Just Do What?

Nike is a monster. It is the largest athletic apparel and footwear manufacturer in the world.

It sports mouth-watering returns on invested capital (25-30%), and has been consistently growing revenues and EBIT in the 6-9%/year range for well over 10 years now.

It is a growing, profitable, wide-moat business with an iconic brand.

Its has sales of over $34B, net-income of $4.2B, which towers over Adidas ($20B sales) and Under Armour ($5.5B) sales. Footwear and apparel account for 65% and 30% of revenues, respectively; the remaining sliver comes from equipment sales.

International sales now account for over half of Nike’s sales (~55%). About 30% of its revenues are DTC (website and company owned stores). In the medium-term both these slices are likely to continue growing.

Unlike Under Armour, Nike is a shoe company gate-crashing into the apparel market. The total addressable apparel market is $135B, almost 2x that of footwear. The size of the market and the popularity of athleisure provides a tailwind, and a new market for Nike to grow into.

It has stellar management (interview with CEO), and high insider ownership.

Essentially it is a great business. Usually such businesses are not cheap.

However, a glance at its chart reveals that it currently sits close to its 2-year low.

Screenshot from 2017-10-08 16-49-46

Might this be a good time to ease into NKE? Before we look at valuation, it might be useful to understand what the bear case might be.

Amazon. Of course.

It is killing retailers (Footlocker etc.) which still account for a majority of Nike’s sales. It is also jumping into Amazon branded apparel.

While I respect Bezos too much to dismiss Amazon, I think the actual threat posed by Amazon to Nike is far weaker than perceived.

Nike is a powerful identity brand. Like Ferrari, Harvard University, and Rayban. Unlike Gillette, Tide, or Hanes underwear, whose brands were protected through the premise of lowering search costs. Amazon (or Dollar Shave Club or Kirkland) could kill such categories with their store branded products. And they probably will.

Perhaps a bigger threat is that the apparel industry is subject to fashion trends. Nike knows how to engineer performance shoes that are sought after. The transition to a casual fashion brand may be not be easy.

The game is different. Just because someone has a black belt in karate, doesn’t mean they will do well in the boxing ring.

Currently, the North American market environment is overly promotional. This will eat into margins. However, over a few years, one would expect this latest catfight for market-share to have play out, and settle. So while this does present short-term headwinds, perhaps we should be thankful to it for allowing us to buy a great company at a reasonable price.

Which finally brings us to valuation.

Graham’s formula for growth companies, suggests a fair P/E ratio of (8.5 + 2g). In NKE’s case growth is approximately 7% for quite a few years to come. So that would suggest a reasonable P/E of 22. For FY2018, EPS is expected to be around $2.40.

This would imply a fair value of 22*$2.40 = $53, which is close to today’s share price.

One could also use a terminal value formula to come up with an alternative fair P/E, and isolate the drivers of value.

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

If we assume Nike is a truly great company capable of growing profitably for quite some time, we might assume growth = 7%, COC = 10%, and ROC = 25%. This yields a fair P/E of 24, which after subtracting the $2.50 debt/share brings us to a fair value of $55.

If Nike we treat Nike like an solid (but not extraordinary) company, with growth ~ 4%, and ROC = 20%, we get estimates of value between $35-40.

Thus, despite the fall in stock price Nike is not really cheap. For $50-$55, we are, at best, buying a wonderful company for a fair price. It will probably turn out to be a fine investment. However, this is not a back-up-the-truck price, just yet.

In my opinion the $35 estimate provides a lower bound. It implies a P/E less than 15 for a company like Nike!

Given the liquidity of the stock and share price, NKE might be an ideal candidate for selling cash secured puts. I would like to try to build a sizeable long-term position in NKE, especially if I can reduce the cost basis to the lower of mid $40s.

 

 

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Valuation Updates

Here are some updates on companies I valued earlier this year

First Solar: I came up with a fair value of ~$31/share in January, and suggested huge uncertainty around that estimate. I even embarked on a put campaign when it dipped to my target buy price near $25, before it roared back to nearly $50.

Under Armour: I estimated UA to be worth about $17.50. Since then, it has simply hovered in the $15-$20 range. I’ve been trying to build a position in UA by writing puts. In August 2017, I bought 40% of my target allocation for $16.15. The recent swoon in prices has me eyeing a second slug.

VF Corp: I thought VFC was worth about $65, when it was selling in the low $50s. Since then, it has bounced back to $63 and change. I have no position in the stock currently, although I did make a decent return writing puts.

Hanesbrand: I came up with a conservative $20-25 range for HBI, when it was trading at the lower end of that range. Currently, it is trading at the higher end of that range.

Compounding Insurers: In April, I updated by valuation of BRK ($200), MKL ($1080) and Fairfax ($580). Since FFH was cheap for a large part of the year, I doubled my position. Just today, the price breached $500 on the back of a stellar Fairfax Asia deal.

ALJ Regional Holdings: A depressed fair value estimate for the company is about $3.40. But buying ALJJ is a bet on the jockey. It could be worth more than $5 shortly. I have been buying ALJJ since June.

