Posts In: Idea Exchange

Geoff Gannon October 18, 2017

NACCO (NC): The Stock Geoff Put 50% of His Portfolio Into

On October 2nd, Hamilton Beach Brands (HBB) was spun-off from NACCO Industries (NC). That morning I put about 50% of my portfolio into NACCO at an average cost per share of $32.50. Since that purchase was announced, several members of Focused Compounding have sent in emails asking for a write-up that explains why I made this purchase.

Unfortunately, there just isn’t much to say about my NACCO purchase. So, this write-up will be both brief and boring.

I bought NACCO, because the stock’s price after the Hamilton Beach spin-off seemed low relative to the earning power of the coal business.

 

All Value Comes from the Unconsolidated Mines

After the Hamilton Beach spin-off, the earning power of NACCO comes entirely from its “unconsolidated mines”. NACCO – through NACoal – owns 100% of the equity in these mines and receives 100% of the cash dividends they pay out (which is almost always equal to 100% of reported earnings). However, the liabilities of these mines are non-recourse to NACoal (and thus NACCO). Each mine’s customer (the power plant) is really supplying all the capital to operate the mine. This is why NACCO doesn’t consolidate the mines on its financial statements (because it isn’t the one risking its capital – the utility that owns the power plant is taking the risk).

You can see the financial statements for the unconsolidated mines here.

(It is very important that you click the above link and read through it carefully).

 

There Are Risks

NACCO also owns one consolidated mine (MLMC) which could potentially destroy value. And at the parent company level – so NACCO rather than NACoal – the company has legacy coal mining liabilities (“Bellaire”) and losses related to general corporate overhead.

NACCO’s customers are almost all “mine-mouth” coal power plants. They sit on top of coal deposits that NACCO mines and delivers to the plants to be used as fuel.

Coal power plants throughout the U.S. have been closing. The power plants NACCO supplies could close at any moment. And it would only take one such closure to seriously dent NACCO’s earning power.

NACCO’s largest customer accounts for probably 35% of the company’s earning power. NACCO’s two largest customers account for probably 50% of earning power. And NACCO’s three largest customers account for probably 65% of earning power.

 

NACCO’s Business Model

NACCO sells coal to its customers under long-term (most contracts expire in 13-28 years) supply agreements. The agreements are “cost-plus” and indexed to inflation.

 

 

Each Share of NACCO is Backed by 5 tons of Annual Coal Production

As you can see in this investor presentation, NACCO delivered 35.5 million tons of coal over the last twelve months. The company has 6.84 million shares outstanding, so each share of NACCO is now backed by 5.19 tons (35.5 million / 6.84 million = 5.19) of coal sold under a cost-plus contract indexed to inflation. I paid an average of $32.50 a share for my stake in …

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Kevin Wilde September 27, 2017

Hamilton Beach Brands (NYSE:HBB) – Quick Valuation

I took a quick look at Hamilton Beach Brands after reading about it in some of Geoff’s articles.  In the 10-K, the company segments profits by NACoal, KC, NACCO & Other, and HBB.  So, I’m talking about HBB here and I’m just crunching numbers without doing any sort of qualitative analysis.

  • 5Y median Return on Tangible Capital ~23%.
  • HBB Revenue ~$600MM.
  • 5Y median revenue growth 3.8%, so estimate 3-4% moving forward.
  • 5Y median operating margin ~7%.
  • Normalized operating profit ~$42MM.
  • 5Y median CFFO / operating profit is 84%, so normalized CFFO = $35MM.
  • Maintenance Capex ~$5MM.
  • FCF ~$30MM.
  • Assume forward market return of ~8%.  Conservatively, HBB should grow revenues by about 3% per annum.  So, a fair multiple in today’s terms is 20x.
  • Multiple of 20x on $30MM FCF is $600MM.
  • I would want a minimum of a 10% annual return, so I wouldn’t pay more than a 14.3x multiple (1 / [10% – 3% annual growth]).  Hence, I’d want to pay around $425MM to consider an investment.

