Costco Wholesale (COST): Great Business, Mediocre Price

Summary

Costco Wholesale (COST) is a large membership warehouse retailer that sells a variety of bulk goods in several countries.

-Seven year average revenue growth: 9%
-Seven year average EPS growth: 8.6%
-Dividend Yield: 1.18%
-Dividend Growth Rate: 13%

Overall, I think Costco is a fantastic company, but at the current time, it’s fully valued with little or no margin of safety, and doesn’t offer a very appealing dividend yield.

Overview

Founded in 1983, Costco Wholesale (NASDAQ: COST) is a large warehouse-based retailer, primarily located throughout North America but with a presence in Europe and Asia as well.

With over 160,000 employees, Costco operates 598 warehouses. Of these, 433 are in the US and Puerto Rico, 82 are in Canada, 32 are in Mexico, 22 are in the UK, 11 are in Japan, 8 are in Taiwan, 7 are in Korea, and 3 are in Australia. In addition, Costco operates its large online retail site.

Category Sales

Costco warehouses offer various items, clothes, food, electronics, glasses, pharmacy drugs, gasoline, car-washes, and more. There are bulk items for cheap shopping, but there are select higher-end items.

Sundries (cleaning supplies, tobacco, alcohol, candy, snacks, etc.) accounted for 22% of 2011 sales.

Hardlines (electronics, hardware, office supplies, beauty supplies, furniture, garden, etc.) accounted for 17% of sales.

Food accounted for 21% of sales.

Softlines (clothing, housewares, small appliances, jewelry, etc.) accounted for 10% of sales.

Fresh food accounted for 12% of sales.

Ancillary and other (gas, pharmacy, food court, optical, etc.) accounted for 18% of sales. (This is their fastest growing segment, as they put more of these areas in newer Costcos.)

Revenue, Earnings, Cash Flow, and Margin

Costco has been growing revenue at an impressive rate, while earnings and cash flow have grown more slowly.

Revenue Growth

Year Revenue
2011 $88.9 billion
2010 $77.9 billion
2009 $71.4 billion
2008 $72.5 billion
2007 $64.4 billion
2006 $60.1 billion
2005 $52.9 billion
2004 $48.1 billion

Over this period, revenue growth has averaged over 9% per year on average, which is excellent. The trailing twelve month period boasts over $91 billion in revenue.

Earnings Growth

Year EPS
2011 $3.30
2010 $2.92
2009 $2.47
2008 $2.89
2007 $2.37
2006 $2.30
2005 $2.18
2004 $1.85

Earnings growth has averaged 8.6% over this period, which is reasonable. It’s fairly unusual for a company to have faster revenue growth than EPS growth over this long of a period.

Cash Flow Growth

Year Operating Cash Flow Free Cash Flow
2011 $3.20 billion $1.91 billion
2010 $2.78 billion $1.73 billion
2009 $2.09 billion $0.84 billion
2008 $2.18 billion $0.58 billion
2007 $2.08 billion $0.69 billion
2006 $1.83 billion $0.62 billion
2005 $1.78 billion $0.79 billion
2004 $2.10 billion $1.39 billion

Over this period, operating cash flow grew by 6.2% annually, and free cash flow grew by 4.6% annually. These numbers where somewhat erratic; especially FCF which had a high year in 2004 which lowers the annualized growth calculation over the period. If FCF growth was calculated between 2005 and 2011 instead, the growth rate would have been nearly 16%. The “real” FCF growth rate lies between these numbers.

Metrics

Price to Earnings: 24
Price to Free Cash Flow: 20
Price to Book: 3
Return on Equity: 12.5%

Dividends

Costco currently has a 1.18% dividend yield with a payout ratio of slightly under 30%. The yield is fairly low despite the reasonable payout ratio because the company has a high P/E.

Dividend Growth

Year Dividend
2011 $0.925
2010 $0.795
2009 $0.70
2008 $0.625
2007 $0.565
2006 $0.505
2005 $0.445
2004 $0.30

Costco began paying a dividend part of the way through 2004. Between 2005 and 2011, Costco grew the dividend by an average rate of nearly 13%. Among dividend stocks, it’s not a high-yielder, but it has the makings of a dividend champion.

