The Moat around Magic Kingdom

This summer we took a family vacation to Magic Kingdom in Orlando. My experience, (especially the $150 entry pass) re-emphasized the enormous pricing power of Disney.

While there were many other excellent theme parks in the vicinity, suggestions of substitutes went unproposed to my 4- and 8-year old daughters, due to perceived cruelty.

Next summer, we are also going on a Disney cruise with a bunch of extended family. The cruise costs nearly 2.5x as much as its competition.

I always knew that Disney had a strong moat. However, the observation of how powerless someone as cheap and brand-agnostic as me is, in avoiding paying up premium dollars, forced me to look at Disney the business after we got back from the trip. The recent swoon (after earnings) forced me to pen down my thoughts.

Background

Disney has four business segments. In the order of revenue generated in FY 2016,

  • Media Networks (ABC, ESPN, cable channels) – 43%
  • Parks and Resorts – 30%
  • Studio Entertainment (film, TV, home video) – 17%
  • Consumer Products (books, video games, licensing) – 10%

We can think of Disney as two units, Media Networks + Studio Entertainment, which contributes 60% revenues and 65% EBIT, and Parks + Products, which constitutes 40% revenues and 35% EBIT.

DIS is insanely profitable.

It boasts of consistent gross and net margins of approximately 45% and 15%, respectively. The return on equity has been around 15% since forever, and has occasionally breached 20%. The company is generally well managed; its long term debt/capital is about 25-30%. Over the past 10 years, the number of shares outstanding has been shaved by 20%.

Risk Factors and Opportunities

Subscriber Loss at ESPN and pay TV channels

ESPN earns ~$8/month per subscriber in bundled cable plans. People are moving away from bundled cable packages. This will hurt ESPN (and other channels) in the short and medium term.

  • Longer term (10 yrs), new sports contracts will reflect this deterioration, and will probably be priced accordingly.
  • Management will figure out a way to best monetize these assets. The situation may be more serious for other pay TV providers, which lack a franchise or differentiation.
  • The recent “DTC” move while painful in the short run, was inevitable. In the long run, it will probably look smart.

Heightened CapEx at Parks will Subside

Currently, CapEx/Sales at Parks and Resorts is high (25%). If and when it normalizes to the 15% level,  cash will start gushing out of the pike. Credit Suisse estimates that cash-flow will grow from $800m in 2016 to about $2.7B, when that happens.

Valuation

ROE

The long-term ROE is in the vicinity of 15%. If you hold DIS for long enough, your returns should be pulled or pushed towards this number, unless the story changes dramatically.

Multiple

For FY 2017, EPS is estimated to come in at about $6. At $103, DIS is trading at a PE of about 17. Given the quality of the company, it probably deserves to trade at a premium to the market. If we say it deserves a multiple of 20 (arbitrarily for now, will contextualize later), then it is probably worth around $120.

Terminal Model

Let’s use a simplified “terminal” model. Revenues have been growing at 5% or more since a long time. Operating and net income have been growing at 10% CAGR in the past, but let us suppose that this will taper down to 5% (same as revenue growth).

The return on capital has been around 12%, historically, while the cost of capital has been 8-9%. Given Disney’s moat, let us assume that is one of those rare moaty companies which can earn above its cost of capital, and continue to grow, thereby creating value. Note that this implies a reinvestment rate of 5%/12% = 40%.

It is estimated that DIS will earn an EBIT of about ($15.7B) $9.80/share in 2018 (fiscal years end in October).  Thus, the value of its operating business is,

Operating Value = NOPAT(t+1) (1 - growth/ROC)/(COC - growth)

= $9.80 * (1-0.35) *  (1 – 0.05/.12)/(.08 – 0.05) = $124/share. If we subtract the present value of the long term debt (~$13/share) from this, we get an estimate around $110/share for the equity.

Past Relative Valuation

Over the past 5 years, the PE ratio has varied between 15 and 25. Based on current earnings this implies a $90-$150 band. The EV/EBITDA has varied between 8.6 and 14 implying a slightly narrower $88-$140 valuation band. It must be remembered that over the past 5 years the stock has basically doubled.

Revisiting GME

I looked at GME late last year, just as the share price moved away from me. I was not able to establish a position, but have been keeping an eye on it ever since.

