With that in mind, consider our current case: Yankee Candle. Yankee is an excellent business in every sense of the word. The returns on tangible capital are through the roof, the business enjoys a wide competitive advantage and franchise value with around fifty percent (50%) market share in the premium candle segment, management is intelligent and disciplined by returning virtually all excess capital to shareholders each year through stock repurchases and cash dividends, and the business has a lot of potential now that they are creating other candle companies to sell through mass premium channels such as Costco and Kohls.
The only drawback is that paraffin wax is a byproduct of petroleum. Given the high cost of oil and the strained refining capacity (exasperated by the fact that one of Yankees main wax providers put them on seventy percent (70%) allocation after suffering damages from Hurricane Katrina last year), and its not a surprise that the cost of raw wax skyrocketed more than twenty percent (20%) during the most recent quarter, thus leading to a scheduled increase in Yankees flagship Housewarmer candles this autumn. These factors led management to lower its quarterly and annual guidance last week, causing the stock to fall substantially from as high as $32 in the weeks prior to as low as around $21.
The Joy of Low Stock PricesAs an investor, I was doing handstands. Why? In ten years, I dont expect the problems that are facing Yankee today to still be a major factor. In the meantime, I was buying a company that had a market capitalization of $850 million, that earned $80 million in cash but generated free cash flow of $110 to $120 million and, by utilizing borrowed funds, repurchased $185 million worth of its stock in the prior fiscal year. As an added bonus, a cash dividend yielding a little over 1.1% per annum was paid to shareholders. With factors such as this, it didnt take a rocket scientist to figure out that if Yankee continued to repurchase shares at a rate where the actual float of outstanding common stock fell rapidly, the existing shareholders would be very, very well served as time passed. Factor in higher earnings down the road, and it left me feeling much better about my odds of getting a satisfactory rate of return from this particular stock versus the S&P 500.
On Wednesday, July 26th, however, management announced that the company was partnering with Lehman Brothers to look into strategic alternatives Wall Street speak for we are going to look into selling the company to a financial or strategic buyer. (A note for readers: financial buyers are those who come into a business, often using high amounts of leverage, with the intent to resell it at a later time after growing earnings or closing underperforming segments. A strategic buyer is someone who has an interest in the business for what it can do for their existing operations; another candle company, for example, would fall into this category.)
This announcement caused the stock to skyrocket by nearly 20% in morning trading. In the conference call, one of the executives mentioned (Im paraphrasing here), that it was clear the company was undervalued at its recent price and we felt it was our duty to shareholders to explore other ways to unlock the value of their investment. My point exactly! Management and the Board of Directors had a beautiful opportunity to use the recent price weakness to buy back another massive block of the companys shares and retire them; it would have been possible for them to actually acquire fifteen percent (15%) or more without straining the corporate resources significantly. In the meantime, shareholders with a long-term perspective would be able to continue buying up shares for their personal accounts. Instead, they viewed the low stock price as a problem to be solved rather than an opportunity of which to take advantage.