Just do it! Brand Name Lessons from Nike'sTroubles!

     I have spent the last week reading "Shoe Dog", Phil Knight's memoir of how  a runner on the Oregon University track team built one of the great shoe companies in the world, in Nike. In addition to its entertainment value, and it is a fun book to read, I read it for two storylines. The first is the time, effort and grit that it took to build a business, in a world where risk capital was more difficult to access than it has been in this century, and in a business where scaling up posed significant challenges. The second is the building of a brand name, with a mix of happy accidents (from the naming of the company to the creation of the swoosh as the company's symbol to its choice of slogan), good timing and great merchandising all playing a role in creating one of the great brand names in apparel and footwear. The latter assessment led a more general consideration of what constitutes a brand name, what makes a brand name valuable and what causes brand name values to deplete and disappear. Of course, since my attention was drawn to Nike in the first place, because of a change at the top the company and talk of brand name malaise, I tried my hand at valuing Nike in 2024, along the way.

Brand Name - What is it?

    The broadest definition of a brand name is that it is recognized (by employees, consumers and the market) and remembered, either because of familiarity (because of brand name longevity) or association (with advertising or a celebrity). That definition, though, is not particularly useful since remembering or recognizing a brand, by itself, tells you nothing about its value. After all, almost everyone has heard or recognizes AT&T as a brand/corporate name, but as someone who is a cell service and internet customer of AT&T, I can assure you that neither of those choices were driven by brand name.  The essence of brand name value is that the recognition or remembrance of a brand name changes how people behave in its presence. With customers, brand name recognition can manifest itself in buying choices (affecting revenues and revenue growth) or willingness to pay a higher price (higher profit margins). With capital providers, it may allow for lower funding costs, with equity investors pricing equity higher and lenders accepting lower interest rates and/or fewer lending covenants. For the moment, this may seem abstract and subjective, but in the next section, we will flesh out brand name effects on operating metrics and value more explicitly.

Corporate, Product and Personal Brand Names

    Brand names can attach to entire companies, to particular products or brands, or even to personnel and people. With a company like Coca Cola, it is the corporate brand name that has the most power, but the soft drink beverages marketed by the company (Coca Cola, Fanta, Sprite, Dasani etc.) each have their own brand names. With companies like Unilever, the corporate brand name takes a back seat to the brands names of the dozens of products controlled by the company, which include Dove (soap), Axe (deodorant), Hellman's (mayonnaise) and Close-up (toothpaste), just to name a few. There are clearly cases of people with significant brand name value, in sports (Ohtani in baseball, Messi in soccer, Kohli in cricket) and entertainment (Taylor Swift, Beyonce), with a spill over to the entities that attach themselves to these people. In fact, a critical component of Nike's brand name was put in place in 1984, when the company signed on Michael Jordan, in his rookie season as a basketball player, and reaped benefits as he became the sport's biggest star over the next decade.

Brand names and other Competitive Advantages

    One reason that brand name discussions often lose their focus is that companies are quick to bundle a  host of competitive advantages, each of which may be valuable, in the brand name grouping. The table below, where I have loosely borrowed from Morningstar and Michael Porter is one way to think about both the types and sustainability of competitive advantages:

Companies like Walmart and Aramco have significant competitive advantages, but I don't think brand name is on the top five list. Walmart's strengths come from immense economies of scale and bargaining power with suppliers, and Aramco's value derives from massive oil reserves, with far lower costs of extraction, than any of its competitors. Google and Facebook control the advertising business, because they have huge networking benefits, i.e., they become more attractive destinations for advertisers as they get bigger, explaining why they were so quick to change their corporate names, and why it has had so little effect on value. The pharmaceutical companies have some brand name value, but a bigger portion of their value added comes from the protection against competition they get from owning patents. While this may seem like splitting hairs, since all competitive advantages find their way into the bottom line (higher earnings or lower risk), a company that mistakes where its competitive advantages come from risks losing those advantages.

Brand Name Value

    At the risk of drawing backlash from marketing experts and brand name consultants, I will start with my "narrow" definition of brand name. In arriving at this definition, I will fall back on a structure where I connect the value of a business to key drivers, and look at how brand name will affect these drivers:

Put simply, brand name value can show up in almost every input, with a more recognizable (and respected) brand name leading to more sales (higher revenues and revenue growth), more pricing power (higher margins), and perhaps even less reinvestment and less risk (lower costs of capital and failure risk). That said, the strongest impact of brand name is on pricing power, with brand name in its purest form allowing it's owner to charge a higher price for a product or service than  a competitor could charge for an identical offering. To illustrate, I walked over to my neighborhood pharmacy, and compared the prices of an over-the-counter pain killer (acetaminophen), in its branded form (Tylenol) and its generic version (CVS) :

The ingredients, in case you are wondering, are exactly the same, leading to the interesting question, more psychological than financial, of why anyone would pay an extra $2.50 for a product with no differentiating features. If you are wondering how this plays out at the business level, the operating margins of pharmaceutical companies that own the "brand names" are significantly higher than the brand names of companies that make just the generic substitutes.

    The Tylenol example also serves to illustrate when it is easiest to value brand name, i.e., when it is the only competitive advantage, and when it will become difficult to do, i.e., when it has many competitive advantages. It is for that reason that valuing brand name is easier to do at a beverage or cereal company, such as Coca Cola or Kellogg's, where there is little to differentiate across products other than brand name, and you can attribute the higher margins almost entirely to brand name. It is at the basis for my valuation of Coca Cola's brand name in the picture below, where I value the company with its current operating margin:

Coca Cola valuation

Note that while the company comes in as slightly overvalued, it is still given a value of $281.15 billion, with much of that value coming from its pre-tax operating margin of 29.73%. We estimate the value of Coca Cola's brand name in two steps, first comparing to a weighted average margin off 16.75% for soft-drink beverage companies, where many of the largest companies are themselves branded (Pepsi, Dr. Pepper etc.), albeit with less pricing power than Coca Coal and then comparing to the median operating margin of 6.92%, skewed towards smaller and generic beverage companies listed globally:

Coca Cola valuation

This is undoubtedly simplistic, since it assumes that the brand name value shows up entirely in the margin, and it likely understates the value of Coca Cola's brand name. That said, valuing Coca Cola at the median beverage company margin yields a value of $51 billion, suggesting that 82% of the company's intrinsic value comes from its brand name. Comparing to other beverage company and valuing at the weighted average operating margin still yields a differential brand value of $131.4 billion for Coca Cola, indicating that having a premium brand name has significant value.

    Brand names become more difficult to isolate and value, when a company has multiple competitive advantages, since the higher margins or growth or returns on capital will reflect the composite effect of all of the advantages. With companies like Apple, where brand name is a factor, as is a proprietary operating system, a superior styling and a unique app ecosystem, the higher margin can be attributed to a multitude of factors, making it more difficult, perhaps even impossible, to isolate the brand name value. When valuing Birkenstock, at the time of its IPO, I wrestled with this problem, and with the help of a series of assumptions along the way, did find a way to break the value of the four intangibles that I saw in the company: a world-recognized brand name, a quality management team, free celebrity advertising and the buzz created by Margot Robbie wearing pink Birkenstock in the Barbie movie.

