Stock Ideas – Page 11 – Focused Compounding

Geoff Gannon October 19, 2017

What’s NACCO’s Margin of Safety?

After reading my write-up, a member asked me about the margin of safety in NACCO (NC):

“…why would someone put half of their portfolio weight in a stock like this where there is customer concentration risk plus a real risk that one of the customers may close shop? Agree that its FCF yield is 10% or so but does it deserve that kind of weight?”

I don’t want to exaggerate the safety of this stock. I didn’t write it up for a newsletter. This isn’t a recommendation for anyone else to buy it. I put 50% into it knowing I would have future control over decisions to sell that 50%. I don’t think I’d recommend this stock to anyone else because the headlines will all be negative and that is very tough for people to hold through.

Having said that, let me take you through how I might have seen the potential margin of safety when I bought the stock at under $33 a share on October 2^nd. The way I framed it, the margin of safety in NACCO was a lot higher than what I can get in other stocks. That’s despite the customer concentration and the possibility those concentrated customers are coal power plants about to be shut down.

When I bought the stock, I believed it was then trading at something like a 10% to 15% free cash flow yield. I also believed that the company’s balance sheet will be essentially unleveraged pretty soon (taking into account build up of cash during this year, the expected $35 million cash dividend from Hamilton Beach just before the spin, etc.). The parent company has liabilities but these are not immediately payable in full. Meanwhile, the unconsolidated mines pay cash dividends immediately each year. So, what I’m saying here is that I don’t believe the parent company is more leveraged, more short of cash relative to potential liabilities, etc. than an average stock.

So, the balance sheet is like an average stock.

But, a normal, unleveraged stock usually trades at about a 5% free cash flow yield.

So, NACCO’s free cash flow yield is 5% to 10% higher than an average stock while the balance sheet is similar.

Now, if it is true that when NACCO loses a big contract this means it mostly loses an equal percentage proportion of both revenues and expenses (this is an exaggeration – but I don’t think it’s a huge exaggeration because the mines really are administered very independently and are non-recourse to NACCO), you can kind of think about your margin of safety and the value in this stock as follows…

NACCO has a free cash flow yield no lower than 10% to 15%.

A normal stock has a free cash flow yield no higher than 5%.

5% is 0.50 to 0.67 times less than 10% to 15%. Therefore, NACCO would decline to a normal valuation after it has lost about 50% to 65% of its earnings. Let’s …

Geoff Gannon October 18, 2017

Does NACCO (NC) Have Any Peers?

A Focused Compounding member who analyzed and bought NACCO himself read my write-up on NC and was curious if I did a “peer analysis” for NACCO:

“Did you consider looking at any potential peers with your analysis? I was quite simplistic with my approach. Omnicom splits cash out year in year out. Its current EV to free cash flow is around 10x whereas I looked at NACCO and thought its EV to free cash flow was around 5x (NOTE: At the much lower spin-off price he bought at) and appeared very undervalued as it should at least be 7 to 10x even though Omnicom is a higher quality business. My hurdle for any new position is Omnicom.”

I tried to keep it simple. Really, I asked myself 3 questions early one:

After the spin-off, will the balance sheet be pretty close to net no debt/no cash (you did something similar seeing there would be the $35 million dividend but then there’s the asset retirement obligation and the pension).

Would NACCO produce its earnings mostly in the form of free cash flow?

Would “earning power” be 10% or higher as a percent of my purchase price.

In the end, the decision is really just whether you would buy a stock or wouldn’t buy a stock. To me it didn’t matter if the stock’s earnings would be $3.25 a share or $6.50 a share if I was buying at $32.50. What mattered was how certain I was of the $3.25 number. Once I think I have a 10% yield, I don’t spend a lot of time wondering if I have a 13% yield, 15% yield, or 20% yield. So, I didn’t spend time worrying about this. If the stock was pretty much unleveraged, the earnings pretty much came in the form of free cash flow, and the earnings yield was greater than 10%, that would be enough.

As far as growth, it’s difficult to value that. The company has a goal of growing earnings from unconsolidated mines by 50% within the next 5 years or so. However, they had the same goal about 5 years ago. Because the Kemper project was cancelled, they won’t achieve this. However, they will achieve growth of say 15% or so over last year due to newer mines producing closer to the tons they were eventually expected to produce.

