Tag Archives: WJA

Why I sold WestJet

Earlier this year I said goodbye to WestJet (WJA on TSX). I realized a 40% gain on average that essentially matched the market. WJA was cheap and so was the market. I sold because I think the new CEO at Air Canada (WJA biggest competitor) is pretty smart. At the time it seemed that Air Canada’s unions and Air Canada were going to come the a compromise that would close the gap that WJA has over AC.A.

WJA was about 30-40% below my fair value target, but I was also getting nervous about the economy. Not that I have any insight on the macro side, but I noticed that market participants were getting comfortable with some of our large imbalances again. Confidence has returned and it makes me nervous.

WJA is a very well run company in a tough space. The share price may decline in a slower economy, but so will many other company’s. WJA is well followed as well. This makes it tougher for the share price to stray too far from intrinsic value.

In order for me to be interested in WJA again, I would have to see some sort of disaster specific to WJA. This would cause forced selling. I’m not too optimistic that something like that would happen though.

Dean

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Q1 2011 Performance, Updates and Thoughts

Performance

I have ended Q1 2011 almost at the exact same spot as I left 2010. Still trailing my target portfolio by almost the exact same amount. Though both me and the mock portfolio ended  up around 3.7% for Q1 2011. There has been some changes to the portfolio so I would expect the underperfomance to continue, especially if this rally in the equity market continues.

Updates

I have sold WJA, FES and EQI (formerly GHC). WJA was around 25% below my low end fair value. The same with FES. EQI was almost at fair value. None of the companies have done anything wrong, but I am finding better value in smaller names. I added to MGO and have bought a few new companies. I hope to have write-ups on them in the coming weeks.

Thoughts

The markets have had a very nice run. The higher they move, the less I like them. I start to get nervous about my holdings in large companies. QE2 is ending soon, and we will this economy on its own footing for the first time. I think that “the economy” is no longer a catalyst going forward. Picking specific companies that have their own internal catalysts will be more important than just plowing money into what’s hot. I don’t think that you will see another recession, but I doubt the mean reversion growth rates in GDP continue. Some large US companies are cheap and some look cheap. Looking back over the last 10 years you see excess. Excess borrowing and spending. I don’t think that profit margins and growth rates will look so rosy over the next 10 years. Profit margins are quite high and have the potential for mean reversion to the downside. With steady revenue and closer to normal margins will take away any margin of safety in the broader market. That is why I am focusing more and more on small companies with their own internal catalysts.

Given the extreme debt levels, a small increase in interest rates will dramatically increase the cost to service those debts. That’s money that won’t be spent further to buy more flat-screens, cars, or other discretionary items.

Japan

Japan was horrible. The damage isn’t completely tallied yet. The Nikkei is off 7-8%. That’s not really that much. Japan is not a long term investment. Their companies are not shareholder friendly. The have an even worse debt/GDP ratio than America. Their aging demographics are the worst in the first world. Japan would be nothing more than a sentiment trade. In order to minimize risk on that type of a trade you need panic. I don’t see panic. As soon as Buffett says “buying opportunity” you money flowing in whether it’s warranted or not. Maybe the eventual trade would be uranium, but again I see no panic.

Dean

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WestJet update

Reviewing your companies is extremely important. When your are like me and have many undervalued companies (at least I think so), you have to keep tabs on all of them. This doesn’t mean you should sell when they miss a quarter, but it is important to monitor the businesses through their various cycles.

Well WestJet didn’t miss their quarter, but I still think there are some things I think I should point out.

WJA is running like a well oiled machine. Imagine an airline that didn’t lose a ton of money during the recession, in fact WJA earned a profit every quarter.

  • WJA has generated cash currently of $8.58 per share and net cash of $0.85. This is a company that generates cash every quarter (if you smooth out lumpy capex).
  • They now have an interline agreement with American airlines. This may lead to a code share agreement in the future, which is possible in the next couple of years.
  • WJA has now been authorized to buy back 5% of its shares. This is good news, but the diluted share count can still grow from the employee profit-sharing agreement.
  • WJA has introduced a new bag fee when checking a second bag, of $20. This shows WJA ability to pass on costs, and should add $8-10 million in revenue.
  • WJA is going to pay a dividend of $0.05/share each quarter. This gives WJA a yield of 1.5%.
  • Capacity growth is more muted than in previous quarters.