Share Repurchases
In addition to returning value to shareholders in the form of dividends, Costco repurchases some of its shares. For example, in 2011, Costco spent $398 million on dividends to shareholders, but spent $624 million on net share repurchases. The same can be said for most recent years: Costco spent more on share repurchases than dividends every year from 2005 onwards, with the single exception of 2009. Of course, 2009 was the absolute best time to buy Costco stock, but that’s the year that Costco was pinching pennies instead of buying its stock as it was every other year. They bought stock high, but wouldn’t buy stock low, and this example perfectly highlights a primary critique of share repurchases among dividend investors.

Share repurchases make good supplementary purchases, but in my opinion, dividends should usually be the primary form of shareholder returns, especially for a stable business like Costco. Energy companies and tech companies at least have the viable excuse of being in cyclical industries, and so they have to keep payout ratios low. But with so much free cash flow generation, Costco could easily shift more towards dividends and less towards repurchases.

Balance Sheet

Costco has a total debt/equity ratio of under 0.20, and the interest ratio is over 20. The total debt load is only 1.5x annual net income. Since Costco doesn’t rely on acquisitions, goodwill is negligible. Overall, by every metric, Costco has an excellent balance sheet.

Investment Thesis

Costco’s business model is meant to maximize efficiency. The warehouse format keeps costs low, as they buy and sell items in bulk. Shoppers (both consumers and small business owners) pay membership fees, and in return receive exceptionally low prices. The warehouse model also generally operates moderately reduced hours compared to typical retailers. Although Costco offers a large range of products, they limit their selections in each category to only the best-selling ones, so the number of individual products is actually lower than many other retailers. This further streamlines their business.

Costco’s memberships keep customers loyal, and they have a high renewal rate. Costco can keep its prices reasonably competitive with Wal-Mart by maintaining such a low profit margin. The company gets most of its profit from membership fees (which they recently successfully increased by 10%), while its goods are sold at very low markups.

Growth

Year Warehouses Gold Star Members Business Members
2011 592 25.028 million 6.352 million
2010 540 22.539 million 5.789 million
2009 527 21.445 million 5.719 million
2008 512 20.181 million 5.594 million
2007 488 18.619 million 5.401 million

Each year in this snapshot, as well as in many previous years, Costco increased their number of warehouses, and saw an increase in both gold star members and business members. As of the most recent report, Coscto now has 598 warehouses. Costco management has the goal of operating 1000 warehouses by the next 10-12 years, and I think that target is a fairly conservative estimate.

In addition, Costco has been reporting consistent same-store sales growth. In general, as a given Costco exists longer, it gets more sales per year. A year or two after opening, an average Costco will bring in approximately $100 million in annual sales. After ten years, that average number is around $150 million. In fact, between 2010 and 2011, the number of Costco locations with over $200 million in sales jumped from 56 to 93. And, 4 of their Costco locations now bring in over $300 million in sales, including their #1 Costco which brings in an enormous $400+ million.

Despite Costco’s mild setback in 2009 due to the recession, Costco became the 3rd largest retailer in the US compared to its spot at 5th in 2008. It is the 9th largest retailer in the world.

Costco reports that its most recent warehouse openings in Japan, Taiwan, and Korea had record-breaking opening-day sales, and that the warehouse they opened in Australia was particularly well-received. The company expects these countries to be great places for continued expansion.

The Three Point Case for Bullishness

There are a few key things I want to highlight that, in my view, makes Costco not (quite) as overvalued as it seems.

1. FCF is solid. Costco is currently a business that generates more free cash flow than net income. It’s not as highly valued in terms of FCF as it is net income. DCF analysis with an estimated FCF growth rate of 5% going forward, and a 10% discount rate, gives me an intrinsic value of approximately $32 billion, compared to the current market cap of over $35 billion. Therefore, if the valuation were to decrease by 10%, I’d consider Costco fairly valued. If a lower discount rate is used, Costco is reasonably valued as-is, although without a margin of safety.

