Gavin Graham writes:
In my last column I discussed the apparent contradiction between developed market indices hitting new all-time highs while the emerging markets were down so far this year. This is a paradox because emerging markets are more highly exposed to economic growth than well-established economies.
The truth of the matter is that we are seeing an improvement in economic growth in such countries as China, India, and Brazil. However, many investors prefer to play it through multi-national blue chips, which have a high percentage of their revenues derived from these economies, rather than buy the locally listed companies. There are the usual concerns about accounting standards and management competence and honesty, especially given the track record of numerous U.S. and Canadian listed Chinese companies over the last few years, such as Sino-Forest.
However, while it's true that companies listed in developed markets usually have high standards of accounting and management, this doesn't help if revenues from their domestic markets are under pressure. The cuts imposed by the US$85 billion "sequester" of U.S. federal government expenditures last month mean that such sectors as defense contractors, healthcare stocks, and education companies are feeling the pinch. Meanwhile, the austerity programs in the U.K. and the eurozone are hitting businesses dependent on government spending there.
Let's look at how my economically-sensitive recommendations are faring in this context and whether they are well positioned to ride out the headwinds.
Linamar Corp. (TSX:LNR) (LIMAF)
Originally recommended on July 3/12 (#21223) at C$19.72. Closed Friday at C$23.09, US$22.72.
Linamar, the second largest auto-parts manufacturer in Canada, reported record sales of $3.22 billion for the year ended Dec. 31, up 12.6% over the previous year. Adjusted operating earnings gained 32.7% to $218.5 million while net earnings were up even more at 36.7% to $144.9 million ($2.24 per share). That compared to $106 million ($1.64 per share) in 2011.
Revenues in the Powertrain/Driveline segment, which makes transmissions and driveshafts, were up 3.2% to $667 million in the fourth quarter of 2012. Revenues for the Industrial segment, which includes the Skyjack crane business, grew 25% to $88.8 million. Operating earnings were up slightly in the Powertrain segment at $48 million and the Industrial segment swung from a $3.9 million loss in the fourth quarter of 2011 to a $0.3 million profit.
The company's return on capital employed (ROCE) rose to 13.1% at the end of the year and its debt to total capital fell to 39.9%. CEO Linda Hasenfratz, daughter of the founder, noted: "Earnings growth continues to outpace sales by a considerable factor, our balance sheet continues to strengthen, positioning us well for continued growth and investment. We continue to see great improvements in ROCE and return on equity."
With a launch book of new business of $2.3 billion and higher volumes in the all-important Powertrain/Driveline segment on increased consumer demand in the U.S. and Asia, the slowdown in European demand is being more than offset.
The shares have increased in value by almost 20% in the last six months against 5% for the S&P/TSX Composite Index. However, they still have a price/earnings ratio of less than 11 times 2012 earnings and 7.64 times 2013 forecasts.
Action now: Linamar remains a Buy. Their new factories in China and new launch business will help earnings to grow, as will falling debt.
A&W Revenue Royalties Income Fund (TSX:AW.UN) (AWRRF)
Originally recommended on July 25/11 (#21127) at C$19.52 US$20.55. Closed Friday at C$22.14, US$21.65 (April 2).
A&W Restaurants runs the second-largest quick service hamburger restaurant chain in Canada with over 770 locations coast to coast. The company has retained its income trust structure, having concluded that transforming into a corporation would not benefit its unitholders. The trust receives 3% of the gross revenues of those restaurants in the royalty pool for the use of the A&W trademarks.
Proving that even low ticket items such as the chain's Mamma or Papa burger and a root beer are not immune to the slow economy, A&W's revenues were only up 3.6% to $823.4 million in 2012, although revenue growth did increase by 5.7% to $258.4 million in the fourth quarter. Furthermore, same-store sales growth (SSSG), which measures the revenues from restaurants open for at least a year, was down 0.2% in the third quarter and only up 0.5% in the fourth quarter, leaving SSSG down 0.7% for all of 2012.
Pat Hollands, the CEO of A&W Food Services of Canada which manages the trust said that "the current economic climate continues to affect sales in A&W restaurants, particularly in Ontario and British Columbia. The launch of our Value deals in the fourth quarter, anchored by the new Buddy Burgers, was an important step in responding to the market conditions. We are pleased with the success of this new initiative. Our 31 new restaurant openings in 2012 is the greatest number of new openings since the inception of the fund (in 2002)." The trust has opened a net 175 restaurants since going public, increasing its total from 585 to 760.
