A Quick Look at Western Digital

Western Digital (WDC) does storage; it designs, makes, and sells hard disk and flash drives. These are used from PCs/notebooks, consumer electronic products, all the way to enterprise servers.

The company’s 2016 investor presentation, and this 2017 update provide a good overview of the business and opportunities.

WD has a history of bolstering its storage offerings by arguably decent acquisitions. It has morphed from a pure HDD play to a more general storage play over the past 10 years.

acq

The company’s presentation also lays out positive and negative factors.

headtail

Headwinds

  • secular decline in PC and notebook industries; but the company expects the storage portion of this market to work out better
  • HDD industry is essentially a duopoly (with Seagate); but overall storage industry (particularly HDD) is cyclical
  • commodity product; no durable competitive advantages

Tailwinds

  • in the near term, HDD to remain dominant fraction of total stored data
  • decent management, good acquisition and capital allocation record
  • increased demand due to “big data”, more digitalization
  • datacenters, cloud computing

Valuation

The company lays out numbers to anchor a valuation.

finmodel

  • TTM revenues are ~$19.5B (up from $8B in 2008); EBIT is $2.6B (up from $1B in 2008). EPS numbers are noisy, but FCF is indicative of a cash generating business.
  • Share count has increased from 226M to 301M over the past 10 years.
  • Historical tax rate has been 7-12%, in line with future expectations. Probably should not expect tax bill to help much.
  • Total debt is $13.1B (about 2.75x EBITDA), peaked at $17B in 2016. WDC is develering. Interest expenses are currently ~$800M (compared with EBIT of $2.6B). Debt looks manageable, especially when compared to competition like Seagate, which has a much more levered balance sheet.

The adjusted FCF/sales has been 13-14% (in line with target). Sales growth is expected to be low single digits.

If we use FCF/sales = 13%, sales growth = 3%, then FCFF/share = $9.05. Subtracting the $2.75 of interest payments/share, we get FCFE for the next year of $6.30. Using the Gordon growth model with a hurdle rate of 10%, we get a target price of $85.

If we use less conservative numbers (FCF/sales = 13.5%; sales growth = 3.5%, and interest payments of $2.50 from continued delevering), we get a target a target price of $115.

Thus, the range of values is probably between $85-$115. Currently, it is trading below the lower end of this range.

 

 

 

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Learning the Wrong Lessons

2017 was my first full year of “mindful investing”. As expected, I made many mistakes. These can be classified into two buckets.

Selling Winners Early

I sold WTW around $18. It soared to nearly $50 over the next few months.

I sold AAPL at an average price ~$130-140. It kept rising to $175.

Peter Lynch said, “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”

I should hold my winners longer.

Historically my worst mistakes have been “successful investments”.

I sold MSFT and EBIX for 80% and 300% gains, only to see both stocks double from there. And don’t even get me started about Priceline. I sold it only because I had made 10x on the stock. There was no fundamental reason for selling. It was agonizing to watch it soar 10x from that point, over the past 7-8 years.

Sucking my Thumb too Long

I dabbled with a few stocks, hoping to buy them at more attractive prices, only to watch them fly away. I watched FSLR go from $25 to $60, MSM from $70 to $95, FAST from $40 to $55, VFC from $50 to $75, WFC and NKE from $50 to $60+, and on and on.

So perhaps, the lesson is don’t be too picky. But is that the right lesson to draw?

I began the year with a certain view of the overall market: I expected it to return somewhere between -25% to +15%.

One can ask two questions: (i)  was the view correct, and (ii) was the strategy (of being patient with buying) correct, given the view?

In retrospect, the S&P clearly overshot the optimistic end of my expected range. The pendulum had swung more than I thought. My view was wrong.

However, given a view that is negatively biased, the strategy of waiting for more attractive prices was not necessarily wrong. Or at least, a single year (esp. one like 2017) may not be sufficient to draw that conclusion.

 

Portfolio Review 2017

As 2017 winds down, here is a review of my top holdings.

