Trinity Bank is a bank in Fort Worth, Texas and it blows my mind. It is a real gem of a bank run by a real gem of a CEO. The bank is actually focused on customer service, maximizing efficiency, and sound lending. Unlike just about every other bank that claims to do this, Trinity Bank actually does show evidence of this when you look at the results.
I would normally expect a small bank to have a generally higher efficiency ratio than a large bank due to economies of scale, but this is a dumb assumption on my part. Their efficiency ratio is at 45%, which isn't the lowest in the world, but is still low. They also aren't operating at full capacity either (revenue should pick up if the economy improves without much additional staffing) so a normalized efficiency ratio might turn out to be lower. The bank opened in 2003 with capital raised by Jeff Harp, the current CEO. After a few years of losing money as the bank ramped up, the bank has been steadily profitable and growing to this day. They haven't lost money on a loan in their history (a handful were nonperforming, but all balances were recovered) and achieved a ROA and ROE of 1.42% and 12.90% respectively in the most recent quarter. It trades at 1.7x book value, which isn't cheap, but it's not overpriced and the bank's quality indicates it deserves a premium to book. The numbers are excellent and seemingly for all the right reasons.
The bank is hopelessly illiquid, even by the standards of...anyone. The stock hasn't traded since June 21st. Maybe it's a Munger moment where I could just invest and then sit on my ass, but then I'd have nothing to do. I wonder why anyone would sell their shares at this point. The reason for celebration though is that the CEO includes a letter to shareholders with each quarter's results written in the same vein as Buffett's. Everything is pretty straightforward and simple, which is too complex of a concept for many CEO's to execute. The letters focus mainly on the 3 key traits of an outstanding bank: efficiency, good loans, and working with customers. There's nothing novel or profound about any of this, but the same could be said for Berkshire letters. There is minimal non-banking commentary and I would characterize the banking commentary in the same way that Buffett comments on insurance. It's possibly too simple and doesn't equip you with the tools to go invest in banks (although this is not the point of the letters) but it puts you in the proper mindset. The CEO offers some macro commentary, but it's intentionally vague with healthy confessions of ignorance. Some choice quotes for the bank investor (the letters are all worth reading):
“It has been brought to our attention by our outside accounting firm that Trinity Bank cannot justify, based upon loss history (none) and the current level of problem loans, the amount of money we have set aside in our Allowance for Loan Losses. Therefore, you will notice that the bank did not make a provision for loan losses in the first quarter of 2011. And we probably will not be able to add any more to the Loan Loss Reserve this year unless loans start to increase.” (This is by far my favorite from an operational and irony standpoint.)
"The key is not to have zero problem loans. If that is the case, a bank is not taking any risk and is not serving its customers (and ultimately, will not prosper). The key is how much money do you get back when you make a mistake. We will make some mistakes, but we will protect the bank while working to help good people through bad times." (Pithy, but the essence of sound loan underwriting)
“All things considered, Trinity continues to perform well. However, our performance reminds me of the swimmer that won the Olympic gold medal in a very slow time – because everyone else drowned. To really meet our long-term investment objectives, we must increase the returns on your investment to the 15-20% level (Return on Equity). It is difficult to do that in a soft economic environment without taking on a lot of risk. We are trying to be patient and avoid the “vulture” tendency. The vulture tendency is an old joke about two emaciated vultures sitting on a tree limb. One of them says to the others, “Patience hell! I’m going to kill something”. He was tired of waiting around for something to do so he could get a meal. He decided to make something happen.”
“The down side to the increase in loan demand is that it is mostly from people buying assets at reduced prices. Believe me, we think these are good loans and we are finally able to obtain good equity and decent rates. But these loans typically are not putting people back to work. I would much rather be financing business expansion, i.e. new equipment purchases, working capital requirements from growth in sales, new buildings, hiring more people, etc.” (Note this is not altruistic. The bank piggybacks on the growth of its customers, which is blindingly obvious but not the focus of many banks who instead try to pitch credit cards and HELOCs - see previous quote.)
“I wish I knew what to do. Obviously, I don’t or I would be selling advice instead of trying to run a bank.”
Anyone know of any other good bank shareholder letters? I know they exist, but most are usually just corporate garbage and thin. Yes yes, I know that MTB and JPM have good letters.
Sunday, July 24, 2011
Friday, July 22, 2011
The narrative fallacy of thrift conversions and their deposits
I was going to focus on other aspects like loan quality, but I think looking at the deposit mix of some of the recent thrift conversions is enough to prove my point. I might be making this up, but I sense that people make the assumption that thrifts by virtue of being local have these great local relationships and strong deposit bases. This is plainly false to hold as a rule and its easy to prove/disprove by looking at the types of deposits the bank attracts. Just because Peter Lynch and Seth Klarman have singled out thrift conversions as a fertile hunting ground for investments doesn't mean that all conversions are brimming with investment potential. It's kind of easy to determine that they are cheap with huge discounts to TBV, but you still need to consider whether or not the business is any good. Deposits are very important to banks, so it stands that examining them in greater detail is worthwhile in judging the bank's overall attractiveness.
I'd also caution people that because it's difficult (not impossible) for an amateur investor that isn't less than incredibly enterprising to get in on the initial offering, purchase prices are higher so you need to pick out the overcapitalized conversions that have the most potential. If you do participate in the offering, you really are getting a dollar for 50 cents and the markets generally boost the price a cool 10-15% once they list on the exchange. If the deposits give the bank some additional franchise value, it can still be had for 50 cents on the dollar without trading at 50% of TBV.
