Blog – Page 17 – Focused Compounding

Luke Elliott October 9, 2018

DHI Group (NYSE: DHX)

This will be short and sweet.

DHI Group (NYSE: DHX) is the parent company of subsidiaries that are engaged in online career sites and services. Think indeed.com or monster.com. Their major platforms (assets) are Dice.com, ClearanceJobs.com, and efinancialcareers.com. The sites are more targeted to specific groups than their larger competitors with dice.com being geared towards technology/software professionals and the other two, I’m sure you can guess.

The company’s performance over the last decade has been less than stellar. Ten years ago today, the stock price was at $6.40/share. It reached a peak of $18.75/share in 2011 and has since, steadily tumbled to its $1.85/share price today (all while the job market has boomed and their competitors have grown larger). Naturally, this has drawn the attention of activists.

Most recently, on May 25, 2018, TCS Capital Management filed a 13D, announcing that they had purchased 9.7% of the total shares. On August 23,2018, they released a scathing Letter to the Board, reprimanding them for the usual: terrible performance compared to S&P and peers, bad strategy, enriching themselves at the cost of long-time shareholders, low insider ownership etc. etc.. However, the interesting part is that they publicly disclosed that they were prepared to buy the Company for $2.50/share in cash (a 25% premium to the $2.00/share closing price the day before the press release). TCS closed with the ultimatum that if they didn’t accept, they’d start a proxy battle next year (2019) to campaign for seats. They closed the letter telling the company to respond to the offer by September 5, 2018.

DHI’s response the next day- “The Board and Management, consistent with their fiduciary duties, plan to fully explore and respond to TCS’ new proposal. The Board and Management are committed to acting in the best interests of the Company and its shareholders and will continue to explore any opportunity to enhance shareholder value. In its review and discussions with TCS, the Company is being advised by Paul, Weiss, Rifkind, Wharton & Garrison LLP, Evercore and Arbor Advisory Group.”

The price moved up to $2.40 in the following days.

Since, no word from either side. The September 5 date has passed, and the price has moved down to $1.85/share.

Maybe there’s an expensive 2019 proxy battle on the horizon, but then again, the company is definitely worth $2.50/share to a private buyer (and probably more since they wouldn’t make an offer they thought was a bad bargain). In other words, the $2.50 price tag probably has some margin of safety baked in. At some point, there will be an update on the review and discussions.

May 2019 Call options are available for those interested.

Disclosure: I hold no position

https://www.sec.gov/Archives/edgar/data/1167167/000092189518001829/sc13d10608004_05242018.htm
https://www.sec.gov/Archives/edgar/data/1167167/000092189518002471/ex991to13da110608004_082318.htm
https://www.sec.gov/Archives/edgar/data/1393883/000095014218001796/eh1801013_ex9901.htm…

Geoff Gannon October 5, 2018

How Big Can Amazon Get?

(Note to Focused Compounding Members: Geoff here. This is one of my general investing posts – not a specific stock write-up. The first half of this post was made available free for everyone at “Gannon On Investing”. The second half of this article is exclusive for members like you. My actual stock write-ups are always exclusive to Focused Compounding. The first half of my general investing articles are available free at “Gannon On Investing”; you get the whole article here because you’re a member.)

Someone emailed me this question:

I’ve been looking at Amazon for a little short of a year and because the equity doesn’t provide a good price to value ratio and margin of safety, in my view, I’ve held back from investing so far.

There’s a little brainteaser which involves asking people how much sales, as a percentage of total sales, are done online. The numbers people answered were surprisingly high. Right now they make up 10% of total sales in the U.S. and I’m positive that number won’t stop there.

Assuming internet sales grow at 8% for the next 10 years (16% right now) one-fifth of sales will be online (also assuming 4% historical growth rate on U.S. retail sales). It would be a $1.8tn industry, x4 the size of today. Is an 8% growth rate overly optimistic given that as the base grows, percentage growth usually slows? Not looking for exact numbers, just rough measures.

Amazon has 50% market-share and I would assume that isn’t sustainable and the market’s perception of a winner-takes-all is exaggerated, many businesses could co-exist. I don’t think this is a Facebook/Google “aggregator” situation in which the viability of a new company competing with them decreases as they get more users and advertisers. The viability surely decreases to some extent but not to the extent that it does for the other two advertising companies, the retail industry is also much bigger.