The trust's earnings per share (EPS) were also lower, partially due to higher tax, which the trust estimated reduced EPS by $0.082 to $1.312 from $1.398 in 2011. This was due to changes in partnership tax rules and no tax loss carry-forwards being available, unlike the previous year. It was also due to higher royalty income ($24.7 million vs. $23.8 million), hence more profits to be taxed, and more units outstanding (13.08 million vs. 12.59 million in 2011).
Each year, all new restaurants opened in the 12 months between October and September are added to the royalty pool. A&W Food Services receives trust units for these restaurants which it then sells in the open market. In 2012, it received 490,000 units, and in 2013 it received 880,000, which it sold at $21.90 in February, reducing its stake in the trust from 16.5% to 10%.
Despite these headwinds, A&W remains a successful and well managed operation, being voted one of Canada's best managed companies for the tenth year in a row. With the January refinancing of a $60 million loan due to mature in 2015, A&W was able to reduce its interest rate from 5.03% to 4.03% for the first three years and 4.26% for the next two years while extending the maturity to 2017. This will add $0.038 cents a unit to cash flow, reducing the over-distribution that occurred in 2012 when the trust paid out $1.40 against EPS of $1.31.
With an average check of $4.69 in 2011, having an A&W burger and drink remains an affordable pleasure for the new entrants to the labour force and those already employed. The stock is flat over the last six months against a 6% increase in the S&P/TSX Composite, giving it a p/e ratio of 18.8 and a yield of 6.4%
Action now: Hold until it is apparent that the growth in A&W's earnings are sufficient to cover its distributions for 2013.
Beam Inc. (BEAM)
Originally recommended on Sept. 17/12 (#21232) at $58.87. Closed Friday at $60.54. (All figures in U.S. dollars.)
Liquor company Beam is named after its eponymous Jim Beam brand. It is the largest bourbon maker in the world, also owning Maker's Mark. But there's a lot more here than bourbon. The company also produces Sauza tequila, Pinnacle vodka, Courvoisier cognac, Canadian Club and Teachers' whiskeys, and Skinnygirl cocktails.
In 2012, Beam increased its revenues by 7% to $2.5 billion and its earnings by 13% to $398 million. That was $2.40 per share compared to $2.12 in 2011, a 13.2% increase, excluding the charges incurred in 2011 to separate the Fortune Brands' businesses.
North American sales were up 7% and overseas sales rose 5%. Operating income after charges was $575.9 million, up 46%, while free cash flow was $336.8 million. Its net debt/EBITDA ratio was 2.8 times. New product innovations, higher pricing, and consumers trading up contributed to this strong result.
In the fourth quarter, sales gained 11% to $709 million. Operating income was $156.7 million, up 15%, and income from continuing operations was $126.8 million ($0.67 per share, down 3% from $0.69 the year before). The fall in net income reflected a 20% increase in brand building investment.
CEO Matt Shattock commented: "Beam continued to deliver excellent results in its first full year as focused pure play spirits company. We created value through…growing sales faster than the market, operating income faster than sales, and EPS faster still. We exceeded our expectations with better-than-anticipated global sales of bourbon and higher-than-expected accretion from the Pinnacle (vodka) acquisition."
Both its Power Brands (the major brands mentioned above) and its Rising Stars (smaller, faster-growing brands such as Laphroaig scotch, Cruzan rum, Knob Creek bourbon, and Kilbeggan Irish whiskey) grew revenues 10% in 2012. However, Local Jewels and Value Creators (smaller local and cheaper brands) shrank 1% each.
Beam sold its Wolfschmidt vodka and Calvert and Canada House Canadian whiskies to value spirits house Luxco for $65 million in January. The brands had generated $30 million from sales of 1.8 million cases in 2012 so Beam is increasing its profit margins and reducing the number of brands through the sale.
The company increased its dividend by 10% to $0.90 a share from $0.82 at the same time. The stock now yields 1.5%.
