Update: CFX

So CFX is buying DJO Global for $3.15B. At prevailing prices of $25/share, the market cap of CFX is $3.1B.

This acquisition is a merger of equals.

CFX put out an investor presentation outlining their thinking and vision. Part of the investment thesis in CFX is good operation and capital allocation.

There are things to like and dislike about this merger. On the plus side, there is improved diversification, superior margins, higher growth, and less cyclicality. On the negative side, there is integration risk elevated by the level of leverage.

The company has outlined a path to deleveraging, including disposing off its A&GH unit.

Before the merger, CFX was expected to earn $2.20 – $2.30/share this year. At at 15-18x multiple (good management in a cyclical, low margin business), it was probably worth $33-40/share. Given the 123M shares out, this would imply a value of $4.15-4.95B.

CFX is paying 12x EBITDA for DJO Global (adj EBITDA = $269M). Its peers in the Health Care Equipment & Services sector trade for mid to high teen multiples. So the price CFX paid doesn’t seem crazy, especially given the $800M in NOLs that they inherit.

The TTM FCF (EBITDA) for the combined entity is $650M ($767M). At the current share price of $25, the market is valuing CFX’s FCF at a 9.5x multiple [9.5 * $650M – $3.15B)/123M ~ $25].

If CFX can sell A&GH at a decent price, they can delever and improve overall margin. Then the 10%+ FCF implied in the current price appears attractive.

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Update: WDC and JD

JD and WDC have both been cut in half over the course of the year.

In this 3Q 2018 Commentary FPA Capital Fund look at the bear case on WDC more closely. They lay out the four main drivers of the bear thesis and “rebut” by claiming:

  • this NAND cycle is different
  • gross margin declines are real, but expect them to be more muted
  • stock price bounces back before EPS bottoms
  • company now has a buyback budget

Hayden Capital in his 3Q 2018 Letter to investor provides an update on JD:

  • Richard Liu’s corporate character is at odds with his personal character
  • JD is run like a military, and “lacks data-driven creativity”
  • Long-term thesis is intact; growth is strong, especially if margins head in the right direction.
  • Backing out Logistics and Finance, the core retail operation is trading extremely cheap.

Update: Codan Ltd

I’ve owned Codan Ltd since 2014, and have written about it here and here. The last time I looked at it, it was trading at ~$2.20. I thought it would earn ~20c in 2017, put a $3 AUD target on it. Currently shares trade at ~$3.25.

Over the past three years, the performance of the company has improved steadily. Here are some numbers for FY 2016, 2017, and 2018:

Revenue: $170m, $226m, $230m

NPAT: $70m, $45m, $40m

EPS: 12c, 25c, 22c.

2017 was a blockbuster year, which as 2018 results confirm, may be a preview of things to come. If you apply a 15x multiple as I have done previously, (15*0.22) you get $3.30. This indicates that shares are probably trading at fair value. A small wrinkle is that the net cash position has improved from -$4.4m to +$28m, which when divided by the number of shares out (178m) gives a value of $3.30 + 28/178 ~ $3.45 AUD.

I own shares of CODAF, which trade (infrequently) in USD. The target price in USD is 0.72*3.45 = $2.48. 

My original cost basis was $0.72 in 06/2014. I never added to my small original position (5000 shares). The last CODAF trade was at $2.31 – a 3x return in 4 years, implying a +30% CAGR. In addition, the company has returned nearly 40% of my original cost basis ($1360+, through FY 2018) in dividends.

I continue to hold the stock, in part thanks to its illiquidity. Gold prices have been mostly flat through my holding period, while AUD has weakened ~20% from 0.92/USD to 0.72/USD. Perhaps a good time to sell Codan would be when gold prices spike or AUD strengthens (or both!)? I don’t know – but as long as the business continues to execute, despite macro headwinds, I see no reason to bail.

Yet Another ALJJ Update

My financial stake in ALJJ is not a particularly meaningful (~1.6% portfolio weighting). Yet, I’ve spent a disproportionately large amount of time following it.

It has taught me a whole lot – both from an investment standpoint, and a psychological standpoint. From an investment standpoint it showed me how accounting can obscure true cash flows, and how one ought to relentlessly focus on normalized free cash flow – because, eventually, the stock price catches up. I wouldn’t have taken a meaningful position in CHTR, if I didn’t understand these drivers.

It has also taught me how leverage can be dangerous, especially if it is intertwined with the financial and deal-making skills of a leader, who is accused of sexual harassment (key man risk).

For me, the financial/business risk spilled into behavioral risk as the stock got cut by more than half of my initial purchase price. Bankruptcy seemed a possibility. Some investors I admire bailed on the stock (for good reason!).

In May, as the stock fell to $1.80, I increased my position by 40%. It didn’t feel good when I was buying – but the valuation was too compelling, and insiders were buying. It felt a lot worse as the stock got chopped to ~$1.50 rather quickly. Talk about instant invalidation! Since then, it has bounced about 40% off the lows to $2.00-$2.20 range.

ALJJ recently reported quarterly earnings for the quarter ending on 6/30.

I thought it might be a good idea to take a longer term view first. The revenue and EBITDA numbers for the past few years are below (from Morningstar)

Year       Sales     EBITDA
2014     $149.6M      $17M
2015     $209.9M      $16M
2016     $268.4M      $27M
2017     $326.7M      $29M
 TTM     $366.1M      $25M

Overall, sales and earnings seem to be moving in the right direction. The expected adjusted EBITDA this fiscal year is $31-34M. Since we are three quarters in, and the 9-month adj EBITDA is $23.7M, landing in this range seems reasonable even from simple extrapolation.

