RMCF Query

I posted my RMCF article on Seeking Alpha and got a great question about my valuation of Hersheys and Mondelez. I adjusted RMCF’s forward P/E for taxes at 13x while seemingly ignoring Hershey and Mondelez’s potential tax benefits:

The chocolate business can still generate $4 million per annum but with President Trump’s tax cuts (15% tax rate assumption), it goes up 25% to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.

The actual TTM P/E’s for Hershey’s (HSY) and Mondelez (MDLZ) are 30x and 40x. The multiples above for HSY and MDLZ are Pro-forma or ‘adjusted’ earnings, which are inflated, whereas their GAAP earnings are significantly lower. So the multiples above are more than already inclusive of a tax discount even though MDLZ doesn’t deserve it — the real valuation discount is much higher than 25% when one compares apples to apples. Investors and sell-side analysts have come to expect ‘adjusted’ earnings from those two. HSY and RMCF have similar historical tax rates (about 35%), and MDLZ’s tax rate is much lower so the discount shouldn’t change much in a post-tax adjustment scenario. Hence why I was comfortable comparing the adjusted earnings to RMCF’s tax-adjusted forward net income. The scale and brand advantage that MDLZ and HSY have over RMCF indicates that it should certainly trade lower — the question is how much lower? Hence why I have a price target just 20-25% higher than my purchase price.

 

Rocky mountain Chocolate Factory $RMCF

5 yr chart

I recently added Rocky Mountain Chocolate Factory (RMCF), my cost basis is $10.99 @10% of the portfolio. The company manufactures and sells premium chocolate and has a long history of profitability. The company makes money by wholesaling chocolate to its franchisees and collecting revenue-based royalties. In 2013, the RMCF took a controlling interest in Yogurt maker, U-Swirl (SWRL). SWRL made some debt-financed acquisitions and defaulted and so RMCF took over SWRL and effectively guaranteed its debt. The takeover proved to be expensive as SWRL is still losing money, and in dissent, outspoken shareholders sold off the stock while management maintained its confidence in SWRL.

Risk

As consumers, specifically millennials, become more health conscious, confectionery will likely stagnate. I don’t see the stagnation as much of a big deal because the pace of a decline, if so, will be negligible and people will still eat chocolates in 100 years. If anything, the industry is likely to be stable over the long run and even with a zero growth, RMCF still presents an attractive entry point.

Catalysts

  • Management has historically been shareholder friendly (paying quarterly dividends and repurchasing shares)
  • Management made a mistake but has realized that the assumptions for the yogurt business were a bit optimistic, and as of  Q3’s earnings call in January, the CEO acknowledged that. Given that franchisees control the majority of these stores, it only makes sense that they exit the business if it remains unprofitable which is evident in the chart below.
  • RMCF’s current and historical tax rate is about 36%, and the company will significantly benefit from President Trump’s expected tax cuts (more so than the general markets).
  • 50% of products sold at the stores are produced on premises, 45% of products sold are manufactured in the company’s Colorado factory, with the remaining 5% being purchased from third-party suppliers. In essence, the company relatively immune from President Trump’s border tax.

Stores

Source: RMCF SEC Filings

The chocolate business can still generate $4 million per annum, and with President Trump’s tax cuts (15% tax rate assumption), it goes up 25%, to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.

Syntel Earnings Update

Syntel reported earnings last month and guided below analyst expectations. Analysts were expecting 2017 EPS of $2.32 while Syntel’s guidance came in at $1.7 to $2.0. I had mentioned that the analyst expectations looked a bit too optimistic in the 2016 performance report and was quite frankly surprised when the stock took off and ran up 17% prior to the earnings report.

Screen Shot 2017-02-17 at 3.11.31 PM

Could markets be pricing in something I ignored? Such as the concentrated nature of its clients? I don’t know, but I don’t think so. I believe it has more to do with growth — the customer concentration is, to a great extent, priced into the stock. I also believe management may have been a bit disingenuous with analysts from what I can see. It is clear that President Trump will ease banking regulations which should be a positive development for the financial sector, so what uncertainty is there? the election is over and the path to deregulation has never been clearer. What I do understand, however, is the uncertainty arising from Healthcare. Given that no one knows what the healthcare environment is going to look like in two years, uncertainty in healthcare makes sense. I think management needs to up the marketing/ad budget and execute to win more business.

