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.

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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.

Revisiting WDC

I wrote about WDC earlier this year and appraised it at $85-$115. At that time it was trading around $80, but by mid-March, it had breached its 52-wk high of $105+.

In the 4 months since, it crashed over 35% to its current trading range of ~$65. What changed? And is it worth taking a stake in now?

The TTM revenue has increased to $20.6B (from $19.5B), debt outstanding has dropped to $11.2B (from $13.1B), and has been refinanced at rates below 4%. Consequently, interest expense has dropped from $800m/yr (~$2.75/share) to about $600m/yr (~$2/share), and is expected to decline further to about $450m over the next year. The FCFF/sales held firm at its long term average of 13-14%.

If I use the same valuation methodology, (Sales * (1 + growth) * FCFF/Sales – interest) / shares), I get a FCFE of $8+/sh. Using a conservative multiple easily gets me over $100.

The Subtext

The financial position of the company is secure. Data storage has strong long term tailwinds. The company authorized a $5B buyback announcement (could buy back a fourth of outstanding shares at current prices).

Strategically, WDC is well positioned for the long term. So what gives?

Well, its the consensus view, which is decidedly bearish.

Memory is a cyclical business. WDC made hay while the sun was shining, and now winter is approaching. The SSD/NAND business which has many producers is “normalizing”: it will likely suffer from oversupply issues, and hence lower margins. The other part of WDC’s business (HDDs), while a virtual duopoly with Seagate – and hence insulated from irrational behavior – is in terminal decline.

All of these claims are either partially or completely true!

Bear Thesis

Let’s say this bear thesis plays out. In the previous down cycle revenues declined about 15% over 3 years (2013-2016). Assume FCFF margins hold steady; this would imply FCFF of (revenue $20.6B * decline 85% * FCF margin 0.13)/(300m shares)~ $7.50/sh; subtracting $1 in interest payments, we are looking at FCFE = $6.50/share. Slap a 12x multiple, and we are looking at $80/share, or a 6%+ CAGR.

Not great, but not devastating either. Yes, things could and probably will get worse, but this calculation, doesn’t include the residual earnings of $10-$15 that the company will generate between now and then – so let’s call that even.

I am not saying things can’t get scary in the interim. I can imagine dire scenarios where the stock plummets to $30-40/sh (recession, China tariffs, etc.), but I don’t think survival is an issue for WDC.

Variant Perception

As perverse as it sounds a severe downturn might actually help WDC in the long run. How? Well, the SSD/NAND market might consolidate. WDC stands to benefit directly and indirectly from consolidation. Its rival in the HDD business (Seagate) is highly levered, which might help WDC squeeze out more juice. WDC’s stock price will probably languish as a result, which is great news given the massive $5B buyback.

So while I believe that the bear case is reasonable, the current price more than fully accounts for it.

However, if any part of the bear thesis turns out to be overly pessimistic, then the upside can be fantastic. Perhaps, as many argue convincingly, the decline in HDDs may plateau given new technology and price benefits (10x) over SSDs.

Given the number of gadgets requiring flash memory, the NAND market might prove more elastic than suspected – new demand may arise from unseen places to exploit declining prices. The short term pain, if any, may be much more muted, while the persistent long term tailwinds eventually come roaring back.

 

Bought Facebook

Facebook tumbled over 20% recently. I took the opportunity to start a position. I bought 100 shares @$175.

I also wrote puts to potentially triple that allocation, and lower my cost basis to the mid $160s. At these levels, I think it is virtually a no-brainer.

The qualitative bull case is straightforward:

  • dominant, wide moat “inevitable” company
  • Instagram and WhatsApp undermonetized
  • margin compression is a preemptive, self-induced act of aggression. It will increase moat in the long term
  • any forthcoming regulation will probably entrench incumbents like FB and GOOG

FB has historically sported 40%+ EBIT margins. They are now coming down to 35% levels – still higher than Google’s. Its topline growth rate will also temper from a scorching 40-50% to more reasonable levels as expected!

