Monday, November 22, 2010

Bargain hunting - Gladstone Capital (GLAD)

A friend asked me to take a look at Gladstone Capital (GLAD) the other day, so I added it to the site (you need to sign in to view it; registration is free). Gladstone is a small cap - not something we've covered so far, but happy to on request from a frequent user.

A few observations. GLAD is trading below its book value, currently at price to book (P/B) ratio of 0.96. They've been in this territory for a few quarters now, with the valuation dipping below half the book value at times:

A drop to P/B of 0.5 may present an opportunity for a Graham-style bargain basement investment. I have not researched the balance sheet, so do not know if there are any skeletons in the closet. From a longer term perspective, however, GLAD does not look appetizing - they are barely eking out earnings, with ROE and ROA numbers in the 5 to 8% territory.

Personally, I much prefer companies with strong earnings compounding, even at P/B of 2 or so - and there are quite a few of those around nowadays. If you know about GLAD and why they are valued below book, please comment!

Disclosure: no position.

Monday, November 1, 2010

Walgreens and CVS Caremark - same business, different results

Walgreens (WAG) and CVS Caremark (CVS) operate in the same business - pharmacies - although present a very different picture to investors. In this article we examine each company, and compare their performance and position from the long-term shareholder perspective.

Walgreens has one of the cleanest financial track records that easily lends itself to fundamental analysis. Over the past 15 years, the company has been compounding shareholder equity per share at the rate of 15.4%. Adding in accumulated dividends, we get the compound annual growth rate (CAGR) of 16.9% in shareholders wealth – very respectable wealth compounding.

In the case of CVS, shareholder equity CAGR over the past 15 years is at 11.2% (12.3% with dividends) – average for a large US company. The story, however, is more complicated. The company underwent a major merger in 2007 – the one that brought CVS and Caremark together – shown as the “M” indicator in the chart above.

If we look at the 10 years prior to the merger, CVS equity had been compounding at the rate of 15.2% (17.7% including dividends) – performance similar to that of WAG, although achieved by using some leverage, whereas Walgreens had no long-term debt at the time (see the Long-term Debt to Equity ratio charts for Walgreens and for CVS). In fact, by looking at the returns on total assets, which eliminate the effect of different capital structures, we can see that WAG has always been better at operations, consistently maintaining ROA above 10% (with a 10.7% median), while median ROA for CVS is at 6%, and the firm never got ROA above 10%:

The elephant in the room, however, is the 2007 merger between CVS and Caremark. Events like this are rare, but their impact is disproportionately large. The total consideration for the Caremark purchase was $26.9 billion. Of that, $3.2 billion was in cash, and the rest was CVS shares. Shares outstanding thus jumped from 828 million to 1,564 million – dilution of 89%. What should we think of this merger?

From the top level fundamentals, we cannot be certain yet whether the merger was a mistake. However we see it as a worrisome development. The merger brought $30 billion of goodwill and intangible assets to the CVS Caremark balance sheet. That’s right – Caremark had no tangible equity. And neither does CVS now:

There is a significant risk of goodwill impairment, which would be a major hit against CVS shareholder equity, all of which is now intangible. Many investors apparently agree: before the merger, CVS had been valued at around 3x its book value; after the merger, the P/B ratio dropped to 1.5x, and has remained below 2x since. The “quality” of equity has significantly declined, and the merger made the CVS balance sheet more vulnerable.

CVS has been using the low stock prices of the past 2 years to buy back some of the shares issued in the acquisition. 13% of shares have been bought back since 2007. While we applaud this shareholder friendly action, concerns over intangible equity and a low ROA, brought down to 6% by the acquisition, give us pause.

The picture is very different with Walgreens. Intangibles comprise a minute share of the book value of its equity, and leverage is very low.

The ROE and ROA have been hurt by the condition of the economy, but remain decent, and there are reasons to believe that they will recover to their pre-recession levels. The company has also been taking advantage of the recent low share prices to buy back its stock – a good way to allocate capital:

And by historic standards, WAG is rather attractively valued, with the current P/B ratio at 2.3:

We believe that a long-term view of companies such as WAG and CVS is critically important. We strongly prefer WAG, which grows organically, to CVS, which makes disruptive acquisitions introducing uncertainties and vulnerabilities, as the 2007 CVS Caremark merger demonstrates. At, you can find a wealth of long-term analytical charts and data covering over 15 years of corporate fundamentals, such as the charts in this article.