Others: I thought Charles Schwab was an excellent company worth somewhere between $30 and $40, and that GameStop was a struggling retailer that might still be worth about $25-30. Finally, I estimated the value of Disney to be $120.

MSC Industrial Direct

MSC Industrial Direct (MSM) is an 75-year old industrial distributor with a focus on metalworking and maintenance, repair, and operations (MRO)-related products and services.

It is primarily a US based company (>95% revenue), where it has 5 large distribution centers and 80 branch offices.

Since its IPO in 1995, it has grown top and bottom lines at 12%. Here is its fundamental performance since 2007.

Screenshot from 2017-08-26 16-45-19

Here is the performance of its stock price, annotated with some plausible narrative:

Screenshot from 2017-08-26 16-47-44.png

In 2017, it fell from a high of $105 to its current price in the $65-$70 range.

Alan Mecham had this to say about industrial distributors (emphasis mine):

… an industrial distributor, like MSM, has very low cap ex requirements but large working capital needs. What I have an affinity for are companies with staying power that I feel I understand well.

I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well-managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers.

So here we have a $4B market cap company with $2.9B in TTM sales, and $382M in EBIT, whose price has fallen ~40% from recent highs. It is probably worth a look.

The rest of the post follows a Q&A format. I raise questions that seem relevant, and try to address or counter them, as best as I can.

EBIT and sales have grown at 13% for 20 years. Is this extraordinary growth sustainable?

The MRO business in the US is fragmented. Not just the suppliers and the customers, but also the distributors.

The top 50 distributors account for less than 30% of the market. MSM is in the top 10. Currently, there are 145K companies like MSM in the US; most of them operate at a much smaller scale.

Management estimates that the total addressable market for MSM is $160B. With revenues of $2.9B, MSM has a market share of under 2%. There is plenty of room for consolidation. MSM could acquire or displace smaller companies. It is also small enough to get acquired itself.

If MSM continues to grow at 13% for another 20 years, its revenue would be ~33B. Over the time period, it is possible that the TAM would have increased further, making this scenario (brisk and steady growth) completely within the realm of possibility.

Industrial distributors like MSM have high gross margins near 45-50%. Are these sustainable?

MSM has boasted gross margins in the neighborhood of 45% since inception. That said, product cost is a tiny sliver of the total operating expenditure, which is instead dominated by the procurement and inventory operating costs. Thus, focusing on gross margins might be somewhat misleading.

Screenshot from 2017-08-26 17-17-36

If this is a big market with juicy margins, won’t Amazon Supply step in to defragment the market and eat their lunch?

Bezos is famous for saying, “your margin is my opportunity”, and even during these time of “peak Amazon”, I wouldn’t willingly compete against Bezos or Amazon.

But AMZN is not infallible. That I am willing to bet on.

Amazon’s entry into a large market with juicy margins, doesn’t mean incumbents are toast. Amazon tried to compete with Priceline in the online travel business before giving up. The Fire smartphone was a debacle – it couldn’t hold its own against the iPhone or Samsung. In these markets, it was Amazon that had to retreat.

In other domains, including groceries I suspect, AMZN will be a player – perhaps, even an important one – but it won’t suck the oxygen out of the room. 15 years ago people worried that Walmart would displace all the local and regional grocers, yet stores like Publix and Wegmans have continued to thrive.

You don’t want to fight Amazon (or yesteryear Walmart) only on price. When outmatched, like David against Goliath, the key is to play the game by different rules. For example, I happily go to my neighborhood Publix, even though there is a Walmart offering better prices at the same distance, because of three reasons: (i) The staff is familiar, and I feel my presence is acknowledged (low churn unlike Walmart), (ii) shopping is more pleasurable; the lighting, the produce; if I don’t find something I need there is someone close by happy to help, and (iii) I absolutely love their store branded (Greenwise) cereal.

There are some lessons here for industrial distributors like MSM, which runs a well-oiled call-center that fields customer queries. They might not be able to compete with AMZN in logistics, but so long as they play in a field where customer relationships are important, they will be resistant to AMZN attacks. Even if AMZN somehow makes deep inroads, MRO is not necessarily a winner-take-all business.

Also, who knows, at a $4B market cap, AMZN might even see MSM as an acquisition target. Of course, the Jacobson family who owns most of the voting power would have to bless any such merger.

ROIC has decreased from 20% in 2012 to 13% TTM. Operating margins have declined from 15-17% to 13%. EBIT has stagnated. Earnings have declined. Is the best behind?

MSM operates in a cyclical industry. Currently demand and pricing are soft, and yet MSM spews off cash throughout the cycle.

CEO Erik Gerstner once remarked:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace. The pace will accelerate the longer these conditions hold. We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

At some point, the cycle will turn. Perhaps, the infrastructure bill will be the first domino to fall. It might be something else. Whatever it is, it will cause the earnings numbers to explode. If tax-reform happens around that time (currently MSM pays 35% in taxes), any savings will flow to the bottomline, and lace the upside.