I've seen a narrative floating around that these thrift conversions have been happening due to regulator shopping. This is dumb. This reeks of sloppiness. I'd call it intellectually irresponsible, but I don't want to taint the idea of intellect with this notion. An awful credit bubble occurred over the past decade, banks have lost money, mutual thrifts weren't in a position to earn their way out of their reduced capital and now they need to go to markets to raise funds. This isn't rocket science and even if I put forth this reasoning solely out of stubbornness and knee jerk contrarianism, it reduces my risk of making a mistake (although possibly at the expense of return).
It reflects a political bias because the inverse is that different regulators need to justify their existence and therefore would not act in an egregious manner to justify their constituents abandoning their regulatory structure for another. This is equally plausible under the same set of assumptions. The entire discussion of regulators neglects the fact that plenty of mutual banks still exist and don't look like changing.
It reflects a political bias because the inverse is that different regulators need to justify their existence and therefore would not act in an egregious manner to justify their constituents abandoning their regulatory structure for another. This is equally plausible under the same set of assumptions. The entire discussion of regulators neglects the fact that plenty of mutual banks still exist and don't look like changing.
The investment opportunity lies not in the idea that management is being so kind offering us these amazing banks to avoid regulatory uncertainty, but in the fact that these banks end up raising more capital than they need (it was the only way they could) and now are incentivized to generate greater profits on that capital. To even entertain this regulator shopping idea is just to distract people from the fact that many of these banks are not worth considering post-offering. I wouldn't pay something like 70 cents on the dollar for a bank that has enormous interest rate risk from a poor deposit mix and loads of 30 year mortgages unless the bank is very efficient, demonstrates conservative underwriting standards, and has generated a nice ROE preconversion (see Versailles Financial).
A recent thrift conversion demonstrates my point well in that it is totally unexciting and a pass. Naugatuck Valley Financial Corporation (NVSL) recently completed its second step conversion and trades at the offering price. Second steps aren't quite as profitable historically from an investment standpoint since the bank raises equity for 75-80 cents on the dollar instead of 50 cents on the dollar. It still does result in a discount to TBV which is generally unwarranted. It can be plenty rewarding if the bank is capable of double digit ROE's and now has even more capital to do that with, but this hasn't been the case over the past 2 years. NVSL trades at about 70% of book value post offering, although their NPLs are a good measure above their allowances so the denominator in that equation might fall in coming quarters (they could also have no problems, but I'm a pessimist).
NVSL does mention regulatory uncertainty in is prospectus as one of the top reasons for converting. While this may be fairly plausible since they were half public, half mutual, the reality is that they have a depleting capital cushion. If you adjust their allowances to be 100% of NPLs, instead of the current 35%, this becomes clear. Instead of lacking a profit motive though like most straight mutual conversions, the bank really just lacks profit. I attribute this a good part due to deposits, which is what I want to focus on.
It has a poor funding mix. The bank is dependent on CDs and FHLB advances for 80% of its funding. What is really absurd about this is how much they pay for them. The part that really sticks out about this is that they pay very similar interest rates for both: ~2.60%. CDs account for $238m out of $409m of deposits with FHLB advances totaling $88m out of a total of $497m in total interest bearing liabilities. They are starved for funding in an environment where there it is cheap and plentiful.
One reason I will put forth is that they only give their customers 0.07% on their checking accounts, which is insultingly low. They clearly face competition for local deposits, but have adopted a strategy that is not going to lead to a high return business. They are paying above average rates for unattractive deposits and below average rates for attractive ones, which explains why the deposits are what they are. They are just desperate and short term oriented. Since I can't frequent their branches to verify this, I interpret this as a sign of poor customer service and poor banking in general.
I realize it might sound ludicrous to say a bank shouldn't be paying as little as possible for funding. The reality is so much more complicated than that. A small bank that seeks to differentiate itself should be paying a nice rate on its core deposits (non-CDs). While not a perfect proxy, it does indicate a management's focus on the consumer first rather than the bottom line, which will follow. There will be different scenarios that call for different approaches, but in the case of small thrifts I think my assertion is correct. From my limited to non existent knowledge of banking, a superior consumer experience is a key part of what really generates strong profits over an entire cycle. That's how a small bank can differentiate itself from a behemoth bailed out bank and get people to turn to them for loans and repay them to the best of their ability in hard times.
There are plenty of customers who are actively pursuing higher interest rates on their money and are called rate shoppers. They aren't attractive customers. That doesn't mean that an ordinary customer can't expect a decent yield on all their deposits. While people generally remain passive about rate shopping, if you schtup them hard enough, they will leave and never come back. Then you are left with what it is the banking equivalent of what Keynes called hot money. These depositors are gone when the next new best thing comes around in the form of a high rate CD. This is not an absolute truth of banking, but this fairly consistently applies to a vanilla S&L type bank. A company like Bank of Internet or Beal Bank (neat little bank) has different advantages such as low costs or high yielding assets . I'd also like to point out that BofI was paying 2.30% on their CDs as of last quarter, which is less than NVSL, although still high (and they specifically target rate shoppers). Their ROE is about 7x that of NVSL though, so clearly deposits are not the only thing that matter.