Download Birkenstock valuation at the time of IPO

The pricing premium effect of brand name also becomes an effective device to strip companies that hold on to the delusion that their brand name values have value, long after they have lost their shine. If a company has margins that trail that of other companies in its industry grouping, it has lost brand name bragging rights (and value), and it is time to either accept that reality or rebrand to acquire pricing power again. Applying this test, you will find that nine out of ten companies that claim to have brand values have really nothing to show for that claim.

    Nike, in my view, falls somewhere between the two extremes. It is not as pure a brand play as Coca Cola, since athletic footwear, in particular, has physical differentiation that may lead some to prefer one brand over another. At the same time, it is not as complex as Apple, insofar as even a Nike aficionado can find a relatively close substitute in another brand. To measure how Nike's brand name has played out in its operating metrics, we compared the company's operating margins to the weighted operating margin of the two businesses (two thirds footwear and one third apparel) that Nike has operated in for much of the last two decades:

Other than 2023, Nike has consistently earned a higher operating margin (1.5% to 3% higher) than the rest of the industry, and since much of this industry is composed of brand name companies, it would suggest that Nike has a premium brand name, not surprisingly. If you are a Nike-pessimist, though, the drop off in the margin differential in the last five years is troubling, but almost all of that drop can be attributed to the company's troubles in 2023. Clearly, the company is taking the decline seriously, bringing back a Nike employee of long standing in Elliott Hill to replace John Donahoe, who cut his teeth in tech companies (ServiceNow, eBay and PayPal). 

    I valued Nike, using its compounded annual growth rate and average operating margin over three period - 2014-2108, 2019-2023 and just the last twelve months:

Nike valuation

You can see why Nike acted swiftly to change its CEO, since its value will dip substantially, if its growth stays down and margins do not bounce back. At the $71 stock price that the stock was trading at, just six weeks ago, the investing odds would have been in your favor, but the bounce back in the stock price to $88, after the new CEO hire, suggests that the market is pricing in the expectation that the company will bounce back to higher growth and better margins.

Brand Name Creation

    Brand name does add value, if it gives the company that owns it pricing power, but how does a company end up with a valuable brand name? There are facile answers and they include longevity, with long-lived companies having more recognizable brand names, and advertising, where more spending is assumed to result in a more valuable brand name. To see why I attach the "facile" prefix to these answers, consider again the example of AT&T, a company that has been around for more than a century and remains one of the ten largest spenders on advertising in the United States. None of that spending has translated into a significant brand name value, thought there may other benefits that the company accrues. 

   I am sure that someone who immerses themselves in in this topic, perhaps in marketing and advertising, may be able to provide a deeper answer, but here is what I see as ingredients that go into developing a valuable brand name:

1. Attachment to an emotional factor/need: As marketing has recognized through the ages, the key to a powerful brand name is a tie to a human emotion. Rational or not, consumers may reach for a branded product, because they associate the product with freedom, reliability, happiness, patriotism or aspiration, if that association exists in their minds. The challenge, of course, is to find an emotion that attaches well to your product, either because of its history or its make-up, but the association, once made, can be powerful and long-lasting.
2. Celebrity connection: Earlier, we talked about personal brand names, and argued that Nike benefited from its association with Michael Jordan, in building its brand name. In fact, Apple (in its streaming service) and Major League Soccer benefited mightily from Lionel Messi playing Inter Miami, with the former adding hundreds of thousands of subscribers to it soccer streaming service, and the latter increasing attendance in stadiums around the country. Here again, there are perils, since attaching a brand name to a person also exposes the company to the failings and foibles of that person, as Nike found out in its associations with both Tiger Woods and Colin Kaepernick.
3. Fortuitous events/ choices: There is a third factor that is not covered in most brand name management classes, and for good reason, and that is the effect of luck. In an alternate universe, Phil Knight might have stayed with Dimension Six, his initial choice for the company name, picked a different symbol than the swoosh (for which Nike paid $35 to the designer) and even a different slogan ( than the "Just do it" picked by the advertising team), and the end result could have been very different.
4. Advertising: While there may be little or no link between overall advertising spending and brand name, it is undeniable that there are ads that catch people's attention and alter perceptions of a product. I was an Apple user already in 1984, when it ran its famous 1984 ad during the Super Bowl, setting itself apart from the PC makers, and while that ad yielded little monetary benefit to Apple in the immediate aftermath, it contributed to creating the brand name that now allows the company to charge $1600 for a new smart phone. Nike has had its share of iconic commercials, and I still remember this Nike ad, with Michael Jordan, from 1997, showing how long the shelf life can be for a great ad.

If asked to advice a company that was intent on creating a brand name, my suggestion would be to start with a product or service that is differentiated from the competition, and to give the brand name time to build around that differentiation. That may require sacrifices on scaling up (accepting less growth to preserve the product differential), a higher cost structure (if it is a quality difference) and perhaps even more reinvestment, but trade offs are inherent to almost everything of value in business. If the expected costs of building a brand name exceed its benefits, though, it may be worth asking whether brand name is the competitive advantage that the company should be aspiring for, since there are other competitive advantages that can add as much or much more value in the business the company operates in.

Brand Name Destruction

    The benefit of building a strong brand name is that it remains one of the most sustainable competitive advantages in business, with the advantages often lasting decades. However, even brand names eventually lose their luster, but the reasons they do so vary:

1. Aging brand/consumer base: In my posts and book on corporate life cycle, I talk about how and why companies age, and how aging is inevitable. The same can be said of brand names, since even the most highly regarded brand names eventually age, and no matter how much managers try to resurrect them, they never recover their mojo. When valuing Kraft Heinz in 2015, when the most venerable name in value investing (Warren Buffett) teamed up with one of the shrewdest players in private equity (3G Capital) to buy the company because it was under valued, I wondered whether the reason the market was turning down on the company was because the portion of the population that were drawn to the company's products (fifty seven types of ketchup, all of which taste bad, and cheese that stays liquid through a nuclear winter) to be tasty was getting smaller and older. In hindsight, it is clear that Kraft Heinz will not reclaim its former glory, because its products and customer base have aged.
2. Benign neglect: Brand names may provide sustainable competitive advantages, but only if they are cared for and maintained. There are legendary brand names that have been neglected, treated as cash cows with no new investment or sprucing up needed, and have faded in value. Quaker Oats, a longstanding mainstay of the US cereal business, not only allowed itself to pushed to the sidelines by aggressive cereal companies, but failed to take advantage of the rise in demand for oatmeal as a heart-healthy substitute. 
3. Cultural changes: There are products and services that have lost their allure over time, because the cultural mores or social norms of the consumers have changed. If you binge watch Mad Men, the television series about advertising in the 1960s, you should not be surprised to see ads for products and services that you would now view in a very different light. 
4. Changing tastes: There are some businesses, where the demand for products is transient and fad-driven, and new brands replace old ones, as tastes shift. This has generally been the case with  apparel retail in the United States, with the Gap's reign at the top lasting about a decade, with newer and cooler retail brands like Abercrombie and Fitch and Tommy Hilfiger replacing them, and then were themselves being displaced by H&M and Uniqlo. 
5. Toxic connections: A brand name that is built up over time can sometimes very quickly fall back to earth, if the company or its personnel bring toxic connections. Abercrombie and Fitch, for instance, which became a hot destination for the young in the first decade of this century, found its brand name devastated by accusations of racism and sexism in its ranks. 
6. Brand overreach: There are cases where a company with a valuable brand name may dilute or even destroy that brand name by overreaching, and putting it on products that cut agains the brand name narrative. A good argument can be made that Disney, usually masterful at managing its brands, diluted the value of both its Avengers and Star Wars franchises by rushing headlong into the streaming business, with new series.