 …

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Kevin Wilde September 18, 2017

Cheesecake Factory (NAS:CAKE) Comparative Analysis

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Kevin Wilde September 14, 2017

Cheesecake Factory (NAS:CAKE)

The Cheesecake Factory (NAS: CAKE)

14-SEP-2017 (EV $1.82B; Mkt Cap $1.88B; 49.0MM shares outstanding; $40.29/share)

STATUS

  • At end of 2016, CAKE had a total of 208 company-owned restaurants (all U.S. based):
    • 194 Cheesecake Factory restaurants
    • 13 Grand Lux
    • 1 Rock Sugar Pan Asian
    • NOTE: Each restaurant has sales of ~ $10.5 annually. Maintenance CapEx over the last 3 years has been between $26MM and $29MM per year.  Bakery & Training center capex has averaged $11MM annually over the last 3 years.
  • 2016 sales of $2.276B.
  • Highly consistent operating margins with 25-year weighted average of 8.0%.
  • Consistently convert 150% of operating income into Cash Flow from Operations.

GROWTH

  • At end of 2016, CAKE also had 15 international locations owned by licensees.
  • In the past:
    • Opened between 8 to 10 new restaurants in the past 5 years @ average cost of $8.0 to $10.5MM per location.
    • Have closed ~ 4 restaurants in the past 5 years (1x Cheesecake Factory + 3x Grand Lux).
    • 15-year median comparable restaurant sales 1.2%.
  • Going forward:
    • CAKE believes that there is room for >300 U.S. company-owned Cheesecake Factory locations.
    • Current plans call for 8 company-owned Canadian locations.
    • CAKE expects to add 3 to 5 international licensed restaurants / year for the foreseeable future.
    • CAKE has an investment in new concept restaurants North Italia and Flower Child; however, I don’t currently put any value on these opportunities because they are an unproven concept.
    • CAKE is also looking at expanding its consumer goods sales and a fast casual restaurant concept; again, I don’t put any value on these opportunities at this time.
    • Expect costs for 8 new company-owned restaurants (ie. Cheesecake Factory + Grand Lux in U.S. & Canada) each year @ $10.5MM each for a total of $84MM; however, expect to only net 7 more restaurants per year due to restaurant closures of 1 per year.
    • Expect revenue / net earnings / free cash flow benefit of 4 new licensed restaurants per year ($0.01 EPS/restaurant * 4 restaurants * 49MM shares = ~$2MM /year) at $0 capex per restaurant.
  • GROWTH SUMMARY:
    • Within 5 years, CAKE should net 35 new company-owned restaurants at an annual capex cost of $84MM. These stores should add sales of $367MM by the end of the 5-year period.
    • Over the next 5 years, same restaurant sales should increase to $2.415B ($2.276B * 1.012^5).
    • Within 5 years, CAKE should add ~20 new licensed restaurants at $0 capex which add $10MM to FCF.

VALUE

  • Sales in 5 years time should total $2.828B (CHECK: 4.4% annual increase is in line with the recent past).
  • Operating Income in 5 years time should total ~$225MM.
  • CFFO in 5 years time should total ~$340MM.
  • New restaurant capex of in 5 years time should be ~$90MM. Maintenance capex in 5 years time should be ~ $50MM.  Working Capital effects should be negligible.  After-tax stock based compensation is likely to ~ $15-20MM in 5 years time.  Hence, free cash flow in 5 years time should be ~ $180MM.
  • CAKE is an above
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Jayden Preston August 7, 2017

RLI Corp (NYSE:RLI) – Just Wait for the Price

Introduction

 

Founded in 1965, RLI Corp. is a specialty insurance company with a niche focus. Initially, the company was called Replacement Lens Inc.*, as the company started out as an insurer for contact lens. They were once the largest insurer of this product in the world. In 1976, RLI expanded beyond contact lens insurance into property and casualty insurance.

