I'd like to introduce you to two companies. I won't identify who the companies are during the description -- I simply want you to read along and determine which you would prefer to own. Bonus points if you can figure out who one or both of them are (without cheating).
Company 1
This company controls about 75% of a market that has recently gotten attention as an alternative to more unhealthy, higher-risk products. It has not one, but both of the most powerful brands in a business that engenders enormous brand loyalty among its customers. Each of these brands generates more than $1 billion in annual revenues, and the company's gross margins from its products exceed 77%. There are only a select few types of businesses that have lower costs of goods sold -- software companies such as Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL), and pharmaceutical companies like Pfizer (NYSE:PFE) and Merck (NYSE:MRK) are in the only industries that come close to approaching such high gross margins.
This business is priced at a P/E of 13, but its free cash flow multiple sits at about 8. The company has minimal ongoing capital expenditure requirements, so it is aggressively repurchasing shares on the open market, buying back nearly $110 million in the last 12 months. The company's share count has dropped by more than 20% in the past decade as it continues to retire shares -- meaning that existing investors garner a larger and larger portion of earnings. Further, it's increased its dividend payout by over 300% in the same timeframe. At present prices, even with a dominant market share and unbelievable economics, it offers a dividend yield exceeding 5.3%.
The company owns, in addition its core product, several adjunct, unrelated businesses that provide some 14% of its operating revenues. These consumer products are also high margin/low capital intensity and provide some diversification in varying consumer cycles.
Company 2
In 2002 this company lost its final appeal of a lawsuit and had to pay the plaintiff in excess of $1 billion dollars, which had the effect of obliterating every penny of shareholder equity. In 2001, it had $3.47 in tangible book value per share; today it has none -- its liabilities are larger than its assets. The stock has nearly tripled off of its lows hit in 2000, though in that period of time it has grown revenues less than 3% per year. Its market is nearly 99% domestic -- its main product has very little appeal outside of the United States, and its efforts to introduce products have in the past generated little success.
The company's debt level has risen dramatically over the last five years, from $100 million to well over $1.1 billion. At the same time, its return on assets ratio plunged, from well over 50% in 1997 to less than 26% in 2001, to none in 2002 as the company failed to generate a profit -- instead losing more than $270 million, down from a profit of nearly half a billion in 2000. Prior to 2002, management was earmarking a higher and higher percentage of its earnings for dividends, rising from 50% in the mid-1990s to well over 61% in 2001. Most troubling is that this company makes annual recurring payments into a government trust fund that none of its competitors are required to pay -- it also faces an increase in frequency and amounts of ad valorem excise taxes as state governments seek new sources of revenue.
The company's main products suffer from substantial competition from discount brands, and its market share continues to decline, dropping more than 360 basis points between September 2002 and September 2003, according to Value Line. One of its largest global competitors has recently introduced a competing product into the U.S. market, with the potential of increasing price competition in an already cutthroat environment, even though analysts already project the company's cash flows to remain flat for the next few years.
Would you be surprised to know?
Given the above research -- all of which is factually accurate and taken directly from company financials, research reports, press releases, or newsletter comments -- which company would you prefer to own? Do you think that you know the identity of either Company 1 or Company 2?
In fact, these two vignettes refer to the same company -- tobacco and wine purveyor UST (NYSE:UST). I went through the exercise of looking for the most positive information possible about this company, and then the most negative possible -- though I left plenty of additional details out in order to obscure its identity. All of these things that I describe are real components of UST's performance and existence. It has had a hard time attracting international business, and now rival Swedish Match (NASDAQ:SWMAY) has began testing Exalt -- a "spitless" snuff pouch -- in the U.S. nearly simultaneously with UST's offering of a similar product called Revel.
UST certainly showed negative earnings in 2002, and it does have a shareholder's deficit, both caused when the company had to stroke a $1.3 billion check to Conwood after losing an antitrust suit. Management has recently increased its dividend payment and restarted share repurchases, so it feels that its business is strong enough that the temporary setback in its asset and equity accounts are not of deep concern.
What you get when you count on others
If you're going to refer to other people's research to inform your investing opinions (and you should -- there are great resources out there), you still have to take responsibility for your ultimate opinion and decision. As the above exercise shows, you can take the exact same situation and come up with analyses that appear vastly different. What is true of the above analyses is that neither was complete. Company 1 completely ignored the competitive risks and financial hardships it has faced of late, and Company 2 avoids even mentioning the nearly unbelievable economics of its core business, its dividend, its share buybacks, and the strength of its brands.
And yet, there are people who would be willing to read the analysis for Company 1 and decide that it's worth buying no matter what, and people who wouldn't want Company 2 at any price.
The problem is that neither analysis is correct, though one will turn out to be more correct than the other. As a shareholder of UST, I have substantial interest in it more resembling Company 1 than Company 2. But I am always baffled that there are so many investors who have no interest in knowing what risks their companies face, and they certainly don't appreciate seeing these risks enumerated in print. But here's a news flash for you: The act of naming risks doesn't make them more real or less real.
Investors in aaiPharma (NASDAQ:AAII) should at this point recognize the distinction -- as this stock has recently been shellacked over sales issues that some analysts have harped upon for months. Stock values don't plunge 65% because someone out there was pointing out the risks -- they dropped in this case because the risks were both real, and have at least partially been realized. For months Raymond James analysts savaged the company for what they perceived to be substantial channel stuffing and earnings-quality problems, and what do we see this week but management investigating "unusual sales" of two products. Between the time that Raymond James made its criticisms known and this past week, the stock has been hammered. Were they "bashers?" Or did they have something that those who saw nothing but Carolina blue skies for aaiPharma really needed to heed? I'm guessing the latter.
No company has ever existed, or will ever exist, that has no faults and no potential risks. You can't know them all. But ignoring the ones that you see doesn't lessen their chances of costing you money. When I look at UST, I don't see Company 1 or Company 2. I see both.
Fool on!
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Bill Mann owns shares of UST. Come see his favorite band, Letterbox, perform at Small's Bar & Grill, 10339 Conant St., Hamtramck, Mich., Saturday, March 13. If you're looking for companies that offer good risk/reward characteristics (who isn't?), check out a free issue of Mathew Emmert's Income Investor. The Fool has a disclosure policy.