Cash

I started the year with 16% of my portfolio in cash. As the year wore on, I added new capital, and sold off more positions than I bought.

As a result, I ended the year with an uncharacteristically high cash position of 38%. I am starting to get uncomfortable, and hope not to get trigger-happy.

I disposed off significant stakes in Apple, Cisco, and Cullen-Frost as the positions reached my estimates of fair value. I also began cleaning house by eliminating several small positions that had accumulated over the years (Staples, Hanover Foods, and SPE). I did not have much conviction, or meaningful exposure in these names.

I also sold Weight Watchers for an approximately 40% loss ($15-18) just before it blasted off to nearly $50.

I added to Fairfax Financial and Oaktree Capital, and opened (small, but potentially growing) new positions in ALJ Regional Holdings, Under Armour, and GameStop.

Berkshire Hathaway

BRK.B started the year at $163, climbed to $190 in mid-October, before slouching down to the low $180s in early December. Since then it has whipsawed to nearly $200. It represents over 10% of my portfolio. I did not add or subtract from my holdings during the year. I believe the intrinsic value of BRK is probably a little north of $200.

Fairfax Financial

FFH was a 4.5% holding at the end of last year. For much of the first half of 2017 FFH traded between $420 and $460. I took the opportunity to raise my position to nearly 6% of my portfolio. Currently the stock price is in the $520-$540 range. I believe its intrinsic value is at least 10-15% higher ($580-$600).

Leucadia National

LUK is a 6% position. It has been tossed around between a “support” of $22-23 and a “resistance”  of $26-27 for much of the year. The operational performance, especially at National Beef, has improved considerably.

My latest estimate of IV pegs LUK at $32. It also raised its dividend yield to about 1.5% during the year.

Oaktree Financial

OAK started the year at $40, dipped to $37.50 in the first quarter, and subsequently spent the bulk of the year in the upper 40s. I added to my position at $39 and sold a similar-sized chunk at $47 a few months later, thus lowering my cost basis.

Recently, I updated my valuation notes, and figured OAK was worth $55-$60. I started writing puts and ended up buying a slug in the low 40s, recently. It is a 5.5% position.

IBM

IBM started the year at $170. Since I had assessed its IV to be around $165, I began writing $175 covered calls on 2/3 of my position, which eventually got called away, when the stock rose to $180 in February. Then the news of Buffett paring down his position became public, and IBM drifted down to $140 by mid-August.

Unfortunately, I bought back the position I had sold a little too early (around $165), and rode the roller-coaster all the way down to the 52 week lows. It looks like things have started to turn. The stock is currently in the low $150s, and pays a nearly 4% dividend. It is currently a 4.4% position.

Wells Fargo

WFC started the year at $55, and oscillated between $50 and $60 throughout the year. While I did not add to my 4% position, I wrote plenty of cash-secured puts in the low 50s, with the intent of adding to my position. I earned well over $1000 in premiums, almost twice what I earned from its nearly 3% dividend yield. I believe that WFC is a buy in the low $50s or below, since its IV is probably somewhere around $60.

 

Other

Other ~3% positions, which I did not touch over the year include:

  • MKL: 3.7% position, trading nears its IV of $1080.
  • XOM: 3.1% position, trading in the low 80s, after starting the year strong in the low $90s (IV ~ $90).
  • CFX: ~3% position, spent the year between $35 and $43. I collected nearly $2700
    ($6.75/share) in covered call premiums by offering to sell around $40.
  • MNDO: 3.1% position, trading above $2.50 for much of the year (IV ~ $3)

New Positions

I initiated positions in ALJJ (2.8%), UA (2.0%), and GME (1%) this year. I plan to build these positions up on price weakness. I believe all three stocks are materially undervalued.

In 3-5 years, it is easy to visualize a scenario where ALJJ could be worth >$5.0, UA > $30, and GME ~ $30.