First Connecticut Bancorp (FBNK), which converted a day after NVSL, is a much more interesting bank that fits the mold of thrift conversion worthy of further investigation. Just looking at the deposit mix, they manage to have about 15% of their deposits with no interest, which is different than offering an interest bearing deposit with an insultingly low rate (the bigger this balance the better - while not potentially better than free money like insurance float, banks don't have tail risk from catastrophes - since it it is free money they get to lend out). For instance, there is no limit on deposit insurance for these accounts, which is a clear trade off between risk and reward. While First Connecticut pays a 4x higher interest rate on checking accounts (0.30%), they pay less than half the interest rate that NVSL does on CDs (1.18%). The same idea holds true for their other deposit products. They still have a good amount of CDs in their funding mix, but not nearly to the same overwhelming degree or at the same expense as NVSL.
This isn't a paradox, it's just better banking. It's a pretty quantifiable way of figuring out how a bank treats their customers, although not a surefire trick. Clearly if the bank has little to none CDs on its balance sheet, the bank is doing something right. If you have a better idea for how someone in Kenya can assess the customer service of a bank in Idaho though, I'd be interested in hearing it.
While I am interested in turnarounds of companies that are simply adapting their formula within reasonable parameters, I have a hard time considering thrift conversions turnaround candidates. I would differentiate between an improvement in operations from which many conversions benefit and a turnaround which implies that operations suffered from past mismanagement. A bank can be a turnaround in the sense that the economy turns around so reasonable loan growth can resume and NPLs go down since most banks are priced for a continually stinky economy. There are far too many moving parts that are not easily identifiable for a bank to turnaround its fundamental approach to lending or deposit gathering in a way that I could identify and profit from. I can try the new fries at Wendy's (meh, but I never was a fan of potato sprinkled sodium) and get an idea of how store remodeling and traffic is coming along, but I can't figure out if a bank has lowered its costs or has started to insist on and receive higher down payments on loans. By the time this comes through in the numbers, the stock price would likely respond faster than I would notice.
For NVSL to be attractive, they would really need to alter their fundamental model. Joe Stilwell, an activist investor involved in another bank I've mentioned, filed a 13-D on NVSL that seems to pushing for such. The CEO had stated a desire to use proceeds from the conversion to expand. While I've just passed on this opportunity to invest into an expanding empire of high cost deposits, Stilwell is capable of rattling the cage for change. Stilwell is very against potential expansion if you couldn't tell by him stating:
"If the Issuer opens even a single branch while non-performing assets remain above 2% or return-on-equity remains below 8%, or if the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation."
While this is possible, I would question their basic ability to earn an 8% ROE since their funding costs are going to be persistently high and their underwriting and efficiency don't compensate for this. There isn't a newfound incentive post-second step. Management had a share price to be interested in well before that. Maybe I'm not brimming creativity or I'm overly fixated on the deposit base, but I have a hard time fathoming how a bank goes about fundamentally altering its approach to deposit gathering. I wouldn't expect it to happen in a year, but even on a longer timeline a bank faces constant competition to make an improvement in deposit gathering difficult. Deposits are just one factor that can make a bank a great investment or an easy pass.
Thursday, July 14, 2011
K Swiss: Funny for everyone but investors?
This K Swiss/Kenny Powers video is nothing short of hilarious:
The comments section are filled with "K Swiss is awesome! I'm buying a pair of these shoes." Is this bankable scuttlebutt? No. Eastbound and Down, the HBO comedy series that created the Kenny Powers persona is going to be a cult classic for years to come. K Swiss is a different story. While I don't think there is much value in the stock, there is value in looking back at what was once a turnaround situation with what I might have thought was once a margin of safety.
In late 2008, when the shares were around the same price, the company had 75% of it market cap in net cash, $327m in sales, and $24m in profits for Fiscal 2008. In 2010, the company did $217m in sales and lost $68m and currently 25% of its market cap in net cash. The CEO owns a big slug of stock and has grown the company over the past few decades, so by that traditional indicator of aligned interest, shareholders are in decent hands. The situation has changed, but the stock price is about the same (using year end 2008 prices). The company has tripled sales of its Palladium brand in the past 3 years from $11m to $31m, but the K Swiss brand has seen a 40% contraction in sales despite the release of new products and the Kenny Powers centric ad campaign from $315m to $185m. The recent video might be the funniest of them all, but it is not a brand new branding approach - Kenny Powers K Swiss commercials are about a year old).
One reason for the losses is that the company hasn't righted the ship in terms of expenses. Instead of bringing its costs in line with revenue, it has continually sought to find ways to force its revenue to justify its costs. In 2006 with $489m in revenue, the company had $130m in selling, general and administrative costs, but fast forward to 2010 and the company had $217m in revenue and $142m in SG&A. The lowest SG&A has been in the past 5 years was $118m in 2009, before the company started pumping money into an aggressive ad campaign. Even if the company wants to hide behind a long-term view approach to their SG&A, the past 5 years of >50% sales decline has not seen the cost structure budge to be remotely in line with sales. At the same time, it is hard to envision reviving a consumer brand without an aggressive advertising campaign.
