James Altucher made some great points in his article for why Warren Buffett has added to his position in US Bancorp and why it might still be a good buy now.  US Bancorp has been outperforming other banks with a 23 percent return on equity.  The average for the banking industry as a whole is only 10 percent. Even more impressive is the fact that US Bancorp’s return on equity has been increasing even while the yield curve has inverted. Many banks struggle to be profitable when short term interest rates climb above long term interest rates because it makes it difficult for them to profit from the spread between the money they lend out and the interest they pay depositors.

James’s thinks Wall Street is throwing the baby out with the bath water with US Bancorp. The collapse of stock prices in the subprime mortgage sector has also dragged down stock prices for almost all banks. There is widespread concern about credit quality.  However as James points out, the credit quality of US Bancorp’s loans has actually gone up over the past quarter.

Warren Buffett is an expert in investing in regional banks. Given that USB is almost 5% off its recent lows and its price is close to what Warren Buffett recently purchased it for, James argues that the stock is a strong buy here. The argument is very compelling, so I decided to try my hand at valuing this company.

Since I’m not familiar with valuing bank stocks, I decided to visit the website of an expert on stock valuation, Aswath Damodaran.  On his site, I found a dividend discount model spreadsheet designed specifically to value financial service called eqexret.xls. The spreadsheet uses the payout ratio for the high growth period and the expected growth rate in earnings per share to estimate the expected dividends in the high growth period.  The expected growth rate in earnings is calculated by simply taking the retention ratio and multiplying it by the return on equity.  I understand the basics of how this model works, but I’m not familiar enough to know its weaknesses.

I used the following inputs in the dividend discount model:

• Net Income = $4,703.00
• Book Value of Common Equity = $20,197.00 in 2006 and $20,086.00 in 2005
• Current Earnings per share = $2.64
• Current Dividends per share = $1.39
• Number of shares outstanding = 1,778
• Beta of the stock = 1.00
  (It was actually 0.75 on Yahoo but I prefer to use a risk neutral beta.)
• Riskfree rate= 4.65%
• Risk Premium= 5.00%
• Length of high growth period = 10 years
  (Because I feel this is a wide moat business.)
• Growth rate in stable growth period = 5.0% based on nominal GDP growth

After making these inputs the spreadsheet output the following:

• Return on Equity = 23.41%
• Retention Ratio = 47.35%
• Expected growth rate = 11.09%
• Cost of equity = 9.65%

Since earnings have been stable at US Bancorp, I did not normalize earnings.  I also maintained all the same inputs for the stable growth period, except for the growth rate.  The bottom line is that I found each share of USB to worth $62.69. Shares of USB are currently trading for $34.90, so the margin of safety is 44%.

I definitely encourage you to review my inputs and assumptions. You can review my whole USB dividend discount model spreadsheet online using Google Spreadsheets. I’m sure many of you have a different take on these inputs and some of you might even challenge the model I used. Do you know of a better way to value banks? Share your thoughts below. I look forward to the discussion.

Full Disclosure: I do not currently own shares in any of the stocks discussed in this article.

Pfizer

First and foremost, Pfizer has a huge stable of drug patents. Patents grant holders the right to exclude others from making, using, or selling an invention. According to the FDA, Drug patents have a 20-year patent life from the date of the first filing of the patent application. However, the effective length is often shorter, because patents are often obtained before the product is actually ready for sale. Drug companies can apply for patent extensions to recoup some of this lost time, but the extensions cannot exceed 14 years from the product’s approval date. As you can see, patents provide significant moats for a significant period of time. Pfizer’s leading drug patents include the following:

• Lipitor – The most widely used treatment for lowering cholesterol. However, it is starting to face generic competition.
• Norvasc – World’s most-prescribed branded medicine for treating hypertension.
• Exubera – The first inhaled human insulin therapy.
• Geodon/Zeldox – An anti-psychotic medication for the treatment of schizophrenia and acute manic or mixed episodes associated with bipolar disorder.
• Lyrica – Relieves two of the most common types of nerve pain: Diabetic Nerve Pain and Pain after Shingles. Lyrica is also approved to treat partial onset seizures in adults with epilepsy who take one or more anti-seizure medicines.
• Celebrex and Bextra – Approved to treat the joint pain, stiffness, and swelling of osteoarthritis and adult rheumatoid arthritis.
• Eraxis – An antifungal approved to treat candidemia, the most deadly of the common hospital-acquired bloodstream infections, and other forms of Candida infections.
• Stutent – A treatment for two types of cancer, an advanced form of kidney cancer and a cancer of the stomach and intestines called gastrointestinal stromal tumor (GIST).
• Xalatan/Xalacom – A drug used to lower the intraocular pressure associated with glaucoma and ocular hypertension.
• Zyrtec – The most prescribed antihistamine in the U.S. for seasonal and year-round allergies and hives with once-daily dosing.
• Chantix/Champix – A prescription treatment for smoking cessation that became available to patients in the U.S. in August 2006.
• Viagra – The leading treatment for erectile dysfunction and one of the world’s most recognized pharmaceutical brands.

