Cash Secured Puts: VFC Example

The most valuable skill I’ve learnt this year has been using cash secured puts (CSPs) more effectively. While I’ve used CSPs before, these resources at the “Great Option Trading Strategies”, especially on opportunistically rolling out options, greatly clarified the philosophy and mechanics of adjusting a trade for me. (Thanks, Brad Castro!)

The best part of a CSP is that it is completely congruent with a long-term value investing focus. It lets you buy securities on the cheap, or generate an income stream.

Let me illustrate its use with a real-life example.

Earlier this year, I looked at VFC, and guessed that it was probably worth around $65. At that time, VFC was trading around $53, having bounced back from a multiyear low of $48. I believed that there wasn’t much downside left.

So on 2/23, when the stock was trading at $52.55, I wrote 2 $52.50 Mar17 puts and collected about $205 in premiums. The stock hovered in the range $52.50-54 in the lead up to expiration, and the option died worthless (~$54 at expiry).

Screenshot from 2017-06-02 15-46-41

Five days later, the stock fell back to $53.09. I again wrote 2 $52.50 Apr 2017 puts for about $245 in premium. I closed the position 12 days before expiry on 4/10 for $35, after the stock jumped to $55. This allowed me to book nearly $210 in profits.

After that VFC continued to rise to nearly $58, and I lost interest in it. On 4/28, the stock fell back to $54.75, and I wrote 2 $55 May17 puts for $205.

After reporting lackluster earnings a few days later, the stock fell down to $52, and I learnt my first options lesson: be cautious of earnings announcements.

The stock recovered above $55, before falling to nearly $51.50 around expiry. My puts were now deep ITM.

In such a situation, there are a few options. Since I thought $51.50 was a great price, I increased my position, and on 5/17 rolled out the previous put, and committed more capital. Effectively, I closed the old puts, and wrote 3 new $55 Jun17 puts, for a net inflow of $452. The table below summarizes my actions so far.

Screenshot from 2017-06-02 16-04-10

Currently (June 2, on the day of writing) there are two weeks left before expiry. VFC is trading near $54. I don’t know what the stock will do between now and then.

Even if I decide to take delivery, I will have reduced the effective buy price to $51.50. I may be able to reduce it further if the stock remains range bound. If it jumps well beyond $55, I will happily walk away with over $1000 in earned premiums, and a solid return on capital employed.

Update on CSCO

CSCO was the first stock I valued on this blog. I came up with a $30-$35 valuation band.

At one point in time CSCO was my largest holding. Today, it is a 4.5% position. It’s stock price fell nearly 10% recently, and I thought I’d value it again in light of these developments. Unlike the previous valuation, I also capitalized R&D expenditures this time around.

Here are the assumptions I made in my valuation. I used a 10-year explicit forecast, based on the notion that CSCO remains a solid, profitable company experiencing some temporary hiccups. I assume operating margins will decline somewhat from 24% currently to 18% in year 10. I also assume that tax reform will happen, reducing CSCO’s tax rate marginally. It will also be able to repatriate its cash hoard – but I assume a 20% hair cut [PS: I have a python program to automate DCF analysis, which I plan to share on this blog after I clean it up, and apply some make-up.]

I can model some uncertainty in the margins and growth. I come up with the following range of estimates.

figure_1The median is $34. At today’s price of $31 and change, CSCO looks mildly undervalued. There is clearly a lot more upside than downside.

I continue to hold, and opportunistically write (and roll) covered calls.

Capitalizing R&D

Industrial companies reinvest in plant, property, and equipment to grow revenues. Technology companies grow by investing in research and development. However, on an income statement, these R&D investments are treated as an operating expense (instead of a capital investment).

One can reorganize financial statements of such companies by capitalizing R&D expenditures. You can check out this video, and this spreadsheet (look for R&DConv.xls) from Aswath Damodaran to understand the logic and mechanics of this reclassification.

The R&D asset you create goes to the asset side of the balance sheet.

Since assets = equity + liabilities, this increase in assets leads to an increase in the book value of equity, and hence the invested capital.

Similarly, we adjust the operating earnings by adding back the R&D expense and subtracting the depreciation of this asset in the current year.

When we capitalize R&D, we get a more authentic view of the earnings, reinvestment, and returns on capital. This alters the fundamental inputs that go into a discounted cash flow valuation, including earnings, growth and reinvestment rates (sales to capital ratio), and operating margins.

Process

To begin the process of capitalizing, we need the following inputs

  • An amortization period, N years, over which R&D is expected to deliver results (software ~ 2 years, hardware ~ 3-5 years, pharma ~ 10 years; Damodaran’s spreadsheet has some numbers for guidance)
  • Collect R&D expenses for the prior N (or N+1) years from the income statement. You can get these from company filings or a data service like Morningstar.
  • Create a table (see spreadsheet) to determine (i) the net value of the R&D asset on the balance sheet, and (ii) the current year amortization number.
  • Recompute operating earnings, net income, invested capital, and reinvestment rate.
  • Use these numbers to inform inputs in the DCF analysis

Example

I took Damodaran’s spreadsheet, and modified it slightly to account for partial year data. I did this to understand the spreadsheet better; not necessarily because I think such an adjustment is important. Of course, it uses the latest numbers, so it has that thing going for it.