I came close to selling SYNT to buy Infosys after INFY reported earnings and fell while Syntel ran past $22. I made the emotional, mistaken decision to carry on with SYNT. At the price of $22, INFY made so much sense. It’s a mistake I almost regret but bad decisions and mistakes are usually the lessons that stick.

Even under the worst case scenario of an EPS of $1.7-$2.0, the stock is still cheap at these levels relative to competitors and general markets. We’re paying, as of Friday’s closing price, between 8.8 and 10.3 times earnings which is reasonable. For Q1, my goal is to figure out if growth is lagging because of the volatility coming from one of their large clients or if it some other variable. Top-line volatility from one of the large customers should be expected given the nature of the business, the less dependent Syntel is on one client, the better off they are because it decreases future volatility. Determining the reason for the revenue volatility is integral to determining if I hold on to the position or sell.

One other interesting point is that Mr. Desai increased his stake. I thought that was bullish but I was wrong.. my question, though, is — why would one buy more shares of the company if they were expecting more bad news and thus, a lower stock price? It still has my head spinning..

Because I take large, concentrated positions, I require larger discounts to average down. I am willing to increase my position if I can do so at the $15 level. I had initially mislabeled a line-item which was why I was so comfortable running the position at a large percent of the portfolio. I cut my position immediately after I realized my mistake, but I do wish I had given myself room to buy more shares.

 

 

Target Corp. And The Tale Of Discount Retailers

Is retail in a ‘terminal recession’? Not according to Ross and TJ Maxx — both apparel retailers are still posting single digit comps despite the notable threat from Amazon. Their shareholders haven’t done too shabby:

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5-Year Chart of Ross Stores, Inc., S&P 500, and T.J. Maxx. (Source: Yahoo Finance)

I’ve been an Amazon Prime member for about five years. I signed up because I could purchase goods online at lower prices and have them shipped to me at no cost (free 2-day shipping) — it was a no brainer. While most people contend online shopping to convenience, convenience has its price and at the end of the day, consumers are price conscious. Ross and TJ Maxx offer unsold apparel from the big box department stores at depressed prices which makes them attractive even in the face of Amazon. A pair of Levi Jeans that one might purchases at Macy’s for $60 sells at Ross for $20. Ross hasn’t even put much of any effort into online shopping — a visit to the website refers you to a physical store and yet, the retailer posted 7% increase in comparable sales last quarter. So is retail dead? Depends on who you ask. Discount retailers that sell commoditized products are more likely to survive, or better yet, die at a slower pace than their specialty counterparts so I do not think they should be written off.

I do agree that stagnation is likely going forward for Target but the stock traded at a decent valuation relative to the general market and that made it attractive to me. What happened post earnings was less about Amazon and more about the guidance and management’s strategy — price cuts to drive foot traffic (lower comps, less income) and $7 Billion CapEx program. Why management would reinvest 20% of their market cap into a terminal business mystifies me. Investors are already skeptical of retail’s ability to compete with Amazon, and so I believe the reaction was warranted.

I was satisfied with receiving a forward 8% earnings yield, 4% dividend yield, and at 1% terminal decay rate. My assumption was that the bad news was priced in, but I did not expect mgmt to pull tricks out of the hat. Management’s decision to reinvest into a terminal business leaves me uneasy. I’m not sure if mgmt actually believes spending $7 Billion will make a difference or if it is just a way to save face and prolong the inevitable. I sold my position at a total loss of 8.7% on earnings day because the stock became too pricey for me based on the new revelations. It sucks, but it is a lesson learned. I am willing to buy some shares in the low 40s if it gets there.

 

Walmart

Walmart reported earnings last month with revenues and comparable store sales rising 3% and 1.8% (currency adjusted), respectively. The results were driven by a 1.4% increase in traffic. The operating side wasn’t exactly stellar but it was better than what markets expected and hence the price appreciation and Markets to a certain extent had priced in a bad quarter. My goal was to ride the post-earnings momentum wave to $75 and then sell but the Target mayhem ruined the possibility of that. I’m likely going to trim or sell off my position in the near future.