GameStop is something of a wildcard. It has healthy current cash-flows and pays a fat dividend (>8%), but its core business is seriously impaired. I don’t plan on allocating more than 2% to GME.

With ALJJ and UA, I can see myself taking on a full 5% position if prices remain or become more attractive.

A Pile of MCK?

McKesson Corporation (MCK), founded 1833, is the largest distributor of drugs, medical products, and supplies in the US.

Distributors like MCK connect pharmaceutical manufacturers like Pfizer, Merk, and Bristol-Meyer-Squibb to outlets like Walmart, Albertsons, and hospital pharmacies.

Industry Landscape

McKesson’s fingerprints can be found somewhere on nearly a third of all prescriptions in the US. MCK is a supplier to more than 75% of US hospitals with more than 200 beds. The breadth of their products and services, combined with their geographical scale allows them to offer attractive package deals to their customers.

The US distributor market has characteristics of a mature oligopoly. 90% of the market is dominated by three relatively equisized players.

McKesson  (MCK): ~$30B market cap, ~$200B revenue
Cardinal Health (CAH): $17B market cap, $130B revenue
AmerisourceBergen (ABC): $19B mcap, $150B revenue

As a result, pricing in the US is mostly rational.

While US retail is a $400B opportunity, Europe is a ~$200B market.

MCK has recently been growing its presence in Europe, Canada, Brazil etc., where the distributor landscape is much more fragmented, and opportunities from consolidation abound.

In 2016-17, MCK merged its legacy technology solutions business with Blackstone owned Change Healthcare to form a new IT company. MCK owns 70% of the new firm. This allows McKesson to focus on its core drug distribution business. The end-game is to spin it off as an independent company.

Financial Overview

As of 09/2017, TTM revenues were $202B. However, the margins in this business are brutal. Despite the huge topline number, only $4.5B flowed to the bottomline.

Operating margins are generally in the 1.5-2% range, with net margins slightly over 1%.

It is hard for me not contrast these terrible margins with the fat 15-20% EBIT margins for industrial distributors like Fastenal (FAST) or MSC Industrial Direct (MSM). It is no surprise that FAST or MSM boast impressive returns on capital and equity. The ROIC and ROE for both these industrial distributors is in the 15-25% range.

It might therefore come as a surprise that McKesson also has racked up impressive ROIC (10-12%) and ROE (15-20%) numbers, despite terrible margins.

How in the world is it able to do that?

The short answer is that it plays the Costco game.

If you sell a lot of stuff without using much capital, then you can generate high returns on capital. The sales/capital ratio for industrial distributors (FAST and MSM) is in the 1.5-2.0 range.

For MCK, sales/capital is in the 7-10 range!

ROIC = NOPAT/IC = (Sales/Capital) * (EBIT Margin) * (1-tax rate)
ROE  = NI/Equity = ROIC * (1 - interest/EBIT) * (1 + debt/equity)

If we use normalized numbers for sales/capital (8.5), EBIT margin (1.75%), tax rate (30%), interest/EBIT (10%), and debt/equity (0.75), one can easily see how MCK hits ROIC in the 10-12% range, and ROE in the mid-high teens.

Unlike FAST or MSM, the healthcare market, and MCK by extension, is more recession resistant. It can afford the luxury of running a more leveraged operation to lower its cost of capital and turbo-charge returns to equity (and it does!).

Nevertheless, debt levels remain manageable; the entire debt can be paid off in 2 years from operating cash flows. Indeed, the company is delevering (a little).

MCK has grown topline at a steady 7-10% rate for nearly 10 years now. The business survived the 2008-09 crash relatively unscathed. The share count has declined almost 30% from 290M in 2008 to 214M in the most recent quarter. The company also pays a small dividend (~1%).

