Blog – Page 21 – Focused Compounding

Geoff Gannon April 15, 2018

Computer Services Inc., “CSI” (CSVI)

This is the core processor stock that was just written up by Jayden Preston:

https://focusedcompounding.com/computer-services-inc-csvi-an-unlisted-but-super-predictable-company-trading-at-an-unleveraged-p-e-of-15-times-next-years-earnings/

I also spent the better part of today’s Sunday Morning Memo on CSVI. You can find that memo entitled “Fear, Greed, and Boredom” here:

https://focusedcompounding.com/memos/

Since CSVI doesn’t file with the SEC, it’s not on EDGAR. For that reason, I thought I should include links to the specific pages where you can find “EDGAR-like” information on the company.

The company’s “Disclosures” page over at OTCMarkets.com has annual reports going as far back as 2006 (filed in 2007, covering the year 2006):

https://www.otcmarkets.com/stock/CSVI/disclosure

CSI always includes a “Selected Financial Data” table in the annual report that goes back a full 10 years. So, the 2006 annual report has data going back to 1996.

The company also has an investor relations page that includes financial data in other summary forms:

https://www.csiweb.com/investor-relations

I don’t know if I’ve mentioned this before, but I always read a company’s Glassdoor page as well. This is a site that includes employee reviews. CSI has a lot of reviews on its Glassdoor page. So, you might want to check it out in this case. I usually read the reviews more to get a sense of what the company actually does day-to-day, what incentives are like for lower-level employees especially those that deal with customers, etc. than because I prefer companies with higher reviews from employees or something like that.

I’ll summarize the reviews in general here by saying this company doesn’t have very high base pay, it does have benefits, it doesn’t have very high employee churn, and management cares about hitting profit targets (and probably the stock price). Employees also mentioned something that had been disclosed in a press release:

“..non-executive full-time employees with the company more than 12 months will receive a one-time $1,300 cash bonus in March. Part-time and other employees with the company less than 12 months will receive a one-time cash bonus of $650 also in March. The company also stated that all eligible employees will receive an additional one-time contribution to their retirement plan.”

This is due to the tax savings that Jayden mentioned in his article.

Anyway, this is the thread to use to ask me questions about CSI, to ask Jayden questions about CSI, to give your thoughts, etc. Please do so below.…

Geoff Gannon April 15, 2018

AutoNation (AN): A Cheap Cannibal with Minimal Downside

Member write-up by Dave Rottman

Introduction and Overview

AutoNation (AN) is the largest automotive retailer of new and used vehicles in the United States. As of the end of 2017, they owned and operated 360 new vehicle franchises with 33 different new vehicle brands through 253 dealership locations concentrated in major metropolitan areas primarily in the southern Sunbelt region. AutoNation also owned and operated 76 collision centers scattered throughout the continental US.

Prior to 1999, AutoNation was named Republic Industries and was involved in waste management and then later electronic security services, vehicle rentals, and automotive retailing. Since the turn of the century, AutoNation has been focused exclusively on the automotive retail business.

Despite changing conditions in the coming years with the advent of online automotive retailers, autonomous vehicles, increased ride sharing, and electric vehicles, AutoNation offers investors several attractive characteristics.

First, as the largest automotive retailer in the United States, AutoNation enjoys benefits of scale both in terms of lower general and administrative overhead and in volume discounts when purchasing parts for the repair business and even inventory from manufacturers. As the automotive retail industry continues to undergo consolidation into a less fragmented market, these benefits are likely to amplify and strengthen the competition position of those players with scale, like AutoNation.

Next, the business generates a large and noncyclical stream of cash flow related to its parts and service business that has increasingly become a larger portion of earnings. While new and used car sales and the associated finance and insurance revenues are cyclical, parts and service earnings have provided a stable base of cash flow. In addition to stabilizing the cash flow of the overall business, this has also allowed AutoNation to consistently funnel cash into stock buybacks when shares prices are attractive, leading to a 5, 10, and 15 year growth rates of approximately 10% in earnings per share. This is impressive considering that the sales volume of actual new and used vehicles has essentially been flat over the course of the cycle.

Further, AutoNation holds a large amount of attractive real estate that provides a meaningful asset-based value that can be sold as a next-best use that supports valuations if earnings power were to become impaired or if/when AutoNation decides to decrease its physical presence.

Finally, and more speculatively, in late 2017 AutoNation announced a partnership with Waymo – Google’s autonomous vehicle company – where AutoNation will maintain and repair Waymo’s autonomous fleets. While the actual value this will provide to AutoNation is extremely uncertain at this point, it does serve as an offsetting factor to the risks posed by increased use of autonomous vehicles and ride sharing by hitching AutoNation up to the dominant player in autonomous vehicles in the nascent stages of this development.

