Yankee Candle Company - An Investment Case Study
The Role of Management in Determining Share Price
This investment case study of the then-publicly-traded Yankee Candle Company was written more than a decade ago as part of the Investing for Beginners site that I ran for About.com. It demonstrated a concept that Benjamin Graham talked about with his students at Columbia University; how the market price of a company does not always reflect the intrinsic value of that company despite what those who espouse efficient market nonsense might want you to believe. It highlights how you can approach selecting investments for your portfolio as if you were a private business owner searching for acquisitions. Yankee was subsequently acquired, resulting in a windfall to stockholders, and, through a series of transactions, has become a subsidiary of a much larger publicly traded company after passing through the hands of a private equity group that, in my opinion, lowered product quality and did permanent harm to the company's brand equity.
Often, if you were to ask investors what they want from their stocks, they’d say something along the lines of, “to go higher”. In Price is Paramount, we debunked this myth and talked about how a falling market is actually good for long-term investors and those many years away from retirement as it allows them to buy a bigger percentage of the company’s equity for every dollar invested.
With that in mind, consider our current case: Yankee Candle. Yankee is an excellent business in every sense of the word. The returns on tangible capital are through the roof, the business enjoys a wide competitive advantage and franchise value with around fifty percent (50%) market share in the premium candle segment, management is intelligent and disciplined by returning virtually all excess capital to shareholders each year through stock repurchases and cash dividends, and the business has a lot of potential now that they are creating other candle companies to sell through “mass premium” channels such as Costco and Kohl’s.
The only drawback is that paraffin wax is a byproduct of petroleum. Given the high cost of oil and the strained refining capacity (exasperated by the fact that one of Yankee’s main wax providers put them on seventy percent (70%) allocation after suffering damages from Hurricane Katrina last year), and it’s not a surprise that the cost of raw wax skyrocketed more than twenty percent (20%) during the most recent quarter, thus leading to a scheduled increase in Yankee’s flagship Housewarmer candles this autumn.
These factors led management to lower its quarterly and annual guidance last week, causing the stock to fall substantially from as high as $32 in the weeks prior to as low as around $21.
The Joy of Low Stock Prices
As an investor, I was doing handstands. Why? In ten years, I don’t expect the problems that are facing Yankee today to still be a major factor. In the meantime, I was buying a company that had a market capitalization of $850 million, that earned $80 million in cash but generated free cash flow of $110 to $120 million and, by utilizing borrowed funds, repurchased $185 million worth of its stock in the prior fiscal year. As an added bonus, a cash dividend yielding a little over 1.1% per annum was paid to shareholders.
With factors such as this, it didn’t take a rocket scientist to figure out that if Yankee continued to repurchase shares at a rate where the actual float of outstanding common stock fell rapidly, the existing shareholders would be very, very well served as time passed. Factor in higher earnings down the road, and it left me feeling much better about my odds of getting a satisfactory rate of return from this particular stock versus the S&P 500.
On Wednesday, July 26th, however, management announced that the company was partnering with Lehman Brothers to look into “strategic alternatives” – Wall Street speak for “we are going to look into selling the company to a financial or strategic buyer”. (A note for readers: financial buyers are those who come into a business, often using high amounts of leverage, with the intent to resell it at a later time after growing earnings or closing underperforming segments. A strategic buyer is someone who has an interest in the business for what it can do for their existing operations; another candle company, for example, would fall into this category.)
This announcement caused the stock to skyrocket by nearly 20% in morning trading. In the conference call, one of the executives mentioned (I’m paraphrasing here), that it was “clear the company was undervalued at its recent price and we felt it was our duty to shareholders to explore other ways to unlock the value of their investment.” My point exactly! Management and the Board of Directors had a beautiful opportunity to use the recent price weakness to buy back another massive block of the company’s shares and retire them; it would have been possible for them to actually acquire fifteen percent (15%) or more without straining the corporate resources significantly.
In the meantime, shareholders with a long-term perspective would be able to continue buying up shares for their personal accounts. Instead, they viewed the low stock price as a problem to be solved rather than an opportunity of which to take advantage.
By making the announcement, however, both opportunities were lost. Management cannot continue to buy back stock if they seriously consider a sale of the company and talks progress with interested parties, and those of us on the sidelines who were taking advantage of the low price have now lost the chance to buy more shares in an excellent business at an attractive price. I can’t help but feeling that the executives sold out those of us with truly long-term horizons for the sake of momentary popularity on Wall Street.
This brings up an interesting philosophical question that may be important for you – the investor – to answer. In fact, Ben Graham posed it over seventy years ago in Security Analysis. Namely, does the Board of Directors and management have an obligation to seek to create a fair price for their common stock so that those who need to sell shares for living expenses, etc., have the opportunity to sell at a price that reflect the intrinsic value of their holdings? If the answer is yes, then it is not right for management to buy back stock to take advantage of low prices as they are essentially favoring one group of shareholders (sophisticated business-minded men and women who have the accounting background necessary to see when a stock is undervalued and have the financial resources to hold on, or even buy more, when the stock crashes) over another (regular working folks who don’t have a lot of extra liquidity around and are investing to improve their standard of living).
Unfortunately, only you can answer that question.
In the end, I’m certainly pleased with the large gains generated by my Yankee Candle holdings. I can’t help but lament fortune lost, however, when I stop to consider how those shares could have compounded over the next decade. Who knows? The market is odd; maybe the price will fall back to where it was (indeed, the stock seems to be giving back some of those gains as existing shareholders take their profits). If anything, this serves to prove that opportunities on Wall Street are ephemeral. That’s why it is important for enterprising investors to have the funds to take advantage of them immediately because when they appear, they aren’t likely to stick around for long.
This article was published July 27th, 2006.
Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.