In this section, we feature a few Company Spotlights – either new ideas recently added to our portfolios, or updates on some existing holdings.
We hope these features help you understand how our analysts and portfolio managers recommend stocks to purchase. Each quarter, we'll post several in-depth spotlights here for your review. Portfolio holdings are subject to change, and for specific information about portfolio composition as of the most recent quarter-end, please refer to the specific Fund or Product you are interested in.
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AFLAC, held in both Ariel Appreciation Fund and Ariel Focus Fund, is the leader in supplemental insurance in both Japan and the U.S. Founded in Columbus, Georgia over 50 years ago as a cancer insurer, AFLAC’s entry into the Japanese market in the 1970s proved a mammoth move. The company now insures one in three Japanese citizens, who depend on AFLAC’s products to “fill in the gaps” of their government health care plan. More recently AFLAC built its brand in the United States with its famous duck mascot, who explains the niche product in an amusing way.
Consistent Management
Dan Amos has been CEO since 1991 and has delivered operating results like few other managers. For 17 consecutive years, AFLAC has grown earnings 15% annually; meanwhile, industry peers struggled to meet just their cost of capital. Amos has a rigorous, three-part formula for creating shareholder value: attention to every detail, uncompromised focus on the two largest insurance markets, and heavy investment in the brand.
Unmatched Distribution in Japan
Supplemental insurance policies are relatively cheap, but consumers will not buy them unless they grasp their importance. AFLAC built its competitive advantage in Japan by partnering closely with Japanese corporations. These companies, not the insurer, educate their employees about the need for supplemental insurance and offer it as a payroll deduction item. This relationship keeps AFLAC’s expenses far lower than those of other large Japanese insurers, which has made the company a powerhouse. More than 90% of the companies on the Tokyo stock exchange offer the company’s insurance, and more than 94% of the insured re-enroll yearly.
Brand Recognition in the US
AFLAC became the leading insurer in Japan 30 years ago, but was not well-recognized in its home country until a decade ago. Lively commercials featuring a now iconic duck dramatized the need for supplemental insurance and firmly implanted the brand in the minds of Americans. AFLAC has made strong progress on selling policies that cover lost work time, travel for care, and other out of pocket expenses, available via payroll deduction by employers.
Compelling Opportunity
An insurance company’s balance sheet holds investments on one side and promises to pay on the other. Falling markets, such as the one we have seen lately, can reduce the value of investments, creating concerns for policyholders, regulators and, therefore, stockholders. AFLAC’s decision to purchase only investment grade bonds has helped it dramatically outperform Japanese insurers, who often purchased domestic real estate and equities, which have declined in value over the past 20 years. Thus AFLAC’s strategy made it the strongest insurer operating in the country. Now, however, a small segment of the portfolio is worrying Wall Street. Less than 15% of the bonds in the company’s portfolio are long-dated or perpetual hybrid securities (which combine debt and equity components) from European banks. Recent headlines out of Europe about the possibility of bank nationalization have panicked the market, causing AFLAC stock to sell off. We believe, however, that the earnings power of the insurance franchise will overcome the market’s apprehension.
Rare Valuation Opportunity
AFLAC stock has traded as low as $11 on the fear of markdowns in the portfolio. The $5 per share in earnings power gives us confidence that the company will prosper in the future as investors focus on the business of AFLAC and not headlines about a small subset of their diversified investment portfolio. The string of 15% earnings growth may be at risk, but the company remains potent as well as cheap at today’s price.
As of March 31, 2009, the company traded at $19.36, a 72% discount to our private market value estimate of $68.08.
Aflac Inc. (NYSE: AFL)
1932 Wynnton Road
Columbus, GA 31999
706-596-3278
www.aflac.com
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International Game Technology, often called IGT, held in both Ariel Fund and Ariel Appreciation Fund, is a global gaming company that designs, produces, and sells slot machines and similar games to casinos. It is the largest, most globally diverse gaming company in the world, which gives it the resources to drive trends in an industry where such leadership is critical. Approximately 60% of slot machines in North America are IGT products, as are the highly popular Wheel of Fortune and Megabucks games. We know the company well, having owned it in various portfolios from 1998 to 2002.
Market Perceptions
IGT’s stock sold down to an enticing price as the market cratered last fall. In 2008, IGT lost some market share and saw revenues fall, but did not slash expenses quickly enough to hold margins stable. And Wall Street fears these short-term slips suggest the company has deteriorated fundamentally. The market also is concerned with IGT’s financing. The company’s convertible bond owners will likely put more than $800 million back to the company in December 2009. Plus IGT has a bank loan due in 2010. Many investors believe refinancing would come at a very high cost that would further crimp profits. Finally, the market expects the recession-induced global gaming decline to cause casinos to delay game replacement, possibly for an extended period.