2. Revenue growth is outstanding. Most large businesses aren’t growing revenue at nearly the pace of Costco. Costco’s number of stores is growing, their number of members is growing, and they recently boosted membership fees by 10%, and it was well-accepted.

3. Low profit margins can mean eventual upside. Costco is currently sacrificing profitability for solid ethics and outstanding growth. Costco is a viable competitor to even Walmart, and yet has only existed since the 1980′s. The larger the revenue becomes, the more pricing power they have, and the denser their store locations get, the more efficient they become. I believe Costco will eventually reach a tipping point where net profit margins will improve.

Costco Vs. Walmart

From an investor standpoint, I liked Walmart (WMT) stock better than Costco stock (despite liking Costco better than Walmart as a business) until the recent 20% increase in Walmart stock from around $50/share to over $60/share. This pushed Walmart’s valuation from undervalued to fairly valued, in my view. Therefore, if I absolutely had to buy one or the other, I’d be buying Costco, and here’s why:

1. Costco completely outperforms Walmart’s comparable warehouse business, Sam’s Club. As of 2011, there were 609 Sam’s Clubs compared to 592 Costcos, Costco had 84 million square feet of retail space compared to 81 million for Sam’s Club, and yet Costco’s sales excluding membership fees were approximately $87 billion compared to Sam’s Clubs $49 billion. Costco is growing more quickly than Sam’s Club (the latter only grew the number of locations from 588 to 609 between 2007 and 2011), and at approximately the same size, Costco completely outshines Sam’s Club in terms of sales.

2. Costco’s balance sheet is far less leveraged than Walmart’s. Costco has a total debt/equity ratio of 0.2, interest coverage of 21, and practically no goodwill, compared to Walmart’s total debt/equity ratio of over 0.8, interest coverage ratio of 11, and goodwill of over $20 billion. They’re both fine balance sheets, but Costco could safely take on more leverage than Walmart currently can, since Walmart is already using more leverage. So far, Costco hasn’t needed much leverage to grow very quickly.

3. Costco has had consistent expansion internationally, and it’s likely only the tip of the iceberg. Their Canadian segment is strong, and their Australian presence recently began in 2009 and has had very good success so far. I expect that to be a very good long term opportunity for them. Both companies have solid international prospects, but Walmart is rather saturated in the US, and has had mixed success internationally, and relies partially on acquisitions for international growth, while Costco has grown organically and is far less saturated.

4. Walmart’s net profit margin is comfortably over 3% and I doubt it’ll go much higher (and may go lower), while Costco’s net profit margin is considerably below 2%. With even modest improvements in profit margin over time, I expect Costco’s EPS and FCF to eventually outpace sales growth.

5. Walmart trades at a lower P/E ratio, but a comparable P/FCF ratio, to Costco. Walmart has a larger dividend yield, and a longer dividend history.

I’m not rocking Walmart here; I even picked them for the Dividend Growth Index (before they jumped to $60/share). But the comparison, in my opinion, really helps to highlight Costco’s strengths.

Wrapping Up the Thesis

Overall, my opinion is that Costco has a great business model and is positioned to grow its business for the foreseeable future. Costco is one of my favorite examples of a moat-breaker. Walmart has the quintessential moat of scale; they have such massive purchasing power that translates into pricing power, that they can underprice their competition and attract more customers, in a viciously successful circle. To combat that, Costco has done three main things.

One, they have focused on having a rather small number of products, meaning they can divide their total purchasing power among fewer products, and therefore increase their purchasing power with those businesses. That’s a wise way to compete when you’re the smaller competitor. Offer fewer products, but offer them at unbeatable prices.

Two, they have maximized efficiency, and they have paid highly for employees to reduce turnover and build morale, and have therefore achieved superior sales per square foot.

Three, they have sacrificed net profit margins in order to compete on pricing power, and therefore have grown revenue at a very strong rate, which will pay literal and figurative dividends over time as they become a larger and larger rival.