Mind CTI Earnings Update

Mind CTI reported earnings last week. Important items to note:

  • Revenue fell 2.1%
  • Operating income rose 27%
  • Net Income fell 18.7%
  • Multiple follow-on orders
  • Won two new deals with one being significant
    • I assume this is the same multi-million dollar deal that was announced back in Q2 but was scheduled for 2017.
  • Cash $19.8 million
  • Dividend of $6.2 million (11.2% of 3/6/17 closing Mkt cap of $54.79m) with ex-divided date of 3/7/2017
    • 25% Israeli withholding tax

This quarter was favorable considering the revenue trend of the prior three operating quarters. Gross profit and operating income were 10.7% and 26.7% higher, respectively, because of a one-time decrease in provisions but net income fell 18.7% primarily because of the significantly higher tax rate for the quarter. There is a lot of noise in this report, so it is especially difficult to figure out the reason for the variances. The 20-F has historically been filed around April and should shed some light in due time.

Valuation

Subtract total liabilities from current assets, which is 95% cash, to arrive at an NCAV of ~$12.8 million. The current market cap is $54.8m so under the assumption that the market cap falls tomorrow (ex-dividend date) to $48.6m = $54.8m-$6.2m, a normalized net income of $4.33m can be obtained by averaging the net income of the past seven years. Market Cap/ Net Income = 11.22 normalized P/E.

Given the nature of the business and no growth scenario, I feel uncomfortable holding this above $3/sh (post-dividend) and I will likely sell the majority of my shares before it hits that mark. There isn’t any correlation between the quarterly/yearly fluctuations in revenues and any perceived long-term issue with the business. I think what Monica Iancau has done is amazing — converting a niche market into a cash cow while being what is perhaps the most shareholder friendly executive I’ve come across in my short investing lifespan. Microcaps such as these tend to have very hostile management teams with terrible capital allocation policies, so what Monica has done/does is quite an amazing.

I am working on earnings updates for Walmart, Target, Syntel and should have them published this week.

EasyJet PLC: Aviation At A Value Price

Note: Purchasing is possible in Pounds Sterling (GBP) on the London Stock Exchange or on the Over The Counter market in U.S. Dollars (USD). For liquidity purposes, I will be buying in Pounds Sterling on the London Stock Exchange. All figures listed are in Pounds Sterling unless otherwise noted. Current GBP and USD prices as of 2/21/2017 are £9.6 and $48.9, respectively (google finance price is listed in pence). My purchase price was £9.6, but I received a £0.54 dividend on 2/23, pushing my cost basis down to £9.06.

Real Time price: EZJ 1.163,00 +2,00 +0,17%

Purchase Price: £9.06 (Ex-£0.54 Dividend) Market Capitalization: £3.6 Billion
Price Target: £11.8 (9-15 months) Upside: 30%

If you want to be a millionaire, start with a billion dollars and launch a new airline. – Sir Richard Branson

EasyJet PLC is a British airline based in London, England. The airline operates, as of year-end FY 2016, 803 routes across Europe and North Africa. As the third-worst performer on the FTSE 100 over the past year, the company’s woes have the by Brexit and the subsequent depreciation of the Pound Sterling. The stock is down 37%, and an American that owned the stock the day before Brexit has seen currency adjusted losses of ~48%. The sell-side expects EPS of £0.77 and £0.89 for the years ending 2017 and 2018, respectively, down from £1.71 and £1.89 a year ago.

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EasyJet PLC 5-Year Price Chart (Source: Yahoo Finance)

CONSUMER AVIATION INDUSTRY

The consumer aviation industry can be separated into two categories: Full-Service Carriers (FSCs) and Low-Cost Carriers (LCCs).

Full-Service Carriers (FSCs)

The Largest FSCs in Europe are Lufthansa and International Airlines Group (post the merger of British Airways and Iberia). American and Delta Airlines are prominent players in the USA. Full-service carriers tend to offer decent customer service, better legroom, first/business class seating options, reclining seats, free snacks, free carry-on luggage, amongst other things. The costs of the aforementioned services are usually incorporated in the ticket prices which makes them expensive. Full-service carriers fly short, medium, long, and ultra-long haul routes using what is called a Hub-and-Spoke network, which pools customers into ‘hub’ city before flying them to their destinations — one who lives at a hub airport is more likely to find direct flights than one who does not. For example, booking a flight from Phoenix to Europe will likely involve being flown to Los Angeles, Dallas, or even New York first before heading off to Europe. Going into Europe, the customers will likely get pooled into Frankfurt, Amsterdam or another hub city before heading off to the final destination.

