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Geoff Gannon April 8, 2020

Middleby (MIDD): A Serial Acquirer in the (Normally) Super Steady Business of Supplying Big Restaurant Chains with Kitchen Equipment

Middleby (MIDD) is a stock I was excited to write-up, because it’s rarely been cheap. I’ve seen 10-year financial type data on the company. I’ve seen it show up on screens. And now the government response to coronavirus – shutting down so many of the restaurants that Middleby supplies – looked like a once in a lifetime opportunity to buy the stock. The company also has quite a bit of debt. That can make a stock get cheap quickly in a time like this. So, I was looking forward to writing up Middleby.

I’ll spoil this write-up for you now and tell you I didn’t like what I found. The company’s investor presentation, 10-K, etc. was a disappointing read for me. And I won’t be buying Middleby stock – or even looking into it further. Why not?

Middleby is in an industry I like. The company has 3 segments. The biggest profit contributor is commercial foodservice – supplying restaurant chains like: Burger King, IHOP, Chili’s, etc. – with kitchen equipment. The company sells equipment that cooks, bakes, warms, cools, freezes, stores, dispenses, etc. It sells a very broad range of equipment. A lot of it is good equipment. A lot of the brands the company carries are well known. Plenty of them are pretty innovative. However, I think that innovation most likely happened before – not after – Middleby bought those companies. Middleby talks a lot about innovation – but, it only spends about 1-2% of its sales on research and development. That’s not a high number for a company in an industry like this. Middleby is building this stuff itself – in the U.S. and around the world (in both owned and leased facilities – and it’s making it for some pretty large scale orders. Plenty of the chains Middleby serves have thousands of locations. Gross margins in the commercial foodservice business are 40% or a bit better. Although most of this stuff is sold under just a one year warranty – some is under warranty for up to 10 years. Plenty of these products do last longer than 10 years. For a company making 40%+ gross margins on sales of key capital equipment to big business customers – Middleby doesn’t do a lot of R&D. That fact bothered me a little. It started to bother me a lot more when I looked closer at the company’s acquisitions.

Middleby has bought some leading brands. Chances are – if you’re reading this – you know more about home kitchens than commercial and industrial kitchens. You may eat at Chipotle. But, you don’t know what equipment Chipotle cooks on. You do – however – know brands you might find in home kitchens. Several years ago, Middleby bought the Viking brand and later the Aga brand (Aga is a big, premium brand in the U.K. – it’s less well known in the U.S.). In the company’s investor presentation, they show the EBITDA margins for these acquisitions at the time they were made …

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Andrew Kuhn April 7, 2020

Why Do You Sometimes Price a Stock Off of Its Free Cash Flow Yield Plus Growth Rate Instead of Just Using its P/E Ratio?

Someone sent Geoff this email:

 

Dear Geoff,
In this video   you mention a PE of 26 for OTC and yet use an implicit growth rate of 6% which is not the inverse of 26. I would like to understand why that is.
Answer: If a Company Converts 100% or More of Its Earnings Into Free Cash Flow While Also Growing – a Normal P/E Ratio Would Deeply Undervalue the Stock
I’d assume it’s because 10% = (1/26) + 6%
In other words…
10% – 6% = 4%
And 1/25 (not 26) is 4%
OTCMarkets is unusual. What matters for a stock isn’t actually earnings – it’s truly free cash flow. So, a stock that retains 100% of its earnings and grows 6% a year while doing that still isn’t worth more than many stocks growing 0% and paying all earnings out.
Some stocks – OTCMarkets is one – have a lot of “float”. As a result, they are capable of paying out 100% (actually more than 100% while they are growing) of their earnings in dividends and buybacks while growing. They don’t actually have to retain earnings. You can see that with OTCM. The asset that has grown over time is cash. A tip-off to this fact is that ROIC is often calculated as being very high, infinite, or even negative by some websites (a negative ROIC means that the company’s cash balance is greater than what it has actually invested in the business in stuff like PP&E, receivables, inventory, etc.).
So, my point is that if OTCMarkets grows by 6% a year and you need a 10% return as your discount rate…
Well, OTCMarkets can grows at 6% a year AND pay a 4% a year dividend yield if priced at 25 times P/E.
Note that OTCM does not actually pay such a high dividend though. So, it’s somewhat debatable what the stock is worth if management keeps cash on the balance sheet rather than using all FCF to buy back stock and pay dividends.
For comparison, look at Omnicom (OMC). It actually does pay out dividends and buy back stock equal to at least 100% of reported earnings. So, the calculation there is simple. Assume OMC grows at 0%. Assume your discount rate is 10%. What is the correct price for OMC?
It’s a 10x P/E. Because OMC at 10 times EPS, OMC will pay you dividends and buy back stock equal to 1/10th of your purchase price. What this will actually do is make EPS grow – even when the company’s actual earnings don’t grow, just because share count is falling – plus you get the dividend. If the combination of the dividend and the EPS growth equals 10%, you’ve hit your hurdle rate.
So, what I said about OTCM is somewhat unique to that company and other business models like it, generally:
– Ad agencies
– Subscription services
– Some software companies
– Etc.
Usually, you have to be doing something fairly intangible (you can’t
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Geoff Gannon April 6, 2020