Recently, the stock price fell back to the $20.xx range, and I started writing cash-secured puts, with the intent of establishing a 3-4% position.

Here is a slide-deck, which summarizes my current thoughts (Revisiting GME).

Basically, in the base case, I think the stock is worth somewhere between $25-30. In the worst case, it is worth somewhere around $15, while in the best case, it could be worth nearly twice its current worth. At current prices, it seems like an interesting risk-reward bet.

The stock has declined substantially, has high short interest, is extremely volatile, and pays a fat dividend. The sentiment against retailers is brutal. In short, if we have adequate faith in the valuation, it is an ideal candidate for selling options on.

Ask Chuck about Schwab

Charles Schwab (SCHW) offers brokerage, banking, wealth management and financial advising services. It is one of the largest brokerage and banking firms in the US, founded in 1971, with over 330 branches, almost all of which are in the US.

Resources

Some useful reports on SCHW on the web are listed here:

  • Boyar Research put out a case study in Sep 2013 (pdf) with an estimated value of ~$32/share. At the time SCHW was trading at $14.
  • The Brooklyn Investor looked at SCHW in Aug 2015, after Lou Simpson had established in a position. At the time SCHW was trading at $30, and BI thought that it was relatively cheap (14x PE) if interest rates normalized.
  • In Feb 2017, Argus Research put out a note arguing SCHW was worth $46, when SCHW was trading in the low 40s.

Background

Like Vanguard, SCHW provides real value to its customers.

It lead the drive to lower commissions, ramped up its ETF business with Vanguard like expense ratios, proactively waived client money management fees due to low interest rates, and starting to snowball its RIA services. It is a top notch company, leverages its scale in the brokerage and banking businesses, and has a potentially long runway in front of it.

A company creates value when it grows revenues, and commands high returns on capital. SCHW checks both these boxes.

Over the past 5 years, SCHW has grown revenues at 10%, EBIT and net income by over 15%/year. Operating and net margins have been relatively stable around 35% and 20%, respectively.  Book value has also grown at 15+% rate, while the return on equity has been in the 11-14% range.

SCHW has been able to crank out this amazing performance, despite multiple headwinds. The most significant challenge is the low interest rate environment. It is possible that some of these headwinds will slowly turn into tailwinds.

One can make a reasonable case that the current EPS ($1.30+) greatly understates the true earnings power of the business.

The company lays out the key drivers of near-term value in their April 2017 “Spring Business Update” presentation.

Screenshot from 2017-04-29 23-01-08

Essentially, the company is doing what it can to grow profitably. It cannot control a few factors, like taxes and interest rates. The current climate seems to suggest that both these factors might swing in favor of SCHW. As an example, each 25bp rise in interest rates increases cash flow by about $250m.

Valuation

There are several ways of valuing a high quality company like SCHW.

IRR =ROE

The ROE for SCHW is 10-15%. If interest rates rise then hitting or even exceeding the upper end of that range is likely. If one holds SCHW for a long time, then one should expect return to match ROE.

While this exercise doesn’t give us an intrinsic value, it tells us that if the valuation doesn’t change while one holds the stock, the gravitational pull (or push) is towards this 10-15% return.

10x PTI

Now let us consider Buffet’s 10x PTI rule for high quality businesses. Last year PTI was about $2.25/share, which would put the value around $22.50/share. This is nearly half of the current market price (~$40). As stated previously, SCHW is currently a coiled spring. If interest rates go up by 2%, PTI will go up by nearly $1.60/share, resulting in a 10x PTI of $38/share.

Financial Services Company

We can value SCHW using the equity method.

BV = book value of equity = $16,421M
ROE = return on equity = 15%
COE = cost of equity = 10%
nNI = normalized net income for next year = ROE * BV = $2,463M
g = stable earnings growth into perpetuity = 5%
p = dividend payout ratio = 1 - g/ROE = 67%
Equity Value = nNI * p/(COE - g) = $32,842M
Shares Out = 1,324 M
IV/share = Equity Value/Shares Out = $25.

This gives us a value of $25 without any sudden improvement in interest rates or the tax environment. To justify the current price of $40, we need to either get to high ROEs (20%, at 5.5% growth), or sustain much higher growth rates (8% at 15% ROE).