Its EPS, which is a reasonable conservative proxy for FCF, over the past few years has been as follows:

2015: $1.30

2016: $3.50

2017: $5.40

TTM: $6.50

Still, it is an insanely profitable company with a respectable growth runway.

The quantitative bull case is also compelling.

FB has over $42B in cash on its books. Dividing this by the number of outstanding shares (~3B), it has about $14/share in cash.

In FY 2018, EPS is expected to be around $8.50 or more. At today’s price of $170, it trades at a PE of 20. If you back out the cash, the P/E drops to 18x.

For an insanely profitable, wide moat company, that is still growing like gangbusters, this seems cheap!

More Bang for Your Starbucks?

Starbucks (SBUX) owns/operates and licenses stores in the US and international markets. It positions itself as a “third place“, after home and work, for meeting or hanging out.

In FY 2017, the revenue mix was 58% beverages, 17% food items, 13% packaged and single-serve coffee and teas, and 12% other (including ready-to-serve beverages, coffee cups and coffee-making equipment).

Investment Thesis

It is a growing company with a reasonable runway for future growth. Growth can come organically from increasing same store sales, or expanding into new geographies (China) or other categories categories (food, non-coffee beverages).

Revenue growth in the US is in the high single to low double digits. EPS growth rate exceeds sales growth (12-15%) due to improvements in operating margins (13% – 16%), and a modest decline in the number of shares (1546M to 1438M) over the past five years.

Management has ambitious growth targets, especially in China. It plans to increase its store count nearly 30% by 2021. At that point, SBUX will as ubiquitous as McDonald’s is today. Management also plans to double the food business by 2021.

It is amazingly profitable. As Scuttlebutt investor points out, the unit economics are compelling. A new SBUX earns back its original investment in two years. Thus, growth comes relatively cheap. Stores have proliferated without seriously compromising the ROIC or ROE (~25%).

Habits around coffee consumption tend to be regular and predictable. In some ways this is not different from addictive products like tobacco and cigarettes, where people get into a routine and get the same fix everyday. Digital initiatives and the loyalty program create powerful lock-in effects. One can almost think of SBUX as running a daily subscription business model.

Its brand value is strong. When I travel to other countries, I know what to expect when I enter a Starbucks. Its gift cards are perennial favorites at graduations, Christmas, etc. At many gatherings, it is not uncommon to serve SBUX coffee, when the tastes of the audience are not clearly known.

Generally speaking, the company is good to its employees and other stakeholders. In the US, it spends more on employee healthcare than on coffee bean purchases. It is the largest purchaser of fair-trade coffee in the world, and is committed to sustainability. At current prices it pays a nearly 3% dividend.

Negatives

  • Business is not recession resistant, even though SBUX remained FCF positive throughout the 2008-09 recession
  • It’s M&A track record isn’t exactly inspiring
  • SSS are declining from over 5% to less than 3%, currently
  • Management plans to lever up the balance sheet. Currently the debt is easily covered by cash flow (Debt/EBITDA ~ 1), but debt is on its way up.
  • If the China expansion misfires for some reason, piling on debt can limit their strategic options considerably. It will certainly crimp their growth ambitions.
  • Cheaper alternatives from McDonald’s (which I actually prefer) and Dunkin Donuts
  • Insiders have been selling on average for a while. Counterpoint: People sell for many reasons, but buy on the open market for only one – because stock is cheap. Howard Schultz seems to think so.

Valuation

Growth is an important part of valuing SBUX. If EPS continues to grow at a slower pace (8-10%) down from mid-teens in recent years, a multiple of 25-30 can be justified using, say Graham formula (8.5 + 2*g). Given an FCF/share of $2.30-$2.50, we get a somewhat wide range of $57-$75. A more careful DCF yields a estimate of $65-70, with the following range of plausible outcomes.

DCF

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