I could very well be wrong that costs need to come in line with revenue, because the inversion would be that revenue will come in line with costs. The Kenny Powers-centric ad campaign, as well as several other micro-viral campaigns centered around other personalities, has been around for the past year. In the 2010 Annual Report, management touted the reception of these investments which are being put through the SG&A line item in the financial statements:
"The first spokesperson was the fictional Kenny Powers from the HBO TV show, “Eastbound & Down,” that featured our Tubes training shoes on Kenny and NFL athletes Jeremy Shockey and Patrick Willis, along with mixed martial arts fighter Urijah Faber. These spots were well received even before their official launch. Online sites, social media, outdoors in New York and Los Angeles and a special Tubes micro site featuring Kenny Powers preceded the official launch. We generated great attention for the brand and strong sales for Tubes at retail and at kswiss.com. By late in the year, Footwear News had ranked us as number one on their list of brands with the biggest jump in buzz while our Facebook fans increased 22-fold and our Twitter followers were up 300%"These are all nice metrics in that they show some kind of growth. But how is the business doing? I'm about to use a limited data set since only one quarters worth of financial statements are available to compare pre and post edgy ad campaign. Next quarter's earnings have the potential to clear things up, but there are indications that celebration might be premature. What is the right amount of time to judge traction gained in an ad campaign? I don't know. Maybe it is more than 9-10 months, but I'll work with what I have. The CEO recently said “We are seeing the first fruits of 2010’s investments with sizable year-over-year increases in both our domestic and international futures orders and sequential improvement in revenues." I think when you peel back the numbers and look at the increase in future orders and revenue improvements in relation to metrics such as gross margins, accounts receivable, and inventory, the growth in terms of quality is overstated.
On one hand, the CEO can claim that the ad campaign has gained traction as there has been a YoY growth in revenue of 10%. People are buying more of their products. That is a fact. How and at what price are they purchasing them though? While revenue grew 10%, accounts receivable grew 22% indicating that they are offering merchants better payment terms. The deterioration in gross margin indicates that they are lowering their prices as well.
From the most recent 10-Q explaining the year over year 420 basis point deterioration in gross margin: "The decrease was the result of an increase in inventory and royalty reserves and greater discounts given to customers due to production delays by our factories for the three months ended March 31, 2011 compared to the three months ended March 31, 2010." To what extent each individual reason is responsible is hard to tell. Their guidance for 2011 is that gross margin remains at 39%, so I find it difficult to reconcile their own words with their own words. I didn't include it in the above chart, but gross margins in later quarters of 2010 had 40%+ gross margins, while the full year margins came in at 39%. Full year gross margins should iron out any issues in the quarterly numbers, so that things like production delays necessitating greater discounts should not be the sole cause of a huge drop in gross margins. It could also be that gross margins were abnormally high in the first quarter of 2010.
The combination of higher growth in inventory and account receivable relative to revenue growth can indicate a lot of things. The cynic in me wants to say that the Twitter followers and Facebook friends aren't translating into sales. As a result, management is having to cut prices and give merchants better payment terms in order to drive sales. At the same time, one could look at the inventory and claim that management is very confident in their ad campaign is beginning to gain traction and wants to be able to respond to the increased sales growth. Perhaps even a halo effect has emerged and people are beginning to look beyond the growth in K Swiss Tubes sales. The company's backlog also increased 45% yoy, but this is lower growth than the inventory by a wide margin. My cynicism and the company's growing backlog can contribute to the higher inventory at the same time though.
Late 2008 had the benefit of a large net cash position and strong trailing earnings over a multi year period. At the same time the forward looking environment was not as kind. Luckily, despite what I would consider a weakening financial profile, the share price hasn't really dropped much. Is the opposite true now? Is a smaller cash position and trailing losses obscuring a business in revival? It's hard to tell, although it seems like management's claims that its ad campaign had traction hasn't played out in the first quarter of 2011. This will play out in the next few quarters, but the margin of safety isn't there if a negative scenario plays out - and I don't think that the financials indicate this is six sigma probability event. It's also worth noting that had you invested based on a turnaround in late 2008, you would not have lost money including the $2 special dividend as the price is pretty much unchanged since then. While vindicating the concept of investing in turnaround with a margin of safety, such a scenario doesn't exist for investors today.
Tuesday, July 12, 2011
Brand turnaround - Wendy's
Wendy's is an interesting turnaround situation of sorts. It looks cheap, especially if it can start to resemble McDonald's financials in the next few years. It isn't as cheap as the narrative would have you think. Is it overpriced? Not really. I think there are some really phenomenal characteristics to the Wendy's brand and management, but I'm stuck on the valuation and the margin of safety.
Turnarounds can be interesting if the price is low enough. If you can buy a poor business at a discount to the value of a poor business - as a result of extreme pessimism or the like - that is showing tangible signs of becoming a good business, even a mediocre one, then it seems logical that you could make some money. Seahawk Drilling, one of my least favorite mistakes, qualifies as the wrong type, but a business less bankruptcy risk can be attractive. Wendy's is potentially such a business.
I hit up Wendy's every now, but when they reintroduced the bacon mushroom melt burger, which I was a fan of when they had it 5 years ago, I looked at the stock. It seemed like a turnaround that Bill Ackman had touted once upon a time was actually underway. Not only my specific experience, but Wendy's seemed to be improved the customer experience and trying to create reasons to get people in the store. The nice thing was that the stock price hasn't really moved since then as the turnaround in product offerings and operations has been dealt the blow of hard economic times and food commodity inflation.
Nelson Peltz and Peter May are the guys behind the turnaround at Wendy's. This appeals to me because they can be financial engineers if you go back in their history (National Can) but their focus over the past decade has been activist investing in a way that builds real value. They push for improvements in leveraging the brand and margins. They've been successful at Heinz and Tiffany's. The extent of their recent financial engineering was agitating Cadbury to spinoff DrPepperSnapple. They aren't activists per se at Wendy's since they basically control the company. The corporate structure is that of the former Triarc parent because Wendy's was acquired in a reverse merger with the smaller company taking over the bigger one. Peltz's hedge fund, Trian, has been kind enough to lease the private jet and prior office space from Wendy's. Wendy's still pays for insurance and calendar maintenance on the jet since they own it. Trian should have bought this outright. This ticks me off but it won't make or break an investment.
