Monster Beverage- Quantifying Price of Growth

Monster Beverage Corporation (MNST) develops, markets, sells and distributes alternative beverage, such as non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, single-serve juices and fruit beverages, ready-to-drink dairy and coffee drinks, energy drinks, sports drinks, and single-serve still water (flavored and unflavored) with beverages, including sodas that are considered natural, sparkling juices and flavored sparkling beverages. Company markets its products through retail chains, club stores and specialty stores using exclusive distributor network. 

Energy drinks and shots represent small portion of non-alcoholic beverage market, this industry has seen tremendous growth since 2008, with total sales in United States close to $13.0 billion dollar presently. This growth has been attained on the backdrop of increased consumer penetration and drop in sales for traditional carbonated soft drinks due to health concerns related with cola products. According to “Energy Drinks and Shots: Market trends in US”, sales for energy drinks & shots is expected grow to $ 21.7 billion dollar supported by improvements in distribution channels and sustained economic growth. Energy drinks market is currently in its infancy and is expected to grow significantly as energy drink usage increases among its target consumers (Source: www.packagedfacts.com). Presently energy drinks account for 78% market share followed by 18% for energy shots and 4% for energy drink mixes.

For the last twelve months, company reported revenues of $2.2 billion, operating income of $552.0 million and net income of $331.0 million or $1.98 earnings per share.  Company has realized huge growth in the past 9 years with revenue growth of 12.7%, operating income & net income growth of 16.8% annually, capturing a market share of 35%. Figure 1 highlights y-o-y growth Monster Beverage has realized since 2004.

Year over Year Growth in Revenues, Operating Income & Net Income for Monster Energy

Monster Beverage has been able to maintain its operating margins and net margins for past several years with only exception of compression in margins during 2008. This supports the fact that company is not growing revenues by compromising on margins.  It competes directly with other energy drink manufacturers such as Red Bull and with big stalwarts like Coca Cola (KO) and Pepsi (PEP) to gain the shelf space at convenience stores. Increased health concerns among consumers with the usage of carbonated soft drinks have worked favorably for Monster’s favor but recent allegations related to safety of its products seems to offset the tail wind it had. Figure 2 compares the operating & the net margins for Monster Beverage against Coca- Cola (KO) and Pepsi (PEP).

As business has grown over the last several years so have the reinvestment requirements – enabling the company to grow its revenues.  Management has been very effective in analyzing industry trends, growth opportunities and making decisions to reinvest. Figure 4 highlights relationship that exists between revenue growth and reinvestment rate (Part of Operating Income after taxes which gets invested back into the business)

Monster Beverage has created a huge brand in the marketplace and is aggressively marketing its products to attract youth to switch from coffee & carbonated soft drinks to energy drinks and turn them into loyal customers of the brand.  Additionally it is expanding internationally with sales growing in Europe, Japan, Middle East, Africa and partnering with industry peers to develop a strong distribution network.  

Valuation of Monster Energy

Growth story for Monster energy moving forward is international expansion but the firm also faces strong competition from Red Bull which already has an established international distribution network. Even though the firm currently enjoys strong brand loyalty, maintaining pricing power at the current margin levels will be a challenge, as reinvestment requirements for expansion of business starts to grow.  Growth in future for this company is where the investors need to realize the risks are and factor them in their valuation methodologies. From a valuation perspective, value generated by growth can be categorized in three categories

1. Growth Rate

Revenue Growth Rate expected for next 5 year is 15.6 %, operating income is expected to grow 16.3% per year for next 5 years.

2. Sustainability of growth

Developing a globally recognized brand and establishing partnerships for scaling up their distribution network provides a strong competitive edge for Monster.

3. Return on capital

Brand loyalty, product mix and appealing marketing campaign has helped the company earn higher returns on capital invested. Median ROIC for Monster Energy since 2004 is 47.9% against cost of capital of 8%. Returns generated over and above the cost of capital reflect quality growth generated and value creation for share holders.   

As an investor we should know how much we are paying for growth in business and should be cautious about paying any premium for lower quality growth. Separating value of assets currently in place from market price helps in determining how much price for growth is built in the stock price. Using a cost of capital of 8% (Beverage Industry –US Average), we can see the value of assets in place, value that growth will add and price we are paying for growth.