 

Fast forward to the present, they now offer insurance coverages in both the specialty admitted and excess and surplus markets. Through 3 subsidiaries, they operate their insurance business nationwide in the US.

 

Coverages in the specialty admitted market, such as their energy surety bonds, are for risks that are unique or hard-to-place in the standard market, but must remain with an admitted insurance company for regulatory or marketing reasons. In addition, their coverages in the specialty admitted market may be designed to meet specific insurance needs of targeted insured groups, such as professional liability and package coverages for design professionals and stand-alone personal umbrella policy.

 

The excess and surplus market, unlike the standard admitted market, is less regulated and more flexible in terms of policy forms and premium rates. This market provides an alternative for customers with risks or loss exposures that generally cannot be written in the standard admitted market. This typically results in coverages that are more restrictive and more expensive than coverages in the standard admitted market. Often, the development of these coverages within the excess and surplus market is generated through proposals brought to them by an agent or broker seeking coverage for a specific group of clients or loss exposures.

 

RLI distributes their insurance products through their own branch offices that market to wholesale and retail producers. The top 3 states for RLI are California (16% of total direct premiums earned in 2016), New York (14.1%) and Florida (10.4%).

 

 

Description

To understand an insurance company, it’s important to look at both its insurance operation and investments.

 

Let’s begin with a more detailed look at its insurance operation.

 

In terms of market segment, RLI categorizes them into 1) Specialty Admitted Insurance Market, 2) Excess and Surplus Insurance Market and 3) Specialty Property and Casualty Reinsurance Markets.

 

As mentioned, in the Specialty Admitted Insurance Market, most of the risks they underwrite are unique and hard to place in the standard admitted market, but for marketing and regulatory reasons, they must remain with an admitted insurance company. This market is more regulated than the other two markets RLI are in, particularly regarding rate and form filing requirements, as well as restrictions on the ability to exit lines of business. In 2016, this is the biggest market for RLI, representing about 67% of their total gross premiums written.

 

Excess and Surplus Insurance Market is the second biggest market for them, contributing 30% of the gross premiums written in 2016. This market focuses on hard-to-place risks, with more flexible policy forms and unregulated premium rates. For the overall property and casualty industry, this excess and surplus market represents about 5% …

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Sebastian Schrick July 16, 2017

Merkur Bank (XETR: MBK)

Merkur Bank (MBK) is a small regional bank located in Munich, Germany. In 1986, MBK was acquired by a group of private investors led by Mr. Siegfried Lingel. At this time MBK had total assets of €14 million and 7 employees. Mr. Lingel refocused the bank’s business on financing residential real estate developers in Leipzig, Berlin and, to a lesser extent, Munich. In 1995, the bank extended its business to the financing of leasing companies and SMEs. In 1999, MBK went public on the Munich stock exchange. In 2002, Mr. Lingel’s son, Mr. Marcus Lingel, joined the company’s management team and, after a six-year transition phase, he finally became CEO. Mr. Lingel refocused MBK’s real estate business to Munich (beginning in 2002) and, in 2005, to Stuttgart. MBK operates five branch offices and since 2009 the company has also been offering online retail banking solutions to its clients. Currently, MBK has total assets of approximately €1 billion and 200 employees.

The following are the main arguments for investing in the company:

  1. MBK’s business model is easy to understand.

MBK could serve as a text book example of how banks used (?!) to operate. MBK collects deposits from its clients and uses these funds to provide loans to real estate developers, leasing companies and SMEs. The difference between the cost of taking in clients’ deposits and the interest rate MBK demands from its borrowers is MBK’s most important revenue stream. The second revenue stream are commissions earned by providing various consulting services to clients and borrowers.

MBK is not engaged in any sort of proprietary trading or investment banking. This allowed MBK to survive the financial crisis of ’08-’09 and the “Euro crisis” unscathed because it did not have to record any write-downs. In fact, MBK has been profitable during these times of financial turmoil. MBK also refrains from performing maturity transformation as far as possible.