This list is only a sampling of Pfizer’s drug patents. In addition to having the protection of patents, several of the above names have very recognizable brands. I sure you’ve likely seen advertisements and product placements for Viagra, Zyrtec, and maybe even Lipitor. Pfizer has a very impressive drug marketing capability.

Pfizer also has an animal health business line. Pfizer produces Draxxin for treatment of respiratory disease in cattle and swine. The company also produces Rimadyl for treatment of pain and inflammation associated with canine osteoarthritis and soft-tissue orthopedic surgery. In addition, Pfizer produces Revolution, a parasiticide for dogs and cats.

In June 2006, Pfizer entered into an agreement to sell their consumer healthcare business to Johnson & Johnson (JNJ) for approximately $16.6 billion in cash. Shedding their consumer healthcare brands will force Pfizer to focus even more closely on its drug pipeline to maintain cash flows.

Pfizer’s financials also indicate that it has a wide moat. Return on Invested Capital (ROIC) was 16.8% over the past trailing twelve months and has averaged 15.5% over the past five years. Equity has been growing at over 20% over the past ten years and has only recently tapered off. Revenue growth was also averaging above 12 percent over the past 10 years, but it too has halted this past year. Earnings growth has also been above 10% over the past 10 years. Earnings growth was negative last year but has rebounded over the past twelve months. Finally, you got to love 88% gross margins and net margins over 15%.  Those kind of margins usually indicate you are dealing with a wide moat company.

Recently, Pfizer unexpectedly stopped all torcetrapib Phase III clinical trials on December 2, 2006. Pfizer reportedly spent $800 million developing torcetrapib as a potential replacement to the cholesterol drug blockbuster Lipitor, which will be coming off patent as soon as 2010. This event is what triggered Pfizer’s recent stock price decline of over 13 percent.

The $800 million development cost appears typical, at least according to Wikipedia. I also recently read that over 40% of drugs that enter Phase III trials fail. Given these facts and Pfizer’s large stable of drug patents, I found Pfizer’s recent stumble to not be out of the ordinary. Pfizer’s wide moat appears to remain intact and the company will likely continue to develop drugs that will propel its future earnings growth. The company will refocus resource used on torcetrapib to other ongoing promising drug development projects.

In the mean time, Pfizer is also using its legal resources to protect its current blockbuster patents. Last Friday (December 8, 2006), Pfizer got a Canadan court to block Teva’s (TEVA) Novopharm from launching generic Lipitor.

My take is that Pfizer will recover with time the way Merck (MRK) has after the Vioxx blowout.  The stock is already showing healthy signs of recovery.  I will post my valuation of this stock shortly. Please share your comments.

Disclosure: I now own shares of Pfizer Inc. since December 7, 2006.

There is nothing too complicated about my decision to purchase a stake in Western Union. I have been tracking this spin-off from First Data (FDC) at Fat Pitch Financials Contributor’s Corner for several weeks since this is a special situation opportunity.

Western Union is not just a spin-off opportunity.  It also has a wide moat.  Western Union is a global leader in money transfer services. This company has the ability to send money to more than 245,000 Western Union Agent locations in over 200 countries and territories. Now that grants this company a network effect and economies of scale. Western Union’s brand is also widely recognized and instills trust in users of their service, which is very important for cash transfers.

The network effect comes from the fact that the more people that use the Western Union money transfer network, the more valuable it becomes.  The economies of scale comes from the fact that it would be very costly to recreate a similar large scale money transfer network and smaller networks would be less profitable because they would not provide the same service capabilities. 

The costs of maintaining the money transfer network is fairly low, so increasing the number of users increases the amount of profit exponentially. In economic terms, the fixed costs are high but the marginal cost of processing each money transfer is low. Therefore, I believe that Western Union could dramatically increase their earnings in the future if they get creative at expanding the uses of their money transfer network. For example, Western Union might even be able to expand its service offerings by facilitating cash purchases of online products, a niche that could become increasingly important as those without credit access start to shop online more frequently.  Also, the growth potential of cash transactions occurring over the Western Union network looks very promising.