WestJet and Air Canada operate a duopoly here in Canada. WJA has the advantage and knows it, this is very important. I’m not an expert on game theory, but I’m sure someone will write a book on the these two airlines and the strategic moves they make. WestJet announced a new bag fee, this is actually bigger news than it seems. In the past WJA has been more reactive, but this shows that WJA has the opportunity to raise prices and knows it.

The rapid expansion is over, and all the very low hanging fruit has been picked. WJA can still pick up market share, but it will be more muted. The airline has the lowest cost advantage, and has made the right moves to please shareholders. It is refreshing to see them allocate the excess cash on the balance sheet to me and my fellow shareholders.

I still think that WJA is worth (at minimum) $20/share. The fair value didn’t change, but I have more confidence in my previous assumptions. I think WJA around $11.25 is worth buying.

Dean

The author is long WJA at time of writing.

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Excess Cash

What exactly is excess cash? To me it means cash that is on the balance sheet that is not needed in day-to-day operation of the business. Some companies have no excess cash and some have enormous amounts of excess cash. This post may seem like review to some, but a younger version of myself would have benefited from this insight.

What can affect the amount of cash needed for day-to-day operations:

  • How cyclical/seasonal is the company
  • Length in sales cycle
  • Whether the company does large amounts of contract work, making revenue and expenses lumpy
  • Customer concentration
  • Working capital requirements
  • Capital expenditure requirements
  • Access to funds (reasonable borrowing rate)
  • Dividend rate

Lets look at some examples:

Velan (VLN on TSX) manufactures and markets industrial valves. Revenue growth over the last 10 years has been slightly better than inflation. The company has a very long sales cycle, as evidenced from the CCC being over 200 days. Currently stated net cash is just over $5 per share. This seems extremely attractive to anyone buying the shares now (around $13). You can say that I am buying the business for $8 ($13 minus $5). Average EPS for the last 5 years is $1. So I am paying 8 times earnings, which seems very cheap. This of course is oversimplistic, but it proves my point. But wait a minute, over the last 10 years there has been at least $25 million in cash on the balance sheet (or about $1 per share). This may mean that there will always have to be $25 million cash on hand. Now your valuation goes to 9 times earnings, ($13/share minus $4/share in excess cash divided by $1 in EPS). Also we must consider that VLN has had revenues fall sharply during the recession and are not likely to return for quite some time. Working capital will need to be adjusted as well. Something that is very important is the voting structure of the company. The Velan family has voting power, which leaves almost no chance of activist involvement. The family can take the company private, but I am reluctant to speculate on that. I think there is little chance that the cash will be returned to shareholders anytime soon, meaning there is excess cash in the company, but I wouldn’t consider net cash in any part of my valuation. The cash position should be considered when examining balance sheet strength though. Buying this company at 13 time average earnings is not cheap, especially considering how far away average is from here.

Jewitt-Cameron (JCT on TSX) was originally analyzed by Adam over at ValueUncovered here. JCT has also been extremely hard hit by the recession. The company usually carries some cash on the balance sheet, usually a couple hundred thousand, against revenue (usually) in excess of $50 million. Recently, the company has come into a large amount of cash. Given the fact that the company doesn’t carry much cash usually, and isn’t afraid to use short-term borrowings, I think it is safe to include all net cash as part of the valuation.

Westjet (WJA on TSX) has been mentioned before. The CEO said on a conference call that he thinks the company needs around 40% of revenues in cash on the balance sheet. I think he is being too conservative. I think it is more like 20%. I will have a more detailed post on Westjet shortly. I think you can include some of the cash as part of your evaluation as management seems to be able to deploy it at attractive rates.

