Respecting Capital

Perhaps without exception, every dollar that you have in your possession originally was the product of your labor. That is significant. It represents your own time that could have been spent doing anything you want, but instead, you worked. Not only did you work, but that money is a function of your surplus after paying taxes, housing, food, and the myriad other costs that are part of daily living. There is an almost sacredness to the pool of capital that is your surplus because it is just about the only thing in the world that can have the capacity to make you richer while you sleep. 

With this in mind, I obsessively focus on things that can impair capital or cause it to be lost entirely. If an investment fails, it usually does so for one of three reasons: (1) the good or service fails in the marketplace; (2) the company’s balance sheet is overloaded with debt that cannot withstand a particular cash flow crunch; and/or (3) the company is so overvalued at the point of purchase that the gap between the overvaluation and the truly fair price is so extreme that some portion of your capital must be forfeited when readjustment occurs. 

As we sit here in 2019, a decade into an uninterrupted period of generally rising markets throughout the world, it can be easy to ignore these elements that can lead to failure. Normally, ten-year records are sufficient to give you an idea of a business’ strength through various economic cycles, but this period of economic growth has been so long that we are now largely evaluating data that doesn’t include any recession stressors.

Similarly, interest rates have been so low over this timeframe that the traditional advantages of high cash balances and the traditional disadvantages of high debt loads have not been manifesting. It’s really easy to ignore enormous debt loads that only carry 2-4% interest expenses. Such ignorance without consequences will no longer be possible when a refinancing occurs at a 6-8% rate.  

And finally, with many great businesses trading at a P/E ratio in the 20s or even 30s, it can be easy to forget the lessons of most stock market declines that instruct us that those 50% or greater declines are the result of stock valuations traveling from overvaluation territory to undervaluation territory rather than just fair valuation territory to undervaluation territory. 

The only time I make an exception and agree to pay more than 20x earnings for a stock occurs when I am darn certain that earnings per share growth north of 10% will occur over a 5-10 time frame. And even then, these situations are highly particular where there is something that indicates the higher P/E ratio is not quite what it seems. In the past three years, the only times I have paid over 20x earnings for a stock has been Alphabet/Google, Brown-Forman, and Dunkin Brands.

For Alphabet, the reason was due to the company’s $100+ billion cash balance sheet and a P/E ratio that was only slightly above 20. With Brown-Forman, it was the fact that the company most closely resembles Coca-Cola in the 1960s, where it is sitting on unassailable intellectual property in the form of its alcohol brands and fantastic distribution networks that give the firm a license to mint money.

With Dunkin Brands, which has quietly fallen 12% since September to a price of $73 per share, it is about recognizing that the firm is structured like a beverage royalty override fee. At Dunkin, every single location is franchised. There are 12,900 franchises, and the company now requires each franchisee to pay 5.9% of gross sales to the Dunkin parent as a cost for being able to use its intellectual property (the Dunkin’ brands) and its corporate knowledge of running a shop.

Among many interesting things, Dunkin currently has a blended rate of 4.7% that it charges franchisees because franchisees enter into twenty-year operating agreements with Dunkin’ brands and the firm used to charge 3.9% as royalties, then 4.9%, and now, 5.9%. For shareholders of Dunkin, this is significant. 

Across the globe, stores bearing the Dunkin name engage in about $26 billion of economic activity. Of that, $1.2 billion flows to Dunkin as a franchise fee. The company earns a 18.2% profit margin, so $226 million flows to shareholders as pure profit. Without even taking into account other favorable changes, the mere rolling over of all franchise agreements to the new 5.9% rate means that $1.53 billion will flow to Dunkin as a franchise free. Assuming the same 18.2% profit rate (though I’d expect this to rise), there will be $289 million flowing to shareholders as a franchise fee. In other words, over the coming years, there is a 27.88% increase in Dunkin’s profits that is going to naturally come as a result of the new contractual fee agreement.

There is also the fact that Dunkin has shifted the advertising fees onto the franchisees and now charges a separate 5% fee to the franchisees rather than absorbing this cost directly. This fee used to be 2.5%. I would expect that Dunkin’s cost structure would simultaneously decline in the coming years as the cost of advertising is off-loaded onto the franchisees.

Of course, these new franchisee cost arrangements require us to examine the question: What is Dunkin doing differently now such that it is able to off-load so many costs to franchisees that it previously absorbed at the franchisor/parent shareholder level?

The answer is that the company has transitioned from a doughnut company to a coffee, breakfast, doughnut, and treat company. The company’s sales of espresso coffee is up 40% over the past five years. It has both high-margin and low-margin (but high volume) offerings that allow the firm to appeal to a wide customer base.

A lot of people look at Starbucks and think they have missed the boat. Starbucks is valued at $96 billion, is saturated everywhere, and trades at a rich valuation. Dunkin is the compelling alternative. The business model has momentum, the earnings are set to continue growing at a double-digit rate, and the company is also much smaller (only $6 billion market cap) as the firm rolls out plans to began expansion to the West Coast of the United States over the coming 10-15 years (and generating $40,000-$90,000 franchise fees with each new location it opens along the way, in addition to the fees previously mentioned).

In general, I have a special appreciation for beverage firms because they sell products that are frequently purchased with high profit-margins and the intellectual property in the form of branded drinks can be enduring for generations. The profits at Dunkin have tripled over the past eight years, and the company is positioning itself with better product offerings and stands to collect a higher profit share of its offerings over the coming 5-10 years.

If there is a master plan in place right now, my idea is to fill up as many tax-advantaged accounts as I can with shares of Altria, Imperial Brands, and Philip Morris International so that they can serve as a self-funding mechanism for the likes of Dunkin Brands, Exxon Mobil, Franklin Resources, Brown-Forman, and Alphabet. 

For example, Altria is paying out a dividend of $3.36 per share to shareholders. Over the next five years, each share of Altria purchased at $45 per share will probably pay out somewhere around $18-$21 per share in dividends. I expect that each $1 invested into Altria today will pay out $0.40 to $0.45 in total dividends by the end of 2024. The plan is that the regulatory risk to that investment will be diminished over time as shares of oil giants, beverage giants, investment giants, and tech giants are self-funded from these big tobacco dividends. 

The low valuations in the tobacco sector have always been a product of investors dealing with the possibility that the product will be regulated out of profitability. For those who have accepted that risk, the compensation for doing so has been enormous because the impairment to volume sales has always been over-compensated by price hikes to the cost per pack of cigarettes. For me, if I could get half my investment back as dividends within five years, and the full cost of the tobacco investment back as dividends within a decade, I would hopefully find myself in a situation where, if a one in fifteen chance of wipeout materializes, I’d have all these other funded holdings to show for it. And if the probable likelihood of continued profitability manifests itself, well, there’d be self-funded positions and the remaining tobacco investments continuing to churn out cash for perpetual redeployment from a low base established in 2019. 

As a risk-adjusted proposition, every risk associated with Big Tobacco is being very well-compensated by the high dividend yields of Altria, Philip Morris, and Imperial Brands. And to the extent that the risk remains, the idea is that the passage of time and the reallocation of dividends into Dunkin-type investments will minimize and gradually eliminate whatever risk is actually present in these investments. 

Plus, they come with the important silver linings that they have reasonable debt, low valuations, and a product whose business model can withstand the current regulatory adversity. An additional advantage of Big Tobacco stocks right now is that they are valued so low that they don’t have much further to fall–i.e. If they fell by 30% in a 1987 crash type of event, those stocks would be valued at Great Depression-era valuations. You can’t say that about subjecting many other firms to such a hypothetical shock. Therein lies the margin of safety and protection of capital in a frothy market.

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