While all of these forces can cause a once valuable brand name to lose its value, it is worth noting that there are companies that have redeemed brand name value, sometimes by remaking the product or service, sometimes by repackaging it and sometimes by repositioning it. Crocs, whose brand name soared in the 2000s, but crashed by the end of the decade, repackaged itself around celebrity endorsements to become a successful brand again. Lego, a venerable brand name in the toy business, sold off its theme parks, and refocused attention on its core product, while redirecting its offerings to adults. In general, though, reincarnating a brand becomes easier for niche brands than for mass market ones, for product brands than for company brands, and for younger brands than for older ones.

    I believe that 2023 was a wake up call for Nike, as it awoke multiple disruptions. First, in the post-COVID years, Nike moved from store sales to digital sales, with Nike Digital, accounting for almost 43% of revenues in 2022. While that shift does reflect a change in consumer preferences towards shopping online, there is a question of whether bypassing shoe stores, which over the decades have contributed to the Nike brand, by highlighting their most iconic shoes, has undercut the brand. Second, while the footwear business has been more resistant to fads than the apparel business, Nike;'s mass market strategy of being all things to all people is exposing it to disruption. The company is losing market share, especially among younger customers, to newcomers in the space like On and Hoka, and among runners (Nike's original core market) to older companies like New Balance that have rediscovered their mojo. Third, in an age where celebrities come with problems, and politics divides us on even the most trivial of issues, Nike's celebrity-driven advertising campaigns may hurt more than help the company. In short, Nike's new CEO has his work cut out for him!

YouTube Video

Links

1. Coca Cola - Intrinsic Valuation in September 2024
2. Nike - Intrinsic Valuation in September 2024
3. Operating Metrics by Industry group, with distributions (Quartiles and Median)  

 

 

Fed up with Fed Talk? Fact-checking Central Banking Fairy Tales!

     The big story on Wednesday, September 18, was that the Federal Reserve’s open market committee finally got around to “cutting rates”, and doing so by more than expected. This action, much debated and discussed during all of 2024, was greeted as "big" news, and market prognosticators argued that it was a harbinger of market moves, both in interest rates and stock prices. The market seemed to initially be disappointed in the action, dropping after the Fed’s announcement on Wednesday, but it did climb on Thursday. Overall, though, and this is my view, this was about as anticlimactic as a climactic event gets, akin to watching an elephant in labor deliver a mouse.  As a long-time skeptic about the Fed’s (or any Central Bank’s) capacity to alter much in markets or the economy, I decided now would be as good a time as any to confront some widely held beliefs about central banking powers, and counter them with data. In particular, I want to start with the myth that central banks set interest rates, or at least the interest rates that you and I may face in our day-to-day lives, move on to the slightly lesser myth that the Fed's move lead market interest rates, then examine the signals that emanate supposedly from Fed actions, and finish off by evaluating how the Fed's actions affect stock prices.

The Fed as Rate Setter

      As I drove to the grocery story on Fed Cut Wednesday, I had the radio on, and in the news at the top of the hour, I was told that the Fed had just cut interest rates, and that consumers would soon see lower rates on their mortgages and businesses on their loans. That delusion is not restricted to newscasters, since it seems to be widely held among politicians, economists and even market watchers. The truth, though, is that the Fed sets only one interest rate, the Fed Funds rate, and that none of the rates that we face in our lives, either as consumers (on mortgages, credit cards or fixed deposits) or businesses (business loans and bonds),  are set by or even indexed to the Fed Funds Rate. 

    The place to start to dispel the “Fed sets rates” myth is with an understanding of the Fed Funds rate, an overnight intra-bank borrowing rate is one that most of us will never ever encounter in our lives. The Federal Open Market Committee (FOMC) has the power to change this rate, which it uses at irregular intervals, in response to economic, market and political developments. The table below lists the rate changes made by the Fed in this century:

Note that while most of these changes were made at regularly scheduled meetings, a few (eleven in the last three decades) were made at emergency meetings, called in response to market crises. As you can see from this table, the Federal Reserve goes through periods of Fed Funds rate activism, interspersed with periods of inactivity. Since the Fed Funds rate is specified as a range, there are periods where the effective Fed Funds rate may go up or down, albeit within small bounds. To gain perspective on how the Fed Funds rate has been changed over time, consider the following graph, where the effective fed funds rate is shown from 1954 to 2024:

Download data

In addition to revealing how much the Fed Funds rate has varied over time, there are two periods that stand out. The first is the spike in the Fed Funds rate to more than 20% between 1979 and 1982, when Paul Volcker was Fed Chair, and represented his attempt to break the cycle of high inflation that had entrapped the US economy. The second was the drop in the Fed Funds rate to close to zero percent, first after the 2008 crisis and then again after the COVID shock in the first quarter of 2020. In fact, coming into 2022, the Fed had kept the Fed Funds rates at or near zero for most of the previous 14 years, making the surge in rates in 2022, in response to inflation, shock therapy for markets unused to a rate-raising Fed.

    While the Federal Open Market Committee controls the Fed Funds rate, there are a whole host of rates set by buyer and sellers in bond markets. These rates are dynamic and volatile, and you can see them play out in the movements of US treasury rates (with the 3-month and 10-year rates highlighted) and in corporate bond rates (with the Baa corporate bond rate shown).

Download data

There is a final set of rates, set by institutions, and sometimes indexed to market-set rates, and these are the rates that consumers are most likely to confront in their day-to-day lives. They include mortgage rates, set by lenders, credit card rates, specified by the credit card issuers, and fixed deposit rates on safety deposits at banks.  They are not as dynamic as market-set rates, but they change more often than the Fed Funds rate.