The Business

There are four parts to AutoNation’s business: new vehicle sales, used vehicle sales, parts and service (P&S), and finance and insurance (F&I).

New and used vehicle sales are straightforward: generally speaking AutoNation purchases new vehicles from …

Geoff Gannon April 15, 2018

Computer Services Inc. (CSVI): An Unlisted, But Super Predictable Company Trading at an Unleveraged P/E of 15 times Next Year’s Earnings

Member write-up by Jayden Preston

Introduction

Computer Services Inc (often called “CSI”, the ticker is CSVI) is an unlisted stock in the US. It does not file with the SEC. But it does trade over the counter. The Company also publishes annual reports and quarterly earnings reports. You can find more information about the Company on OTCmarket.com.

As you would expect from an unlisted company, their annual report is not as extensive as you would find in a 10K. However, there are financial figures of the Company going back to 1996. There are also three main comparable companies that are listed. So, you can gather enough information to make an educated judgement on the Company.

CSI provides service and information technology solutions to meet the business needs of financial institutions and corporate entities. Their main clients include community banks, regional banks, multi-bank holding companies and a variety of other enterprises. They emphasize that their services are tailor-made to the clients’ needs.

The Company categories their revenue sources into two major parts: 1) core processing and 2) integrated banking solutions. Below I quote from the annual report on the range of services they offer:

“We derive our revenues from processing services, maintenance, and support fees; software licensing and installation fees; professional services; and equipment and supply sales. In addition to core processing, our integrated banking solutions include digital banking; check imaging; cash management; branch and merchant capture; print and mail, and electronic document delivery services; corporate intranets; secure web hosting; e-messaging; teller and platform services; ATM and debit card services and support; payments solutions; risk assessment; network management; cloud-based managed services; and compliance software and services for regulatory compliance, homeland security, anti-money laundering, and fraud prevention.”

As you can see, their solutions cover a very wide range of operational needs of financial institutions. They are almost like an outsourced IT department for financial institutions, with many functions they provide being highly critical.

Within the bank core processing industry, CSI is a distant fourth player, with a market share of 6.6% in 2017. The biggest player is Fiserv, with 37.1% of the market. The next two players are Jack Henry and FIS, with market share at 17.6% and 16.6% respectively.

Durability

For the business of core processing and other bank IT services to be durable, two key conditions are needed: 1) Financial institutions, such as banks and credit unions, remain durable and 2) Outsourced solutions continue to be an option.

Historically, banks are some of the most durable businesses. Now, with cryptocurrencies being all the rage, there are people who will question whether banks will remain durable. That is too big a topic to discuss in full here. But in short, my personal thought is it is too speculative to believe bitcoins will take over the whole banking industry. A more reasonable scenario to me is the blockchain technology will be incorporated within the current banking system instead.

As …

Philip Hutchinson April 13, 2018

Facebook – making implicit assumptions explicit

Obviously, Facebook has been in the news a lot recently. And Geoff has written a couple of articles that touch on the company directly and indirectly. Also, I’ve been reading up on the company recently and thought it would be interesting to post about whether Facebook could be a value investment.

This is basically just addressing directly some of the implicit assumptions that get made when you look at a fast growth stock like Facebook. I’m not going to go into Facebook as a business in detail. This is more about testing how realistic assumptions about Facebook’s growth really are. Now that said – I do have a view on Facebook’s business quality. In short – it’s extreme. This is a company that can convert 35 – 40% of sales into free cash flow while growing at very very fast rates. But I’m not going to break that down or look at the sustainability of the business in this post.

First, I am going to start with the premise that, economically, Facebook is a media network wholly dependent on advertising revenue. Right now, that’s true. There is a tiny amount of non advertising revenue, but it is immaterial. Of course, this may not always be true. It could find other sources of revenue. But that is completely speculative.

So we can say, one, the addressable market for Facebook is global ad spending. And two, we can assume that ad spending will grow over time with nominal GDP.

The most recent figures I can find estimate global ad spending for 2018 to be $558 billion. Obviously, you can find other estimates, but they’re not going to be hugely different, so we can work with that figure.

Let’s assume that grows at 4% per year for the next 10 years (roughly, nominal GDP – maybe this is a bit on the conservative side). 2028 ad spending would be $826 billion.