As illustrated in the table above, assuming Monster Beverage will only be able to earn its cost of capital; price of growth comes at 3.7 times the value which growth assets will generate. At current price level, market is implying a growth rate of 23% in the operating income for the next 5 years. This level of implied growth rate seems higher than our expectations of growth in operating income but Monster’s ability to generate returns far higher than its cost of capital add value for share holders which needs to be factored in company’s valuation. Price investors pay for growth is a variable that investors should pay close attention to. Using the median ROIC which Monster Beverage since 2004, we come up with value of assets currently in place, value added by future growth, price we are paying for future growth, intrinsic equity & enterprise value of the business. For growth oriented investors, entry price lower than the sum of value of assets & price paid for growth ($62.87) – offers growth at a reasonable price and provides margin of safety as well.

I will publish a follow up article highlighting in detail the inherent business risk for Monster Beverage,  quantify stock price risk with ±1% growth variation , risks reflected in options markets and relationship which exists between business risk, growth risk and options market perceived risk 

Trading Volatility Spread between S&P and Gold Options

There are only predominantly two main topics of discussion floating around financial markets these days- Are we in a bubble ( with S&P at its all time highs) and has the gold  bottomed out at these levels. Arguments can be made to the both sides for both asset classes, but we as traders have to deal with situations we are handed in present and exploit mis-pricing in market place to generate profits. 

I wrote few days back about what I believe drives gold prices from a macro perspective, and what we should be focusing on  moving forward.  If interested you can read the article by clicking the link below 

http://atraderstory.blogspot.com/2013/11/investors-have-always-flocked-to_12.html

As I dug deeper into analysis of gold and equity markets, one thing which struck me quiet interesting was the relationship between implied vol for both asset classes. Interestingly , implied vols for both have historically tracked each other very closely until this relationship got whacked in April this year. Gold volatility (normally  priced cheaper than S&P 500 )exploded to the upside due to sharp moves we saw in gold earlier this year. Currently spread between gold and S&P implied volatility is 5.57 points which is quiet high from a historical perspective. 

Red -30 day Gold Implied Volatility, Blue- 30 day SPX Implied Volatility

Based on realized volatility in both asset classes, I expect realized volatility in Gold to continue the declining trend and expect SPX realized vol to spike up in future. Having said that, this spread can also converge to historical levels with  volatility in gold declining lower than SPX. I want to create a trade structure which takes advantage of this convergence. 

Starting up with Gold,  below is my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  18.3%   
Expected IV 120 day :  18.6%  

Using above stated numbers , I calculated  one standard deviation  of $8,  selected 133 & 115 as price levels  which gold prices should stay with in.  Instead of selling them naked and exposing the position to significant losses, I add hedges to both upside & down side- there by creating a structure similar to iron condors. ( Essentially short gamma, short vega,slightly short delta and positive theta)

Moving to SPX, my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  14.6 %   
Expected IV 120 day :  15.0 %  

Presently  IV 90 & IV 120 for SPX is at 12.65 % & 13.57 % with budget talks and debt deal discussions scheduled to resurface back again in Feb , I expect IV for Feb & March to pick up significantly . Combine this with QE taper you should be strong upside move in volatility

Now putting some perspective of bubble talks we are faced with on a daily basis these days. Well, when every body is talking about a bubble - they last longer than everybody thinks. Secondly if everybody thinks equity markets are in bubble - one would expect smart participants to position themselves accordingly. There is no bidding up of Skew for SPX - which leads me to believe , this market will keep grinding higher until it doesn't. Supporting this bias of mine, I use a prop indicator which I had developed earlier to analyze current momentum of equity prices and understand where we stand 

  
Clearly it seems that we are not yet in ridiculously expensive state.  With this in mind, I want to create a trade structure which will let me enjoy the grind higher and offer me downside protection. In addition , I want to take advantage of theta decay from holidays. Based on  this, I used OTM Feb/March 182 calendars with March  173 puts in ratio. Position is essentially short delta, short gamma , long vega and slightly negative theta . 


How do you manage the risk for this trade. Risk for trade in gold is to the upside move in gold which based on my analysis will come from pick up in inflation  or drop in value of dollar. Both these factors are positive with S&P till the time they de-couple. If rise in gold is  due to liquidity risk in markets, we have sufficient downside protection in  S&P which will help.  Ability to ride the S&P's upside move limits our upside risk in gold. 