I don’t know what they’ll use free cash flow on. I know that the two businesses I like are the unconsolidated contracted coal production and the lime rock draglines. But, neither of those businesses absorbs capital. So, they will grow through signing new deals in that area but they shrink through losing existing customers. I couldn’t judge one way or the other on this.

I feel they have no peer. Omnicom (OMC) is not a good peer, because OMC is permanently durable in my view. I think advertising agencies will be around in 2047 and even 2067. It’s …

Geoff Gannon October 17, 2017

MSCI

Guest write-up by Jayden Preston.

Overview

Spun off from Morgan Stanley in 2007, MSCI is a leading provider of investment decision support tools to investment institutions worldwide. They produce indexes and risk and return portfolio analytics for use in managing investment portfolios.

Their flagship products are their international equity indexes marketed under the MSCI brand. They also offer other products that assist investors making investment decisions. These include portfolio analysis by their Barra platform; risk management by their RiskMetrics product; provision of ratings and analysis that institutional investors to integrate environmental, social and governance (“ESG”) factors into their investment strategies; and analysis of real estate in both privately and publicly owned portfolios.

Their clients include both asset owners and financial intermediaries.

Their principal business model is to license annual, recurring subscriptions to their products and services for a fee, which is, in a majority of cases, paid in advance.

They also charge clients to use their indexes as the basis for index-linked investment products such as ETFs or as the basis for passively managed funds and separate accounts. These clients commonly pay MSCI a license fee, primarily in arrears, for the use of the brand name mainly based on the assets under management (“AUM”) in their investment product. Certain exchanges use their indexes as the basis for futures and options contracts and pay them a license fee, primarily paid in arrears, for the use of their intellectual property mainly based on the volume of trades.

Clients also subscribe to periodic benchmark reports, digests and other publications associated with their Real Estate products. Fees are primarily paid in arrears after the product is delivered.

As a very small part of their business, they also realize one-time fees related to customized reports, historical data sets and certain implementation and consulting services, as well as from certain products and services that are purchased on a non-renewal basis.

Business Segment

MSCI categories its business segments into the following: 1) Index, 2) Analytics, and 3) All Other.

Index Segment

This is their key segment. As I will explain below, this is where I believe the lion’s share of value of MSCI lies.

MSCI indexes are used in many areas of the investment process, including index-linked product creation and performance benchmarking, as well as portfolio construction and rebalancing. Index-linked product creation generates asset-based fees and the latter is the source of their subscription revenue within the Index segment.

MSCI currently calculates over 190,000 global equity indexes, including approximately 7,300 custom indexes.

For 2016, Index generated $613.5 million in revenue, or 53% of their total revenue. Adjusted EBITDA from this segment was $431.5 million, or 76% of total EBITDA. You can see that the EBITDA margin from this segment was 70%.

Analytics Segmen

This segment uses analytical content to create products and services which offer institutional investors an integrated view of risk and return. A few examples of major offerings under …

Andrew Kuhn October 9, 2017

A Few Thoughts on Hostess Brands

“Your premium brand had better be delivering something special, or it’s not going to get the business”

-Warren Buffett

For the past few weeks I have been studying and doing research on Hostess Brands, the maker of the classic chocolate cupcake with the squiggly white frosting line and of course the iconic, golden, cream-filled Twinkie. At first glance, the company passed almost all my filters on my investment checklist for a company I would want to be involved with. They claim to have a 90% brand awareness among people in the United States, they benefit and profit on the nostalgia that their products create within people, they are growing internally at a decent rate and they are run by a very capable management team. Before we can dive into the investment case, let’s go back through the history of the company to better understand how we got to the present.

Hostess 1.0

The first Hostess cupcake was introduced to the public in 1919, followed by the formation of Interstate Baking company and the introduction of Twinkie in 1930. The company progressed with their normal course of business only to later file for Chapter 11 bankruptcy protection in 2004. For those who don’t know, Chapter 11 bankruptcy gives a company time to re-organize their debts and pay them off without having to “go out of business”. Chapter 7 bankruptcy on the other hand, is when a company or individual must sell off their assets to repay debts; in other words, liquidate. In most events the shareholders get wiped out, but I just wanted everyone to know the difference. Although that sounds terrible at first glance, Interstate Bakeries filing for bankruptcy protection was never due to failure of their brand. It was the result of union issues, zero efficiency within the company (stay with me here, I will go into more detail in a bit), high fixed costs and an excessive amount of debt…. A true recipe for disaster within any company. During this time, the company employed a Direct to Store Distribution Model which meant they needed a high number of employees (more than 33,000), tons of trucks to deliver their products frequently due to a 28-day self-life and 57 bakeries around the country to produce fresh products close enough to the stores that they deliver to. All of this compounded together created a company that, although had great products that people loved, had a structure that economically did not make sense. Their operating and labor costs where through the roof which led them to begin the bankruptcy process.