All in all, bigger but perhaps fewer companies will co-exist in the online space, and when it comes to smaller online commerce firms, they’ll perhaps cater more to niches as a European pet food company is doing. However, even a 20% market-share comes out to a huge revenue number when we extrapolate what the internet sales number might be in the future.

Very successful U.S. retailers like Walmart have ~6% market share of total retail sales, that’s significantly higher for specific categories. In terms of online though I would apply a higher than average market share for Amazon because the supply chain is significantly harder to build and optimize (e.g. more nodes) and therefore in my view this increases barriers to entry. My second question is: Do you think this is a fair assumption?

Anything I say in this post is not a suggestion to buy Amazon as a stock today. This is because of the price. We’ll get to that at the end of my article. For now, let’s just say that Amazon stock is priced high enough that …

Geoff Gannon October 3, 2018

Resideo: Honeywell’s Boring, No-Growth Spin-off Might Manage to Actually Grow EPS for 3-5 Years

Yesterday, Honeywell set the distribution date for the spin-off of its home comfort and security business “Resideo”. So, I thought now would be a good time to do an “initial interest post” on Resideo. In this article, I’ll give my first impressions of the stock and then I’ll conclude by giving you an idea of how interested I am in following up with this stock idea. As always, I’ll grade the idea on a scale ranging from of 0% interest to 100% interest.

To give you some context, let’s start with a review of how interested I was in the five other stocks I looked at.

Keweenaw Land Association (KEWL): 90% initial interest level

Pendrell: 90%

Maui Land & Pineapple (MLP): 80%

U.S. Lime & Minerals (USLM): 50%

Babcock & Wilcox Enterprises (BW): 10%

The details for the ratio of shares of Resideo to Honeywell (1-for-6), record date (October 16^th), and distribution date (October 29^th) can be found here:

https://www.sec.gov/Archives/edgar/data/773840/000119312518290912/d528228dex992.htm

The notes I took when reading the Resideo spin-off document can be found here:

https://focusedcompounding.com/wp-content/uploads/2017/06/Focused_Compounding_Resideo_Notes_by_Geoff_Gannon.pdf

Resideo includes a products business (“Honeywell Home” or “Products”) and a distribution business (“ADI global distribution” or “Distribution”). Resideo will operate in multiple countries. And it will spin off with about $1.23 billion of debt from Honeywell and liabilities related to over 200 environmental clean-up sites. We’re interested in valuing the stock (the equity portion, not the debt). So, it’s easy to get lost in the complexities of this situation. The first thing we need to do, then, is to focus on those aspects of this spin-off that could drive returns in the stock. In other words, we need to start simplifying things right from the start.

Here are some of the first questions we need to ask:

How much debt will Resideo have when it spins off?

How big will Resideo’s environmental liabilities be when it spins off?

How expensive will the stock be when it spins off?

Where will most of Resideo’s “owner earnings” (“free cash flow”) come from?

Let’s start with the last question first. In recent years, Resideo has gotten about 75-80% of its profits from the “products” business rather than the distribution business. There’s a lot of information in the spin-off document – and therefore, in my notes – about ADI. However, ADI only accounts for about one-fifth of profits (about half of revenue) at Resideo. It’s easy to get sidetracked by spending as much time on ADI as we would on Honeywell Home (“products”). On a sales basis, the two businesses are equal in size. But, sales aren’t what matters to a shareholder. Profits are what matters. Gross margins at Honeywell Home (the products business) are about 4 times higher than gross profits at ADI (the distribution business). Therefore, the same amount of sales at each business translates into roughly 4 times more profit (80% of profits versus 20% of profits) at Honeywell Home.

In this initial interest post, I really want to set ADI …

Geoff Gannon October 3, 2018

Homasote (HMTC): A Perfect “Cocaine Brain” Candidate

Member Write-up By Luke Elliott

Quote: $10.58

Shares Outstanding: 360,219

Market Cap: $3.81M USD

Before getting started, read Geoff’s latest memo “Cocaine Brain,” if you haven’t already.

https://focusedcompounding.com/wp-content/uploads/2017/06/2018_09_23_Sunday_Morning_Memo_Cocaine_Brain.pdf

Homasote is a well-known brand name associated with the product generically known as cellulose-based fiber wall board. The material is 98% recycled paper fiber and 2% environmentally-friendly materials. The company has two divisions and claims to be America’s oldest green building products manufacturer. The millboard division makes sound insulation and concrete joint filler and their industrial division focuses on protective shipping products for glass, paper, and steel.