For prior years, I assumed that R&D expenditures were distributed evenly throughout the year. Thus, if $100M were spent over an year, I assume $25M were spent each quarter. This spares me the burden of having to deal with quarterly filings.

I used this modified spreadsheet to analyze CSCO after two quarters of fiscal 2017.

1

Cells in yellow are inputs, while those in green are computed. This yields the following calculation for the value of the R&D asset and the amortization.

2

It also yields some summary statistics. In CSCO’s case, capitalizing R&D did not have a big effect on (i) operating income/margin and (ii) net income/margin. It had a modest effect on the reinvestment rate, which increased. The amount of capex, invested capital, and depreciation increased dramatically, while the return on capital went down modestly.

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.

Valuing Financial Services Companies

Financial services companies are not quite amenable to a discounted cash flow analysis, because there is no wall separating operating and financial assets.

In such cases, it is difficult to figure out an ROIC, because “IC” in this context is a nebulous concept. This problem pops up in one form or another, when one attempts to do a firm level valuation (debt + equity). For example the sales/capital ratio which is handy in modeling reinvestment for growth is not particularly meaningful.

One way out of this quandary is to focus on equity (from Damodaran), and use a (potential) dividend discount model based on the Gordon growth model.

Let us define the relevant terms.

BV = book value of equity
ROE = return on equity
COE = cost of equity
nNI = normalized net income for next year = ROE * BV
g = stable earnings growth into perpetuity

The amount of free cash is determined by the g and ROE. This free cash can be distributed as a potential dividend. The payout ratio of this “free cash dividend” is

p = dividend payout ratio = (1 - g/ROE)

As a reality check, it is useful to compare the historical payout ratio to this value of “p”. One might have to account for all forms of cash return including dividends and buybacks while doing this.

Thus, the value of the equity is:

Equity IV = nNI * p/(COE - g)

Of course, if it makes sense, then the future can be split into explicit stages in which variables vary with time before settling into their terminal values.

Comparison of Apparel Companies

Earlier this year, I looked at a bunch of apparel companies. Sometime during my research, I compiled the following table to take a cross-sectional view of the space.

Untitled

NKE at $90B+ market cap is the big kahuna. It has stable growth of nearly 8%, high ROIC. Not surprisingly, it commands a premium price.

Adidas is also quite large. It seems to be getting its act together. Historically ADDYY has been a laggard in terms of ROIC, margins, and growth.

LULU and UA had spectacular growth spurts that seem to be slowing. LULU has delicious margins, and ROIC, but view from the wind-shield is not as rosy as that in the rear-view mirror. Unlike LULU, UA’s margins and ROIC have been okay, but not great. LULU is more expensive than UA.

VFC is a mature, boring, slowing, and solidly profitable company. Operationally, HBI seems the lousiest of the lot. However, it uses leverage and tax shields to play in the big leagues.

Note that good companies (growth, margins, ROIC) are more expensive than so-so companies. This is the free market at work.

On ROIC

ROIC and growth are the two central drivers of value.

ROIC = NOPAT/IC

The numerator comes from the income statement. The denominator comes from the balance sheet.

NOPAT is net operating profit after taxes. It is often modeled as EBIT (1 – tax rate). While depreciation is a real cost, the amortization of intangibles is often added to adjust EBIT. Thus,

NOPAT = EBITA (1 - tax rate)

There is a fair amount of subjectivity in defining the denominator IC (invested capital).

It can be obtained from the asset or operating side of the balance sheet (recommended), or the right or financing side. I found this position paper from Credit-Suisse very useful. The authors present practical tips on how to think about IC, instead of getting caught up in some particular formula.  An illustrative example (CSCO) is used to animate some of these ideas.

Screenshot from 2017-05-08 08-56-19Essentially, IC should include all the “capital” (inputs that generate revenue over long time frames).

To the first approximation,

IC = total assets - non-interest bearing current liabilities

It definitely should include current assets, net PPE, and other operating assets. One can make several commonsense adjustments:

  1. If a company carries excess cash or marketable securities (over that required to run the business), then that should be excluded from IC. A recommended rule of thumb is cash equal to 2% – 5% of sales (ranging from mature to growth companies) are required in the running of the business. Any excess should be excluded from IC.
  2. If M&A is part of the company’s modus operandus, then one should not exclude goodwill, as it represents a true cost of doing business.
  3. Capitalize leases and R&D, since they have characteristics of debt and long-term assets, respectively.

Here are some other resources on ROIC that I found useful.

This paper by Damodaran, “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications”, is quite readable, and presents some useful insights.

John Huber has some of the most well-articulated thoughts on ROIC. He has written several articles (compounding and high ROIC, and legacy versus reinvestment ROIC), which can be found on his website here.

This Bears-Stearns presentation on the role of ROIC in valuation has been floating around in a lot of different places.