Headwinds

  • Although brand Rx drugs constitute a large fraction of the revenue (~60%), generic drugs constitute most of the gross profit (~65%). After a blockbuster 2015 in which the price of Gx increased, subsequent deflation has pressured profits.
  • 2016 was an election year, and drug prices were in the spotlight. These temporary unfavorable pricing dynamics should eventually normalize.
  • There is continued uncertainty regarding the future of healthcare reform, and any regulatory risk that may entail.
  • Customer consolidation (Target/CVS, RiteAid/Walgreens) affects contracts. Their resulting heft implies a weaker negotiating position for distributors.
  • Just recently (11/20/2017), the stock fell more than 3% on a report that Amazon would slice away a significant portion of MCK’s revenue. I think this fear is overblown. Just look at the low margins in the business. They provide a basis to mount a strong defense against Amazon.

Valuation

If there are no major disruptions, we should anchor expectations close to the return on equity (~15%).

Terminal Model

Let’s use a simple terminal model. TTM revenues were $202B. Since CapEx is modest, we can assume FCF ~ NI (FCF margins 1%), and growth rate of 5% for the next decade or so, and a cost of capital of 9%, we get a TV of $52.7B.

Subtracting the net debt ($5.8B), and dividing by the number of shares, we get an IV/share of $220.

Relative Valuation

Historically, MCK has traded in P/E band of 11x-24x, with a midpoint around 17. For 2018 and 2019, S&P estimates EPS to be $12.14 and $12.98, respectively. At a P/E of 17, this implies a target price of 17*$12.14 = $207.

At current prices of $130-150, shares are attractively priced.

ALJJ Update

I initiated a small position in ALJ Regional Holdings earlier this year. I was hoping to add more when the stock drifted below $3, but was not able to build out the position to its desired size.

I thought ALJJ was worth at least $3.60, and quite possibly $5-$7.

Then a few weeks ago, I read Dave Waters’ (Alluvial Capital) letter to partners. I have tremendous respect for him as an investor and writer.

He made ALJJ his largest position. Some key takeways from his assessment:

  • accounting obfuscates FCF (amortization of intangibles); true cash flow > reported earnings
  • using numbers, not terribly different from the ones I used, he came up with a valuation of $4.70, somewhere between my bear and base cases
  • the jockey, Jess Ravich, provides upside optionality

I have been waiting patiently for the price to dip back closer to $3 to increase my position.

 

Oaktree Update

I looked at OAK over a year ago. At that time, I thought OAK was worth at least $38, and more likely close to $54 based on normalized earnings.

I added to the position earlier this year, when the price dipped to $40.

Over the past week or so it dipped back to the low $40s, after spending much of the year in the mid to upper 40s.

The overall narrative remains unchanged. It is a high-quality asset manager, focused on debt securities, which seeks to earn money the right way – by making outsized returns for its clients. With the stock market getting somewhat frothy, it remains poised to capitalize on any significant downturn or crash.

Valuation

I used the same template as the previous valuation. I used updated numbers from their Q3-2017 report for balance sheet items. For earnings, I used TTM numbers.

Screenshot from 2017-11-10 20-39-19

The year-to-year performance of OAK is quite lumpy. The IV increased from $38 to $66 based on TTM numbers. I believe that the average numbers are probably more reliable. They suggest that the IV remained roughly unchanged (increase from $54 to $57).

Based on these numbers, OAK is looking attractive at these levels.

Leucadia Update

In September 2016, I thought Leucadia was worth somewhere between $27-$32. At the  time, it was trading around $19, having bounced off of of lows in the summer. The company was still under-earning, although some of the winds had started to shift.

Earlier last month, the company put out an investor presentation (link), and I came across this well-reasoned article in SeekingAlpha, which pegs the intrinsic value around $33.

I updated my SOTP analysis, and come up with a fair value near $32.

Screenshot from 2017-11-10 07-37-11

The discount to intrinsic value has narrowed considerably from 50% ($19 versus $30 in 09/2016) to about 20% ($26/$32). The intrinsic value itself has improved marginally, mostly on the backs of improvements at National Beef and Berkadia.

The dividend has also been increased by 60% from 25c/share to 40c/share. At current prices, this implies a yield of over 1.5%.

I continue to hold.