To get a snapshot of where the company was in 2012, take a look at this Oddball Stocks post by Nate Tobik.

http://www.oddballstocks.com/2013/09/homasote-is-it-cheap-or-bankrupt.html

As Nate notes, this is a company that went an 11-year duration, from 2002 to 2011, losing money hand over fist. They somehow managed to destroy almost $40/share in equity over that period and accumulate over $6M in long term debt on a $1.4M Market Cap. The company had negative $15/share in book value when Nate wrote up the stock. Fast-forward 5 ½ years and the company has made some serious progress.

The company posts their financials on OTCMarkets.com, although their reporting is not the most punctual. The 2017 Annual Report was just posted a few weeks ago in August 2018. From 2012 through the first half of 2018, the company has sustained profitability. Below is a Five Year Highlights Table the company provides in their Annual Report, but I’ve consolidated two to show the last decade.

The table gives a clear picture of Homasote’s Jekyl and Hide history.

At this point you’ve probably picked up on a few things. At a superficial glance, the company looks really cheap on an earnings basis. It’s trading at a trailing P/E of 2.2 (10.57/4.77). This is what perks investors excitement. Two, the company has used that profit stream to take a chunk out of the debt and subsequently reduced the equity deficit to negative $6/share at the end of 2017. Looking at the below chart, we’re starting to infer that this must be a turnaround. We’ve seen it in the movies so many times that we immediately identify the same story playing out in real life.

These results are good and well. The company has survived and scrapped back. But here’s where we typically pump the brakes a little and try to force ourselves to be rational. We know that it can’t all be good news. When we look at the balance sheet, it’s clear that the creditors still own the company.

Now the brain starts searching for a way to discount or justify the remaining leverage and pension obligations. We want to believe it’ll get paid down before the company experiences a downturn and that the 2002-2011 period won’t happen again. The company has turned a new leaf, right? To be fair, the company has come a long way and their results have been impressive.

Take a look at the aggregate maturities of …

Geoff Gannon September 22, 2018

Geoff’s SEC Filing Notes for: Resideo (a Planned Honeywell Spin-off)

Notes on Honeywell’s planned spin-off of Resideo Technologies

I’m trying something new here. A lot of you want to see more “initial interest” write-ups from me. But, those write-ups are actually step two of my investment process. I first read a 10-K (or, in this case, a spin-off document) on EGDAR and mark-up that SEC filing. I make my notes directly on the 10-K through a combination of highlights and questions, comments, etc. in the margin and at the bottom of the page. I never put these highlights and scribbles into any sort of formal document. But, I thought I’d try doing that here with Resideo so Focused Compounding members could see what my notes would look like if put in a single document.

It turns out such a document runs to over 6,000 words. So, my “notes” are much longer than any write-up I’d create out of them.

I’ll do an “initial interest” write-up of Resideo later this week.

For now, here are my notes:

Notes on Honeywell’s planned spin-off of Resideo Technologies

By the way, I’m going to let Andrew tweet out these notes, I may share them on my blog, etc. Any write-up I do of Resideo (like an “initial interest” post) will be exclusively for Focused Compounding members. But, at least for more liquid stocks like Resideo, I think we’ll share the notes widely.

In the comments below, let me know if you found these notes interesting and whether you’d like more SEC filing “notes” posts from me. In the future, I can do one post with my notes first and then a second initial interest post later. But, I won’t do that unless I get feedback from members saying they have an interest in seeing these notes.