Wendy's has so far under delivered on expanding the store margins, but this is probably due to a weak economy and commodity prices. There has been an uptrend since 2008 despite all this, although 2011 has been pretty bad due to commodity costs. So far, 2011 has been bad for margins. Prices fluctuate, but it seems like part of the pessimism over the stock lies in continued commodity pressures. A case for optimism might be made since 40% of the corn crop is used for ethanol and the government may or may not be coming around the insanity of this proposition. The company has the system in place to get at least a couple points in margin improvement once commodity costs come under control.
The company is also under represented internationally. They are taking steps to get franchisees abroad and seem to be doing a decent job knocking off country after country with franchising deals. This will increase the high margin, high return royalty stream. This is happening as more deal are being signed and the first restaurants in new countries are beginning to open.
Like I said, there is a lot to like about the company. It is taking steps in the right direction that I would expect of a fast food restaurant to improve its brand and operations. This is the problem though. The business model (franchising) is a great business that generates tons of cash flow. Naturally it is a fiercely competitive field. That McDonald's is easily the most swaggering it's ever been in its history creates a very steep obstacle to overcome. There is plenty of room for McDonald's, Wendy's and plenty others to exist.
The problem is that I think a lot of the bull case for Wendy's is based on them replicating McDonald's. This may very well be the case. The problem is that McDonald's is an 800 lb. gorilla because as the largest of the pack, it can stomach the commodity pressures the best, and if Wendy's or BK raises their prices on the menu - especially value menu - then price conscious people will just go to McDonalds, increasing their volume, and reinforcing their advantage. McDonald's is still increasing sales and has higher margins currently than Wendy's is even targeting. This is a wide gap to overcome, all Wendy's would be very valuable were it to successfully accomplish this.
Breakfast strikes me as the hardest segment to gain momentum in simply because less people eat out for that meal, let alone eat it in the US. Wendy's doesn't have breakfast mindshare and isn't in people's routines. Burger King - maybe for reasons not having to do with mindshare (PE deal maybe) - has not been effective in rolling out breakfast. Products aren't the only thing that need to be strong, but service as well. Breakfast isn't a slow, casual time for most people, so one bad experience waiting 15 minutes in a drive thru line could scuttle a location's hope of gaining traction in breakfast. McDonalds has a really strong breakfast offering - their coffee offering is highly regarded by Consumer Reports and has the most loyal coffee consumers. On the downside, Wendy's franchisees will be annoyed and reluctant for further change if breakfast is a flop after they had to purchase additional equipment. While Peltz's influence would make me lean towards conceding that breakfast has a good chance on succeeding, Wendy's isn't arriving early to an untapped market.
Any company that is in the process of a turnaround, even if its headed by a guy like Peltz, means an investor needs a margin of safety. Despite giving the impression that I think McDonald's torpedoes the entire turnaround, I don't think that. I think the valuation torpedoes the idea of investing in the turnaround with a margin of safety. Wendy's doesn't even have to be half of as good of a business as McDonald's in order for it to be an attractive business. It would have to be half of its valuation to be a good investment though. I would own an underperforming business at a low valuation that has identifiable reasons why the business can perform in the future. Even a turnaround of a poor company can be a good investment if you buy it at the right price and there are some signs that margins and profits will improve (SVU or WINN come to mind as potential candidates in that category).
Since people seem fond of the WEN/MCD comparison, WEN trades at 9x EV/EBITDA (their proforma TTM EBITDA and EV based on Q1 post Arby's sale) and MCD at 11x. While that may appear to already be a discount, WEN's Debt/EBITDA is ~4x while MCD's is only ~1x. Just focusing on capital structure, the large amount of debt on Wendy's balance sheet is deserving of a discount. This is nothing to say the premium MCD deserves for consistent top and bottom line growth, strong international presence, and higher margins. They also return almost all their FCF in the form of buybacks and dividends. Just to throw in one more comparison, YUM has many of the same characteristics of MCD give-or-take - you might say inferior brand, I say the amazing success in China. YUM also trades for about 11x EV/EBITDA and its debt/EBITDA is less than 1x.
The problem using an EV/EBITDA multiple is that even if the net debt is well below the gross debt, they still have to pay interest on the gross debt. There is a decent amount of cash flow to cover the interest in addition to cash. Even if the debt load is entirely serviceable, the cash used to do so does not accrue to shareholders. If the company fails at turning itself around, the debt load starts to look like more of an issue. They could halt capital expenditures and pay off the debt in 4-5 years with FCF, but that is assuming the business doesn't deteriorate. They could pay off some debt for 2-3 years to make it more manageable, but that would still give rivals time to take advantage. The debt load will be less of a knock if the business improves to consistent growth and more profits. While not the only sticking point, the debt requires an investor to demand a greater margin of safety and have greater confidence than usual that the company is being turned around.
To use a metric that actually looks at what a shareholder gets in terms of cash flow, I prefer owner earnings or FCF. I'm having a hard time pegging their FCF because of the Arby's numbers, but maintenance capex is probably around the levels it is at now and approximately depreciation - $145m for 2011. They are going to be revamping stores for the foreseeable future. Taking their TTM pro forma adjusted EBITDA for Wendy's of $328m and using $110m in adjusted interest and $145 in capex/depreciation results in $73m pretax and $51m in FCF. This is not a bargain and FCF really needs to boom for the valuation to make sense. If they get the recipe right - capex trails off, sales grow, margins widen, international gain traction, debt paid down - then the company could easily rack up $200m in FCF in a few years and be worth more than it is today. It begs the question though, why would you pay 11x 2015 FCF for this business? Is it that predictable or the downside that limited?