Sadly, in the near future we will likely see easing of U.S. immigration enforcement and anti-terrorism measures, if no further terrorist attacks occur in the U.S.  Relaxing these measure will likely boost Western Union’s cash flows.

Western Union reported 2006 third quarter earnings on October 23rd.  Revenues were up 12 percent from last year.  This is in line with management’s previous guidance for future earnings growth.

To estimate the value of Western Union, I used a 12 percent growth rate for 2007 estimated net income of $1 billion.  I projected out net income (assuming it’s close to owner’s earnings) for 10 years and then I calculated the terminal value using a 10 percent discount rate and 3.5 percent stable growth rate.  That gave me an intrinsic value per share of $32 after adjusting for net debt of $2.1 billion ($3.5 billion in debt minus $1.3 billion in cash).  That’s a 46 percent discount to what I bought the shares for if I did a good job of estimating intrinsic value.

You can read some of the stories that help me come to my decision about Western Union at Value Investing News.

Full Disclosure: I now own shares in Western Union.

For those of you who are followers of Rule #1 investing, I recommend using the great set of free spreadsheets available at the Rule One Investing Community. I particularly recommend the ADVFN based spreadsheet since it pulls in 10 years of data and has all the fundamental data you need to conduct Rule #1 analysis.

I was just about to start my research when I discovered that Justin Brand at ROIC had already done a huge amount of the work that I was about to do.  He uncovered roughly twenty new stocks on my wide moat lists worth further investigation. They include:

• Apache Corporation (APA)
• Building Materials Holding Corp. (BMHC)
• CRA International, Inc. (CRAI)
• Coventry Health Care, Inc. (CVH)
• Coldwater Creek Inc. (CWTR)
• CYTC Corporation (CYTC)
• Diodes Incorporated (DIOD)
• Global Payments Inc. (GPN)
• Hovnanian Enterprises, Inc. (HOV)
• Hydril Company (HYDL)
• Lennar Corporation (LEN)
• M.D.C. Holdings, Inc. (MDC)
• NovaStar Financial Inc. (NFI)
• Patterson Companies, Inc. (PDCO)
• Qualcomm Inc. (QCOM)
• Encore Wire Corporation (WIRE)
• Seaboard Corporation (SEB)

I think I’m going to start my research using the twenty some stock Justin thought were truly wide moat companies. Maybe we’ll even find a fat pitch hiding in this list. Stay tuned throughout this week for posts regarding my research on these stocks.

USG is the maker of Sheetrock. I did not realize Sheetrock was the brand name of USG’s gypsum wallboard, also known as drywall. It looks like the Sheetrock brand however is going the way of Xerox and maybe even Google, but I’m not too worried about that.  USG’s moat is really their economies of scale and low cost producer status.

USG Corporation’s shares have taken a beating and are selling for a discount right now as a result of three main factors.  First, their legal liability from asbestos cases had almost destroyed this company.  As a result of their legal problems, USG filed for Chapter 11 bankruptcy protection. I believe the stigma associated with bankruptcy and the associated complicated contingency funds is also holding the stock price down.  Finally, the recent rapid increase in real estate inventories and the start of a real estate slow down are also keeping away many short term investors.

Based on a rough discounted cash flows model, I’m estimating that USG has an intrinsic value between $85 and $100 per share.  Given that potential margin of safety that this investment currently provides, I feel confident in having taken a swing at this fat pitch. I’ll get into more details regarding this stock purchase over the coming week.

In terms of what the analysts had to say, I found it interesting that the analysts’ value targets ranged from $30 to $33. I reported back in early May that I estimated that the intrinsic value of Microsoft’s stock was about $31.  I took some heat for that estimate but it doesn’t look like I’m too far off from the professional analysts for whatever that’s worth.  Rick Sherlund of Goldman Sachs came in at the lower end with a target of $30 and the UBS analyst, Heather Bellini’s target came in at the high end of the range.

Brendan Barnicle of Pacific Crest Securities noted it looked like work on Office was going better than Windows Vista. I did not realize that another version of Office was already in the works. If it does a good job in facilitating online collaboration, I think a new version of Office could help add to revenue growth.

There is a lot of change underway at this giant wide moat tech company. I think if they can turn this ship in the right direction, there will be a lot of value generated by this stock.