Now let’s look at Facebook. 2017 sales were $40.7 billion. Then let’s assume Facebook can grow sales at 15% per year for the next 10 years. This gives 2028 sales of $164 billion.

If Facebook grows like that, it will get further scale benefits so I am comfortable assuming a 40% free cash flow margin. That gives free cash flow of $65.9 billion.

Shares outstanding could be 3,603 million in 2028 (assuming dilution of 2% a year). So, that gives free cash flow per share of $18.29.

If you assume a 15x FCF multiple for “mature Facebook”, that gives a 2028 value of $274/share. So, roughly 65% higher over 10 years. Now, some of that is quite conservative. For example, it gives no credit for the huge cash buildup that would take place over this period (though that raises questions of capital allocation which are not easy to answer in Facebook’s case). It quite probably understates what Facebook’s margins could look like. And a 15x multiple is pretty cheap for a business of Facebook’s quality, even if it’s just a nominal …

Andre Kostolany April 5, 2018

National Cinemedia (NCMI)

Would very much appreciate everyone’s thoughts / comments / feedback / criticism. If there’s interest, I might follow-up with a full writeup.

Notes

NCMI has the #1 market share for on-screen advertising (about 50%)
The industry is an oligopoly with NCMI and Screenvision having about 85% market share
Basically NCMI owns the right to run a 30-minute pre-movie show in its founding members US theaters, which includes advertising. This right is backed by long-term exhibitor agreements with the founding members which, to the best of my understanding cannot be revoked
Let me repeat, 90% of the opportunity around NCMI revolves around their ability to monetize the 30-minutes BEFORE the movie trailers start
Founding members (and co-owners of NCMI) are AMC, Cinemark, Regal
NCMI derives revenue principally from selling advertising during these 30 minutes
NCMI has produced stable OIBDA margins since its IPO as well as relatively stable revenues
NCMI, Inc., the publicly listed entity owns a 49.5% stake in NCMI, LLC. The rest of LLC is owned by the founding members
AMC, the largest owner of NCMI, LLC is being required to divest the majority of its equity interests after an anti-competitive DOJ ruling (this was a condition for its takeover of Cinemark)
AMC has until June 2019 to dispose of 9.5% of its stake (to reduce its stake below 5%)
At the same time, 2017 had a relatively mediocre movie slate and attendance was down. Somehow this led to the stock falling from $16 to $5
At its current price of $5.24 NCMI trades at a 13% dividend yield
The company pays out almost the entirety of its free cash flow via dividend to shareholders and founding members
2018, so far, has been a better year in terms of theater attendance led by Black Panther
Optimism and pessimism about the slate come and go, offset by probably 6 to 12 months
MoviePass could help increase theater attendance as well

Further Comments

I find this situation highly interesting and am looking for reasons why this traded at a 5-6% dividend yield forever and now should trade at 13% yield. Note I am using dividend yield as a simplified proxy for FCF, which is somewhere in the range of $120MM-$150MM per annum (to LLC, not Inc, so cut this in half)

Risks

Further decline in theater attendance
Weakening in pricing power if the US moves due to impact of reserved seating/online ticketing. Advertisers may be worried that nobody will watch the pre-shows (which start 30 minutes before the advertised movie start time) if this happens
AMC somehow finds a way to wiggle out of its contract with NCMI as once it only owns <5% of NCMI, LLC interests are less aligned
The threat of cinemas losing their exclusive right to screen movies a couple of months before DVD/other releases

Geoff Gannon April 1, 2018

Killing Your Horse

Monday, March 26th, Keweenaw Land Association by Geoff Gannon
Friday, March 30th, EM Systems by Clayton Young
Friday, March 30th, ExxonMobil by Trey Henninger
To Focused Compounding members:
Two-thousand-ninety years ago, a man by the name of Spartacus was leading a group of rebels – all escaped gladiators like himself – in the hopes of escaping Italy and finding freedom in what is now France. The gladiators’ passage was blocked by a Roman army. Spartacus had no choice but to fight. On the eve of battle, thousands of men gathered round to hear Spartacus speak. They were, no doubt, expecting to hear a great and rousing speech. What they witnessed instead was a simple act. Spartacus ordered his horse brought out. And there, in front of all his men, he cut the horse’s throat. His rousing speech consisted of these words: “If we win the battle, I will have many fine horses that belonged to the enemy. If we lose the battle, I will have no need of a horse.”

Forty-five years ago, a man by the name of Benjamin Graham wrote: “Investment is most intelligent when it is most businesslike.” One difference between all the investors reading this memo and all the businessmen running companies is that the investor often has an exit strategy. The businessman does not. Ben Graham also wrote: “The true investor scarcely ever has to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement.” What if an investor chose to behave as if he had no market quotation at all?