Risks

Costco, like any other company, has risk. As a retailer, Costco is a middle-man, with limited pricing power, and the retail industry is incredibly competitive. Costco faces competition from warehouses like BJ’s and Sam’s Club (owned by Wal-Mart), general retailers like Wal-Mart, Target, and Kohls, as well as from other threats like Amazon. In addition, since the stock has a fairly high valuation, there is considerable risk of poor stock performance if Costco doesn’t continue to outperform as a company. One of Costco’s strengths is its free cash flow, which can be highly variable, and may decrease if the management team spends more. In addition, Costco’s CEO Jim Sinegal has retired from his position. The board and management team of Costco is very experienced, and Sinegal will remain on the board of directors for now, but it is still a transition to be aware of.

Conclusion and Valuation

Costco is a fantastic company in my view. Their growth is decent (and their revenue growth is excellent), their business model is very strong, and it’s a very well-respected business that is known for its integrity. I’d wager that an investor 20 years from now probably wouldn’t regret purchasing this stock at these prices, even though shares are rather pricey at the moment. That being said, I do think it’s fully valued with little or no margin of safety. I would not be inclined to pay more than around $72 for the stock. Writing long term puts near the current share price may be a reasonable way to enter a position at a lower cost basis.

Costco’s P/E of 24 and P/FCF of 20 represents a lot of justified optimism. When everyone knows an investment is going to work out; it’s generally too late to get great returns. There is a lot of expectation built into the price, so any long-term disappointment, or any major error in an investment thesis such as this one, can mean sub-par returns.

Excellent companies are worth paying up for, but there’s a limit, and currently Costco’s price is a bit more than I’d be willing to pay. If Costco stock were to drop back to the low $70s, I’d be interested in the stock even though it would still be a bit pricier than most of my portfolio holdings.

Full Disclosure: At the time of this writing, I have no position in COST.
You can see my dividend portfolio here.

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6 Solid Dividend Payers with Particularly Powerful Brands

This is the second in a series of articles highlighting dividend companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the last article, examples of unrivaled economies of scale were provided.

Some companies, over the years, have chosen to throw enormous sums of money at particularly effective advertising campaigns. If done correctly, this can allow a company to charge higher prices for its products, or can bring in more customers per restaurant, or provide other benefits along those lines.

This article provides 6 examples of dividend-paying companies that have powerful or even iconic brands that keep customers coming back.

Coca Cola

The Coca Cola Company (KO) has among the most powerful, if not the single most powerful, of brands in the world. Total 2010 advertising costs were $2.9 billion, and that doesn’t include bottler advertising.

I calculate that the company is currently moderately overvalued based on a discounted cash flow analysis with conservative growth estimates. The current rather low P/E is somewhat misleading; the price to FCF ratio is over 24. The company currently provides a 2.75% dividend yield as it pays out approximately half of its free cash flow to shareholders, and last year the company raised its dividend from $0.44 to $0.47 per quarter to continue its multi-decade streak of increases. I’m looking for a soon-to-be-expected raise to push the quarterly dividend to at least $0.50. Still, I’d look for a substantial dip before initiating or adding to a position, based on my targeted rate of return.

I’d suggest, however, that on a risk-adjusted basis, it’s likely not a bad place to park moderate-risk capital that one would desire to grow over the next ten years, even at this price. Expecting mid-to-high single digital total returns from EPS growth and dividends would not be unreasonable. Writing long-term puts for the company could potentially allow an investor to initiate a position or add to a position at a lower cost basis.

The current annual per-capita worldwide consumption of products within Coca Cola’s portfolio is under 100 (compared to approximately 400 for the United States). The high population countries of China, India, Pakistan, Nigeria, and Indonesia, each consume less than 40 annual per-capita servings, which is less than a tenth of the market penetration in America. The company, therefore, has considerable room to grow, even if soft drinks face headwinds in the United States. Coca Cola distributes its products to over 200 countries and constantly invests in increasing its distribution network.

Dividend Yield: 2.75%
Total Debt/Equity: 0.75
Price to FCF Ratio: 24
FCF Dividend Payout Ratio: 50%
Most Recent Dividend Increase: 6.8%
Full Coca Cola Analysis

PepsiCo

PepsiCo (PEP) spent $1.9 billion in advertising for 2010, which is considerably below Coca Cola, but still huge.