Summary

In the long-term, there are many ways to win with SCHW, because the intrinsic value is constantly increasing. There are not too many ways to lose, although depressed interest rates can impair its underlying earnings power.

Estimates of value are all over the place. The floor seems to be somewhere around $25 (a price it was trading at not too long ago) – and can be justified essentially if nothing clicks as hoped. On the other hand, the current price of $40 seems fully priced, and assumes about a 1-2% increase in interest rates in the next year or so.

Yes, SCHW is an above average business, and probably deserves a premium. It is stock that one could hold on to for a long time, without any headaches. Perhaps, a good strategy might be to scale into a position in the $25-35 range.

If the market undergoes a correction (as it certainly will sometime in the future), I might have to keep an eye out for SCHW. But right now, it is a pass.

ALJ Regional Holdings

ALJ Regional Holdings (ALJJ) is a small-cap jockey stock, led by an enterprising CEO – Jess Ravich. It has attained celebrity status in the tiny universe of small-cap value stocks.

Over the years, it has been chronicled by OTC Adventures, Whopper Investments, Ragnar is a Pirate, GeoInvesting, etc. It has an active presence of COBF, and (is?) has been owned by savvy investors like Arquitos Capital Management, and JDP Capital Management.

As it was being showered with attention, it rose nearly 20x, from a penny stock ($0.30 in early 2011) to a high near $5.50/share in mid 2016. It has since deflated a bit, and currently sits around ~$3.40.

The clamor around the stock has also subsided substantially.

Since things had cooled off a bit, I thought I’d take a closer look.

If you want to know what happened to ALJJ in the last two years, I recommend looking at the following three sources:

  • In June 2015, Arquitos Capital Management published a case study (pdf). At the time, it had only two subsidiaries.
  • In Jan 2016, JDP Capital did a fantastic slide deck outlining ALJJ’s history, value proposition, and investment thesis (pdf).
  • In Aug 2016, Ares took a deep dive into the three segments at VIC, and came up with three valuation scenarios. Although the stock was trading at ~$4.80 at the time, the author was bullish.

The first two sources are useful in understanding the company, while the third provides a decent valuation framework.

Here’s the narrative. Jess Ravich, the “outsider”-ish CEO, inherited a company with significant NOLs. These NOLs have to be used before they phase out, starting from 2020. ALJJ has three subsidiaries (Faneuil, Carpets, and Phoenix color) all of which operate in tough niches. However, the CEO has demonstrated skill in acquiring businesses on the cheap through his deal-flow network, fixing them up by retaining and incentivizing management, shielding profits using NOLs, and, if needed, selling them when appropriate. The company runs a lean operation, and there is plenty of skin in the game.

Valuation

We can piggy-back on the VIC valuation. In that writeup, the author considered three cases – bearish, base and bullish. You should read that report, but I present some updated numbers (all numbers in million $), just to see how things are tracking since his report.

Screenshot from 2017-05-13 17-19-07

Essentially, 2016 was a year of sowing, and things seem to be turning a corner in 2017 (after two quarters). Currently, the performance of the units is tracking the “bear case”, based on which one could justify a price target of $3.40-$3.60. This is slightly essentially where it is currently trading.

However, if one is betting on the jockey and his team to turn things around, then one ought to look at normalized numbers. The numbers presented in the base case seem quite reasonable to me in a 1-2 year time-frame. If the stock rises to $5.40 in two years, we are looking at a respectable 25%/year return.

What are possible downsides?

The debt load, while manageable, is larger than I would like. The time-clock on the NOLs is ticking out – gradually, but surely. Collectively, this might reduce their edge in landing and monetizing new deals. Jess Ravich is 59; while there is “key man” risk, it doesn’t seem imminent. The operating businesses occupy tough niches; a big recession could create a perfect storm.

Overall, though, this is starting to look like a good risk-reward bet, in an environment with few bargains. I bought a starter position at $3.30.

Update: Codan Ltd

Codan is a sub $500m Australian company, that I have written about in the past. It is a decent, if superficially rough business, with both net margins and ROE near 15%.

For FY 2016, its EPS was $0.12 (all numbers in AUD, unless otherwise stated). At 12-15x EPS, I had reckoned that CDA.AX shares were worth about $1.50. In July 2016, they were trading at $1.13.