Notes on Honeywell’s planned spin-off of Resideo Technologies

Geoff Gannon September 18, 2018

Standard Diversified (SDI / SDOIB): Get a Solid Tobacco Brand and a Solid Marijuana Brand at a 33% Discount to Their Market Value

Member Write-up by André Kostolany

Geoff’s Note: Standard Diversified also has extremely illiquid super voting shares that trade under the ticker SDOIB. SDOIB shares are sometimes available at a discount to SDI shares (for example: last week, 400 SDOIB shares changed hands at something like 30% less than the then current price of SDI). SDOIB shares have 10 times the votes of SDI shares and can be converted into SDI shares. Buying Turning Point Brands (TPB) directly is usually the most expensive way to get exposure to Turning Point Brands stock, buying SDI is often the next most expensive, and buying SDOIB is sometimes the cheapest. This is not always the case. So, make sure you always check the bid/ask prices of each of these 3 stocks against each other before deciding which of the 3 stocks to buy to get direct or “look-through” exposure to Turning Point Brands. SDI discloses it owns 51% of TPB. So, you can multiply the number of TPB shares outstanding by 0.51 and then divide that number by the combined number of SDI and SDOIB shares outstanding. This will give you the “look-through” value of SDI shares. Right now, I believe each share of SDI (or SDOIB) represents a “look-through” interest in about 0.59 shares of TPB.

Standard Diversified Opportunities (SDI) is a HoldCo that is majority owned by Standard General. SDI has three operating subsidiaries: Turning Point Brands (TPB), Standard Outdoor and Standard Pillar. At this point the majority of SDI’s value is made up of TPB. With TPB stock currently at $40 SDI’s stake in TPB is worth about $23.67 per share. Standard Outdoor is worth about $1.07 per share at cost and Pillar General about $0.78 per share. Net debt is -$0.94 cents. In total, SDI’s per share NAV is $24.58, or about a 49% premium to SDI’s stock price of $16.50. The company’s slide deck also has good details on the SOTP. Having established that the stock is cheap to its NAV, let me try to explain why I like the underlying businesses.

SDI is controlled and majority-owned by Standard General. Standard General is a special-situations investor that tends to take highly concentrated positions in off-the-run situations. Standard General owns over 86% of SDI. Adding insider stakes this becomes well over 90% of SDI’s total ownership. Before taking over SDI, Standard General owned a majority stake of 9.84MM shares in TPB, which it has placed inside SDI. Basically SDI is now Standard General’s public vehicle through which it holds TPB shares and other long-term investments for an indefinite time horizon. The following company slide does a good job of illustrating the SOTP:

TPB

TPB is in the other tobacco products business. Their products fall into three categories: Smokeless, Smoking, and New Products. TPB’s main asset is ZigZag, which is the #1 premium cigarette paper brand with 33% market share. ZigZag has been the paper brand of choice for cigarette and pot smokers for decades now. The main thing to …

Andrew Kuhn August 28, 2018

KLX Inc/KLX Energy Services Spinoff

Member Write-up by Yuvraj Jatania

Spinoff Background

In May 2018, KLX Inc. (KLXI) announced an agreement to sell their Aerospace Solutions Group (ASG) to Boeing for $63/share in an all cash deal.

The deal was based on a successful spinoff of KLXI’s Energy Services Group (KLXE) because Boeing had no interest in buying this part of KLX’s business.

The management team led by founder, Chairman and CEO, Amin Khoury, initially tried to market the energy business for sale to trade and financial buyers. Bids were received from a mixture of competitors and PE houses in the range of $250-$400m but management felt very strongly that these valuations undervalued the potential of the business based on the rapidly improving market conditions, the higher market value of comparable companies and strong forecasted financial performance of the business.

Instead they decided to initiate a spin off which would allow them to run the energy business as a standalone, publicly traded entity.

Our investment opportunity lies in the spinoff of the energy business which will trade on the NYSE under ‘KLXE’.

The spinoff is expected to take place before the end of Q3 2018. Not long.

KLX Inc

KLXI is a US listed company which used to be part of BE Aerospace (BEAV).

BE Aerospace was founded by Amin Khoury in 1987 through an acquisition of an aerospace interiors parts manufacturing and services business with only $3m in revenue at the time. Khoury grew the business and sold the manufacturing side to Rockwell Collins in April 2017 for $8.6bn and retained and managed the services business which became known as ‘KLX Inc’.