At the current time, I consider PepsiCo to be a better value than Coca Cola. My DCF analysis estimates the current price to roughly match the intrinsic value. The price to FCF ratio is a reasonable 20, which is still a bit on the high end, but in my opinion fair for a premium-quality, defensive, established company. PepsiCo is more diversified than Coca Cola, as they not only have some of the top-branded drinks, but also the top-branded chips and snacks.

Overall, I don’t consider PepsiCo’s moat to be quite as substantial as Coca Cola’s, but it’s still significant. And any comparative lack in the robustness of the economic advantage is arguably offset by PepsiCo’s increased level of product diversification. Based on the the lower stock valuation of PEP and comparable company metrics, I’d expect slightly higher annualized returns over the next decade for PEP, at the cost of what I consider to be a slightly higher amount of risk.

Dividend Yield: 3.09%
Total Debt/Equity: 1.20
Price to FCF Ratio: 20
FCF Dividend Payout Ratio: 50%
Most Recent Dividend Increase: 8.3%
Full PepsiCo Analysis

McDonald’s

In 2010, McDonald’s Corporation (MCD) contributed $687 million to advertising cooperatives and another $94 million for production costs. Franchisees also contribute significantly towards advertising costs, so the whole amount spent on advertising for the company is rather immense. It’s perhaps no surprise, then, that McDonald’s gets more customers per restaurant than their competitors, and double the net profit margin of their competitors.

I calculate that the company is trading slightly above intrinsic value based on my targeted rate of return, but if there were to occur any significant market corrections, I’d be willing to increase my position if the price dips enough to produce a dividend yield of comfortably over 3%. Like Coca Cola, I expect McDonald’s to be able to produce comparatively low risk mid-to-high single digit annualized returns over the next decade.

Dividend Yield: 2.82%
Total Debt/Equity: 0.79
Price to FCF Ratio: 22
FCF Dividend Payout Ratio: 57%
Most Recent Dividend Increase: 15%
Full McDonald’s Analysis

Diageo

Diageo (DEO), the world’s largest producer of spirits, holds the number one spirit brands in most of its categories. Smirnoff is number one in worldwide vodka sales, Johnnie Walker is number one in worldwide scotch sales, Guinness is number one in worldwide stout sales, Baileys is number one in worldwide liqueur sales, and Captain Morgan is number two in worldwide rum sales, and the company has many more brands than those. The company has solid emerging market exposure.

Diageo spent a whopping £1.538 billion marketing its brands in 2011, and the focus was on their top 14 brands. Diageo stock has gone up almost continuously over the last three years, and I calculate it now to be somewhat overvalued, especially when taking into account the leverage on the balance sheet. With any significant market correction, DEO could be a fine purchase.

Dividend Yield: 2.92%
Total Debt/Equity: 1.60
Price to FCF Ratio: 20
FCF Dividend Payout Ratio: 58%
Most Recent Dividend Increase: 6.0%
Full Diageo Analysis

Philip Morris International

Philip Morris International (PM) is one of the largest producers of cigarettes in the world, and markets tobacco products in over 160 countries outside of the United States. The company has rights to the internationally recognized brand, Marlboro. Compared to Altria which operates only in the US, and so has consolidated regulatory risk, the widespread operating area of PM spreads regulatory and other risks out.

The company’s free cash flow is especially impressive, as FCF exceeds net income and grows at a very robust rate. This is partially offset by the company’s weak balance sheet. The company has the largest dividend yield, the largest recent dividend increase, and the one of the lowest price to FCF ratios, on this list. Due to low capital expenditures, PM converts nearly all of its operating cash flows into free cash flows, and the company uses practically all of its free cash flow for dividends and share repurchases.

Dividend Yield: 4.01%
Total Debt/Equity: 4.70
Price to FCF Ratio: 13
FCF Dividend Payout Ratio: 47%
Most Recent Dividend Increase: 20%

General Electric

General Electric (GE) fell from grace during the financial crisis, as this once pinnacle blue-chip with an ex-perfect credit rating had to cut its dividend. It has since started its recovery, and the dividend is now 70% higher than it was during the market bottom in 2009, but still considerably below the peak. Consistency means a lot to dividend investors, and GE broke that trust.