Hamilton Beach Brands (HBB): A Simple Business and a Super Cheap Stock Facing a Tough Cash Situation in 2020

Hamilton Beach Brands (HBB) looks like a cheap stock. As I write this, the stock is trading at $8.71 a share. The company – or, at least the continuing part of the company now that Kitchen Collection is gone – earned anywhere from $1.50 to $2.00 a share over the last 3 years. That puts the P/E ratio at something like 4-6. Other ways to look at the stock include pricing it off of its EBIT or free cash flow. Over the last 5 years, the continuing portion of the company reported EBIT of between $33 million and $41 million. The company’s enterprise value is about $186 million (just take the market cap and add about $55 million in debt). So, that gives us an EV/EBIT ratio of anywhere from 5 to 6 times. Again, not expensive. A “normal” EV/EBIT ratio given today’s tax rates would probably be about 12 times. Free cash flow has averaged just under $30 million a year over the last 3 years. That gives you an EV/FCF ratio of about 6. All of these point to the stock being pretty cheap. The company also has a plan to one day achieve revenues of between $750 million and $1 billion and EBIT margins of 9-10%. It’s a long-term plan. But, a company that hit even the bottom end of that range could be worth closer to $800 million than the less than $200 million enterprise value at which Hamilton Beach Brands now sits.

The cheapness of Hamilton Beach Brands stock is the good news here. There is some bad news. And I’ll start with the news that concerns me the most – the balance sheet. On the one hand, Hamilton Beach has a solid balance sheet. Current assets exceed total liabilities. That’s usually a great sign. The company is always solidly EBIT profitable. However, it isn’t always very solidly cash flow positive. If we look at the make-up of Hamilton Beach’s balance sheet we can see why. At present, 38% of HBB’s assets are held in the form of receivables. 36% of assets are held in the form of inventory. Less than 1% of assets are in the form of cash. The company’s undrawn portion of its credit line is only about 20% of its total balance sheet as it stands now. In fact, the amount HBB can draw on that line is less than 50% of either its receivables or its inventory. Furthermore, HBB is a seasonal company. It does things like selling its receivables off and drawing on its credit line in a normal year. Normally, HBB builds up inventory during the first half of the year. Things turn around starting in the fall. And then the cash comes flowing in as we go through the holiday season. Will that happen this year? Hamilton Beach has already promised it will. The company had – as of December 31st, 2019 – promised to buy $210 million worth of inventory this year. That’s against …

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Andrew Kuhn April 4, 2020

Why Shouldn’t I Count EPS Growth from Buybacks When Valuing a Stock?