Since then, shares have doubled and are trading at about $2.10. The narrative around the company’s core business has been improving steadily.

Debt has been paid off. This Feb 2017 presentation shows that FY2017 is off to a stellar first half. Here’s a picture:

Screenshot from 2017-04-28 22-05-50

The NPAT in 2016 was $21.1m. The NPAT for 1H 2017 was $22.2m. The latest guidance for FY2017 is $35m.

If Codan manages to hit that, the EPS for 2017 will $35m/177.2m ~ 19.7c. At 15x this (decent ROE, secular tailwinds, 3% dividend), the shares are probably worth $3 a piece. Thus, even after a near doubling, shares are probably undervalued by nearly 30%.

I continue to hold.

 

 

Hanesbrand

One thing leads to the next. I started looking at Under Armour, stumbled into VF Corp, before landing on Hanesbrand (HBI).

All three stocks have been beaten up, and are trading near their 52-week lows. While S&P is up 15% and near its all time highs, VFC, HBI and UAA are down 20%, 30%, and 50% from a year ago, and are trading near 2-year lows.

Naturally, I had to take a look.

HBI was spun out of Sara Lee in 2006. It sells basic innerwear and activewear apparel in the Americas (US accounts for more than 3/4 of sales), Europe, Australia and Asia/Pacific. It owns many popular brands as listed in their 10-K.

brands

Sales have grown from $4.5B to $6B  from 2007-2015, even as EBIT margins have improved from 7-8% to 10-13% over the period. The ROIC has been a respectable 12-13% since 2013. The EPS has increased steadily from $0.33 in 2007 to $1.40 in the past fiscal year.

Their secret sauce has three ingredients:

  1. Acquisition and Integration of Brands: Over the years they streamlined their manufacturing and distribution capability to the point where they could acquire brands, plug them into their manufacturing and distribution pipeline, and end up with EV/EBITDA ~ 5 in a couple of years. Measured against its historic appetite to gobble up new brands, the last two years have been outliers. HBI spent nearly $1.3B acquiring Pacific Brands ($800m), Champion Europe (€200m), and Knight Apparel ($200m). For a company with a $7.5B market cap, this is serious!
  2. Turbo-charged with Debt: How has it been able to finance these acquisitions? The total number shares has remained somewhat stable (385m). HBI has always employed a lot of debt; currently, debt accounts for 75% of capital. This leverage obviously juices the return on equity. It allows HBI to lower the cost of capital, and reduce taxes. Leverage might be okay,  if cash flows are dependable. Since HBI sells a staple rather than a fashion product, it is somewhat shielded from unpredictable swings. As of the last filing, debt was about 3.5 EBITDA, and interest payments ($200m/year) were amply covered by operating income ($775m).
  3. Low Tax Rate: Finally, HBI benefits from a low tax rate (single digits to teens). I don’t understand why this is so. On their IR site, they have a FAQ which addresses this question:

Q: Do you believe a high‐single digit to low double‐digit tax rate is sustainable?

A: Yes. Assuming no changes to various global tax laws, we believe a high‐single digit to low double‐digit tax rate is sustainable for many years to come. Our tax rate is the by‐product of our global business model. We do not use artificial tax management, such as inversions or earnings stripping. Our accounting and tax strategies are sound. In fact, we were recently audited by the IRS (see our third quarter 2015 Form 10Q) and the audit was closed with no adjustments.

I can’t pretend I understand this answer.

Valuation

Let’s look at this in different ways.

Once the current acquisitions have been digested, a conservative estimate of normalized earnings is say $500m/year. FCF has hovered between $450m and $550m since 2012. The new acquisitions are expected to increase this historical number by about 10%. Using an 8% cost of capital, the  no-growth EPV estimate would give us something like $500/0.08 = ~$16/share.

However, this assumes no growth. Over the past 5 years, HBI has grown revenues, EBIT, and net income at a CAGR of 5%, 10%, and 15%, respectively. Let us see the effect of a small but non-zero growth rate (say, 3%). Now the EPV = $500/(8%-3%) ~ $26/share. This suggests a reasonably conservative range of $20-$25 for HBI. If it can grow faster than this, then the value may be much higher.

Let us look at this another way.