Beam has lagged the S&P 500 Index over the last six months after its sharp increase on the Fortune Brands break-up in 2011, gaining just 3% against an 8.9% increase for the index. Beam sells at a p/e ratio of 24.8 times last year's earnings and 21.1 times its forecast earnings per share in 2013.
Action now: Beam remains a Buy on strong revenue and earnings growth plus the possibility of a takeover by a major beverage alcohol company looking to gain exposure to bourbon, one of the fastest growing spirits in the world.
Loews Corp. (L)
Originally recommended on May 2/11 (#21117) at $44.267. Closed Friday at $43.80. (All figures in U.S. dollars.)
The two conglomerates that I recommended in 2011and 2012 have demonstrated that having numerous divisions means that their earnings are "lumpy", i.e. events in one division can offset steady progress in others. For example, with Loews one of the divisions is property/casualty insurance. For 2012 as a whole, Loews reported net income of $568 million ($1.43 per share) compared to $1.1 billion ($2.62) in 2011. This was due to the effects of Hurricane Sandy which cost Loews $243 million after tax. Also contributing to the lower profit was a $433 million write-down on its HighMount Exploration & Production oil and gas business due to the decline in natural gas prices. Excluding these charges, net income for 2012 would have been $1.2 billion.
For the fourth quarter, Loews actually lost $32 million ($0.08 per share) as it took the majority ($171 million) of the Hurricane Sandy losses in this period as well as writing down HighMount by $97 million. Excluding these losses, Loews would have earned $236 million, down from $271 million in 2011, due to lower earnings at its Diamond Offshore drilling subsidiary as well as lower investment income. Its Boardwalk Pipelines unit is still doing well.
The small Loews Hotel business is expanding, opening two new establishments and buying two others to bring its total to 21.
Loews management has always stated that book value per share is the best way of measuring its progress and that rose 4.9% from $47.33 in December 2011 to $49.67 in December 2012.
Action now: Selling at a 12% discount to its book value, and at 11 times 2013's forecast earnings, Loews remains a Buy.
Leucadia National (LUK)
Originally recommended on May 7/12 (#21217) at $24.61. Closed Friday at $27.49. (All figures in U.S. dollars.)
Leucadia, my second conglomerate, announced the successful completion of its merger with independent investment bank Jefferies (NYSE: JEF) in March. However, the company showed equally lumpy results.
Income from continuing operations rose from $409 million in 2011 to $590 million last year while earnings from its associates, which include Jefferies and base metals miner Inmet (TSX: INM) swung from a $394 million loss to a $276 million profit. As a result, Leucadia earned $854 million ($3.49 per share) last year against $25 million ($0.10 per share) in 2011. The swing was largely due to a plunge in Jefferies' share price due to false rumours over its European debt exposure after the collapse of MF Global in late 2011. With the recovery in 2012 culminating in the merger with Leucadia, the share price recovered sharply and Jefferies' senior management is now responsible for running Leucadia in the future, as co- founder Ian Cumming is stepping down. The Jefferies merger has increased the number of shares outstanding by 50% to approximately 365 million.
Leucadia's acquisition of 79.8% of cattle processor National Beef Processing saw its revenues shoot up from $1.43 billion to $9.19 billion and accounted for some of the increase in net income. However, major customer Walmart decided to bring production of "case ready" (beef already cut into joints) in house this year. This business accounted for 7% of National Beef's revenues, but, as a high margin business, closer to 25% of its $59 million in earnings in 2012, which National Beef is looking to replace.
The company continues to derive much of its earnings from gains on its securities positions. The largest of these was its holding in Australian iron ore producer Fortescue Mining, from which Leucadia had received $2.3 billion by the time it finished selling off its position in 2012. It also sold its oil and gas business, Keen Energy, for $100 million, booking an $18 million loss. Leucadia also tendered its 15.9% stake in Inmet to the First Quantum takeover in the first quarter and spun off its Crimson Wine subsidiary to shareholders in a tax-free transaction, equivalent to a $197 million dividend.
Other operations such as Idaho Timber, plastics manufacturer Conwed, the Hard Rock Hotel and Casino in Biloxi, Miss., and its 50% stake with Berkshire Hathaway in mortgage servicer Berkadia continue to provide positive cash flow.
Action now: Selling at a slight discount to its book value of $27.67 and at 10.2 times 2013's forecast earnings, Leucadia remains a Buy.