Someone sent me this email:
…you mentioned Omnicom, and you said that per share numbers should be avoided when computing growth…as you mentioned Omnicom buys back its stock, therefore why remove this information I have about this company from the implicit hurdle rate? Suppose we have 3 companies: a historically savvy buy backer, an automatic buy backer and a company who doesn’t buyback, shouldn’t we be able to discriminate between them if they were to all have the same FCF yield?
Answer: It’s Best to Assume Future Growth in Earnings Per Share Caused by Buybacks Will Be Tied to the Price at Which Future Buybacks Are Done
The reason I said you shouldn’t use per share numbers is to avoid double counting. Here’s what I mean.
You buy Omnicom at a P/E of 8.6 and a dividend yield of 5%. You know free cash flow is normally equal to or greater than earnings per share. However, in a recession like the one we’re in now for Omnicom – it’s likely free cash flow will come in below reported earnings. This would happen if there was a decline in billings (similar to how an insurer’s “float” drops an insurer takes in less premiums this year than last year).
So, what does that P/E of 8.6 and dividend yield of 5% buy you?
What I’m worried about is investors saying: “Well, 1/8.6 = 11.6%. My earnings yield is 11.6% AND the company has grown sales PER SHARE by 5% a year over the last 10 years. So, My return is 11.6% + 5% = 16.6% for as long as I own the stock.”
Now, I don’t doubt your return if you bought Omnicom today and sold it in the future could be 17% a year or higher. However, you’ll get that return from multiple expansion. Without the P/E multiple expanding, you won’t make 17% a year in this stock.
Why not?
There are two ways of looking at this.
One, you CAN count the earnings per share growth (or sales per share growth if we’re avoiding looking at changes in EBIT margins) and count the dividend. However, if you count the EPS growth – you CAN’T count the money used on stock buybacks. So, it’s a question of EITHER credit the company’s use of stock buybacks as if it’s as good as a dividend OR count the growth in per share figures caused by stock buybacks, but don’t count the growth in EPS caused by the falling share count.
Personally, I prefer counting all of the free cash flow used on buybacks and dividends as your “hold” return in the stock. I have a good reason for doing this that has to do with timing an investment in OMC to maximize your returns.
However, it is theoretically permissible to do the calculations as:
Dividend Yield = 5%
Sales Per Share Growth = 5%
“Hold” Return = 10%
I think this undervalues the stock as of today. But, that is more consistent with
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Geoff Gannon April 3, 2020

Hanesbrands (HBI): A Very Cheap, Very Leveraged Stock That’s #1 in an Industry that Changes So Little Even Warren Buffett Loves It

Hanesbrands (HBI) has gotten very cheap lately. In fact, the stock is back at prices that are pretty close to where it was spun-off from Sara Lee back in 2006. I talked a little about the stock back then. It was a spin-off I liked – I haven’t found many of those lately – and I’d assume the business has become more valuable over the last 14 years, not less. We’ll see if that’s true.

The business hasn’t changed much in 14 years. Hanesbrands acquired other businesses. It has grown in athleticwear. And it has grown internationally. However, a lot of this growth was acquired with the free cash flow produced by the innerwear segment. Hanesbrands divides itself into 3 parts: U.S. innerwear, U.S. activewear, and international. By my math, profit contribution is roughly 55% from U.S. innerwear, 25% from U.S. athleticwear, and 20% from international. All segments are profitable. And innerwear has seen shrinking profits over the last several years while international has grown (mostly through acquisitions).

Hanesbrands has a very strong brand position in U.S. innerwear and a pretty strong position in U.S. athleticwear. It also owns a lot of the top brands in various countries through acquisitions made to build up its international business. There may be some synergies between international and U.S. – but, they aren’t brand synergies. This gets into the issues I have with the company: 1) Acquisitions, 2) Debt, and 3) Management / Guidance etc. I’m not necessarily opposed to acquisitions, the use of debt, or management here. But, each of those 3 issues do complicate things a bit. For example, I’m not sure I like what the company has done in terms of acquisitions over the years – but, it’s hard to tell.

So, this is one area that changed over these 14 years. Originally, Hanesbrands seemed like it was interested in taking its core brands: Hanes, Champion, Maidenform, Bali, Playtex, Wonderbra, etc. and exporting them into other countries. This never seemed like a great strategy to me. Underwear brands are sold mostly as “heritage” brands. They’re like chocolate bars and breakfast cereal. There are countless countries around the world that have some very popular chocolate bar or very popular breakfast cereal that they’ve been eating since about 1900 or 1950 or whenever. They love it. The rest of the world hates it. It’s successful in their country. It flops everywhere else. Trying to convert someone who eats Cadbury to switch to Hershey – or trying to get an American to start eating Weetabix instead of Kellogg’s Cornflakes just isn’t going to work. These are commodity products. Do they taste a little different? Maybe. Is one brand of underwear a bit cheaper, a bit higher quality, a bit more comfortable, a bit more stylish – maybe. But, any of those things can and will be tweaked. Any company can invest in some different synthetics or different cotton, can do a slight bit of R&D work combined with a lot of consumer research …

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Andrew Kuhn April 2, 2020

Question: Why Are You 40% in Cash?