Low-Cost Carriers (LCCs)

The largest LCCs in Europe are Ryanair and EasyJet. Spirit and Frontier airlines are prominent players in the USA. LCCs tend to exhibit poor customer experience and service: they charge for carry-on luggage, checked luggage, reserving seats, and food and snacks on the airplanes, and also have fewer employees per customer. LCCs have less seat leg room, which enables them to squeeze more passengers into the plane, they have non-reclining seats which are not only cheaper to maintain but also decrease fuel costs because they are lighter. Customers lose out on the aforementioned features but also pay lower airfare prices and have the option and flexibility to utilize and pay for whatever features they choose. LCCs fly short and medium haul routes and use a point-to-point network which is more direct than a central hub. 

 

Advantages of Low-Cost Carriers

  1. Fleet
    • LCCs tend to utilize a fleet of one or two types of aircraft. This is advantageous because when it comes to training pilots, crew, engineers, and mechanics who fly and maintain the aircraft, it only has to be done for one or two aircraft types rather than multiple. This translates to lower salaries and greater economies of scale from the expensive maintenance equipment and it also increases the feasibility of automation.
    • EasyJet owns and leases 144 A319s and 108 A320s aircraft. The company recently placed an order for 100 A320neo aircraft (with an option to purchase 100 more), which is not only more fuel efficient but also has more capacity than the A319s and is expected to decrease cost per seat by 13%.
  2. Low Fares/Low Marketing and Advertising costs
    • LCCs spend less money on marketing and advertising than their FSC counterparts because the fares are cheap and the cheap fares advertise themselves. When customers go online to book flights, they compare prices. The FSCs are forced to differentiate themselves through expensive advertising campaigns that market the value-added features whereas the LCCs spend less on advertising and let the low prices speak for themselves.
  3. Business/First class and no reclining seats
    • LCCs have higher seat densities than FSCs, they generally do not offer business/first class although they do have some larger seats that cater to customers that are willing to pay more, it is not the forefront of their offerings. Higher seat densities with less leg room which crams more passengers into the plane coupled with fixed operating costs decreases the carrier’s cost per seat. The seats also do not recline, making them not only cheaper to maintain but also lighter, which saves fuel in the process. The lack of first/business class also decreases the number of staff needed per flight.
  4. Higher Aircraft Utilization and Multi-disciplinary Employees
    • LCCs fly during off-peak hours which translates to lower airport and landing fees. They also have crew members that are multi-disciplinary who clean planes, leading to higher aircraft turn times. The planes are cleaned and maintained at a faster pace than their FSC counterparts primarily because of the simplicity of the aircraft. They also push for online check-ins which decrease the number of additional personnel at the airport, and some LCCs charge customers that choose to physically check-in at airports.
  5. Hub-and-Spoke (H&B) vs. Point-to-Point (P2P)
    • FSCs use the Hub and Spoke network which pools customers into a hub city before flying them to their destination whereas Point to Point tends to be more direct and the lower number of connecting flights means less baggage, landing, and other airport fees to the carrier and thus, lowers costs. When a flight is delayed, the customers miss their flights and are prioritized for the next available flight with H&B whereas this is less likely to happen with P2P because P2P connecting flights generally have longer layover times which reduces the probability of missing a flight even when it is delayed.

Customers are less receptive to food on the plane, reclining seats, and other features that FSCs offer on short-haul (1-3 hour flights) which is why the LCC model works. Ryanair went as far as floating standing room seats or even charging customers to use the bathroom. The fares are low upfront, but customers make up for it through the various fees it charges. One who does not check-in before getting to the airport has to pay fee of 45 Euros, which is ridiculous given that the average ticket price Ryanair sells is less 50 Euros. Ryanair, without a doubt, is the undisputed king of LCCs so why buy EasyJet? As the old saying goes: you don’t have to outrun the bear to survive, you just have to run faster than the person next to you. Although FSCs now offer some features the LCCs initiated, EasyJet is still sandwiched between the FSCs and Ryanair regarding cost structure and value, and EasyJet also faces temporary headwinds that could improve margins within the next 12 months.

RISKS AND HEADWINDS

Scottish Referendum

Scottish First Minister, Nicola Sturgeon, has threatened the UK with a Scottish referendum on the basis that Scotland voted to remain in the European Union (Scotland voted 62-38 for the remain camp). FM Sturgeon is convinced that exiting the UK and joining the European Union would leave Scotland in a more prosperous position but economic data from the Scottish government contradicts this notion.