I would look at the FCF the company generates above all else because the company needs to revamp all its older stores if it is going to start to even remotely resemble just the sales growth of McDonalds (to say nothing of margins). On top of the capex, the interest payments mean that EBITDA is a very separate figure from which equity owners will benefit. Companies with plenty of debt can still generate tons of FCF. Maintenance cap ex would imply what the company could spend and still maintain it's position. Sales are declining or bobbing around the same number right now, so I don't know what the figure for zero change in sales is, but they need to spend money to at least ring up consistent sales even if the capex results in sales growth (implying it wasn't maintenance capex). If they invest their cash pile in the stores and distribute cash along the lines of EBITDA-tax, the EV/EBITDA calculation gets a huge boost in the wrong part of the equation for shareholders. It increases the net debt and raises the hurdle to overcome for earnings.
The market is already rewarding Wendy's with a reasonably high multiple since the QSR franchise business is a typically a high ROIC and FCF business. Wendy's is still a ways off from replicating McDonald's success. They have to remodel tons of stores, fire up sales growth, keep expanding margins, and solidify a strong international presence. One could play time arbitrage and just wait, but it looks contingent on Wendy's becoming another McDonald's, which seems hard to do. At best, a Pepsi to their Coke - although Pepsi is still a valuable business. Wendy's has a slightly inferior brand in terms of positioning and intangible value than Heinz ketchup (old Malcom Gladwell article on ketchup) or the Tiffany's box. I would caution people against following the McDonald's narrative or the past Peltz activist narrative when reading the tea leaves about Wendy's. I don't predict armageddon, but the valuation doesn't offer a margin of safety.
Please share dissenting views.
Turnarounds can be interesting if the price is low enough. If you can buy a poor business at a discount to the value of a poor business - as a result of extreme pessimism or the like - that is showing tangible signs of becoming a good business, even a mediocre one, then it seems logical that you could make some money. Seahawk Drilling, one of my least favorite mistakes, qualifies as the wrong type, but a business less bankruptcy risk can be attractive. Wendy's is potentially such a business.
I hit up Wendy's every now, but when they reintroduced the bacon mushroom melt burger, which I was a fan of when they had it 5 years ago, I looked at the stock. It seemed like a turnaround that Bill Ackman had touted once upon a time was actually underway. Not only my specific experience, but Wendy's seemed to be improved the customer experience and trying to create reasons to get people in the store. The nice thing was that the stock price hasn't really moved since then as the turnaround in product offerings and operations has been dealt the blow of hard economic times and food commodity inflation.
Nelson Peltz and Peter May are the guys behind the turnaround at Wendy's. This appeals to me because they can be financial engineers if you go back in their history (National Can) but their focus over the past decade has been activist investing in a way that builds real value. They push for improvements in leveraging the brand and margins. They've been successful at Heinz and Tiffany's. The extent of their recent financial engineering was agitating Cadbury to spinoff DrPepperSnapple. They aren't activists per se at Wendy's since they basically control the company. The corporate structure is that of the former Triarc parent because Wendy's was acquired in a reverse merger with the smaller company taking over the bigger one. Peltz's hedge fund, Trian, has been kind enough to lease the private jet and prior office space from Wendy's. Wendy's still pays for insurance and calendar maintenance on the jet since they own it. Trian should have bought this outright. This ticks me off but it won't make or break an investment.
Wendy's has so far under delivered on expanding the store margins, but this is probably due to a weak economy and commodity prices. There has been an uptrend since 2008 despite all this, although 2011 has been pretty bad due to commodity costs. So far, 2011 has been bad for margins. Prices fluctuate, but it seems like part of the pessimism over the stock lies in continued commodity pressures. A case for optimism might be made since 40% of the corn crop is used for ethanol and the government may or may not be coming around the insanity of this proposition. The company has the system in place to get at least a couple points in margin improvement once commodity costs come under control.
The company is also under represented internationally. They are taking steps to get franchisees abroad and seem to be doing a decent job knocking off country after country with franchising deals. This will increase the high margin, high return royalty stream. This is happening as more deal are being signed and the first restaurants in new countries are beginning to open.
The rollout of breakfast is a catalyst for the stock as it would provide a ~10% boost to sales if the $150k+ in additional unit sales projection is to be believed. That's less than 100 customers buying $5 worth of breakfast stuff daily or 17 customers/hour if breakfast is served 5am-11am (even less on a transaction basis, ex. 2 construction workers on their way to a site). This is reasonable assuming they do a good job with the rollout. Management has also claimed people have been ordering burgers in the morning where breakfast hours have been rolled out, so maybe the breakfast products don't have to be all that successful.
Like I said, there is a lot to like about the company. It is taking steps in the right direction that I would expect of a fast food restaurant to improve its brand and operations. This is the problem though. The business model (franchising) is a great business that generates tons of cash flow. Naturally it is a fiercely competitive field. That McDonald's is easily the most swaggering it's ever been in its history creates a very steep obstacle to overcome. There is plenty of room for McDonald's, Wendy's and plenty others to exist.
The problem is that I think a lot of the bull case for Wendy's is based on them replicating McDonald's. This may very well be the case. The problem is that McDonald's is an 800 lb. gorilla because as the largest of the pack, it can stomach the commodity pressures the best, and if Wendy's or BK raises their prices on the menu - especially value menu - then price conscious people will just go to McDonalds, increasing their volume, and reinforcing their advantage. McDonald's is still increasing sales and has higher margins currently than Wendy's is even targeting. This is a wide gap to overcome, all Wendy's would be very valuable were it to successfully accomplish this.