KLXI operates through two distinct and unrelated businesses:

1. KLX ASG – Aerospace after-market services and parts/consumables for commercial and private aircrafts

2. KLXE – Onshore oil and gas field services – focused only on serving North American onshore Exploration and Production (E&P) companies

KLX Energy Services Group

The energy business was founded through a quick succession of acquisitions in 2013-14 of seven regional oilfield services companies which each operated in the major shale basins in North America – the Southwest, Rocky Mountains and the Northeast. The execution and integration of the acquisitions was managed by Khoury and his executive team.

The business provides well completion, intervention and production services and equipment to major oil and gas E&P companies. Their customers include Conco Phillips, Chesapeake Energy and Great Western amongst others. These companies drill and create wells in the shale basins looking for oil and natural gas. When they have a pump issue, equipment gets stuck or loss, a valve becomes faulty or loose, or any other well-related issues they call in technicians or equipment and tools from a company like KLXE. Historically, some of these players would resolve these issues by having an in-house team but now a majority of them outsource the support services to companies like KLXE as the work is considered non-core to their daily activities.

One of the very attractive features of this type of business is …

Andrew Kuhn August 24, 2018

BUKS follow-up: A catalyst could emerge within a month

Member write-up by VETLE FORSLAND

I wrote up BUKS on the website earlier this month. After discussions with Geoff, we agreed that a follow-up article was relevant, as there were important parts of the thesis that I left out in the original write-up (which you can read here if you missed it).

https://focusedcompounding.com/butler-national-corp-buks-an-illiquid-ben-graham-style-mini-conglomerate-in-aerospace-and-casinos/

This article will focus on a real estate deal that could act as a drastic catalyst for the stock, which is desperately needed.

BUKS’ real estate deal, and why it’s a bargain

BUKS has a buyout option on the Boot Hill Casino, which they have been renting since 2009. They are paying $4.8 million in leases annually on the property right now. If we cap this at an aggressive rate like 8%, we get a valuation on the property of $60 million. BUKS has the option to buy the very same property for $45 million – or $16 million below what we can expect is a conservatively fair price.

That difference alone is worth BUKS’s entire market capitalization.

And, that $60 million valuation isn’t just from a lease cap assumption. The CEO himself, Craig Stewart, said in an earnings call that the official appraisal is «significantly higher» than the $45 million price tag, which he again claimed was «definitely substantially under» appraised values. Understandably, an analyst on the call asked for specifics on the appraisal value. He didn’t get a clear answer on his question, as it’s confidential, but Stewart claimed $55 million was «close» to the fair value presented by the bank they’re working with, when he was pressed on the subject. Stewart also revealed that it will cost $1 million to get the deal financed. So, what does this mean?

I got the impression that the leasing contract expires in 2034, as they agreed on a 25-year lease in 2009 (2009+25=2034). Therefore, if they don’t buy out the casino, BUKS is stuck with $77 million in leasing costs over a 16-year period. Instead, they can buy a property for $45 million, when it’s worth 30% above that figure, and then finance it with a one-time expense of $1 million – sound good yet?

If BUKS wanted to, they could buy the casino, and instantly look for a buyer, and potentially make 70% of their market cap in one transaction. However, there is probably more value for the company if they keep the real estate for themselves and cut lease expenses.

What does this mean for the stock?

Obviously, this is a good deal for the company, and the value added to the firm should be reflected in the stock price. However, there is clearly a lot of value in BUKS already that the market is either not seeing, or blatantly ignoring. It might very well be the latter, and I explained why in my original write-up. In a nutshell, the executives, represented by the CEO and his brother, his cousin and his son-in-law, are using BUKS to get generous salaries year in and year …

Geoff Gannon August 19, 2018

Outperformance Anxiety

To Focused Compounding members:

I spend a surprising amount of time talking with members about other investors – investors who are doing better than them. The truth is: returns much beyond 20% a year aren’t even worth thinking about. Sure, you can find investors who have done better than 30% a year for a ten year stretch. I have a copy of Joel Greenblatt’s “You Can Be a Stock Market Genius” sitting here on my desk. And if I flip to the back of that book, I’ll find a performance table that goes like this: 70% (1985), 54% (’86), 30% (’87), 64% (’88), 32% (’89), 32% (’90), 29% (’91), 31% (’92), 115% (’93), and 49% (’94). The works out to a 10-year compound annual return of 50%. Then there’s Warren Buffett’s partnership record which reads: 10% (1957), 41% (’58), 26% (’59), 23% (’60), 46% (’61), 14% (’62), 39% (’63), 28% (’64), 47% (’65), 20% (’66), 36% (’67), 59% (’68), and 7% (’69). That works out to a 13-year compound annual return of 30%. One member wanted to talk to me about the performance of a fund manager – better than 30% a year for longer than 5 years – who followed a concentrated portfolio. For the managed accounts, Andrew and I target six equally weighted positions. So, I’m always interested in seeing what a concentrated portfolio looks like. This fund manager had most of his portfolio in 4 stocks: Herbalife, Cimpress, Credit Acceptance, and World Acceptance. A portfolio like that is taking risks very different from the ones you’re taking. They may be right about all those risks. But, they have to have opinions about subprime credit risks, pyramid schemes, tax avoidance strategies, etc. It isn’t just that those stocks are often shorted, controversial, etc. as stocks. The actual businesses are doing riskier things than the businesses you likely own. You don’t have to take big risks to get rich. But, you often do have to take big risks to get rich quick. I mentioned Joel Greenblatt’s record at Gotham Capital. It was 50% a year over 10 years. Charlie Munger’s record was just 20% a year over 14 years. Warren Buffett’s record at Berkshire – not his partnership – has been 22% a year over 53 years (and Walter Schloss did 15% a year over something like 45 years managing smaller sums). During the time Berkshire did 22% a year, the S&P 500 did 10% a year. Those are the two yardsticks you should look at: 10% a year and 20% a year. In every year where you manage to do 10% a year, you are on pace to match or beat the long-term rate for the S&P 500. In ever year where you manage to do 20% a year, you are on pace to match or beat the long-term rate for some of the very best investors in the world. People mention the performance of investors like Joel Greenblatt and Peter Lynch a lot. But those performances are …

Geoff Gannon August 12, 2018

Pre-Judging a Stock

To Focused Compounding members:
This week, a Focused Compounding member sent me a link to a blog post about Brighthouse Financial (BHF). Brighthouse Financial is the spun-off retail business of MetLife. Although websites often list Brighthouse Financial under the industry group “Life Insurers”, the stock is really a seller of annuities. Many of these annuities are tied to the performance of the S&P 500 or other stock indexes. So, the company’s investor presentation includes a slide where it shows how badly affected the company would be by various percentage declines in the S&P 500. Based on that slide, the writer of that blog post eliminated the stock from consideration. He had spent – perhaps – an hour or less looking at this company. That was enough to tell him no to invest. Should it be? What we are talking about here is literally prejudice. It is judging a business before you fully understand it. It is making a snap judgment based purely on your initial impressions. And especially on this stock’s resemblance to other such stocks you’ve seen before. You think back to all the stocks you know that have some similarities to this one and you make a snap judgment – assigning this stock to the same group as those stocks. It’s definitely a time saver. And for those who believe in Peter Lynch’s motto that he who turns over the most rocks wins – it’s an efficient approach. If you can quickly glance at a thousand stocks and find ten that really excite you on your first impression and buy those – maybe that’s enough. A lot of investors follow the pre-judging approach. I tweeted about the KLX Energy Services business. This is technically going to be a spin-off. However, what is really happening is that Boeing is buying KLXI’s aerospace business for cash and leaving KLX Energy Services for KLXI’s current shareholders. This is the spin-off I’ve most been looking forward to this year. Someone on Twitter mentioned that “…if I recall ESG is a collection of absolutely garbage businesses.” KLX Energy Services was formed as a super fast roll-up of a bunch of
U.S. energy service providers that served “tight oil / tight gas” (shale oil) producers in the U.S. The price of oil dropped quickly around the time of KLX’s acquisition spree (late 2013 through 2014). Some of these acquisitions were made when oil was around $100 a barrel. So, KLX paid high multiples of EBITDA for businesses where the EBITDA completely vanished in the oil price crash. This collection of businesses may be garbage. But, it’s impossible to know they really are if you only have data going back about 5 years and those 5 years don’t include anywhere near a full cycle in oil.
Brighthouse Financial and KLX Energy Services are both tempting stocks to pre-judge, because if you don’t pre-judge them you have to do some heavy lifting. Brighthouse Financial is complicated. KLX Energy Services doesn’t have the past financial performance data …