Being Yum'mmed !!!

Tracking the order flow in YUM brands

We all are aware of YUM brands, the company which own & operates 3 major fast food chains KFC, Pizza Hut & Taco Bell.  If you want to dig more about this company you should check out the link below

http://finance.yahoo.com/q/pr?s=YUM+Profile

Lately this company has been in news due to slumping sales in China, which contributes almost 40 % to its operating income. Slowing sales can potentially be the result of increased health concerns regarding poultry supply in China and outbreak of Avian flu.

It’s not any analyst report which sparked my attention on YUM, rather a very huge of option trade which went through yesterday (Nov 15^th, 2013) got my attention and made me dig further into it. Part of my home work before trading this name, involves investigating how much growth market is expecting in this company’s stock price. Reverse engineering a DCF model revealed, market is expecting 34.70% growth in operating income over the next 5 years.  Price of current assets in place is only $20.90 and future growth should add $36.50, which puts the enterprise value close to $57.39. Last closing price I checked up was $73.98 – 29% more than enterprise value.   This seems to align well with discussion related to expensive multiple for markets which everybody is discussing these days!!  We‘ll see that later

Second leg of my analysis involves technical review of YUM to understand how it has been behaving lately.

Chart from Think or Swim Platform

Stock has been range bound since April 2012, with 75 ish being the upper bound and 60’ ish level – lower bound.  Long term trend from March 09 lows has been broken and stock is consolidating and even short term trend from earlier this year seem to following the same path as well.

Third leg of my analysis (most crucial to me) - How the implied vol and realized vol have been doing lately. No surprise that with the stock close to all time highs, implied vol currently is at 22th percentile. 30 day historical vol has ranged between 10.9% & 44.4% for the last 4 years and currently is at 28.5%.  I believe current 30 day realized vol still has the movement from earnings release captured and should decline shortly as earning move of 7.25% is priced out of it.

Chart from LiveVol Pro

Here’s a snap shot from order flow from Nov 15^th

Someone structured a big bearish position on this name or is trying to hedge an existing stock position by locking in the gains below 65.  Order flow raised IV for Dec 65’s by 5 points and Jan 65 ‘by 2 points – creating vol difference between the two expiries.  Dec/ Jan Calendar makes perfect sense if you feel  this stock has seen it s high for now and is due for a trip south.

Selling Options Premium in Gold (GLD)

Gold has been a hot topic of discussion among investors & traders lately, supported by media frenzy over how gold as an asset class has done this year . We all have our thoughts on why gold prices tanked and continue to opine on how gold will perform moving forward . Increased volatility in gold prices stretched options premiums as option markets priced in sharp downside moves in gold even though gold is not moving at levels seen during April this year . For those who like to trade options in Gold, you have to put into context how gold has moved historically , how are options currently priced  and take advantage of opportunities which exist.

For an options trader it is extremely critical to have an opinion on direction of volatility in addition to the price of underlying. Chart  displays the realized volatility in gold over a 30 day period for the last  4 years. 30 day realized (historical) volatility currently stands at 16.0%  and it has ranged between 7.5% to 37 % putting it in 50 th percentile.

Let's see how Implied volatility levels are priced across the tenor and what I expect  values of implied vol should be.  We can see front month options are priced fairly and second month ( IV60) options are  priced cheaper than expected- this can be explained by holiday theta effect- as theta during holidays gets decayed out of option prices. What we lack into our current analysis  is our view point on realized volatility. We can clearly see it spiked up-to 36.8% level before it started its slow descent down.
Gold was down almost down by 9.5% on April 14 and since then has been only down by 6.5% . Speed at which gold moved subsided dramatically which is reflected through declining realized volatility levels. My take is gold's realized volatility will continue to decline and will hit single digit levels.This is supported by the fact that market is not expecting QE taper by March now in addition to declining inflation expectation in developed economies.

As I wrote in my previous post, I expect gold prices to continue tracking the price patterns gold exhibited during late 70's and early 80's - making me short term bearish on gold.  I expect gold prices to move down close to 120  with 116 as my limit and upside capped close to 131'ish level. With opinion on price and volatility in place - my inclination is to create a trade structure which is short delta, short gamma and short vega. Positive theta is  a compensation which I am getting paid for being short gamma.