Unlike the other brands on the list, which sell primarily to consumers, GE sells primarily to other businesses. GE, however, is indeed a household brand name, and it’s the only company currently on the Dow Jones Industrial Average that was listed there from the beginning over 100 years ago. The conglomerate, originally founded by Thomas Edison and others, currently has a strong presence in numerous businesses, including wind and gas turbines, jet engines, healthcare, and capital.

The company has a solid current dividend yield. I’m bullish on GE at the current price.

Dividend Yield: 3.55%
Total Debt/Equity: 3.60
Price to FCF Ratio: 10
FCF Dividend Payout Ratio: 32%
Most Recent Dividend Increase: 13% (or 21% compared to the same quarter last year)

Full Disclosure: At the time of this writing, I am long KO and MCD.
You can see my dividend portfolio here.

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Hasbro (HAS) Might Be Undervalued

Summary

Hasbro (HAS) is a major toy and game company with several powerful brands including Transformers, Nerf, G.I. Joe, My Little Pony, and Monopoly.

-Seven year revenue growth: 6%
-Seven year EPS growth: 16%
-Dividend Yield: 3.66%
-Dividend Growth Rate: 27%
-Balance Sheet Strength: Medium

With a P/E of 11.2, a P/FCF of 16.5, a dividend yield of 3.66%, an acceptable balance sheet, and good long term potential, I calculate Hasbro to currently be mildly or moderately undervalued.

Overview

Hasbro (NASDAQ: HAS) is among the largest toy and game companies in the world. Hasbro produces toys, games, and characters that lead to not only physical products, but movies, video games, and electronic media as well.

Major Brands:

Transformers
Avalon Hill
Wizards of the Coast (Magic the Gathering and other trading card games, Dungeons and Dragons and other role-playing games)
G.I. Joe
Playskool
Littlest Pet Shop
My Little Pony
Milton Bradley, Parker Brothers, and other games (Monopoly, Scrabble, Trivial Pursuit, Twister, Battleship, Candy Land, Operation, Cranium, Life, Jenga, Yahtzee, Clue, Risk, etc.)
Nerf
Tonka
Supersoaker

Hasbro is also involved in licensing their brands and characters to other companies, such as Electronic Arts and Universal Pictures, to produce further entertainment products.

The company operates in three main segments:

U.S. and Canada
This segment sells products to the United States and Canada, and accounted for 57% of revenue and 58% of operating profit, in 2010.

International
This segment sells products to many other countries. Hasbro is attempting to achieve strong growth in emerging markets. For 2010, this segment accounted for 39% of revenue and 35% of operating profit.

Licensing and Entertainment
This segment licenses Hasbro brands to television, movies, games, and various other media. The segment accounted for less than 4% of total revenue, and 7% of operating profit, for 2010.

Breaking down revenue in another way, 34% of revenue came from products marketed to boys, 32% came from games and puzzles, 21% came from products marketed to girls, and 13% came from products marketed towards preschool age children.

Revenue, Earnings, Cash Flow, and Metrics

Hasbro has experienced a fair amount of revenue growth over the last several years.

Revenue Growth

Year Revenue
TTM $4.235 billion
2010 $4.002 billion
2009 $4.068 billion
2008 $4.022 billion
2007 $3.838 billion
2006 $3.151 billion
2005 $3.088 billion
2004 $2.998 billion

Over this seven year period, Hasbro has grown revenue by approximately 5% annually.

Earnings Growth

Year EPS
TTM $2.78
2010 $2.74
2009 $2.48
2008 $2.00
2007 $1.97
2006 $1.29
2005 $1.09
2004 $0.96

EPS growth for this period was over 16% annually. This is great, but don’t count on this level of growth for the future.

Cash Flow Growth

Year Operating Cash Flow Free Cash Flow
2011 $363 million $255 million
2010 $368 million $255 million
2009 $266 million $161 million
2008 $593 million $476 million
2007 $602 million $510 million
2006 $321 million $239 million
2005 $497 million $426 million
2004 $359 million $279 million

Cash flow growth has been flat over this period. In the last three years specifically, inventory, accounts receivable, and other changes in working capital have kept cash flows pretty low.