Many investors love to use enterprise value (EV) in their valuation, myself included. EV is equity plus debt minus excess cash. But determining that cash part can be very tricky. Lets run some numbers to give you an example:

ABC is at $10, have sustainable earnings of $1, net cash of $5. Net cash P/E is 5. Very cheap. You could consider “fair value” at 10x earnings plus net cash, making $15 a target. You are buying at 67% of fair value. What if the company was like VLN, meaning there is cash, but you aren’t likely to see it. Your 10x earnings plus net cash now yields a $10 stock, or current purchase price. You have NO margin of safety. What if the earnings are $0.75 and the company has $7.50/share in cash. Fair value is still $15 (10x earnings of $0.75, plus $7.50 cash), but now the valuation is 50/50 business and cash. If you are not going to see that cash, then fair value moves to $7.50, meaning that buying at $10 gives you negative margin of safety. I think you get the point.

A big thing to consider is how much of fair value is cash and how much is earnings power. In the previous example, $15 fair value was 67% earnings and 33% cash. If fair value is mostly cash, then I think there is an added element of risk that isn’t discussed enough. Most of the value is cash, then a simple return to shareholders is best, but the company can go on an acquisition streak at the height of a leveraged economic expansion. Buying back your own shares at a huge premium to book or earnings is not accretive, yet most companies to just this. My point is the larger the cash portion is of the total valuation, the better the company should be at deploying that cash. Makes sense, right?

It is up to each investor to determine what exactly is excess in the excess cash calculation. It is easy to punch some numbers in a spreadsheet and have it spit out a fair value, but investing is an art not a science. Despite what many think, the market is pretty efficient, and it takes some pretty big extremes to get outsized returns with little work.

Disclosure:

The author own share in WJA at time of writing, and would like to own shares of JCT (if it was cheaper).

Dean

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Westjet

In Canada we have many great companies, eh. Tim Hortons has helped keep our workers going to work through our ridiculous winter. We have some oil, potash and other raw materials that other countries want/need. Our banks are pretty bulletproof, and have been voted among the safest in the world, though I would give some credit to our regulators. We also have a great airline, but does that make it a good investment?

When I first started taking this whole investing thing serious, I felt that if I didn’t buy a company with a “moat” I was doing something wrong. You are supposed to buy a company with a moat and just leave it alone. Nobody told me about valuations getting extreme in one direction or another. Take a look at some of the most popular moat businesses: JNJ, WMT, MSFT, KO, HD, etc. Now, look back 10 years and see the return. After you’ve done that look at them in the currency I get paid in, the Canadian dollar, and you’ll see that moats may not always be a good investment. Very high valuations and an undervalued Canadian dollar would have given an average return less than a Government of Canada 10 year bond. Up until this point, the blog has focused on non-moat businesses, the companies do not operate at a competitive advantage but they also do not operate at a disadvantage.

WestJet has a sustainable competitive advantage, it our largest low-cost airline. WestJet’s business model was based on the wildly successful Southwest Airlines. It’s largest competitor, Air Canada (AC.A), is stuck with much higher operating costs than WJA. Both are debt heavy, but AC.A is so leveraged that it needed emergency loans from the government during the slowdown. There are 2 main reasons why WJA has an advantage:

  • AC.A has higher operating costs, mostly from the unionized labour force and the long-term pension liabilities.
  • Major US carriers aren’t allowed to fly in Canada (from one Canadian city to another). WJA can simply chip away at AC.A, as long as AC.A avoids bankruptcy, like Toyota did with GM.

Lets take a look at the RASM (revenue per available seat mile) and CASM (cost per available seat mile) and the load factor of the two.

Load Factor 2005 2006 2007 2008 2009 TTM
WJA 74.6% 78.2% 80.7% 80.1% 78.7% 80.0%
AC.A 79.5% 80.2% 80.6% 83.0% 80.7% 81.3%
ASM growth            
WJA 0.0% 17.3% 16.1% 17.8% 2.6% 4.6%
AC.A 0.0% 3.9% 2.8% -1.2% -4.4% 0.0%

Load factor looks to favor AC.A, until you look at the  massive capacity expansion that WJA has undertaken. Since 2005, AC.A has almost the same ASM (available seat miles) while WJA has almost doubled theirs.