Breakfast strikes me as the hardest segment to gain momentum in simply because less people eat out for that meal, let alone eat it in the US. Wendy's doesn't have breakfast mindshare and isn't in people's routines. Burger King - maybe for reasons not having to do with mindshare (PE deal maybe) - has not been effective in rolling out breakfast. Products aren't the only thing that need to be strong, but service as well. Breakfast isn't a slow, casual time for most people, so one bad experience waiting 15 minutes in a drive thru line could scuttle a location's hope of gaining traction in breakfast. McDonalds has a really strong breakfast offering - their coffee offering is highly regarded by Consumer Reports and has the most loyal coffee consumers. On the downside, Wendy's franchisees will be annoyed and reluctant for further change if breakfast is a flop after they had to purchase additional equipment. While Peltz's influence would make me lean towards conceding that breakfast has a good chance on succeeding, Wendy's isn't arriving early to an untapped market.
Any company that is in the process of a turnaround, even if its headed by a guy like Peltz, means an investor needs a margin of safety. Despite giving the impression that I think McDonald's torpedoes the entire turnaround, I don't think that. I think the valuation torpedoes the idea of investing in the turnaround with a margin of safety. Wendy's doesn't even have to be half of as good of a business as McDonald's in order for it to be an attractive business. It would have to be half of its valuation to be a good investment though. I would own an underperforming business at a low valuation that has identifiable reasons why the business can perform in the future. Even a turnaround of a poor company can be a good investment if you buy it at the right price and there are some signs that margins and profits will improve (SVU or WINN come to mind as potential candidates in that category).
Since people seem fond of the WEN/MCD comparison, WEN trades at 9x EV/EBITDA (their proforma TTM EBITDA and EV based on Q1 post Arby's sale) and MCD at 11x. While that may appear to already be a discount, WEN's Debt/EBITDA is ~4x while MCD's is only ~1x. Just focusing on capital structure, the large amount of debt on Wendy's balance sheet is deserving of a discount. This is nothing to say the premium MCD deserves for consistent top and bottom line growth, strong international presence, and higher margins. They also return almost all their FCF in the form of buybacks and dividends. Just to throw in one more comparison, YUM has many of the same characteristics of MCD give-or-take - you might say inferior brand, I say the amazing success in China. YUM also trades for about 11x EV/EBITDA and its debt/EBITDA is less than 1x.
The problem using an EV/EBITDA multiple is that even if the net debt is well below the gross debt, they still have to pay interest on the gross debt. There is a decent amount of cash flow to cover the interest in addition to cash. Even if the debt load is entirely serviceable, the cash used to do so does not accrue to shareholders. If the company fails at turning itself around, the debt load starts to look like more of an issue. They could halt capital expenditures and pay off the debt in 4-5 years with FCF, but that is assuming the business doesn't deteriorate. They could pay off some debt for 2-3 years to make it more manageable, but that would still give rivals time to take advantage. The debt load will be less of a knock if the business improves to consistent growth and more profits. While not the only sticking point, the debt requires an investor to demand a greater margin of safety and have greater confidence than usual that the company is being turned around.
To use a metric that actually looks at what a shareholder gets in terms of cash flow, I prefer owner earnings or FCF. I'm having a hard time pegging their FCF because of the Arby's numbers, but maintenance capex is probably around the levels it is at now and approximately depreciation - $145m for 2011. They are going to be revamping stores for the foreseeable future. Taking their TTM pro forma adjusted EBITDA for Wendy's of $328m and using $110m in adjusted interest and $145 in capex/depreciation results in $73m pretax and $51m in FCF. This is not a bargain and FCF really needs to boom for the valuation to make sense. If they get the recipe right - capex trails off, sales grow, margins widen, international gain traction, debt paid down - then the company could easily rack up $200m in FCF in a few years and be worth more than it is today. It begs the question though, why would you pay 11x 2015 FCF for this business? Is it that predictable or the downside that limited?
I would look at the FCF the company generates above all else because the company needs to revamp all its older stores if it is going to start to even remotely resemble just the sales growth of McDonalds (to say nothing of margins). On top of the capex, the interest payments mean that EBITDA is a very separate figure from which equity owners will benefit. Companies with plenty of debt can still generate tons of FCF. Maintenance cap ex would imply what the company could spend and still maintain it's position. Sales are declining or bobbing around the same number right now, so I don't know what the figure for zero change in sales is, but they need to spend money to at least ring up consistent sales even if the capex results in sales growth (implying it wasn't maintenance capex). If they invest their cash pile in the stores and distribute cash along the lines of EBITDA-tax, the EV/EBITDA calculation gets a huge boost in the wrong part of the equation for shareholders. It increases the net debt and raises the hurdle to overcome for earnings.
The market is already rewarding Wendy's with a reasonably high multiple since the QSR franchise business is a typically a high ROIC and FCF business. Wendy's is still a ways off from replicating McDonald's success. They have to remodel tons of stores, fire up sales growth, keep expanding margins, and solidify a strong international presence. One could play time arbitrage and just wait, but it looks contingent on Wendy's becoming another McDonald's, which seems hard to do. At best, a Pepsi to their Coke - although Pepsi is still a valuable business. Wendy's has a slightly inferior brand in terms of positioning and intangible value than Heinz ketchup (old Malcom Gladwell article on ketchup) or the Tiffany's box. I would caution people against following the McDonald's narrative or the past Peltz activist narrative when reading the tea leaves about Wendy's. I don't predict armageddon, but the valuation doesn't offer a margin of safety.