Metrics

Price to Earnings: 11.3
Price to FCF: 16.5
Price to Book: 2.6
Return on Equity: 24%

Dividends

Hasbro currently has a dividend yield of 3.66%, a solid dividend growth rate, and a payout ratio of around 40%.

Dividend Growth

Year Dividend
2011 $1.15
2010 $0.95
2009 $0.80
2008 $0.76
2007 $0.60
2006 $0.45
2005 $0.33
2004 $0.21

Hasbro has grown the dividend by over 27% per year, on average, over this period. The most recent quarterly increase, in 2011, was from $0.25 per quarter to $0.30 per quarter, which is a 20% raise. Eventually, in order to keep the payout ratio static, the dividend growth rate will have to slow down to match earnings or FCF growth rates. Hasbro isn’t among the greatest dividend stocks, but with time, it could be a long-term dividend grower.

Over the last several years, the company has spent more money on net share repurchases than on dividends. In the first three reported quarters of 2011, for instance, the company spent three times as much money on share repurchases as they did on dividends. Shares outstanding have decreased from 204 million in 2004 to 139 million currently. I find share repurchases acceptable compliments to dividends, and based on my view of the intrinsic value for the shares, I do view this as value creation instead of value destruction, but I don’t like to see this much being spent on repurchases compared to dividends.

Balance Sheet

Hasbro has a fairly mediocre balance sheet. The total debt to equity ratio is 1.02, which is a bit high. About a third of shareholder equity consists of goodwill, which is fine. The interest coverage ratio is between 6 and 7, which is a bit low for my tastes. Total debt/income is approximately 4.

Hasbro was improving its balance sheet until 2007, when the company began taking on more debt. From 2008 to 2010, the total debt basically doubled, and it’s been rather flat from 2010 to 2011. I’d rather see an improving balance sheet than a worsening one. Overall, Hasbro’s balance sheet is safe, but it’s not as clean as I would like. They’re using some substantial leverage.

It’s interesting that the debt increase and the amount of share repurchases over these two years, is approximately equivalent. Hasbro isn’t borrowing because they need to; if they weren’t buying back shares, they could have kept debt levels static. Based on my calculated intrinsic value of the shares, the share repurchases likely do result in a higher rate of return than the interest on debt used to buy them, but I view it as an unnecessary degree of leverage.

Investment Thesis

Hasbro is more than just a toy company; it’s a brand company. Hasbro has many memorable brands which have lasted through generations and which can be converted to various media. This is why, according to management, they put brands at the center of their business model. By strengthening the core brands, Hasbro is setting up substantial, long-lasting sources of cash flow that can withstand all sorts of technology and generational shifts through time. Their games can be played on physical boards or digital boards. Their characters can be sold as action figures or in movies. Hasbro can deliver their brands across various platforms, and all of it complements itself. It builds a cycle of toys selling movies, movies selling video games, and video games and movies selling more toys. Hasbro spends approximately $200 million on research and development, and over $400 million on advertising, per year.

Transformers in particular is a very powerful brand. In 2009, that segment alone brought in nearly $600 million in revenue. This is cyclical depending on whether it’s a year for a blockbuster movie release or not. Nerf has recently been a very strong brand as well, with over $400 million in revenue in 2010.

Hasbro has not only their own ideas to benefit from, but ideas from others as well. The company makes strategic partnerships with companies like LucasFilms, Marvel, and Sesame Workshop to ensure that it is delivering the characters and entertainment that people of various ages want.

A key concern among investors, I believe, is whether Hasbro will continue to perform well in an increasingly digital age, or whether its toys will become less popular over time. This year is reported to have disappointing, but decent, holiday sales. When I analyzed Hasbro a year ago, the stock price was in the mid-$40′s, and I said it seems reasonably valued but without a margin of safety. It has since fallen to the low $30′s, and I believe it may be undervalued. I drop of this magnitude surprises me. I believe there may be too much pessimism regarding Hasbro’s future ability to adapt.