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Source: Scottish National Statistics

Scotland’s 2015 total value of exports was £78.5 billion. Total international exports were £28.7 billion split between exports to the EU of £12.3 billion or 15.7% of the total and exports to non-EU of £16.6 billion or 21.2% of the total. Exports to the ‘Rest of the UK’ was £49.8 billion or 63% of total exports. The numbers above are nominal and not adjusted for inflation, but the trend is clear — exports to the EU, rest of the UK, and Non-EU since 2002 are up 8%, 74%, and 41%, respectively. I am not exactly sure what the economic rationale is for leaving the UK, but it seems that the UK is Scotland’s fastest growing export market, followed by the Non-EU countries, with the EU lagging behind.

One may argue that the way the government counts exports may be distorting the real figures but the disclosures give me confidence:

International Exports

These exports relate to the sale of goods or services to customers overseas. In calculating these figures we look at the final destination of the exports and ensure exports originating in Scotland are allocated to Scotland. For example, a sale by a Scottish company to a customer in France which is shipped via a port in England, would still be classified as a Scottish export to France, rather than a Scottish export to the rest of the UK.

Rest of the UK Exports

These are exports of goods and services by Scottish companies to customers in the rest of the UK. The majority of these exports will be consumed or remain within the rest of the UK, for example electricity or service exports such as financial services. However some of these Scottish exports to the rest of the UK will feed into supply chains elsewhere in the rest of the UK and in turn, underpin the export of subsequent goods and services internationally.

Regardless of whatever reservations one may have about the statistical margin of error in the data, it is clear that Scotland could be potentially making a mistake by prioritizing the EU single market over that of the UK. If Scotland leaves the UK for the EU and a ‘hard-Brexit’ deal is made with tariffs on both ends, it would instantly trigger a Scottish recession. The politicians are downplaying the complexity of such an exit — it would sever not only a political union but also a currency union because scotland uses the Pound Sterling. I believe any knee-jerk depreciation of the pound resulting from a Scot-exit will be short lived.

 

Brexit Uncertainty

Investors are naturally risk-averse, so the uncertainty arising as a result of Brexit places pressure on the Pound Sterling. Most economists were expecting an immediate post-Brexit recession, but the UK economy fared better than anticipated in 2016 which led both the Bank of England and the IMF to increase their UK economic growth forecasts for 2017. EasyJet’s revenue recognition accounting policies compounded with the uncertainty-led depreciation of the Pound Sterling creates temporary headwinds for EasyJet. Customers book flights months ahead of their desired departure, and the company records revenues when a customer books a flight and records costs when the customer flies. A significant, sharp depreciation in the base currency, GBP, against the USD, which crude oil/jet fuel derivatives, aircraft purchase agreements, and other contracts are negotiated, provisionally elevates costs and depresses operating/net margins. Airplanes run on jet fuel, a derivative of crude oil. If a customer books a flight when GBPUSD trades at $1.48 but the service is provided when the exchange rate is $1.24, EasyJet will receive fewer dollars per pound than the customer initially paid but would still have to purchase a fixed amount of jet fuel.

A rising USD is not necessarily indicative of a depreciating Sterling. If USD continues to rise, as it has over the past two years against other currencies in the world, it will place pressure on commodities priced in U.S. Dollars. The important distinction here is that if the Pound Sterling remains stable, then the artificial increase in jet fuel price increase that was evident last year will not recur. While the GBPUSD is important, an equally or more important metric is the Pound Sterling Index or the Pound Sterling against a basket of currencies.

 

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EasyJet forward bookings at the conclusion of FY 16. (Source: EasyJet FY16 Investor Presentation)
As of 2016 Q4, 49% of H1 seats have been booked. Continued depreciation of the pound going into 2018 is a risk because it would lead to a recurrence of the current issue. The already depreciated pound and the compelling economic data coming out of the UK should mitigate this problem.

Brexit – Legal and Operations

Britain’s exit from the European Union places regulated industries such as aviation in deep water. The company plans to establish an Air Operator Certificate (AOC) in another EU member state that should secure flying rights to continue doing business within the EU. I do not believe that there is any chance that the EU would bar non-EU companies from operating in within the bloc. Switzerland and Norway are not members of the EU but are part of the Single European Sky initiative so I don’t see why the UK cannot do the same.