The company’s debt has increased significantly over the past few years. Isn’t that a cause for worry?

Debt is still only 1/3 of the total capital, and less than 2x EBIT. So debt-levels are very manageable. From a tax perspective taking on some more debt might be the smart thing to do.

By and large, management allocates capital well. Recently, they borrowed $365 million at 1.29% after tax to retire shares which yielded nearly 2.5% in dividends each year [S/O have declined by 10% over the past 10 years]. This would be smart, even if shares were fairly valued. However, if MSM is undervalued, this is even smarter.

So what is it worth?

It is always difficult to value a cyclical company at the bottom of the cycle. Especially, one that gains strength during a down cycle.

Based on history, assuming long enough holding periods, one would expect returns to mimic ROE: mid teens, say 15%.

A DCF with reasonable inputs yields $65-$75 as fair price for the equity. At its current price, it is in the lower range of my estimate.

figure_1However, my DCF anchors too much on the recent past and suppressed earnings, even when it tries not to. It doesn’t factor in the likely levered upswing, when the cycle turns. Both Credit Suisse and Morningstar have target prices in the low $90s. Those analysts probably know how to account for cyclicality better than me.

Over the past 5 years, MSM has traded between $55 and $105. The EV/EBITDA and P/E have ranged between 8.3-15, and 15-27, respectively. The current EV/EBITDA and P/E at 9.7 and 16.8, are at the lower end of the historic range. Unless you believe that the recent stagnation is a secular trend, and not a cyclical low, it would be prudent to bet on some reversion to the recent mean.

Colfax: Getting Warmer?

I wrote about CFX in October 2016 (“Some Cold Facts about Colfax“). At the time, the stock had bounced back from a low of about $20 earlier that year to about $30. In the wake of Trump’s election, it continued to rise above $40, before dropping to the mid-upper $30’s again.

Screenshot from 2017-08-20 10-54-35

Some company-level developments:

  • Top-line growth returning?: Revenue decline stalled. FY2017 sales are expected to tick up marginally to $3.7B from $3.65B in 2016. For a company exposed to cycles, this might be an important datapoint.
  • Effect of leaner operations?: EBIT is expected to grow more than 10% to ~$360M from ~$320M. This growth is significantly greater than sales growth, which suggests better cost-management.
  • EBIT margins have increased from 6.5% (FY2016) to about 7.5% (TTM). This is still much lower than the targeted mid-teen operating margins.
  • ROIC even without goodwill and intangibles is still around 10%.

To summarize, fundamentals have improved modestly (10% EBIT growth). But the stock price has jumped much more (30%+), since last reckoning.

Valuation

To hold the stock at $37-38, where it is trading today, one has to believe that a serious transformation and acceleration is underway. That is, the forward-looking view from the windshield is much better than the rear-view mirror. Some level of faith in the management is important, because no matter what I do with a conservative DCF (which still relies on extrapolation of the recent past), I cannot justify a price much above $32-$35.

So let’s do something simple, but dangerous. Let’s try to visualize how CFX might look like in 5 years from now. Suppose sales grow at 4-5% to yield a revenue of $4.6B in 2022. Suppose management manages to hit mid-teen margins: EBIT = 0.15 * 4.6B = $690M. Factor in a reasonable interest expense (10% EBIT = ~$70M), and tax rate (35%), we get after-tax operating earnings to equity of about $400M. Dividing by shares (124M), we get an EPS ~ $3.20. Since CFX is expected to grow 1-2% faster than GDP, and become more profitable, it might deserve a premium valuation of 18x. This gives us a target share price in 2022 of 18*3.20 = $57.

Of course, I can guarantee things won’t go smoothly from where we are now to $57. There will be plenty of bumps. An acquisition or two can certainly be expected. They will be unexpected tailwinds. Nevertheless, this $57 gives us something to anchor to, if things play out well.

Given today’s price of $37, this implies a CAGR of about 9%, which would be respectable in today’s environment. However, don’t forget that lots of things have to go right for CFX for that to happen.

Strategy

I am a little conflicted on CFX.

I like the management. Incentives of the insiders are aligned with long-term shareholders. They have been trying to do the right things in a trying environment.

Over a long enough holding period, I expect intrinsic value to compound at a decent clip. Things are turning around. Even if they don’t transform immediately, CFX is no melting ice-cube. Time is on its side.

Optically, the performance doesn’t look great. But look at its sister, Danaher. It has never looked cheap to me. But you would have done very well buying that stock just about anywhere, and going to sleep for a long long time.

Okay, so why am I conflicted?

The current operating performance is shit. Operating margins and ROIC are meh. And that is a charitable reading. My cost basis is higher than the current stock price, and given how much stuff I’ve been forced to sell this year, I wouldn’t mind racking up some offsetting losses to ease the tax bill.

So what I’ve ended up doing is something that reflects my indecision. Since March of this year, I have been writing covered calls for $40 and $42.50, and rolling them over. The price action has been very cooperative, and I have collected over $4/share in premiums.

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.