An increasingly digital age is a genuine concern, but I don’t believe kids will stop playing with Nerf guns, will stop playing with girl dolls, will stop playing trading card games, will stop with board games, and so forth. Hasbro will indeed have to make sure it keeps up with the times by licensing their content on as many digital mediums as possible (and they have been; the strategy of viewing themselves as a brand company is key), but if there becomes a time when people spend 100% of their time in front of screens instead of running around outdoors or playing with toys, then I’d have more to worry about than Hasbro, and Hasbro would have a share of that screen time anyway. This is, however, a trend to be aware of when investing.

To combat this, Hasbro’s brand strategy has meant going on several mediums. For instance, Hasbro has a joint venture with Discovery Communications for a television channel called “The Hub”, where they license their own characters as well as third-party entertainment. The Hub accounts for nearly 10% of Hasbro assets, but this venture currently operates at a loss of several million dollars per year. It’s not a huge impact on the income statement, but it ties up capital that could be spent elsewhere. It’s possible that toy sales that occurred due to channel content offset the small losses. The company also licenses its popular board games for mobile content.

It’s worthwhile to note that there’s a movie based on Hasbro’s game Battleship coming out in 2012 with a $200 million budget. It could prove successful, or it could be a disappointment. Hasbro has a deal with Universal Pictures to license at least three movies, and the success of these movies like Battleship might be a key indicator of Hasbro’s ability to monetize its brands with licenses and royalties. I’m somewhat skeptical of its chances of great performance, but then again, I’m not particularly the target audience for the film so I’m perhaps not the best judge. Hasbro also benefits when Marvel and other businesses release outperforming movies, since they can result in strong toy sales.

A last bit regarding the thesis: it’s not out of the question that Hasbro could eventually be bought out, with its market cap of a bit over $4 billion and its attractive collection of intellectual property. I wouldn’t count on this for investment purposes, however. It’s better to invest on numbers than on speculation, in my view.

Risks

Hasbro faces currency risk and commodity cost risk. The company is also reliant upon strategic partnership with both companies that they pay royalties to (such as Marvel), and companies that they license their brands to (such as Universal Pictures). These relationships are extremely important to Hasbro both financially and for the strength of their brands.

In addition, certain brands such as Transformers or Nerf make up large shares of total revenue, so the continued profitability of these brands will have an influence over total Hasbro profitability. It’s hard to say how long transformers will remain this popular; their trilogy of movies has been immensely successful, and there is discussion for more, but I’m not sure how long that can continue successfully. I’d prefer to estimate cautiously in that regard.

Also, retail has become increasingly corporate and consolidated for a while now, and Hasbro’s three largest customers, Walmart, Target, and Toys R Us, account for 23%, 12%, and 11% of Hasbro revenue these days. They collectively account for over 50% of total Hasbro revenue, and more than two-thirds of revenue in the US/Canada segment.

The longer term risk is the estimation regarding how well Hasbro products will sell in an increasingly digital age, and the extent of the digital media pie that they can capture and hold.

Conclusion and Valuation

The increase in debt and the low cash flows over the last few years worry me a bit. I do think the business model is strong, that their products (both physical and digital) will be around for a while, and that they have good global expansion prospects.

A discounted cash flow analysis for Hasbro proves tricky, because both operating and free cash flows have been weak over the last three years. If I use the current low figure of free cash flow, assume a 4% annual growth rate and utilize an 11% discount rate, and then add in the present value of the lesser of either tangible book value or cash (which is cash), I calculate an intrinsic value for the company of only $4 billion. The sum of free cash flows between 2006 and 2010 is roughly equal to net income over those same years, so if I go by that longer trend and assume free cash flow rebounds to higher levels, then the discounted cash flow analysis with the same growth and discount rates results in an intrinsic value calculation of between $5 billion and $6 billion. Overall, since the current market cap is around $4.3 billion, and I believe Hasbro is currently reasonably well positioned, I consider Hasbro to be mildly undervalued, and find the stock price reasonably attractive under about $35/share.

Full Disclosure: At the time of this writing, I have no position in HAS.
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