Our Contrarian View
Given our long-term view, we can look past the clouds. First and foremost, recessions are always temporary phenomena. Gaming has not gone away and is likely to be stronger five years from now than it is today. Similarly, the credit markets have already improved, so IGT should be able to refinance without the pain doomsayers expect. Finally, while last year was difficult for the company, there is no reason to think the franchise has been permanently impaired. Moreover, we think the market is missing an important part of the big picture: municipalities are desperate to shore up their fast-declining tax revenues and are likely to use gaming to offset their losses, a potential boon to IGT.
On Top of Its Game
We think IGT still has an attractive business model. Its great, long-term relationships with customers generate relatively steady revenues. These stable streams of cash allow it to fund a strong research and development budget, meaning a continual flow of new products. Finally, this pipeline allows the company to stay on top of gaming trends to create entertaining games people want to play. Historically IGT led the way with progressive games like Megabucks, and now the company is trailblazing in the next big thing, server-based gaming, which is efficient and allows frequent upgrades and enhancements. And, of course, popular games create satisfied, loyal customers.
A Well-Managed Franchise
Management allocates capital thoughtfully, devoting the right amount of money (not too much or too little) to developing new products. The company’s leaders are also disciplined yet opportunistic in acquisitions, with the purchase of Anchor Gaming in 2001 being the best example. Finally, management has a constant focus on growing shareholder value through share repurchases and dividends. For instance, since fiscal year 2005, the firm has repurchased about $2.7 billion worth of stock, reducing its share count by nearly 15%.
As of March 31, 2009, the company traded at $9.22, a 47% discount to our private market value estimate of $17.54.
International Game Technology (NYSE: IGT)
9295 Prototype Drive
Reno, NV 89521
775-448-7777
www.igt.com
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Nordstrom, Inc., held in both Ariel Fund and Ariel Appreciation Fund, is a specialty department store offering a selection of apparel, shoes, cosmetics and accessories to women, men and children. The company operates 169 stores located in 28 states in the United States as well as a rapidly-growing website, Nordstrom.com. Nordstrom has a stellar brand, built on its unparalleled customer service and a massive, enticing shoe department. Its fundamentals mirror its high-quality merchandise: it is a very well-managed retailer with a strong balance sheet. The company offers its products through multiple retail channels, including its flagship Nordstrom stores, its discount Nordstrom Rack stores, catalogs, and on the Internet. It targets multiple consumer segments, offering brand name and private-label merchandise to the more budget-conscious as well as select designer products for the well-heeled.
Clouds Overhead
Two issues hang over the stock. First, there is the well-known tightening of purse-strings in the recession. Second, many believe department stores have a grim future—or none at all. Indeed, department stores’ market share shrank from 9% in 1997 to 5% in 2007. However, we believe those with a sharp edge, such as those with luxury wares that cater to a wealthier clientele, have the opportunity to not just survive but thrive. Indeed, in the decade ending in 2007, Nordstrom grew at a 6.3% clip, faster than retail in general. We think it can do so again as the country emerges, inevitably, from the recession.
A Model Retailer That is ‘On Sale’
The retail industry is suffering the worst retail and consumer conditions ever, so patient investors should see significant rewards for weathering the storm as normalcy returns. The company exhibits many of the most important attributes we look for in an outstanding retailer: attractive brand, differentiated merchandise, excellent profitability, and well-defined positioning in consumers’ minds. Moreover, it boasts the key traits we seek in all businesses: a healthy balance sheet, conservative management, growth prospects, and a demonstrated track record of prudent capital allocation. A major decline in the stock’s valuation for well-known reasons outside of the company’s control provided us with an excellent entry point for this superior franchise.
Profitability and Presence
Nordstrom is a very well-run company with a healthy financial profile. It has turned around nicely since the early 2000s when it temporarily expanded too aggressively and lost inventory discipline. Since then it has enjoyed a solid run of double-digit operating profitability, cash flow and net income growth. That combination fueled a significant square footage expansion after bottoming hard in the last recession. Management wisely deployed capital to boost profitability and prudently returned capital to shareholders through consistent stock buybacks and dividends. Nordstrom has an attractive return on invested capital which is rare for a capital-intensive retailer in the midst of a growth phase. Furthermore, it only has stores in half of the geographic markets across the US, so it can increase its presence opportunistically.
Macroeconomic Pressure
The market quickly adjusted to the new earnings reality for retailers, reducing estimates and slashing valuation ratios accordingly. In the current recession
Nordstrom shares have suffered the worst multiple contraction, estimate cuts, and stock price decline in the last 30 years. While it would appear the estimates have been properly reset to reflect a bleak macroeconomic picture, we believe the stock is oversold, pricing in weak results for a very long time to come. Shares trade near all-time valuation lows, setting up a virtuous cycle: we expect earning estimates and valuation multiples will both rise as the recovery takes hold. Despite nearly tripling from its November 2008 lows, the stock still sits on the bargain shelf.
As of March 31, 2009, the company traded at $16.75, a 40% discount to our private market value estimate of $27.80.
Nordstrom, Inc. (NYSE: JWN)
1617 6th Avenue
Seattle, WA 98101
206-628-2111
www.nordstrom.com
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