Stock Quick Hits #1

Welcome to stock quick hits! A series of posts where I look at stocks that seem vaguely appealing at the moment. Stocks like China Mobile!

I’ll do about thirty minutes of research and analysis on each stock. That means some background, a look through their financials and a quick calculation in my DCF spread sheet to establish a fair value. If a DCF isn’t applicable, then I’ll use some other metrics.

Then I’ll set a price alert at which point I’d want to revisit the stock and do a deeper dive and/or consider a purchase.

Full disclosure, there’ll be some stocks and industries I’m not 100% familiar with. That means you should take these quick hits as a first look from someone not well versed in a subject. In essence, I’ll be talking out of my ass 20% of the time. Keep that in mind!

China Mobile and General Mills are the first two to make the list. Both recently caught my eye after a couple tough weeks for both.

These picks generally won’t be stocks I think are awesome buys.

More like stocks I think can be good buys if the price is right. These are just companies I want to research more in the future. Doing a quick hit means I can create an alert for a price point so I’ll get an email when that price point is reached.

Since these stocks are ones I think have some issues, I’ll likely be conservative in my valuations.

I’ll try to do this regularly so if anyone has any suggestions for stocks for me to look into then let me know!

Let’s start with China Mobile!

China Mobile (CHL)

China Mobile is the leader in the Chinese telecom market. You can think of it as the Verizon or AT&T of China. China Mobile is actually the biggest telecom provider in the world with nearly 900 million customers.

The company is a free cash flow machine pumping out $10B a year in free cash flow and holds no long term debt.

That free cash flow number includes capex spend for their 4G rollout which is progressing right now. Their strong cash flow generation allows them to roll it out faster than their competitors which gives them an edge. They have over 60% of the 4G market in China and over 60% of the total wireless market as well.

The company currently sits on a hoard of $65B in cash and investments and trades at a $187B market cap. They also pay a 4% dividend and have plenty of room to grow that.

They also own the biggest stake in China Tower(38% ownership) which owns telecom towers and might IPO soon.

Everything so far sounds amazing! The problem is that the Chinese government owns 70% of the company(as it does all Chinese telecos). That means you’re open to random government decisions that are not often in the best interest of the company.

Some examples include;

• The government forcing China Mobile(and all telecos) to use homegrown 3G technology instead of a better global standard. Luckily the homegrown 4G technology being rolled out now is an improvement over the lagging 3G.
• A nearly $6 billion dollar investment by China Mobile to take a 20% stake in a regional bank. China Mobile said this was for synergies around e-banking. However, it seemed more like the government using company money to inject capital into a struggling bank.
• Government regulations that affect all telecos such as mandatory 30%+ price cuts in 2015 and further cost reductions as recently as 2017.

Based on financials alone, I peg the fair value of this company around $65 based on their cash flow generation, strong balance sheet and a conservative 2% growth rate. I think the growth rate can easily be higher which creates further upside. Still, I don’t want to be too aggressive given the recent government interference.

The stock currently trades for ~$45 or a 30% discount to fair value after some recent weakness. They pay a ~4% dividend with a sub 50% payout ratio and recently issued a special dividend as well. The dividend is set as a target % of earnings so will vary depending on earnings per share.

The company has plenty of room to grow that dividend but that’s been the case for a while so I don’t expect a big bump anytime soon. China Mobile pays out ~50% of their free cash flow as a dividend. As a comparison AT&T pays over 70%.

Generally, a 30% discount to FV would be enough for me to pull the trigger but the government ownership makes me vary weary. While China has shown to be more business friendly than say Russia, I’d still want a bigger discount to account for the government risk before I pull the trigger.

FV : $64.82

Current price : $45.42

Target price : $38.89(40% discount to FV).

General Mills (GIS)

Food stocks have been skiing down some slopes lately. Stock prices are down across the board and the outlook sounds dire. A variety of factors has pressure companies like Kraft Heinz, Campbell’s Soup and our friend General Mills.

General Mills is a food producer with a ton of household brand names. They’ve got Cheerios, Bisquick, Pillsbury, Yoplait, Haagen-Dazs and even pet food now!

General Mills was at $60 as recently as the end of January. It was over $70 towards the latter parts of 2016.

Now, it’s back down to $45 after poor guidance during a recent earnings release.

What’s the problem? How can a stock drop so quickly? Especially a household name like General Mills!

Changing tastes towards fresh food, expansion of store brands, rising costs and a more competitive grocery environment have put pressure on margins for food companies like General Mills.

Personally, as a Trader Joe’s shopper, I rarely buy any branded foods anymore and I know plenty of people who do the same. It’s anecdotal but I rarely see people talking about the latest general mills cereal. They often talk about some new hummus they found at Trader Joe’s.

There’s still a big market out there of people who do like the brands General Mills offers. The problem for them and other brand name companies is that there’s more options out there these days that make it more difficult for certain brands to flourish.

Buzz words like Organic and fresh proliferate the space now and brand names are seemingly losing their luster.

Their recent acquisition of Blue Buffalo is the latest in various purchases designed to restart growth and/or pivot towards a more organic food portfolio. They bought Annie’s, Epic Provisions, Food Should Taste Good and others to spice up their portfolio.