Terror Attacks

Terror attacks are unpredictable but present a risk to EasyJet because it decreases travel and tourism activity. There is not much that can be done to mitigate this, but hopefully, we will see less of it in the future than we have in the past.
European Elections

Uncertainty wreaks havoc on markets, and there is no greater risk of uncertainty in Europe than the upcoming elections. With Dutch elections coming up later this month, Geert Wilders is the Anti-EU, Anti-Euro populist candidate that the market is discounting. In France, Marine LePen is expected to win the first round, because there are a lot of candidates and she is expected to take the populist vote which should be enough to propel her to the second round. In round two, however, there are fewer candidates and experts do not expect her to garner enough support to win because the candidate pool will have significantly shrunk. There is also the German election in the fall with Angela Merkel up for re-election.
To put this in perspective, no one expected the leave-camp of Brexit to be successful but they were. No one expected a Trump presidency; the NY Times placed the probability of Donald Trump win over Hillary Clinton at ~20%. Courtesy of the New York Times:
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I don’t know whether these candidates will be successful or not but it would be prudent to take them seriously. As one of the healthier eurozone economies, if there is even a sniff of Nexit (Netherlands), a sharp, severe euro depreciation should not be a surprise. EasyJet runs a euro surplus – it takes in more airfare in euros than it has costs – so a euro depreciation will negatively affect its income statement, though not significantly (see Sensitivities – FY17 below). The positive aspect of this is that the company’s debt is also in euros, so a depreciation will devalue the debt on its balance sheet as well, though this won’t show up on the income statement.

CATALYSTS

Defensive Growth

LCCs have structural advantages, as discussed above, over the FSCs on the routes that they jointly inhabit so LCCs will continue to undercut and steal market share from the inefficient FSCs. LCCs also have the advantage of being ‘defensive’ since price conscious customers in recessions are more likely to fly an LCC, hence why they exhibit very consistent profitability even in economic downturns. EasyJet has grown revenue organically at a CAGR of 16% since 2002 but is still fairly attractive under the assumption of zero growth going forward.

Hedge Expiration

LCCs are more likely than FSCs to hedge their future jet fuel costs because it makes up a larger portion of their cost base. This makes it easier for FSCs to compete in a depressed jet fuel market because they are able to shrug off hedging and thus, push down ticket prices to become competitive.  Hedging protects one from shocks, however, so while it temporarily depresses income, over the long-term the company is more likely than not to survive if it maintains its conservative hedging program.

As of the end of Q1 2017 (12/31/16), EasyJet hedged 83% and 53% of the rest of its 2017 and its 2018 requirements at the crude oil equivalent of $61 and $51, respectively. Heading into 2018, just over 50% of its expected crude oil input is hedged at a price that is equivalent to market rates. The company lost £300 million and £375 million in 2015 and 2016 from its jet fuel hedges but going forward, EasyJet should be able to maximize the benefits of low fuel prices by passing it on to customers via lower ticket prices or even by even trickling it down to the bottom line. Losses are expected in 2017 but the company expects savings of 240 million when compared to last year, which will be passed on to customers. Hedging issues are short-term and will be abated as EasyJet averages down.

Solid Balance Sheet and Access to Capital

EasyJet closed FY16 with approximately £976 million in cash and £664 million debt. Post the recent dividend in Q1, cash likely still exceeds or approximates debt. The company announced a Euro Medium-Term Note Program to potentially borrow 3 billion euros to fund the expected upgrades from the A319s to the A320 neos. As of 9/30/2016, the company had drawn 500 million euros at a fixed 1.5% for seven years.

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EasyJet Gross Capital Expenditure (Source: EasyJet FY 2016 Investor Presentation)

On the conservative side, it is my estimate that company will only need to borrow approximately 1.65 billion euros. My assumptions are that EasyJet will generate a flat £600 million from operations (2016 Brexit-depressed CFFO: 600 million, 2015 CFFO: 750 million) and pay the same February 2017 dividend of £215 million going forward. The assumption ignores the ~£760 million cash sitting on its balance sheet and also assumes that CFFO does not grow.

Lower UK Tax Rates

Phillip Hammond, Chancellor of Exchequer, floated the idea of turning Britain into a tax haven. Lower tax rates translate to higher net income and given that the BOE and the British government are pulling all strings to avoid a recession, a corporate tax cut should not be unexpected. Theresa May floated the idea of cutting tax rates lower than any G20 country to encourage business activity in the UK.

VALUATION

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GBPUSD 1-Year Chart (Source: Yahoo Finance)

EazyJet trades at 11.5x expected 2017 earnings, presenting an 8.7% earnings yield to investors. As the company adjusts prices to reflect the 2016 sterling devaluation, it will recuperate some or all of the FY16 and FY 17 FX losses. Per management’s assertion from the Q1 report, investors should expect £105 million decrease from the £425 million recorded last year as a result of expected FX losses (see Sensitivities – FY17 and GBPUSD 1-Year Chart).