Someone sent Geoff this email:
I’m curious why the SMAs are 40% cash. Did that happen once you learned about the potential impact of the virus? Or was that the case beforehand? I know you were fully invested at some point last year, and I would have assumed your strategy was to stay fully invested. So you either sold things last year and never reinvested, or you went cash this year. I’m interested in anything you’d share.
Part of the reason I ask is I am curious how you are framing portfolio management during this turbulent time. I was fully invested coming into the year and didn’t go cash, so my portfolio, which has a decent amount of small-cap and a mid-cap financials that has gotten hit very hard, is down a lot. I’ve written down intrinsic value for some of these businesses, but they are still cheap. I’ve done just a little bit of “value trading”, either moving money to something the same quality but much cheaper, or similarly cheap but much more quality. And I first started seriously investing in stocks in 2015. So this is my first bear market. Psychologically I am doing fine – I’m not stressed or bothered. As I said, I’ve marked down some of my holdings in value but think the price declines have exceeded them. But my questions above are more aimed at understanding how you are thinking about structuring the portfolio in this sort of environment – I don’t have personal experience with this. Perhaps this is simplistic, but my basic strategy has not changed at all. I’ve always aimed to hold durable businesses, so I don’t feel any of my holdings face bankruptcy risk. So, the process is the same: keep holding businesses who offer attractive long-term returns and shift around when prices warrant doing so. But I haven’t gone cash or done a lot of trading yet. Would appreciate any thoughts you have on how to think about this environment.
Geoff’s answer: I’m A Lot More Concerned About Business Performance in 2020 and 2021 Than Most Other Investors and Experts Are
The decision to be 40% in cash was mainly NOT a decision made because of the virus. I had decided earlier this year – after making several mistakes in the past couple years – that I would stop trying to force myself to be 100% invested and only be invested if I liked the stock and the price. This is how I had run things when managing money for myself and others before. However, clients tend to prefer being 100% invested – or, at least, they tend to have strong opinions about how invested you are or aren’t. I’ve just bought so many stocks over the years that haven’t worked out well when I had more cash than ideas. If I was managing my own money – I might put 33% in each of 3 stocks and thus be 100% invested. But, for clients, we don’t do more
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Geoff Gannon April 1, 2020

Bunzl (BNZL): A Distributor with 20 Straight Years of EPS Growth and 27 Straight Years of Dividend Growth – Facing a Virus That’ll Break At Least One of Those Streaks

Bunzl (BNZL) is a business I’ve known about for a long time. However, it’s not a stock I’ve thought I’d get the chance to write about. The stock is not overlooked. And it rarely gets cheap. EV/EBITDA is usually in the double-digits. It had a few years – the first few years of the recovery coming out of the financial crisis – where the EV/EBITDA ratio might’ve been around 8 sometimes. It’s back at levels like that now. Unfortunately, the risks to Bunzl are a lot greater this time around than in the last recession. Why is that?

First, let me explain what Bunzl does. This is actually why I like the business. The company is essentially like an MRO (maintenance, repair, and overhaul) business. It’s a little different from them. In fact, I think it’s a little better than businesses like Grainger, MSC Industrial, and Fastenal. But, it offers its customers the same basic value proposition: we’ll take the hidden costs out of you procuring the stuff you buy that isn’t really what your business is about. What do I mean by that? Well, with Bunzl – the company is basically a broadline distributor of non-food, not for resale consumables. So, you go to a supermarket. You get a bagel out of the little bagel basket, glass case, whatever in your supermarket – you throw it in a brown paper bag. Bunzl doesn’t supply the bagel. It supplies the brown paper bag. You pick out some tomatoes and put them in a plastic bag and add a little green wrapper to the top to seal off the bag – Bunzl might supply the clear bag and the twist thing, it won’t supply the tomatoes. Obviously, I’m using examples of stuff the customer might come into contact with. Bunzl actually supplies a lot of stuff you wouldn’t come into contact with that also gets used up. But, the point is that Bunzl is neither a manufacturer of anything nor a seller of anything that goes on to be re-sold. It’s a pure middleman. It buys from companies that produce products that businesses will use – but won’t sell. It does bid for these contracts (like Grainger does with its big accounts). But, it’s unlikely that the price of the items is the most important part of the deal. Stuff like whether the company can do category management, deliver direct to your door (or, in some cases, beyond your door and into your stores and factories and so on), order fill accuracy, order delivery speed, consolidating orders, consolidating everything on one invoice, etc. is important. The case for using a company like this is usually not that you save a penny on some product they buy in bulk – instead, it’s that you eliminate the work that would be done inhouse by finding a bunch of different suppliers, comparing prices, tracking inventory, etc. That’s why I say Bunzl is like an MRO.

However, Bunzl would normally be probably more resilient than …

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