Spread (ex fuel+forex) 2005 2006 2007 2008 2009 TTM
WJA $0.0429 $0.0528 $0.0575 $0.0640 $0.0444 $0.0443
AC.A $0.0015 $0.0438 $0.0497 $0.0559 $0.0359 $0.0409
WJA advantage $0.0414 $0.0089 $0.0078 $0.0080 $0.0085 $0.0034

I took out some expenses: forex, fuel and non-recurring. Forex because the charge is volatile and we want to compare how the two operate against each other. Fuel because it is the largest cost to both and also volatile, with WTI fluctuating and each company having their own hedges. Though fuel is a real expense, I just want to take a look at the advantage of WJA. Earning an extra penny does not seem like much, but put over the total ASM of 18,000,000 (ttm) and you can see the advantage. WJA even expanded capacity during the recession, although not by much. We also know that WJA has a pretax ROIC in the mid-teens, excellent for an airline.

Valuations

  • Price to TBV is 1.25
  • Ev/Average Ebitda is 6.0
  • Price to 3yr average E is 14
  • Price to peak E is 7.8
  • Trading at half of EPV

Well, not cheap. But not expensive given the competitive advantage. I know what you are thinking, what about oil prices? Yes, fuel is WJA biggest expense, at around 30%. But there are some things to keep in mind:

  • WJA has only a single class configuration plane, this keeps the maintenance/service expense cheaper as you don’t need to train technicians on many different types of aircraft
  • WJA has a very young fleet, with the average 4.8 years old
  • The average stage length per flight is growing. With so much fuel being burnt on take-off, keeping the plane in the air longer will help the fuel mileage
  • 20% is hedged, although not at an attractive price
  • Generally rising oil price brings a rising Canadian dollar, which will help mitigate the the higher costs when translated back to the Canadian dollar

We can look into our crystal ball and try to predict future earnings through the RASM-CASM spread using normalized numbers. Lets try capacity expansion of 10% in the next year, followed by 5% for each of the next 4 years. The airline has 90 planes now and plans to have 114 by end of 2014, with 135 by 2017. By 2014 WJA could have 23,500,000 ASM. With average RASM at 0.14, gives us 3.3 billion in revenue. CASM (ex-fuel) at 0.055 or 1.2 billion. Now fuel, I will just say that the cost of fuel will double from today, or about 1.3 billion. This brings EBIT to 0.9 billion (3.3-1.2-1.3). I don’t know what WJA debt load will be or how much cash they will have, so I will just say fair price is 5X EBIT or 4.2 billion, or around $29 dollars per share. A another big risk how many shares will be outstanding. The different stock options plans as well as the employee share purchase plans has slowly increased the amount of shares outstanding. Lets say for the next 5 years that the diluted share count increased by 3% per year bringing the total to 168 million shares by 2014. This will decrease the fair value to $25/share by 2014. Using a discount rate of 15% plus an extra 25% margin of safety, I get a trigger of $9.50. I cannot emphasize how crude these numbers are, so don’t let this be your only source of valuation. It just gives you an idea of what is possible. Of course, these can change very quickly, and this is the type of company that may loose its advantage at any time. If that happens, you do not want to own WJA.

Risks

  • Economy
  • Oil
  • Competition. Though WJA still has an advantage over AC.A, there is always the threat of added competition. AC.A has done some restructuring lately, thereby reducing the advantage that WJA has.
  • Management/execution. We hope that management continues to exploit their advantage. They must continue it, even if the capital markets don’t like it.

Summary

I have owned WJA for years, it was one of the first stocks I bought. It is almost a rite of passage to hold on to a cyclical through a recession and feel the pain when the share price gets cut in half. That is why you need to use valuation metrics and have the ability to laugh at the “price targets” of analysts. I remember when everyone was tripping over themselves to raise the price target for WJA. If that isn’t the sign of a top, I don’t know what is. For the record, I went heavy into WJA under 10 (around 12% of my portfolio). Given the strong balance sheet and competitive advantage that WJA has, I am comfortable owning shares here. All this doesn’t take into account any possible new code-sharing plans. I put fair value at $20-$25 and under anything under $11 is time to back up the truck (or plane, get it?). Maybe Mr.Market will give us that gift again.

Dean

The author is long WJA at time of writing.

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