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Screen Shot 2017-03-01 at 10.35.42 PMEasyJet Q1 Stats (Source: Q1 Investor Presentation)

Load factor has been stable even with the increased capacity — the company has not had any problem filling up the plane. A drop in constant currency revenue per seat is expected because jet fuel is a cost input for airfare. Lower jet fuel prices lead to lower costs and thus, lower ticket prices. The highlight of this report is:

  1. Revenue per seat fell 1.2% unadjusted for currency depreciation and 8.2% on a constant currency basis
  2. Cost per seat rose 12% unadjusted for currency and increased 1.1 % on a constant currency basis.

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Cost Per Sear (Source: Q1 Investor Presentation)

The Math

The company records revenues when a customer books a flight and records costs when the customer flies so the significant, sharp depreciation of the Pound Sterling between that period becomes the culprit. As the company adjusts prices to reflect this depreciation, it will recuperate some of the FX losses. This should hold true as long as we do not see another depreciation as severe as that of Brexit.

If GBPUSD holds around $1.23, the company will likely recuperate most of the losses. If it falls below $1.23, then the amount recovered will depend on how much it falls. Per the Sensitivity – FY17 table above, if we assume that crude oil remains stable, which is likely because there is still a glut of oil, and we also assume an exchange rate drop of .13 for each currency (Dollar $1.10, Euro 1.03, and Franc 1.11), then the overall gain can be estimated by subtracting £45.5 (Dollar; 132.4  + Euro; 130.6+ Francs; 13*0.5) from £105 to arrive at £59.5. This assumes that the company does not deviate from the hedging pattern that it has maintained in the past. Because the company adjusts prices, lost income from further devaluations will come out of the potential £105 million and not the expected £320. Today we’re paying 11.8x for a business that faces temporary headwinds with high probability that net income rises next year.

Competitor comparison is difficult in this case because of the variance in the fiscal year ending, hedging, and also the jet-fuel enhanced margins. There are a lot of things that can go right and few things that can go wrong, and an investor today will still receive an 8% forward earnings yield and a >5% dividend yield if all goes wrong. The key here is to watch EasyJet’s hedging strategy, GBPUSD, Pound sterling against an index of other currencies.

Disclosure: EasyJet is 10% of the MaziValue portfolio. I may or may not adjust my my position prior to the Netherlands and French elections, but I will disclose if I do.

Target

Some people have attributed its mishaps to its 2016 controversial bathroom policy. I believe this is false though I should note that my opinion on this is strictly based on conjecture and not fact. If Target’s mishaps are indeed because they lost customers as a result of the policy statement then it strengthens the bullish case because markets have priced it as a permanent, recurring decline. Once those customers are out of the base comparison, it will become easier for the company to post positive comps. Even without that, the stock still looks cheap.

Target $TGT and Walmart $WMT

Real Time price Walmart: WMT 75,69 +0,64 +0,85%

Real Time price Target: TGT 55,87 +0,72 +1,31%

I added Target ($63.55) and Walmart ($66.56) to the portfolio today at 16.66% each. The portfolio now holds approximately 33% cash. Target revised its FY16 guidance earlier in January which sent the stock off 12% YTD. The weak retail environment and Target’s soft guidance sent Walmart off its December highs, down about 8%. Markets seem to be pricing in a weaker than expected quarter for Walmart. In an expensive market where Target trades at half the value of the market and Walmart trades at around 60% of the market, Target offers an 8% forward earnings yield and Walmart offers 7%. They both look like great deals, IMO. Although I do agree that Amazon is indeed taking over the world, the pace at which that happens does not warrant their valuations, especially given that these companies are known for earnings stability. One other headwind facing not just retail companies, but virtually all U.S. domiciled companies or anyone that imports goods is the surging U.S. Dollar.

Another positive to these companies is that both Target and Walmart own the vast majority of their stores. I remember reading about Bill Ackman’s activist circa 2008 campaign to get Target to spin off its real estate to ‘create value.’ Given the obvious threat Amazon poses today, an activist that attempts the same coup will likely be backed by more shareholders. I have no idea what their real estate is worth, but it is likely a significant portion of their market caps.

Disclosure: Long TGT and WMT