Download data

There are undoubtedly other interest rates you will encounter, as a consumer or a business, either in the course of borrowing money or investing it, but all of these rates will fall into one of three buckets - market-set interest rates, rates indexed to market-set rates and institutionally-set rates. None of these rates are set by the Federal Reserve, thus rendering the "Fed sets interest rates" as myth.

Response to comments: It is true that the prime rate remains one of the few that is tied to the Fed Funds rate, and that there is subset of business loans, whose rates are tied to the prime rate. That said, the portion of overall business debt that is tied to the prime rate has declined significantly over time, as variable rate loans have switched to treasury rates as indices, because they tend to be updated and dynamic. It is also true that central-bank set rates can affect a larger subset of rates in some countries, for one of two reasons. The first is that the country has poorly functioning or no bond markets, making market-set rates a non-starter. The second is if the government or central bank can force banks to lend at rates tied to the central bank rate. In both cases, though, the central banking power works only if it is restrained by reality, i.e., the central bank rate reflects the inflation and real growth in the economy. Thus, if inflation is 20%, a central bank that forces lenders to lend at 12% will accomplish one of two objectives - driving lending banks to calamity or drying up the market for business loans.

The Fed as Rate Leader

    Even if you accept that the Fed does not set the interest rates that we face as consumers and businesses, you may still believe that the Fed influences these rates with changes it makes to the Fed Funds rate. Thus, you are arguing that a rise (fall) in the Fed Funds rate can trigger subsequent rises (falls) in both market-set and institution-set rates. At least superficially, this hypothesis is backed up in the chart below, where I brings all the rates together into one figure:

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As you can see, the rates all seem to move in sync, though market-set rates move more than institution-set rates, which, in turn, are more volatile than the Fed Funds rate. The reason that this is a superficial test is because these rates all move contemporaneously, and there is nothing in this graph that supports the notion that it is the Fed that is leading the change. In fact, it is entirely possible, perhaps even plausible, that the Fed's actions on the Fed Funds rate are in response to changes in market rates, rather than the other way around.

    To test whether changes in the Fed Funds rate are a precursor for shifts in market interest rates, I ran a simple (perhaps even simplistic) test. I looked at the 249 quarters that compose the 1962- 2024 time period, breaking down each quarter into whether the effective Fed Funds rate increased, decreased or remained unchanged during the quarter. I followed up by looking at the change in the 3-month and 10-year US treasury rates in the following quarter:

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Looking at the key distributional metrics (the first quartile, the median, the third quartile), it seems undeniable that the "Fed as leader" hypothesis falls apart. In fact, in the quarters after the  Fed Funds rate increases, US treasury rates (short and long term) are more likely to decrease than increase, and the median change in rates is negative. In contrast, in the periods after the Fed Fund decreases, treasury rates are more likely to increase than decrease, and post small median increases. 

    Expanding this assessment to the interest rates that consumers face, and in particular mortgage rates at which they borrow and fixed deposit rates at which they can invest, the results are just as stark.

Download data

In the quarter after the Fed Funds rate increase, mortgage rates and fixed deposit rates are more likely to fall than rise, with the median change in the 15-year mortgage rate being -0.13% and the median change in the fixed deposit rate at -0.05%. In the quarter after the Fed Funds rate decreases, the mortgage rate does drop, but by less than it did during the Fed rate raising quarters. In short, those of us expecting our mortgage rates to decline in the next few months, just because the Fed lowered rates on Wednesday, are being set up for disappointment. If you are wondering why I did not check to see what credit card interest rates do in response to Fed Funds rate changes, even a casual perusal of those rates suggests that they are unmoored from any market numbers.

    You may still be skeptical about my argument that the Fed is more follower than leader, when it comes to interest rates. After all, you may say, how else can you explain why interest rates remained low for the last decades, other than the Fed? The answer is recognizing that market-set rates ultimately are composed of two elements: an expected inflation rate and an expected real interest rate, reflecting real economic growth. In the graph below, which I have used multiple times in prior posts, I compute an intrinsic risk free rate by just adding inflation rate and real GDP growth each year:

Download data

Interest rates were low in the last decade primarily because inflation stayed low (the lowest inflation decade in a century) and real growth was anemic. Interest rates rose in 2022, because inflation made a come back, and the Fed scrambled to catch up to markets, and most interesting, interest are down this year, because inflation is down and real growth has dropped. As you can see, in September 2024, the intrinsic riskfree rate is still higher than the 10-year treasury bond rate, suggesting that there will be no precipitous drop in interest rates in the coming months.

Response to comments: Some readers are suggesting a plausible, albeit convoluted, rationale for this result that preserves the Fed Delusion. In a version of 4D chess, they argue that investors in bond markets are largely in the business of forecasting what the Fed will do and that market rates move ahead of Fed actions. Besides being extraordinarily unhealthy for bond investing, if this is in fact what it is happening, there are four problems with this reasoning, First, bond markets pre-date central banks setting rates, and they seemed to do a reasonably good job before the Fed Funds rate was around. In fact, I started in investing in the 1980s, when the Fed went into hibernation on the Fed Funds rate, and trust me when I say the bond market did not miss a beat. Second, if the entire point of bond investing is forecasting what the Fed will do, how would you explain the rise in treasury bill and bond rates in the first half of 2024 (just to give one instance), when all the talk was about the Fed cutting rates, not raising them? Third, if bond markets exist to bet on Fed movements, when the Fed moves unexpectedly (by raising or lowering rates more than expected), there should be an immediate adjustment in the bond market? Thus, last week, when the consensus was that a 25 basis point cut was more likely than a 50 basis point one, there should be have a significant drop in treasury rates in the days after, and there was not. 

The Fed as Signalman

    If you are willing to accept that the Fed does not set rates, and that it does not lead the market on interest rates, you may still argue that Fed rate changes convey information to markets, leading them to reprice bonds and stocks. That argument is built on the fact that the Fed has access to data about the economy that the rest of us don't have, and that its actions tell you implicitly what it is seeing in that data. 

    It is undeniable that the Federal Reserve, with its twelve regional districts acting as outposts, collects information about the economy that become an input into its decision making. Thus, the argument that Fed actions send signals to the markets has basis, but signaling arguments come with a caveat, which is that the signals can be tough to gauge. In particular, there are two major macroeconomic dimensions on which the Fed collects data, with the first being real economic growth (how robust it is, and whether there are changes happening) and inflation (how high it is and whether it too is changing). The Fed's major signaling device remains the changes in the Fed Funds rate, and it is worth pondering what the signal the Fed is sending when it raises or lowers the Fed Funds rate. On the inflation front, an increase or decrease in the Fed Funds rate can be viewed as a signal that the Fed sees inflationary pressures picking up, with an increase, or declining, with a decrease. On the economic growth front, an increase or decrease in the Fed Funds rate, can be viewed as a signal that the Fed sees the economy growing too fast, with an increase, or slowing down too much, with a decrease. These signals get amplified with the size of the cut, with larger cuts representing bigger signals.

