a company that generates incredible free cash flow, but due to the acquisition it has a bad balance sheet. Management is taking the right course to fix the problems. They have cut the dividend, they will cut expenses, and are now selling non-core assets. This will enable the company to once again get to a point where they are working from a position of strength from a balance sheet perspective.
Teva is the largest generic drug manufacturer in the world. While pricing pressure is an industry reality, Teva is in a position to benefit due to its scale and breadth of products. Teva is the Israeli national champion company, so they wouldn’t likely be allowed to sell themselves, but if they were I doubt the stock would ever have gotten this cheap. When you compare Teva’s product diversification and cash flows to competitors, it becomes very clear that this can be one of the best buys in the industry if management executes. It will be a perfect case of following cash flows to see if the investment will be successful. Management must avoid stupid acquisitions and run the company with supreme efficiency, funneling the cash flow to reduce debt. That will set the stage for the next growth phase for the company or to arbitrage the disconnect between price and value via stock buybacks.
“…this can be one of the best buys in the industry if management executes.”
Below are some more of our past research reports on companies that we have owned. You will see that we’ve invested in many different industries and companies. The common theme is that at the time most of these investments were absolutely hated for some reason or the other, but the business values were there and overlooked by the market.
When I look at stocks like Assured Guaranty and Ally Financial today, I see many of these same themes that have made our clients millions of dollars. Both stocks sell at large discounts to a conservative estimate of intrinsic value. Both companies are aggressively buying back their undervalued stocks, while also paying a reasonable dividend. Both companies have quantifiable short-term issues, which greatly distract market participants from this undeniable value that exists.
As value investors, we use these short-term distortions in price as buying opportunities. The overall market is incredibly expensive, but I feel tremendous excitement about the investments that we are holding. I believe our portfolios are set to gain even if the market is flat to negative over the next few years, which I believe is a very real possibility. As time permits, I’ll try to continue writing about past case studies like HPQ and how they relate to our investments that we are making today.
Thank you very much and as always if you need anything, please don’t hesitate to contact me!
Sincerely,
Tim Travis
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