[Full Disclosure: I own shares of Microsoft (MSFT).]

Gannon On Investing presented a different take on bank moats. Geoff Gannon did not really see high switching costs establishing moats around banks. He instead thought that bank transactions had similar characteristics to Gillette razor blades. Disposable razor blades are sold over and over again at a very low price per transaction, and because the buyer will form a habit and not make much of an effort to compare prices, profits will be higher. In summary, he sees banks as “sticky” businesses. I have a different take on what gives some banks moats.

First, I do not agree with Jim Callahan’s opinion that high relative switch costs give most banks moats. My personal experience is that it is fairly easy to switch retail bank accounts. Business accounts that provide lots of services might be a different story, but personal checking and savings accounts are easy to move to another bank. The only challenge is finding your pin number to change your direct deposits from your employeer.

Second, I agree in part with Geoff Gannon that the small and frequent “costs” (lower interest rates and fees) associated with retail banking keep many consumers from shopping around. The cost of researching alternatives and the uncertainty of switching to an unfamiliar bank can seem to outweigh the benefits in many people’s minds in the short-term. However, I don’t believe that this “stickiness” alone gives a bank a moat, especial in today’s information age. One can easily go online and discover tables detailing the best banks with the highest savings rates and lowest fees.

I believe that the primary way that retail banks now gain a competitive advantage (i.e., moat) is though their networks. With modern consumer banking, there are a lot of small costs associated with straying outside of a bank’s network of branches and ATMs. I know from personal experience that I selected the largest, most wide spread local bank network in order to minimize my costs associated with making deposits and withdrawals. I love the ability to make a free ATM withdrawal almost anywhere in my metropolitan area. If my bank dramatically cut back on the number of branches and ATMs, I would start looking for another bank real soon.

I believe that the network effect of geographic access to a banking network also is important to small businesses. Being able to safely, quickly, and conveniently make large cash deposits is likely to be an important feature that many small businesses that handle cash require. In addition, companies with several business locations likely want to use the same bank for deposits in each of their locations. This likely attracts them to large regional and national banks.

In a similar fashion, I believe that internet banking has a similar characteristic. Convenient access and better rates due to cost advantages have attracted me to online savings accounts like Emigrant Direct and INGDIRECT. I believe in the future, as cash transactions continue to decline, that internet banking will have an increasing competitive advantage over brick and mortar banks.

Traditional large physical banking networks will likely face declining competitive advantages over time as the economy continues to increasingly shift to electronic transactions. In the mean time, however, I believe that the network effect of geographic access to banking networks helps some consumer banks get a competitive edge.

Phil Town recently commented on The Little Book That Beats the Market and his comments sparked an idea in my head. What if you could combine the MFI list with Phil’s Big Five Numbers from the Rule #1 Book that he uses to test whether companies have wide moats? Well, I decided to do just that.

Using Portfolio123, I screened for companies that for the past five years scored better than 10 percent for each of the Big 5 Numbers. Ideally, I would use 10 year averages, but most screening tools only have 5 years of data. Therefore, I used the following rules:

1. ROI%5YAvg > 10
2. BV5YCGr% > 10
3. EPS5YCGr% > 10
4. Sales5YCGr% > 10
5. (((FCFPSA-FCFPSPY)/ FCFPSPY)+((FCFPSPY-FCFPSPY2)/FCFPSPY2)+((FCFPSPY2-FCFPSPY3)/FCFPSPY3)+((FCFPSPY3-FCFPSPY4)/FCFPSPY4))/4 > 0.1

These five rules produced a list of 165 stocks that I downloaded as an Excel file. I then got the top 100 stocks with a minimum market capitalization of $50 million from Magic Formula Investing. Using Excel, I combined the two lists and using the PivotTable function and then I filtered out a list of stock symbols that appeared two times.

The result was a short list of nine stocks on May 30, 2006. Those stocks are:

• American Eagle Outfitters Inc. (AEOS)
• bebe stores Inc (BEBE)
• Deckers Outdoor Corp (DECK)
• Harvest Natural Resources Inc. (HNR)
• Block (H&R) Inc. (HRB)
• K-Swiss Inc (KSWS)
• Nucor Corp (NUE)
• Patterson-UTI Energy Inc (PTEN)
• USANA Health Sciences Inc (USNA)

I’ll be focusing my research efforts over the next few weeks on this list. With the market providing us with a potential Summer Sale, I might even find some long-term buying opportunities. Please share your thoughts below on this technique and the list of resulting stocks.