What if he killed his horse?

It may seem odd to suggest you should tie your own hands and once having bought a stock never allow yourself to sell that stock. After all, a highly liquid market gives you a lot of choices. But, are you sure you make use of the choices in a way that improves your results? Are you sure the stocks you sell go on to underperform the stocks you buy? Have you ever really stopped and spent a day going through all your past trades to prove there’s a point to all this selling you do? I once wrote an article over at Focused Compounding called “Over the Last 17 Years: Have My Sell Decisions Really Added Anything?” My conclusion was that in cases where I chose the right business to start with, my sell decisions did not add anything. So, there are now two questions to ask yourself. …

Geoff Gannon March 31, 2018

NACCO (NC)

As I’m writing this: the stock is back down to $32.85 a share, which is basically what I bought my shares at back in October. So, I wanted to point that out to members who thought the stock was more expensive than when I looked at it and so not worth a look. You can, if you want, get shares at basically the price I got mine.

The company’s first annual report as a stand alone business came out. And they also have transcripts of the two earnings calls.

2017 Annual Report

Q3 2017 Earnings Call Transcript

Q4 2017 Earnings Call Transcript

A lot of members have been emailing me about NACCO instead of talking about the stock on the site. From now on, this discussion thread is the place to ask me questions about the stock, discuss it, etc.

…

Geoff Gannon March 30, 2018

ExxonMobil (XOM): A Blue-Chip Energy Company Likely to Provide Double-Digit Returns

Member write-up by Trey Henninger

Exxon Mobil (XOM) is one of the oil majors. Traditionally, being an oil major has meant being a fully vertically integrated company from oil exploration, drilling, refining, and chemical production. ExxonMobil continues to fulfill that role, but they are much more than an oil company today. Although they are typically billed as an oil AND gas company, they are much more.

Business Model Overview

ExxonMobil is a very complicated business with many different parts. The simple way to look at the business is that ExxonMobil operates as a vertically integrated company. They source and sell commodity products. Since ExxonMobil’s focus is in commodities, they have no general pricing power in the market.

Consequently, Exxon’s profits are quite cyclical, and hard to predict. However, the vertically integrated nature of the company dampens the cyclicality of the business cycle to a large degree. When oil prices are low, refining margins are usually high. Alternatively, the chemicals business could continue to make a profit while both oil sourcing and refining are less profitable.

This vertical integration and diversified structure is the key advantage of ExxonMobil and the other oil majors.

Durability

I believe that ExxonMobil is a company with infinite durability. The company traces its history back to the original days of Rockefeller and Standard Oil of New Jersey. Exxon has been in continuous operation for over 100 years. You should be able to expect them to continue to operate for at least another 100 years. At a minimum, well beyond your investment time horizon.

The reason for this is quite simple. Although ExxonMobil’s business is currently focused on the commodities oil and natural gas, that won’t always be true.

ExxonMobil is best analyzed as an “Energy” company. While the individual commodity product might change, the overall goal is the same. ExxonMobil is in the business of providing energy to their customers. Currently, this takes the form of oil and gas, but they certainly are not limited to that.

ExxonMobil was originally simply a diversified oil company. Then, as the market changed as natural gas become a larger portion of our energy sources, ExxonMobil acquired a major natural gas company, and has become one of the world’s largest natural gas producers.

The same will occur if the mix of energy ever shifts again in the future. Currently, the thought is that renewables, such as solar or wind power will disrupt the oil majors, such as ExxonMobil. This is not likely to happen. Instead, I would expect ExxonMobil to operate in the oil and gas business until they recognize that renewables are finally ready for the mainstream. Once they do, they’ll acquire a major renewable energy company, and quickly build it up. It won’t be long before ExxonMobil is then one of the largest renewable energy producers on the planet.

ExxonMobil has both the scale and the financial resources to accomplish this goal.

Competition

ExxonMobil …

Geoff Gannon March 30, 2018

EM Systems: The Japanese Industry Leader in Pharmacy Software

Member write-up by Clayton Young.

Thinking Points

EM Systems (TSE: 4820) is an industry leader in pharmacy software looking to leverage its strengths in closely related industries.
The company’s biggest strength is its business model, which lowers industry standard system implementation costs and better aligns cost structure to its customers’ operating performance.
Share price is a little elevated today at 1,398 yen per share (13.8 TTM EV/EBIT). Investors can reasonably expect an investment CAGR between negative 2.5% and 8.8% over the next three years.