MBK’s business model, i.e. focusing on the “traditional” banking business, makes the bank quite insensitive to the prevailing low interest rate environment. From 2009 to 2016 the bank’s interest rate spread fluctuated between 3.24% (2010) and 2.78% (2016) and the average (= median) interest rate spread being 2.92%. The main factor affecting MBK’s profitability are competitive pressures, i.e. when its competitors demand lower interest rates on new loans to gain market share. These pressures have intensified in the last three years, as the interest rate spread declined from 2.94% to 2.78% (2016).

  1. Focus on Munich’s housing market should provide potential for further growth.

MBK’s most important business segment is real estate financing and, here, the bank is particularly focused on Munich.

Munich is an attractive city for real estate developers because of a chronic scarcity in housing. This situation will probably not change as Munich’s population is likely to grow in the future, as it has done in the past. This is due to the high quality of living the city offers (it constantly ranks among the top ten cities in the world) and its …

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Jayden Preston July 2, 2017

Kroger (NYSE:KR): A Little Too Hard

On 16 June 2017, Amazon announced a $13.7 billion acquisition of Whole Foods. The announcement then engendered meaningful declines in stock prices of major grocers/supermarkets, not just in the US but also in Europe. Kroger, in particular, dropped as much as 17% that day. This brings its YTD performance to -31% as of 29th June 2017.

Below, we take a brief look at Kroger to see if it is now the right time to consider an investment in it.

 

Introduction

Founded in 1883, Kroger is now one of the largest retailers in the world, with more than $115 billion in revenue in 2016, serving more than 8.5 million customers every day. As of January 28, 2017, Kroger operated, either directly or through its subsidiaries, 2,796 supermarkets under a variety of local banner names. 2,255 of them have pharmacies and 1,445 have fuel centers. They also offer ClickList™ and Harris Teeter ExpressLane— their personalized, order online, pick up at the store services — at 637 of the supermarkets. Approximately 48% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land.

Kroger also operates 784 convenience stores, either directly or through franchisees, 319 fine jewelry stores and an online retailer.

 

Several things stood out in the above description of Kroger:

  1. With sales of $ 115 billion, Kroger is the third biggest retail chains in the world. It is also the largest traditional supermarket chain in the US.
  2. Kroger’s 2,796 supermarkets are operated under a variety of local banner names.
  3. Fuel is a significant contributor to Kroger’s revenue, generating almost $14 billion in 2016. More than 50% of Kroger’s stores have fuel centers.
  4. 48% of Kroger’s supermarkets are operated in their own facilities.

 

We will come back to the above points below.

 

Durability and Moat

The durability of demand for food and groceries is very good. Most grocers do not experience significant fluctuations in real sales per square foot over time. This is especially true for a general food and grocery retailer like Kroger, whose store size is big enough for them to have room beyond providing traditional grocery to also sell items that are popular. In other words, they have more room to experiment and adapt according to the latest trends.

For example, 10 years ago natural and organic was not a central focus in their stores because it was not a central focus for customers. 5 years ago Kroger made a concerted effort to make natural and organic the “plus a little” part of their product strategy (Kroger wants their most loyal customers to say “At

Kroger, I get the products I want, plus a little”). Today, natural and organic foods are integral to their business, reaching $16 billion in annual sales in

  1. In fact, this makes Kroger a bigger organic food retailer than Whole Foods.

In terms of moat, supermarkets’ competitive advantage mostly stems from local economies of scale. Kroger uses a 2 to 2.5 mile radius to define its local market for each …

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Mister Compounder June 26, 2017

Protector Forsikring (OSLO: PRTOCT)

 

Ticker:                  PROTCT

Country:              Norway

Stock price:        71,75 NOK

 

Summary of the thesis:

  • A fast-growing Norwegian insurer with higher than industry growth in premiums. Historically it has grown premiums at 20 %, achieving 92 in combined ratio and an investment return on the float of 5,5 %.
  • A low-cost focused business model with industry leading expense ratios.
  • Protector is trading at approximately 12x normal earnings, which is in line with what the Norwegian market has been priced at historically. This is cheap if the growth and the underwriting record can sustained.
  • The risks involve an underwriting business with many moving parts in combination with rapid expansion in new markets. The company has experienced mispricing in its policies like worker’s compensation in Denmark causing the combined ratio to hit 98 for the fiscal year 2016. Furthermore, the investment portfolio consists of 80 % bonds which might not provide an adequate return.

Overview:

Protector is quite a new player in the Scandinavian insurance market. The company was established in 2004, and listed on the Norwegian stock exchange in 2007. It has 300 employees at offices in Oslo, Denmark, Stockholm, Helsinki and Manchester. In 2006, gross written premiums (GWP) was about 500 million NOK, while in 2016 it wrote 3,4 billion NOK in GWP. In other words, this has been a growth story.

Protector consists of three business segments:

  • Selling insurance to companies
  • Selling insurance to the public sector
  • Ownership insurance

And as of today, 56 % of revenues comes from Norway, 24 % from Sweden, 19 % from Denmark, while others amount to 1 % of the business. It has just started expanding into the UK and Protector insures the London boroughs with Royal Borough of Kensington and Chelsea, City of Westminster and Fulham. You might have noticed the big fire in London recently, and the building Grenfell Tower was insured by Protector. The building lies in the west of Kensington and is a typical example of what kind of risks Protector takes on. At least 30 people were sent to hospital with injuries and several were wounded. This was a tragedy for the people, but most of the risks related to the fire was covered by reassurance. The UK market was chosen based on statistical analysis of the expense ratios and competitiveness of insurance markets across Europe.

The long-term financial goals of the company are the following:

  • Growth rate of gross written premium: 15 %
  • Combined ratio for own account: 92 %
  • Return on equity: >20 %

Protector sells their insurance through insurance brokers. Historically, the focus of the company has been to sell insurance to companies in the segment from 100 thousand NOK up to 3 million NOK. In the commercial lines of business, they have 5 000 customers.

Historically, the company sprung out of ownership insurance. This is where Protector also has the strongest market presence, with more than 50 % market share in the Norwegian market. It is sold through lawyers and real estate brokers. However, today, this line …

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Kevin Wilde June 20, 2017

Under Armour (NYSE:UA)

UPDATED: 20-JUN-2017

Athletic apparel manufacturers typically develop, market, and distribute their own branded apparel, footwear, and accessories for men, women, and youth.  Products are usually sold worldwide and worn by athletes, as well as by consumers of active lifestyles.  Products are most often marketed at multiple price levels with revenue generated from a combination of wholesale sales to independent and specialty retailers, as well as through direct consumer sales channels that include a company’s own stores and its ecommerce sites.

The key players in the industry are NIKE (includes Jordan & Converse which was acquired in 2003), Adidas (includes Reebok which was acquired in 2005), Under Armour, PUMA, and ASICS.  Below is my estimate of the market size and industry market shares:

 

 

The industry is currently benefiting from a number of consumer trends, including an ongoing shift towards living healthier, a shift to more casual work and everyday apparel, global growth in sports activity, and a growing middle class in China and other emerging markets.  Other trends that appear to be affecting the industry are growth in Direct-to-consumer sales and a tendency for consumers to develop brand loyalty at a young age.

The athletic apparel industry is very durable with athletics traced back to 2250 BC.  People often seek to belong to a group and are typically loyal to their favourite athletic brands.  Over the long-term, the industry should be capable of growing sales at rates at least as fast as the global GDP growth rate (ie. ~4.5%+), and faster, if the current trends discussed previously, endure. 