Disappointment you ask?  Well, I figured if someone beat me I’d have a great investment opportunity on my hands.  Even though no one beat my Microsoft entry, there were several other wide moat companies discussed that are worth researching.

Originally posted on January 7, 2006. 

As I started working my way through Barron’s today, I notice an ad by Morningstar. They are offering 15 free research reports on wide moat stocks that currently have their 5-star rating.  No registration is required.  You just have to visit www.morningstar.com/barrons1. (The link didn’t work in Firefox 1.5 for some reason, but it works in Internet Explorer.) The company research reports include:

1. Abbott Laboritories (ABT)
2. Anheuser-Busch Companies (BUD)
3. Avon Products (AVP)
4. Berkshire Hathaway B (BRK.B)
5. Cadbury Schweppes PLC ADR (CSG)
6. Coca-Cola (KO)
7. Dell (DELL)
8. Diageo PLC ADR (DEO)
9. Fifth Third Bancorp (FITB)
10. Johnson & Johnson (JNJ)
11. J.P. Morgan Chase & Co. (JPM)
12. Microsoft (MSFT)
13. Oracle (ORCL)
14. Wal-Mart (WMT)
15. Washington Post Co (WP)

I already own Microsoft.  Avon, Cadbury Schweppes, Diageo and the Washington Post are companies that I have been interested in researching further. The only companies that look unappealing on this list are Dell and Oracle. I don’t think Dell will have a wide moat for long and Oracle’s management concerns me. I’d be interested in hearing your thoughts on this list.

In his latest podcast, Geoffrey Gannon discusses two of the contest entries he has received.  You can hear me discuss why I think Microsoft (MSFT) has the widest moat. 

There is also an entry for eBay (EBAY).  Ebay also has a massive moat like Microsoft.  You can vote on Gannon’s site on which company you think has the widest moat this week.

Gannon’s podcast is the first podcast I’ve downloaded and listened to on my PocketPC. I’ve started listening to his shows as I take the metro to work.  I need to look around for some software to make it easier for me to automatically get podcast updates on my PocketPC.  I think podcasts will be an efficient way for me to get news when I’m stuck standing up on the metro when it is too crowded for me to sit and read. 

Disclosure: Gannon on Investing is a sponsor of Fat Pitch Financials.

You can follow the performance of my model portfolio (FPF Value) by visiting Marketocracy. You can review my past purchases in this long term model portfolio by visiting my FPF Value archives.

This past March, I noted that McCormick’s was a commodity company, exposed to crop risks and other macroeconomic factors.

I have a hard time believing that a company that generates a Return on Equity (ROE) of over 25 percent and a Return on Assets (ROA) of about 10 percent can truly be a commodity company. In fact, I believe that McCormick might have a sizable moat in its consumer spice products. Heck, they may even be a toll booth on the road to cooking spicy meals.

To test out my hypothesis, I went to my pantry. Out of the 29 spices I have, only 2 (Morton’s salt and some spice mixture that I got for free once) were not made by McCormick, and I’m by no means a great cook. That means for most of the meals that I prepare from scratch, I end up paying a little bit of money in spices each time to McCormick.

I am by no means particular about my spices, so I couldn’t understand how I ended up with so many McCormick products. So this week when I went shopping, I took notice of the spices sold at my grocery store. After searching high and low, I couldn’t believe that just about all the spices were made by McCormick even though many of the jars looked different.

I’m not sure if my findings are very representative. I’d like you to look through your own spice racks at home and inspect your grocery store spices. What proportion are made by McCormick?

With McCormick recently reaching a 52 week low, there might be an opportunity here.

In the past, I struggled to take advantage of unexpected downturns in the stock market. In the emotional chaos that often hits after a market plunge, I often was unable to research enough companies fast enough to make a quality purchase decision while prices remained low.

My goal is to identify the highest quality companies now, so that I can swing hard and sure at the next fat pitch that comes over my plate. I am particularly looking for companies with sustainable competitive advantages and will keep them ahead of their competition for years to come. Warren Buffett refers to these companies as having wide moats.

What gives a company a wide moat that keeps the competition at bay? Some companies are very low cost producers, others have key patents on their products, and still others provide services that have high switching costs.

I’ll go into these characteristics in further detail in the examples I discuss in upcoming articles. Feel free to suggest your favorite wide moat companies and I’ll take a close look at them here.