    Viewed through this mix, you can see that there are two contrary reads of the Fed Funds rate cut of 50 basis points on Wednesdays. If you are an optimist, you could take the action to mean that the Fed is finally convinced that inflation has been vanquished, and that lower inflation is here to stay. If you are a pessimist, the fact that it was a fifty basis point decrease, rather than the expected twenty five basis points, can be construed as a sign that the Fed is seeing more worrying signs of an economic slowdown than have shown up in the public data on employment and growth. There is of course the cynical third perspective, which is that the Fed rate cut has little to do with inflation and real growth, and more to do with an election that is less than fifty days away. In sum, signaling stories are alluring, and you will hear them in the coming days, from all sides of the spectrum (optimists, pessimists and cynics), but the truth lies in  the middle, where this rate cut is good news, bad news and no news at the same time, albeit to different groups.

Response to comments: Fed rate change signals, as I mentioned, are tough to read. If you have strong priors on the Fed having power to drive markets, you can always the benefit of hindsight to bend the signal to match your priors. 

The Fed as Equity Market Whisperer

    It is entirely possible that you are with me so far, in my arguments that the Fed's capacity to influence the interest rates that matter is limited, but you may still hold on to the belief that the Fed's actions have consequences for stock returns. In fact, Wall Street has its share of investing mantras, including "Don't fight the Fed", where the implicit argument is that the direction of the stock market can be altered by Fed actions. 

    There is some basis for this argument, and especially during market crises, where timely actions by the Fed may alter market mood and momentum. During the COVID crisis, I complimented the Fed for playing its cards right, especially so towards the end of March 2020, when markets were melting down, and argued that one reason that market came back as quickly as they did was because of the Fed. That said, it was not so much the 100 basis point drop in the Fed Funds rate that turned the tide, but the accompanying message that the Federal Reserve would become a backstop for lenders to companies that were rocked by the COVID shutdown, and were teetering on the edge. While the Fed did not have to commit much in capital to back up this pledge, that decision seemed to provide enough reassurance to lenders and prevent a host of bankruptcies at the time.

    If you remove the Fed's role in crisis, and focus on the effects of just its actions on the Fed Funds rate, the effect of the Fed on equity market becomes murkier. I extended the analysis that I did with interest rates to stocks, and looked at the change in the S&P 500 in the quarter after Fed Funds rates were increased, decreased or left unchanged:

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The S&P 500 did slightly better in quarters after the Fed Funds rate decreased than when the rate increased, but reserved its best performance for quarters after those where there was no change in the Fed Funds rate. At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.

Response to comments: Here again, the 4D chess argument comes out, where equity markets are so clever and forward-looking, they already incorporate what the Fed will do. Without realizing it, you are making my case that when discussing equity markets and where they will go in the future, we should spend less time talking about what the Fed will do, might do or has not done, since if your premise about markets as forecasting machines is right, it is already in prices.

The Fed as Chanticleer

    If the Fed does not set rates, is not a interest rate driver, sends out murky signals about the economy and has little effect on how stocks move, you are probably wondering why we have central banks in the first place. To answer, I am going to digress, and repeat an ancient story about Chanticleer, a rooster that was anointed the ruler of the farmyard that he lived in, because the other barnyard animals believed that it was his crowing every morning that caused the sun to rise, and that without him, they would be destined for a lifetime of darkness. That belief came from the undeniable fact that every morning, Chanticleer's crowing coincided with sun rise and daylight. The story now takes a dark turn, when one day, Chanticleer sleeps in and the sun rises anyway, revealing his absence of power, and he loses his place at the top of the barnyard hierarchy. 

    The Fed (and every other central bank) in my view is like Chanticleer, with investors endowing it with powers to set interest rates and drive stock prices, since the Fed's actions and market movements seem synchronized. As with Chanticleer, the truth is that the Fed is acting in response to changes in markets rather than driving those actions, and it is thus more follower than leader. That said, there is the very real possibility that the Fed may start to believe its own hype, and that hubristic central bankers may decide that they set rates and drive stock markets, rather than the other way around. That would be disastrous, since the power of the Fed comes from the perception that it has power, and an over reach can lay bare the truth. 

Response to comments: My comments about the Fed being Chanticleer have been misread by some to imply that central banks do not matter, and Turkey (the country, not the Thanksgiving bird) seems to constantly come up constantly as an example of why central banks matter. Again, you are making my case for me. There is nothing more dangerous to an economy than a central bank that thinks it has the power to override fundamentals and impose its preferred interest rates in the economy. The Turkish central bank, perhaps driven by politics, seems to think that the solution to high interest rates (which are being driven by inflation) is to lower the rates that it controls. Not surprisingly, those actions increase expected inflation, and drive rates higher.... (see definition of insanity..)

Conclusion

    I know that this post cuts against the grain, since the notion that the Fed has superpowers has only become stronger over the last two decades. Pushed to explain why interest rates were at historic lows for much of the last decade, the response you often heard was "the Fed did it". Active investors, when asked why active investing had its worst decade in history, losing out to index funds and to passive investors, pointed fingers at the Fed. Market timers, who had built their reputations around using metrics like the Shiller PE, defended their failure to call market moves in the last fifteen years, by pointing to the Fed. Economists who argued that inverted yield curves were a surefire predictor of recessions blamed the Fed for the absence of a recession, after years of two years plus of the phenomena. 

    I believe that it is time for us to put the Fed delusion to rest. It has distracted us from talking about things that truly matter, which include growing government debt, inflation, growth and how globalization may be feeding into risk, and allowed us to believe that central bankers have the power to rescue us from whatever mistakes we may be making. I am a realist, though, and I am afraid that the Fed Delusion has destroyed enough investing brain cells, that those who holding on to the delusion cannot let go. I am already hearing talk among this group about what the FOMC may or may not do at its next meeting (and the meeting after that), and what this may mean for markets, restarting the Fed Watch. The insanity of it all! 

YouTube Video

Data

1. Fed Funds Rates, Treasury Rates and Other Market Interest rates - Historical
2. Intrinsic treasury bond rates

Dealing with Aging: Updating the Intel, Walgreens and Starbucks Stories!

      A few weeks ago, I posted on the corporate life cycle, the subject of my latest book. I argued that the corporate life cycle can explain what happens to companies as they age, and why they  have to adapt to aging with their actions and choices. In parallel, I also noted that investors have to change the way they value and price companies, to reflect where they are in the life cycle, and how different investment philosophies lead you to concentrated picks in different phases of the life cycle. In the closing section, I contended that managing and investing in companies becomes most difficult when companies enter the last phases of their life cycles, with revenues stagnating or even declining and margins under pressure. While consultants, bankers and even some investors push companies to reinvent themselves, and find growth again, the truth is that for most companies, the best pathway, when facing aging, is to accept decline, shrink and even shut down. In this post, I will look at three high profile companies, Intel, Starbucks and Walgreens, that have seen market turmoil and management change, and examine what the options are for the future.