Has it worked?

Revenue in the 2012 fiscal year was $17.7B and revenue now is $15.6B. Net income went from 1.8B to 1.6B in that same time frame. Free cash flow went from 2.3B to an average of 1.8B in the past three years. Share counts did shrink which led to an improvement in EPS despite these dropping numbers.

These are not great numbers and while there were some divestments like Green Giant, the lack of any revenue or net income growth is concerning.

The stock has remained in favor with investors due to the yield it offers. I think that is the best explanation as to how this stock reached $70 in 2016 because it wasn’t due to anything you can see in the financials.

Recent years have seen this stock priced at a 23 P/E with a P/CF of as high as 15. That’s a steep price to pay for no growth!

People seeking yield due to low interest rates likely looked upon it as a safe haven for that and pushed prices up. It’s easy to ignore earnings growth when yield is all you seek.

People gotta eat after all and that means the yield is safe! The yield might be safe but the price clearly wasn’t.

Now, that we see a bond market that’s showing signs of life, we start seeing people flee yield names and as signs of weakness in growth emerge, prices drop in tandem.

General Mills’ earnings call this week seemed to be the final straw. Previous guidance called for 3% to 4% growth which may have been taken as a sign of turn around. Management reduced that guidance down 0 to 1%. The stock fell nearly 10% in response as investors sold off their shares.

In essence, the recent drop is a story of growth not materializing and the stock being overpriced.

People seemed shocked at this drop but it seems to me like a reasonable response. It’s a mature company with seemingly no or very low growth potential and it should be priced as such.

General Mills’ stock price is now close to the 2012 range. Revenue, free cash flow and earnings aren’t that far from 2012. It’s not so crazy that the price is back there again.

There are a few problems I see here;

• There’s a lack of growth and innovation beyond acquiring new companies.
• It’s easy to let quality suffer as cost cutting mode moves in and store brands/trader joes/aldi’s/costco have caught up to the brand names in recent years.
• Related to the above, brand stickiness might not have as much power as before leading to less price flexibility for companies like GIS.
• Increasing costs due to transportation or material costs are harder to pass on to customers as the center aisle in grocery store becomes less visible and competition in grocery squeezes margins.

Does that mean general mills and companies like it are dead? Did millennials kills cereal and yogurt too?

I don’t think so. After all, people still need to eat and many love the brands General Mills has in it’s portfolio. They’ve been adept at pivoting to a more organic portfolio but the jury on whether that’s working is still out.

The recent acquisition of Blue Buffalo was costly but gave them access to a faster growing area. People love their pets and more and more people are willing to pay a premium price for higher quality food.

The $8B cost is a hefty price to pay for $1.2 in sales and it saddles GIS with more debt. The plan is to pay this via $1B in equity, cash on hand and the rest via debt. After the deal goes through, GIS will have a 4.2x net-debt to EBITDA ratio with plans to deleverage to 3.5x by 2020.

That’s a lot of debt and some dilution from the equity sale.

That also comes with a dividend and stock repurchase freeze until then which isn’t ideal of investors depending on increasing yield.

It’ll be interesting to see how the Blue Buffalo acquisition goes and whether cost synergies materialize. I do like the brand and think pet food is a good area to get into. However, it’s one that has seen recent interest from many companies and may become more competitive as time passes.

Overall, this is a company with issues but it’s still a free cash flow generator. As such, it will still likely fare pretty well during a recession as food is a daily staple. Investors have to hope that growth will kick in again although the recent guidance gives that line of thought pause.

On a valuation basis, if they can grow free cash flow near inflation or about 2% then I place the fair value at $41.84. I’m a bit more bullish than that and think they can refresh yogurt and cereal lines while integrating blue buffalo well so in my analysis I gave it a 2.5% growth rate. That pegs the fair value at $47.24. This is a conservative growth rate and offers plenty of upside if they can beat it although recent years aren’t that encouraging.

That means it’s trading pretty close to my range of fair values at $45.24.

Since this is a consumer staple with a decent yield and a cash flow I can likely depend on, I’d probably be interested in this closer to fair value than most stocks. I’d still want a discount but I could live with 20% below fair value versus 30% I look at for more risky stocks.

FV : $47.24

Current price : $45.24

Target price : $37.79(20% discount to FV)

Overall, I think both of these stocks are interesting at today’s prices. If I had to buy one, I’d probably go with China Mobile since it’s 30% below my FV.

In either case, I wouldn’t begrudge anyone for opening a position since they offer a decent valuation versus the market today. Still, for me, I’m not in love with either of them due to the various issues I mentioned.

You can see by my target prices that I’m a conservative investor when it comes to stocks like these. Some of you are probably thinking that I’m crazy, GIS won’t drop 17% to my target price and you’re probably right. As I mentioned at the start, these won’t be companies I love so the price has to be really good for me to get into them.

That means these are stocks I likely won’t own anytime soon but ones that still have decent value at today’s price. I just want great value to own them.

That’s it for this quick hit. Let me know your thoughts on these two companies and whether you agree or disagree.

If there’s any stocks you want me to look at then please send me a note or leave a comment below.