Buying  Feb/March ATM or slightly OTM put calendars financed by Selling Feb Call credit spreads ( in a ratio) offers balanced greeks & good risk reward.   

Gold Analysis

Investors have always flocked to the safety of gold to prevent against inflation, systemic and liquidity risks in global economy.  But what do us as investors do when our safe haven has lost or in the process of losing its appeal as a safe haven.  For a long time investors have presented that gold closely tracks the movement in real interest rates. Here’s chart representing movement of gold prices and real interest rates since 1968.

Historical Perspective on Gold

Indeed we see  a silver line between gold prices and real interest rates – negative real rates cause gold prices to explode to upside . Inflationary shocks of 70’s, declining real rate from 1976 to 1979, caused strong upside move in gold prices which followed move in nominal rates as well. Federal Reserve pursued policies to break the back of inflation from 80’s causing real rates to spike up and gold on a path down. Real rates peaked in 1984 following dual mandate policy of Fed towards price stability and full employment.  

I kept asking myself despite all the economic theories in play why would equity markets rise in lock step with gold (which implies a rising inflation and declining margins for corporations in future) and interest rates.  Analyzing profit margins for American corporations seemed to offer an answer to my curiosity.

Charts above help us in putting the pieces together for solving the mystery of price action between gold, S&P500 & interest rates. We found correlation close to 86 % for S&P500 and Gold with corporate profits. Rising corporate profits imply aggregate demand in the economy & productivity improvements captured in economic growth. This growth leads to investment demand, credit growth and last but not the least  increasing investor expectations for future growth.  These expectations along with economic reality feed on itself – increasing  future inflation expectations & pushing gold prices higher.   Historically there have been periods where  interest rates, gold & equity markets have de-coupled from economic fundamentals, sliding into a state of irrational dis-equilibrium.

Economic fundamentals suggest  rising real interest rates even though indicative of growth can also cause a compression in return on capital for corporations unless the costs are passed on to consumers- which can itself depress the aggregate demand.

Corporate profits tend to peak out before S&P does which supports the diminishing return on capital for American corporations but investors treat it as an isolated event and various  theories are presented such as resiliency  & strength of economy and corporations.  I am a strong believer in resiliency and capability to innovate for American corporations but an investor can not overlook diminishing returns for the businesses. Additionally, as an investor you might not be able to precisely identify state and timing of disequilibrium in an economy but can identify the factors & their causative relationships to dis- equilibrium.    

Where do we stand now?

                We hear & read pretty much on an everyday basis that corporate profits as a percentage of GDP are at record high levels and are unsustainable moving forward. This leads to discussions related to bubbly state of equity markets which are supported by QE steroids, low interest rate etc.  Getting back to the basics - rising real interest rate till the point they de-couple from economic reality for whatever reasons- imply shifting dynamics for increased consumption growth, demand for investment in an economy. It remains to be seen and established if this economic growth leads to an improvement in household’s net worth (Even though Federal Reserve will strongly argue it has created wealth affect with unconventional monetary policies). Equity markets should move in lockstep with interest rates -similar to what we saw in late 70’s and early 80’s. Gold as an asset class has under-performed since Oct-2012 and will continue to do so until equity markets and interest rates de-couple.  We can argue gold has bottomed out but I would argue it hasn’t yet and still has room to fall. Recognizing historical pattern of similar price & momentum behavior sheds more insight into this analysis .Current price performance of gold is closely tracking the behavior exhibited by gold from early 1980’s.  Rising interest rate in current economic environment is more indicative of growth as opposed to tightening by monetary authorities.  This dynamic will keep S&P500 anchored to interest rates and low inflation expectations will maintain downward pressure on gold prices

From a technical perspective, Gold should find good support between $1050 and $1200 before it embarks on another rally. Bottom in Gold prices will be matched with a bottom in corporate profits and will most likely mark the top in S&P.  Identifying & differentiating the causative factors will help investors significantly in timing of this position. Few things which need to be watched out carefully

a)      Breakdown in Lockstep relationship between S&P500, 10 yr note, US Dollar

b)      Falling Corporate Profits as % of GDP

c)   Receding deflationary pressures and pick up in inflationary pressures beyond a certain threshold