S&P estimates 2017 and 2018 EPS to be ~$1.90 and $2.30. Suppose HBI trades at 15x (approximately where it is trading now) at the end of 2018. This would imply a  15*2.30 = $34.50 stock price. If we buy the stock at current prices (~$20) and sell in two years, the CAGR return would be about 30%. Not too shabby.

The stock pays a nearly 3% dividend, which may be a suboptimal cash distribution strategy, but makes it easier for people like me to wait for the market to rerate the company. Furthermore, although HBI does buybacks, it seems price insensitive; thus, I prefer dividends over buybacks.

Risks

There are many obvious risks. Any disruption of the three secret sauce ingredients can jeopardize the investment. Taxes are low, and one might be able to argue that HBI is not paying its fair share in taxes. If one can make that argument persuasively enough to change current policy, HBI could be in trouble.

However, it won’t be in mortal danger because of increased taxes. It is the high debt load that has me worried on this count. Sure, currently it doesn’t seem like a problem, but if for some reason earnings start falling, then debt can present an existential threat. Cash flows may be predictable, but Fruit of the Loom (now a Berkshire subsidiary), which is a competitor, did go bankrupt.

Overall, I believe that HBI, like VFC, is modestly undervalued in the 20-25% range. It may be a decent buy, in this otherwise overvalued market. But one has to keep an eye out on the debt/EBITDA ratio and tax rates (and they may end up being correlated).

 

A Second Look at First Solar

The global installed capacity of PV solar is about 250 GW, which represents about 1% of the total electrical power generated. For context, this is smaller than wind (430 GW) and hydro (>1TW). During an average day, solar output peaks in the afternoon, when energy demand is high – a highly desirable feature. It is projected to grow at a healthy (~8%) clip in the foreseeable future, and by 2050 it is estimated that over a quarter of our energy supply will come from the sun.

Overall, it is an industry with secular tailwinds, if you pardon the pun.

History

First Solar (FSLR) is a leader in a fragmented industry. It uses thin films of CdTe to design and manufacture solar modules. In 2008, as oil prices hit $150/barrel, FSLR traded near $300/share. Over the next five years, shares were brutalized, and dropped to ~$10 a pop. From there they surged 7-fold, before getting cut in half again! Currently they trade for a little over $30. FSLR would easily make it to the list of the world’s scariest roller-coasters.

In the glory days of 2006-2009, oil was expensive, and FSLR had delicious EBIT margins of ~30%. Revenue was ballooning at well over 100%/year. FSLR was an industry leader, and could execute at scale. In 2010, it earned nearly $8/share.

Since then, it has seen one disaster after another:

Oil prices dropped precipitously from around $150/barrel to $30. The shale revolution put a ceiling on the price of oil and gas. The shadow cast by the looming expiry of tax incentives (ITC) became darker. According to most estimates, 2016 was a whopper year for solar projects, and the ride is expected to get bumpier. A few solar related bankruptcies (SunEdision) soured sentiment on the entire industry

Perhaps the most catastrophic development has been the flooding of the PV market by cheap Chinese made crystalline silicon wafers. In 2016 alone, module prices declined by 30%. FSLR’s operating margins went down the crapper before stabilizing in the low teens over the last few years. Given the tumult in the industry, it is actually surprising that FSLR has been able to eke out a profit the past few years, without levering up the balance sheet. SunPower, another US firm, for example, seems to be in a worse position from both an operating and balance sheet perspective.

Strengths

FSLR is a leader in a growing, unconsolidated industry. A reasonable case can be made that the malinvestment in cheap silicon will end sooner or later, and pricing will become more rational. This “unsustainablility argument” is not a given, since many Chinese firms are allegedly propped up by uneconomical loans from local banks/government – which means the charade can go on for a while. The longer the madness lasts, the more pain there will be.

Eventually, there will be a day of reckoning.

From past experience, buying the strongest player in an industry temporarily gripped by insanity is a great recipe. FSLR has a strong balance sheet. It has $2B of cash against $400M of long term debt, which corresponds to net cash of about $13/share. It has staying power. The long term secular trend towards more PV solar is not only intact, but may even be more optimistic than previously believed.