Subtracting capex, interest, and tax of $21M, and dividing by #shares (37.9M), we get an FCF of $0.30/share. So currently shares are trading at 7x FCF or a (14% FCF yield), which seems attractive.

Furthermore, bankruptcy risk has abated significantly over the year. ALJJ diverts most of the FCF to delever.

Here are “debt covenant” portions from the past three quarters.

quarter  leverage    fixed charges   net debt 
12/2017   3.38          1,35          $113M
03/2018   3.18          1,29          $100M
06/2018   3.02          1,28           $93M

The leverage ratio needs to be <3.5 and the fixed charges ratio need to be >1.25.

Here too, things seem to be trending in the right direction. Bankruptcy is no longer on the table.

So what next?

If trends continue, adj EBITDA will improve and debt will come down further, which should lower interest costs. Both these should help boost FCF.

Furthermore, the reduction in leverage should make the balance sheet healthier, and make the stock less hairy.

Let’s try to speculate what this might mean by putting together some made-up numbers.

Suppose sales and adj EBITDA increase by 10% ($32.5m * 1.1), and interest payments decrease by 10% ($8m). Assume normalized maintenance capex remains at 2.5% of sales ($366m * 1.1 * 0.025 ~ $10m). This would imply a conservative per share FCF or 40c/share – a 25% improvement!

As the balance sheet improves, perhaps there will be a simultaneous re-rating from 7x FCF to 10x FCF (10*0.40 = $4). If that happens, the stock could be a near double ($4+) in a relatively short time.

I think it is a compelling risk-reward opportunity.

Portfolio Updates

What a difference an year makes.

2017 was relatively uneventful from the point of view of buying stocks for the long term. I started that year with a 16% cash position, which subsequently ballooned to 38%, as I sold more positions than I bought.

2018 has been much more interesting. In spite of contributing substantial amounts of new funds, the cash position is down to 24%. About half that position is tied up in CSPs, so it is quite likely that my true cash position is sub-20%.

I’ve established 3 new 4-6% positions: CHTR (4%), FB (4.2%), and Tencent/JD (5.4%). I also increased by Berkshire position by 35% (~$190), and my position in Colfax by 50%. I am not sure if the latter was a good idea

I also took starter positions in BAM (~$40) and MCK ($130), and might add to them, as opportunity meets the availability of funds. I increased my position in Fairfax and Markel by about 15% each.

I sold off the last bits of Under Armour, Cisco, and George Risk that remained.

JD.com: Also Ran or Long-Term Compounder

Given their recent slide, I’ve started looking at Chinese Internet companies.

Tencent (TCEHY) is down a third from ~$60 to ~$40. JD.com is down even more, falling from ~$50 to ~$32 in a few months.

In this post, I will look at the latter; in a later post, I might visit Tencent.

At today’s closing price of $32.36, JD.com is a $46B market cap company.

Here is the quick thesis: massive and secular tailwinds, long growth runway, decent balance sheet, founder-led, long-term oriented company.

The risks are Alibaba (competitors have more scale), a margin profile that stagnates (empty calories), and its capital-intensive logistics turns out to be an anchor instead of a moat.

The mispricing exists because the reported earnings and margins mask the true earnings power. FCF generation is back-loaded, and not evident in quarterly earnings.

References

Here are some references in chronological order:

  • May 2016: Oracle of Omaha did a deep dive into JD when it was trading near $25. It is a extremely well-researched piece, worth reading in its entirety.
  • In May 2017, APS produced a short piece with a $12 target. Among other things, it claimed that JD was a hedge-fund hotel, margins wouldn’t expand due to Alibaba and its product mix, logistics and JD Finance were over-rated, and some reporting and accounting shenanigans. The stock traded around $40 at that time.
  • June 2017: The short thesis was rebutted by Oracle of Omaha and LG’s Musings. Since then, the stock soared to $50 earlier this year. LG’s Musings subsequently did a couple more posts on JD discussing the efficiency of its logistics, and contrasting it’s “promotional firepower” to Alibaba.
  • Jan 2018: John Huber discussed JD.com his Talk@Google. I found his metaphor of  “a turtle that survived” quite interesting. At that time, it was trading in the mid $40s. He did a back of the envelope 10-year calculation assuming sales go to $600B (~Walmart), and net margin goes to 3%. This would make the company worth about $270B at a 15x multiple. This would, in turn, imply a CAGR in the mid to high teens over a long period of time.
  • March 2018: With the stock now in the low $40s, Wiedower Capital in his interim letter presented another bull case. This is one of the best writeups on JD.com in my opinion, since it focuses on the few key drivers, and avoids getting lost in the weeds. He makes no special effort to put a dollar number on the stock, but argues that the company possesses characteristics of truly exceptional and rare firms.
  • May 2018: In their Q1 2018 letter, Hayden Capital presented another fantastic take on JD.com. The share price was ~$36 at that time. He did a quick SOTP, and concluded that once JD Finance and Logistics were valued separately, the core business was valued at $18/share or P/S ~ 0.3. For a business growing at ~25-30%, with improving margins, this is insanely cheap. In the recent past, margins have actually improved from 0.5% (2016) to 1.3% (2017) and are expected to be between 1-2% this year, despite the massive investment.