Setting the stage

    The three companies that I  picked for this post on decline present very different portraits. Intel was a tech superstar not that long ago, a company founded by Gordon Moore, Robert Noyce and Arthur Rock in 1968, whose computer chips have helped create the tech revolution. Walgreens is an American institution, founded in Chicago in 1901, and after its merger with Alliance Boots in 2014, one of the largest pharmacy chains in the country.  Finally, Starbucks, which was born in 1971 as a coffee bean wholesaler in Pike Place Market in Seattle, was converted into a coffee shop chain by Howard Schultz, and to the dismay of Italians, has redefined espresso drinks around the world. While they are in very different businesses, what they share in common is that over the recent year or two, they have all not only lost favor in financial markets, but have also seen their business models come under threat, with their operating metrics (revenue growth, margins) reflecting that threat.

The Market turns

    With hundreds of stocks listed and traded in the market, why am I paying attention to these three? First, the companies are familiar names. Our personal computes are often Intel-chip powered, there is a Walgreen's a few blocks from my home, and all of us have a Starbucks around the corner from where we live and work. Second, they have all been in the news in the last few weeks, with Starbucks getting a new CEO, Walgreens announcing that they will be shutting down hundreds of their stores and Intel coming up in the Nvidia conversation, often as a contrast. Third, they have all seen the market turn against them, though Starbucks has had a comeback after its new CEO hire.

None of the three stocks has been a winner over the last five years, but the decline in Intel and Walgreen's has been precipitous, especially int he last three years. That decline has drawn the usual suspects. On  the one hand are the knee-jerk contrarians, to whom a drop of this magnitude is always an opportunity to buy, and on the other are the apocalyptists, where large price declines almost always end in demise. I am not a fan of either extreme, but it is undeniable that both groups will be right on some stocks, and wrong on others, and the only way to tell the difference is to look at each of the companies in more depth.

A Tech Star Stumbles: Intel’s Endgame

    In my book on corporate life cycles, I noted that even superstar companies age and lose their luster, and Intel could be a case study. The company is fifty six years old (it was founded in 1968) and the question is whether its best years are behind it. In fact, the company's growth in the 1990s to reach the peak of the semiconductor business is the stuff of case studies, and it stayed at the top for longer than most of its tech contemporaries. Intel's CEO for  its glory years was Andy Grove, who joined the company on its date of incorporation in 1968, and stayed on to become chairman and CEO before stepping down in 1998. He argued for constant experimentation and adaptive leadership, and the title of his book, "Only the Paranoid Survive", captured his management ethos. 

    To get a measure of why Intel's fortunes have changed in the last decade, it is worth looking at its key operating metrics - revenues, gross income and operating income - over time:

As you can see in this graph, Intel's current troubles did not occur overnight, and its change over time is almost textbook corporate life cycle. As Intel has scaled up as a company, its revenue growth has slackened and its growth rate in the last decade (2012-21) is more reflective of a mature company than a growth company. That said, it was a healthy and profitable company during that decade, with solid unit economics (as reflected in its high gross margin) and profitability (its operating margin was higher in the last decade than in prior periods). In the last three years, though, the bottom seems to fallen out of Intel's business model, as revenues have shrunk and margins have collapsed. The market has responded accordingly, and Intel, which stood at the top of the semiconductor business, in terms of market capitalization for almost three decades, has dropped off the list of top ten semiconductor companies in 2024, in market cap terms:

Intel's troubles cannot be blamed on industry-wide issues, since Intel's decline has occurred at the same time  (2022-2024) as the cumulative market capitalization of semiconductor companies has risen, and one of its peer group (Nvidia) has carried the market to new heights. 

    Before you blame the management of Intel for not trying hard enough to stop its decline, it is worth noting that if anything, they have been trying too hard. In the last few years, Intel has invested massive amounts into its chip manufacturing business (Intel Foundry), trying to compete with TSMC, and almost as much into its new generation of AI chips, hoping to claim market share of the fastest growing markets for AI chips from Nvidia. In fact, a benign assessment of Intel would be that they are making the right moves, but that these moves will take time to pay off, and that the market is being impatient. A not-so-benign reading is that the market does not believe that Intel can compete effectively against either TSMC (on chip manufacture) or Nvidia (on AI chip design), and that the money spent on both endeavors will be wasted. The latter group is clearly winning out in markets, at the moment, but as I will argue in the next section, the question of whether Intel is a good investment at its current depressed price may rest in which group you think has right on its side.

Drugstore Blues: Walgreen Wobbles

    From humble beginnings in Chicago, Walgreen has grown to become a key part of the US health care system as a dispenser of pharmacy drugs and products. The company went public in 1927, and in the century since, the company has acquired the characteristics of a mature company, with growth spurts along the way. Its acquisition of a significant stake in Alliance Boots gave it a larger global presence, albeit at a high price, with the acquisition costing $15.3 billion. Again, to understand, Walgreen's current position, we looked at the company's operating history by looking revenue growth and profit margins over time:

After double digit growth from 1994 to 2011, the company has struggled to grow in a business, with daunting unit economics and slim operating margins, and the last three years have only seen things worsen on all fronts, with revenue growth down, and margins slipping further, below the Maginot line; with an 1.88% operating margin, it is impossible to generate enough to cover interest expenses and taxes, thus triggering distress.

    While management decisions have clearly contributed to the problems, it is also true that the pharmacy business, which forms Walgreen's core, has deteriorated over the last two years, and that can be seen by comparing its market performance to CVS, its highest profile competitor. 

As you can see, both CVS and Walgreens have seen their market capitalizations drop since mid-2022, but the decline in Walgreens has been far more precipitous than at CVS; Walgreens whose market cap exceeded that of CVS in 2016 currently has one tenth of the market capitalization of CVS. In response to the slowing down of the pharmacy business, Walgreens has tried to find a pathway back to growth, albeit with acquired growth. A new CEO, Roz Brewer, was brought into the company in 2021, from Sam's Club, and wagered the company's future on acquisitions, buying four companies in 2021, with a majority stake in Village MD, a chain of doctor practices and clinics, representing the biggest one. That acquisition, which cost Walgreens $5.2 billion, has been more cash drain than flow, and in 2024, Ms. Brewer was replaced as CEO by Tim Wentworth, and Village MD scaled back its growth plans.