Hostess 2.0

Interstate Bakeries emerged from bankruptcy in 2009 and changes its name to Hostess Brands. The company gets back to its normal course of business to only again file for bankruptcy in 2012. This time, the company files for Chapter 7 and begins of the process of liquidation. Yet again, the result of them filing for bankruptcy was never due to lack of consumer consumption of their products, but more …

Geoff Gannon May 18, 2017

Car-Mart (CRMT): Like the Company, Hate the Industry

Car-Mart (CRMT) now trades for $35 a share. I picked the stock for my old newsletter, The Avid Hog (you can read all 27 past issues of that newsletter here), when it was trading at $38 a share back in June of 2014. So, it’s now three years later. And the stock is now 8% cheaper. Do I like Car-Mart more today than I did in 2014?

No.

Ideally, a stock should be:

Cheap
Good
Safe

I’m not sure Car-Mart meets all 3 of those criteria. And I am sure it has a harder time meeting those 3 criteria today than it did back in June of 2014. But, let’s start with the criterion that Car-Mart clearly passes.

Receivables Per Share: The Right Way to Value Car-Mart?

Buy and hold investors value a business on its future cash earning power.

So, the correct way to value a business is usually to begin by finding the key determinant – the ultimate source – of a company’s future cash earnings and multiply that number by a second figure. For a timber producer, you’d use the acres of timberland. You might look at a company owning 500,000 acres of timberland and see that buyers normally pay $600 an acre for such land. Based on that, you’d say the business is worth $300 million. If this corporation currently had $120 million in debt on its books, you’d then say all the common stock combined was only worth $180 million. If there were 9 million shares outstanding, you’d say each share of stock was worth $20 a share. In this way, you’ve done an entire calculation for a single share of stock based on something that is:

Constant
Calculable
and consequential

The amount of timberland a company owns varies much less from year-to-year than reported earnings. It’s a “constant” figure. It’s also a very easily “calculable” number. The company states the number of acres it owns in the 10-K each year. Finally, the quality and quantity of acres of timberland owned is clearly the most “consequential” number there is for such a business. Different owners, different managers, different ways of running the business could squeeze a little more profit or a little less profit from the business from year-to-year. But, how much land the company owns and where it owns that land can’t be changed. Clearly, the quality and quantity of acres of timberland owned is the key determinant – the ultimate source – of this company’s future cash earnings.

What is the ultimate source of Car-Mart’s future cash earnings?

What one number can we find that is: 1) constant, 2) calculable, and 3) consequential? We need to find the “essential earnings engine” for Car-Mart.

It’s receivables per share.

Here’s how I explained the right way to value Car-Mart, back in 2014:

“Car-Mart’s value over time should mirror its per share loan balance. This loan balance is what creates value for Car-Mart. So, it is receivables – net of the provision for …

Geoff Gannon May 10, 2017

Grainger (GWW): Lower Prices, Higher Volumes

The Original Pick

I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016. Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s one reason to look at the stock now.

Reason #1 for considering GWW:

I picked the stock when the price was 22% higher than it is now.

There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the shares of is two closest peers.

Grainger: (16%)
Fastenal (FAST): (2%)
MSC Industrial (MSM): +19%

I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough question. Today, it should be a lot easier to answer.

Reason #2 for considering GWW:

Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC Industrial than it was a year ago.

So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus Fastenal and 29% versus MSC?

Before we can answer that question, we need to know why I picked Grainger in the first place.

Reason for Picking Grainger in the First Place

I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a year ago:

“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would pay out 4% of your purchase price each year in buybacks and dividends while companywide profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a reasonable price’ stock even when priced as high as 17 times earnings and when growing sales as slowly as 5% a year. The combination of margin expansion and share buybacks mean the company could grow sales as slow as 5% a year and yet grow earnings per share at close to 10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is only earnings growth and only in per share terms. It doesn’t matter whether companywide sales grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t benefit shareholders. Only growth in earnings per share makes any difference to an investor. So, by that measure, a stock with a P/E of 15 or 20 …

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