The economic moats of an athletic apparel company is based on its brand strength and how well it resonates with consumers.  Protecting a company’s brand and growing its appeal/popularity is crucial to mass-market success. Endorsement deals with popular sports teams and athletes are often critical to brand success.  NIKE dominates industry endorsement spending, sponsoring 70% of the most valuable sports teams and 45% of the top athletes.  Adidas has the second most top endorsement deals (~15-20%) followed by Under (~10-15%). 

In the past, the industry has offered good fundamentals and good stock returns.  Below is a table of the fundamental & price performances over the last 9 years for each of the industry’s key players:

Currently, within the industry, Under Armour appears to be the most likely candidate for mis-pricing.  The stock has dropped approximately 50% in the past year and is trading near its historical low EV/Sales ratio.  As part of the 3Q2016 earnings call, management warned investors that sales growth would slow over the next two years, and then, after 26 consecutive quarters of >20% sales growth, Under Armour’s streak ended in 4Q2016 with sales growing by 11%.  They followed up with 1Q2017 year-over-year sales growth of 6.6% (including North American sales dropping 1%, wholesale revenues increasing 3.8%, footwear sales up 2.0%, and Connected Fitness sales up 2.3%).  Meanwhile, SG&A expenses increased 11.7%.

So, the key questions are:  What has caused Under Armour’s recent struggles and are they temporary or permanent?  …

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Kevin Wilde June 4, 2017

Wells Fargo (NYSE:WFC)

OWNERSHIP: I first bought WFC in FEB-2010. It is my top holding at 12.5% of my portfolio.

Figures as of 24-APR-2017

 SUMMARY

Wells Fargo is one of the biggest banking / financial institutions in the United States.  The company is organized into three operating segments: Community Banking which offers a complete line of financial services for consumers and small businesses (representing ~50% of earnings); Wholesale Banking which offers banking to larger businesses and government institutions (representing ~35% of earnings); and Wealth and Investment Management which offers personalized wealth management, investment, and retirement products (representing ~10% of earnings).

In general, Wells Fargo makes money in two ways.  Firstly, it earns a spread on its interest-earning assets by borrowing at low rates and lending at higher ones.  Secondly, Wells Fargo collects fees for the products and services it offers (non-interest income).  Non-interest income only partially offsets the company’s non-interest expenses; thus, it is only accretive to earnings if it outpaces costs.

Keys to banking include profitability as measured by Return on Assets (ROA), deposit growth, and leverage.  Return on assets is dependent on the cost of a bank’s interest-earning assets (primarily the size of their low-cost and non-interest bearing deposit base), the quality of the loans it makes (the frequency of loan defaults), its ability to generate non-interest income (earn fees for products and services), and its ability to keep costs down (low overhead).  Deposit growth translates into higher earnings by increasing a bank’s low cost deposit base and allowing it to earn a spread on additional loans.  Leverage is important because it can magnify both earnings and losses.

I believe Wells Fargo securities represent a safe investment.  U.S. banks are very durable businesses with high customer / deposit retention.  Most American consumers and businesses use their bank accounts for transactions and are generally indifferent to interest payments on the money they use month-to-month.  Banks could change for the worse, but changing for the better is much more likely. Traffic to branches is declining, which should lead to branch closures and cost reductions.  Wells Fargo has a strong competitive advantage built on a strong branch network, huge base of low cost deposits, conservative lending practices, and an ability to increase non-interest income by cross-selling its products.  Wells Fargo serves one-third of American households and its deposit base accounts for 10.8% of all U.S. deposits.  Credit has seldom been a problem; the bank successfully navigated severe real estate downturns in California (its largest market) in 2009, and the early 1990s, and there are no signs that the company has become a more aggressive underwriter.  The bank has earned a positive net income in each of the last 58 years (as far as I went back) and is less exposed to the risky investment banking and trading business than its peers.  The improper sales practices that occurred in Community Banking are the biggest concern because they have tarnished the bank’s reputation and suggest a problem with the bank’s culture; however, if the company implements …

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