By and large, FSLR appears to have competent management. To use a poker metaphor, it has played a bad hand well. They haven’t sacrificed profitability. They haven’t loaded on debt. When it was appropriate FSLR joined with a competitor (SunPower) to create a YieldCo (8point3, in 2015). When the environment changed, they changed their roadmap and jettisoned their S5-series modules.

Weaknesses

The elephant in the room is that solar modules are commodities, which means that you are fighting solely on price. For a while, FSLR had a technological and cost advantage over its peers. It milked that advantage, when it boasted operating margins of >30%. However, that cost advantage has mostly dissipated.

Another disadvantage in a commodity business is that most of the gains in efficiency and reductions in cost are passed on to the customer. From the consumer’s point of view, things are great. From a company’s standpoint, competitive advantages from R&D and improved technology are not durable.

A second headwind is world politics. In the US, for example, the posture has moved against renewables. There has definitely been “climate change” in the attitude to tax policy. In less than 5 years, the solar industry will have to learn to live in a world without subsidies. Luckily, the relentless decline in costs, means that today, in many sunny parts of the world, solar can compete with fossil fuels, when the sun is switched on. The low price of natural gas, which may represent a new normal, may not be bad news, because solar works best with a steadier complementary energy source.

Technological change can be swift. Given the attention being diverted to the problem, it is quite conceivable that there will be a couple of scientific breakthroughs, which will completely neutralize any (small) advantage that FSLR enjoys over the rest of world. This is the big unknowable unknown.

Finally, cadmium telluride is toxic. While chances are small, possible litigation can pose an existential threat, and toss a monkey wrench into FSLR’s best laid plans.

Valuation

With so many sources of uncertainty, it must be well-understood that any number we put up is subject to a huge error bar.

A possible worst scenario may unfold as follows: The development of S6 modules eats away all the excess cash. The delivered product is delayed, and when it finally arrives, it disappoints in a major way. Meanwhile there is a big breakthrough in silicon PV, which makes it the lower cost technology. There is attrition of senior management, and the company’s response is incoherent. Chinese and Indian economies slow down, diminishing the growth prospects of the solar industry. FSLR gets slapped with a class-action lawsuit which alleges its panels caused widespread environmental damage.

There are many ways FSLR can be a zero. I don’t know what the odds are, but they may larger than what many assume. Maybe 10%. 20%? I simply don’t know.

One can also paint a future with an optimistic brush. The S6 modules are a hit, and delivered right on time. Many competitors which don’t have FSLR’s stellar balance sheet can’t keep up and declare bankruptcy. Simultaneously, the Chinese banks decide they have had enough, and stop making uneconomical loans. FSLR is able to capitalize, by snapping up assets at pennies on the dollar. The industry consolidates, and pricing becomes more rational. In the new equilibrium, FSLR emerges in a much stronger position. Given the synergies with gas-fired electricity, it gets snapped up by an energy major at a hefty premium. The chances of this scenario playing out are also non-negligible.

Finally, we can make some quantitative base case estimates, by visualizing what FSLR might look like three years from now.

The revenue in the past couple of years has been around $3.5B, and the 5-year growth rate has been about 7%. Let us assume 5% growth for the next 3 years, so that in 2020 revenue is slightly over $4B. Let us assume that current EBIT margins of 12% persist. In recent years, FSLR’s capex has been about $350m/year – let us assume that $100m of that was for maintenance, while the rest was for growth. Let us assume a tax rate of 18%.

With these assumptions, we get an estimate for normalized earnings as ($4B*.12 -100)(1-0.18) ~$315m. Net income has been over $500m over the past two years – so this number seems reasonable and conservative. Share count has been increasing at about 3.5%; let us suppose that they increase at 4%, and in 3 years we have nearly 117m shares outstanding.

Dividing normalized earnings by the number of shares, I get $2.71/share. We can slap a 15x PE multiple, and add excess cash to arrive at a target price of $43/share in 2020. Here, I assumed that FSLR uses 80% of the net cash on its balance sheet for the development of S6 modules, and only 20% remains in 2020.

With a 12% discount rate, I get a fair price of $30.75, and applying a 20% margin of safety to this number, we get $24.60. At this number ~$25, we would be buying FSLR at around half its tangible book value, even after the planned impairments. Given the conservativeness of our assumptions, buying FSLR at $25 may be an interesting high-risk, high-reward bet.