Introduction

EM Systems (TSE: 4820) primarily develops, sells and maintains software geared for pharmacies. With a 26% domestic market share, the company is an industry leader. More recently, EM Systems started focusing on Medical systems (Electronic Health Record) and Nursing Care systems. By the end of fiscal 2019 (March 2019), the company aims to achieve market shares of 40% in pharmacy software, 10% in Medical systems, and 5% in Nursing Care systems.

The company has three reporting segments: Pharmacy, Clinic (Medical system), and Other (includes Nursing Care system).

During the fiscal 2017 reporting period, 81% of revenues and virtually all of operating profit came from the Pharmacy segment.

Source: Author calculation based on EM Systems filings

Long-time Value Investor’s Club (VIC) members may be familiar with EM Systems. The company was covered on two occasions: Once in 2015 and again in 2017. I highly recommend reading both before proceeding, as I am hoping to fill in the gaps rather than repeat the same information.

Industry

Since the Pharmacy segment accounts for 81% of EM System revenues, this section will mostly focus on the pharmacy industry in Japan.

According to MAC Advisory (Japanese), the pharmacy market in Japan was a 7.9 trillion yen ($74.2 B USD) market in 2016. The top 10 pharmacy operators (by prescription revenues) accounted for 15.8% of the industry. 70% of pharmacies were operated by individuals. There are approximately 58,000 pharmacies in Japan.

In November 2017, I briefly covered the convenience store, drug store and pharmacy industries. The post can be found here. With a heavier focus on pharmacies, the highlights are below:

The three industries are merging/consolidating.
There is an industry-wide shortage of pharmacists, which is expected to continue.
Japanese government is pushing for “family pharmacist”, lower prices, and generic drugs.

Though it is tempting to look at Japan’s aging population and invest in pharmacies with a tailwind in mind, the Japanese government has a vested interest in reducing drug prices. With Japan’s universal health care system, all residents are required to participate in the public health insurance program. Participants shoulder a maximum out-of-pocket expense of 30% on government approved prescriptions.

The Japanese government reviews health care costs (including drug prices) every two years. Nursing care costs are reviewed every three years. Every six years, both reviews land on the same year, and 2018 is that year. Japan Times writer Tomoko Otake wrote about the highlights of this year’s health care review, effective April 1. In short, …

Geoff Gannon March 26, 2018

Why I’ve Passed on Keweenaw Land Association (so far)

Trey had a good question in response to my Keweenaw Land Association article:

“Are you willing to share your reason for not investing at this time?

My first pass analysis leads me to also not choose to invest at this time. For me, it’s a matter of opportunity cost. Simply beating the S&P500 is insufficient. Since the S&P500 is projected to return much lower than its historic rates of return, my current opportunity set is much better.

That’s really always been my hesitation with owning something like timberland. I’ve been interested for diversification reasons, but in order to achieve double digit returns over long periods of time, you have to really buy at a large discount.

While I agree with the analysis that downside looks limited here, I struggle to come up with a scenario where a long-term owner (10+ years) could earn 10%+ returns. I understand though, that if the company is sold in a shorter amount of time for a premium, you could earn that hurdle rate over a shorter period of time. With that said, I think purchasing below $75-80 per share would offer the additional 2%/year return that I need for a 10 year holding period.

Sure. So, it’s easy to imagine a scenario where a long-term holder of timberland makes 10% plus returns. All you need is high inflation. Timberland’s long-term returns should be driven by: the cash flow produced by the annual harvest, the biological growth, the rate of inflation, and then also there tends to be some return – at least historically this has been true as countries develop – of competing uses for the land. This last factor is not important in Upper Michigan. But, there are places in the U.S. where it is. There’s nothing nominal about any of the factors driving returns in timberland. All the factors driving returns are real factors. So, if you had 6% inflation or higher – it’s likely timberland would return 10% or more a year for as long as that situation continued. You can check the historical record for periods of high inflation in the U.S. and see how timberland performed versus stocks, bonds, commodities, etc. during that period. The answer is good.

Over periods as short as 5-10 years, the factors driving timberlands returns would really just be the purchase price you were getting in at (if you’re buying a timber stock – this means both where we are in terms of timberland pricing and where the share price is versus the appraisal value of its timberland) and then whether demand for housing increases while you hold the timber stock. There are other uses for timber, but the most cyclical use for the more profitable trees is housing. So, when you see a low projected return for the S&P 500 versus a high projected return for timberland over the next 5 or 10 years, what the forecaster is really saying is: stocks are relatively more expensive than timberland right now, home construction …