Venti no more The Humbling of Starbucks

    On my last visit to Italy, I did make frequent stops at local cafes, to get my espresso shots, and I can say with confidence that none of them had a  caramel macchiato or  an iced brown sugar oatmilk shaken espresso on the menu. Much as we make fun of the myriad offerings at Starbucks, it is undeniable that the company has found a way into the daily lives of many people, whose day cannot begin without their favorite Starbucks drink in hand. Early on, Starbucks eased the process by opening more and more stores, often within blocks of each other, and more recently, by offering online ordering and pick up, with rewards supercharging the process. Howard Schultz, who nursed the company from a single store front in Seattle to an ubiquitous presence across America, was CEO of the company from 1986, and while he retired from the position in 2000, he returned from 2008 to 2017, to restore the company after the financial crisis, and again from 2022 to 2023, as an interim CEO to bridge the gap between the retirement of Kevin Johnson in 2022 and the hiring of Laxman Narasimhan in 2023. To get a measure of how Starbucks has evolved over time, I looked the revenues and margins at the company, over time:

Unlike Intel and Walgreens, where the aging pattern (of slowing growth and steadying margins) is clearly visible, Starbucks is a tougher case. Revenue growth at Starbucks has slackened over time, but it has remained robust even in the most recent period (2022-2024). Profit margins have actually improved over time, and are much higher than they were in the first two decades of the company's existence. One reason for improving profitability is that the company has become more cautious about store openings, at least in the United States, and sales have increased on a per-store basis:

In fact, the shift towards online ordering has accelerated this trend, since there is less need for expansive store locations, if a third or more of sales come from customers ordering online, and picking up their orders. In short, these graphs suggest that it is unfair to lump Starbuck with Intel and Walgreens, since its struggles are more reflecting of a growth company facing middle age.

    So, why the market angst? The first is that there are some Starbucks investors who continue to hold on to the hope that the company will be able to return to double digit growth, and the only pathway to get there requires that Starbucks be able to succeed in China and India. However, Starbucks has had trouble in China competing with domestic lower-priced competitors (Luckin' Coffee and others), and there are restrictions on what Starbucks can do with its joint venture with the Tata Group in India. The second problem is that the narrative for the company, that Howard Schultz sold the market on, where coffee shops become a gathering spot for friends and acquaintances, has broken down, partly because of the success of its online ordering expansion. The third problem is that inflation in product and employee costs has made its products expensive, leading to less spending even from its most loyal customers.

A Life Cycle Perspective

    It is undeniable that Intel and Walgreens  are in trouble, not just with markets but operationally, and Starbucks is struggling with its story line. However, they face different challenges, and perhaps different pathways going forward. To make that assessment, I will more use my corporate life cycle framework, with a special emphasis on the the choices that agin companies face, with determinants on what should drive those choices.

The Corporate Life Cycle

    I won't bore you with the details, but the corporate life cycle resembles the human life cycle, with start-ups (as babies), very young companies (as toddlers), high growth companies (as teenagers) moving on to mature companies (in middle age) and old companies facing decline and demise:

The phase of the life cycle that this post is focused on is the last one, and as we will see in the next section, it is the most difficult one to navigate, partly because shrinking as a firm is viewed as failure., and that lesson gets reinforced in business schools and books about business success. I have argued that more money is wasted by companies refusing to act their age, and much of that waste occurs in the decline phase, as companies desperately try to find their way back to their youth, and bankers and consultants egg them on.

The Choices

    There is no more difficult phase of a company's life to navigate than decline, since you are often faced with unappetizing choices. Given how badly we (as human beings) face aging, it should come as no surprise that companies (which are entities still run by human beings) also fight aging, often in destructive ways. In this section, I will start with what I believe are the most destructive choices made by declining firms, move on to a middling choice (where there is a possibility of success) before examining the most constructive responses to aging.

a. Destructive 

1. Denial: When management of a declining business is in denial about its problems, attributing the decline in revenues and profit margins to extraordinary circumstances, macro developments or bad luck, it will act accordingly, staying with existing practices on investing, financing and dividends. If that management stays in place, the truth will eventually catch up with the company, but not before more money has been sunk into a bad business that is un-investable. 
2. Desperation: Management may be aware that their business is in decline, but it may be incentivized, by money or fame, to make big bets (acquisitions, for example), with low odds, hoping for a hit. While the owners of these businesses lose much of the time, the managers who get hits become superstars (and get labeled as turnaround specialists) and increase their earning power, perhaps at other firms.
3. Survival at any cost: In some declining businesses, top managers believe that it is corporate survival that should be given priority over corporate health, and they act accordingly. In the process, they create zombie or walking dead companies that survive, but as bad businesses that shed value over time.

b. It depends

1. Me-too-ism: In this choice, management starts with awareness that their existing business model has run out of fuel and faces decline, but believe that a pathway exists back to health (and perhaps even growth) if they can imitate the more successful players in their peer groups. Consequently, their investments will be directed towards the markets or products where success has been found (albeit by others), and financing and cash return policies will follow. Many firms adopt this strategy find themselves at a disadvantage, since they are late to the party, and the winners often have moats that are difficult to broach or a head start that cannot be overcome. For a few firms, imitation does provide a respite and at least a temporary return to mature growth, if not high growth.

c. Constructive

1. Acceptance: Some firms accept that their business is in decline and that reversing that decline is either impossible to do or will cost too much capital. They follow up by divesting poor-performing assets, spinning off or splitting off their better-performing businesses, paying down debt and returning more cash to the owners. If they can, they settle in on being smaller firms that can continue to operate in subparts of their old business, where they can still create value, and if this is not possible, they will liquidate and go out of business.
2. Renewals and Revamps: In a renewal (where a company spruces up its existing products to appeal to a larger market) or a revamp (where it adds to its products and service offering to make them more appealing), the hope is that the market is large enough to allow for a return to steady growth and profitability. To pull this off, managers have to be clear eyed about what they offer customers, and recognize that they cannot abandon or neglect their existing customer base in their zeal to find new ones.
3. Rebirths: This is perhaps every declining company's dream, where you can find a new market or product that will reset where the company in the life cycle. This pitch is powered by case studies of companies that have succeeded in pulling off this feat (Apple with the iPhone, Microsoft with Azure), but these successes are rare and difficult to replicate. While one can point to common features including visionary management and organic growth (where the new business is built within the company rather than acquired), there is a strong element of luck even in the success stories.

The Determinants

    Clearly, not all declining companies adopt the same pathway, when faced with decline, and more companies, in my view, take the destructive paths than the constructive one. To understand why and how declining companies choose to do what they do, you may want to consider the following:

1. The Business: A declining company in an otherwise healthy industry or market has better odds for survival and recovery than one that is in a declining industry or bad business. With the three companies in our discussion, Intel's troubles make it an outlier in an otherwise healthy and profitable business (semiconductors), whereas Walgreens operates in a business (brick and mortar retail and pharmacy) that is wounded. Finally, the challenges that Starbucks faces of a saturated market and changing customer demands is common to large restaurants in the United States.
2. Company's strengths: A company that is in decline may have fewer moats than it used to, but it can still hold on to its remaining strengths that draw on them to fight decline. Thus, Intel, in spite of its troubles in recent years, has technological strengths (people, patents) that may be under utilized right now, and if redirected, could add value. Starbucks remains among the most recognized restaurant brands in the world, but Walgreens in spite of its ubiquity in the United States, has almost no differentiating advantages.
3. Governance: The decisions on what a declining firm should do, in the face of decline, are not made by its owners, but by its managers. If managers have enough skin in the game, i.e., equity stakes in the company, their decisions will be often very different than if they do not. In fact, in many companies with dispersed shareholding, management incentives (on compensation and recognition) encourage decision makers to go for long-shot bets, since they benefit significantly (personally) if these bets pay off and the downside is funded by other people's money. 
4. Investors: With publicly traded companies, it is the investors who ultimately become the wild card, determining time horizon and feasible options for the company. To the extent that the investors in a declining company want quick payoffs, there will be pressure for companies to accept aging, and shrink or liquidate; that is what private equity investors with enough clout bring to the table. In contrast, if the investors in a declining company have much longer time horizons and see benefits from a turnaround, you are more likely to see revamps and renewals. All three of the companies in our mix are institutionally held, and even at Starbucks, Howard Schultz owns less than 2% of the shares. and his influence comes more from his standing as founder and visionary than from his shareholding.
5. External factors: Companies do not operate in vacuums, and capital markets and governments can become determinants of what they do, when faced with decline. In general, companies that operate in liquid capital markets, where there are multiple paths to raise capital, have more options than companies than operate in markets where capital is scare or difficult to raise. Governments too can play a role, as we saw in the aftermath of the 2008 crisis, when help (and funding) flowed to companies that were too large to fail, and that we see continually in businesses like the airlines, where even the most damaged airline companies are allowed to limp along.
6. Luck: Much as we would like to believe that our fates are in our own hands, the truth is that even the best-thought through response to decline needs a hefty dose of luck to succeed. 

    In the figure below, I summarize the discussion from this section, looking at both the choices that companies can make, and the determinants:

With this framework in place, I am going to try to make my best judgments (which you may disagree with) on what the three companies highlighted in this post should do, and how they will play out for me, as an investor:

1. Intel: It is my view that Intel's problems stem largely from too much me-too-ism and aspiring for growth levels that they cannot reach. On both Ai and the chip manufacturing business, Intel is going up against competition (Nvidia on AI and TSMC on manufacturing) that has a clear lead and significant competitive advantages. However, the market is large enough and has sufficient growth for Intel to find a place in both, but not as a leader. For a company that is used to being at the top of the leaderboard, that will be a step down, but less ambition and more focus is what fits the company, at this stage in the life cycle. It is likely that even if it succeeds, Intel will revert to middle age, not high growth, but that should still make it a good investment. In the table below, you can see that at its prevailing stock price of $18.89 (on Sept 8, 2024), all you need is a reversion back towards more normal margins for the price to be justified:

   

   Download Intel valuation

   With 3% growth and 25% operating margins, Intel's value per share is already at $23.70 and any success that the company is in the AI chip market or benefits it derives from the CHIPs act, from federal largesse, are icing on the cake. I do believe that Intel will derive some payoff from both, and I am buying Intel, to twin with what is left of my Nvidia investment from six years ago.
2. Walgreens: For Walgreens, the options are dwindling, as its core businesses face challenges. That said, and even with its store closures, Walgreens remains the second largest drugstore chain in the United States, after CVS. Shrinking its presence to its most productive stores and shedding the rest may be the pathway to survival, but the company will have to figure out a way to bring down its debt proportionately. There is the risk that a macro slowdown or a capital market shock, causing default risk and spreads to widen, could wipe out equity investors. With all of that said, and building in a risk of failure to the assessment, I estimated the value per share under different growth and profitability assumptions: 

   

   Download Walgreens valuation

   The valuation pivots entirely on whether operating margins improve to historical levels, with margins of 4% or higher translating into values per share that exceed the stock price. I believe that the pharmacy business is ripe for disruption, and that the margins will not revert back to pre-2021 levels, making Walgreens a "no go" for me.
   
3. Starbucks: Starbucks is the outlier among the three companies, insofar as its revenue growth is still robust and it remains a money-making firm. Its biggest problem is that it has lost its story line, and it needs to rediscover a narrative that can not only give investors a sense of where it is going, but will redirect how it is managed. As I noted in my post on corporate life cycle, story telling requires visionaries, and in the case of Starbucks, that visionary also has to understand the logistical challenges of running coffee shops. I do not know enough about Brian Niccol to determine whether he fits the bill. As someone who led Taco Bell and Chipotle, I think that he can get the second part (understanding restaurant logistics) nailed down, but is he a visionary? He might be, but visionary CEOs generally do not live a thousand miles from corporate headquarters, and fly corporate jets to work part time at their jobs, and Niccol has provided no sense of what he sees as the new Starbucks narrative yet. For the moment, thought, there seems to be euphoria in the market that change is coming, though no one seems clear on what that change is, and the stock price has almost fully recovered from its swoon to reach $91 on September 8, 2024. That price is well above any value per share that I can get for the company, even assuming that they go back to historic norms:
   
   I must be missing some of the Starbucks magic that investors are seeing, since there is no combination of historical growth/margins that gets me close to the current stock price. In fact, the only way my value per share reaches current pricing levels is if I see the company maintaining its revenue growth rates from 2002-2011, while delivering the much higher operating margins that it earned between 2012-2021. That, to me, is a bridge too far to cross.

The Endgame

    There is a reason that so many people want to be entrepreneurs and start new businesses. Notwithstanding the high mortality rate, building a new business is exciting and, if successful, hugely rewarding. A healthy economy will encourage entrepreneurship, providing risk capital and not tilting the playing field towards established players; it remains the strongest advantage that the United States has over much of the rest of the world. However, it is also true that the measure of a healthy economy is in how it deals with declining businesses and firms. If as Joseph Schumpeter put it, capitalism is all about creative destruction, it follows that companies, which are after all legal entities that operate businesses, should fade away as the reasons for their existence fade. That is one reason I critique the entire notion of corporate sustainability (as opposed to planet sustainability), since keeping declining companies alive, and supplying them with additional capital, redirects that capital away from firms that could do far more good (for the economy and society) with that capital.

    If there is a subtext to this post, it is that we need a healthier framing of corporate decline, as inevitable at all firms, at some stage in their life cycle, rather than something that should be fought. In business schools and books, we need to highlight not just the empire builders and the company saviors, i.e., CEOs who rescued failing companies and made their companies bigger, but the empire shrinkers, i.e., CEOs who are brought into declining firms, who preside over an orderly (and value adding) shrinkage or breaking of their firms. In investing, it is true that the glory gets reserved for the Mag Seven and the FANGAM stocks, companies that seem to have found the magic to keep growing even as they scale up, but we should also pay attention to companies that find their way to deliver value for shareholders in bad businesses. 

YouTube Video

Links

1. Corporate Life Cycle (my blog post)
2. Corporate Life Cycle (my book)

Valuations

1. Intel in September 2024
2. Walgreens in September 2024
3. Starbucks in September 2024