Please share dissenting views.
Wednesday, July 6, 2011
Risk is volatility.
Risk can be volatility. Hang on with me for just a second, because this is actually a thoughtful idea. People who call themselves value investors often mindlessly repeat the idea that volatility doesn't equate risk. Over and over "risk is the possibility of a permanent loss of capital." Steve Romick, portfolio manager at FPA Crescent, has a slightly different take in this video (20:50ish mark, emphasis mine):
What stuck out in the video to me was his view on risk because it is nuanced and there is truth to it despite the knee-jerk reaction many of you might have had to the characterization of risk as volatility. I think this also reveals a trait that allows someone to boast a good record like Romick's. An ability to form nuanced views that take into account numerous factors (such as the reality of human psychology in relation to risk) is the type of contrarianism that is good since it allows you to recognize mispricings. Absolute contrarianism is not a reliable way to beat the market.
There's a summary of the stock picks Romick mentions in the video on gurufocus. They are good picks, but it's boilerplate value at this point in time - Walmart, Microsoft, CVS. I'd actually never seen Romick speak, but he does a great job explaining his reasoning in a clear and simple manner. Fortune recently had a big article on Bob Rodriguez, his partner and head of FPA, which is also worth a peep while I'm on the topic of FPA.
"Volatility is a silly measure of risk to me, but it's actually a very accurate measure of risk for most people because people get scared into stocks and out of stocks and get scared out of mutual funds and scared into mutual funds."For some reason he just refers to the mutual fund and the research without naming it (it's Ken Heebner and this article explains). The fund compounded 18% over a decade, but investors on average lost 11% since to them risk was volatility. While it might be obvious to many readers, there is potential that subconsciously this is also the case for you since this is largely reflective of human psychology.
What stuck out in the video to me was his view on risk because it is nuanced and there is truth to it despite the knee-jerk reaction many of you might have had to the characterization of risk as volatility. I think this also reveals a trait that allows someone to boast a good record like Romick's. An ability to form nuanced views that take into account numerous factors (such as the reality of human psychology in relation to risk) is the type of contrarianism that is good since it allows you to recognize mispricings. Absolute contrarianism is not a reliable way to beat the market.
There's a summary of the stock picks Romick mentions in the video on gurufocus. They are good picks, but it's boilerplate value at this point in time - Walmart, Microsoft, CVS. I'd actually never seen Romick speak, but he does a great job explaining his reasoning in a clear and simple manner. Fortune recently had a big article on Bob Rodriguez, his partner and head of FPA, which is also worth a peep while I'm on the topic of FPA.
Tuesday, July 5, 2011
Did I make a BLUD-dy mistake?
Immucor (BLUD), a company I thought I had a lot of things to like, just announced that it is getting bought out for a cool 30% premium. Not bad for a ~3 month time frame. Too bad I never purchased it. Stocks, and women for that matter, are a lot like buses. If you miss one, another will be along in 10 minutes. There were a couple factors that are worth mentioning that maybe indicated this buyout would happen, although it's not something I would actively seek in an investment. Looking at the role a CEO can play in how an investment plays out is worth digging into.
The CEO until last month was also the founder. He took this company from nothing to a $1.2bn company. It is hard to depart and it's hard to maybe affect the kind of change necessary when the company needs to put their shoulder to the wheel during hard times. This is a qualitative factor I hadn't really taken into account before, which is why I tend to shy away from a company like this. The Buffett's, Sequoia's, and Simpson's are just so much better at identifying the really good companies with a margin of safety than an amateur.
I identified BLUD as a good company, but I couldn't figure out the margin of safety. I'm not even positive it existed. A 30% premium is mostly a takeover premium and doesn't exactly reflect the idea that I missed some hidden value (this is just a gut feeling). I think noting that a founder/CEO with a decent inside ownership is not always a de facto sign that they are running the company really well, something to look out for with large cap tech as well. Obviously TPG sees room to better the operations and they aren't exactly paying a cheap price at 22x earnings. A new CEO can be a catalyst for public shareholders, although I'm reluctant to believe it's always a positive one.
The new CEO ran a company that was acquired. When I saw that Immucor had a new CEO, my interest was rekindled. A new CEO can mean tons of things. I saw that the new CEO was the former CEO of Mentor (the breast implant maker) that got acquired by JNJ a few years back. Could I interpret this as a sign that the CEO didn't have the typical CEO ego of wanting to not be his own boss? I could, but I don't have industry contacts or the scuttlebutt ability to figure out if that really was true. He did stay at Mentor for 2 years as a subsidiary company. I'm reluctant to read into this too much since it just confirms what I want to believe. It certainly meant that some change would occur at the company, although it's difficult to say it would be an acquisition without hindsight. Certainly the speed indicates that TPG probably was looking at the company before the CEO change, at least beyond preliminary stages. The CEO change probably gave them the courage to step forward with a bid. This is all back room kind of dealing though, which is not the basis of an investment process. It looks hard to do if you aren't a professional.
I can think of one good example of looking at a CEO change as a positive catalyst, although it clearly is based on a lot of research that is scuttlebutt. The hedge fund manager who had lunch with Warren Buffett after sending him stock research focused on a management change to make a profitable investment in Fiat (source):
I can see how this process can work out well, but as you can see from the manager's explanation, it was based in part on meeting the guy. I'm unaware how an amateur investor could access the information pipeline to figure out what exactly Marchionne did at GE and the Swiss quality control company.
I'm not a fan of the anecdotal nuggets that get released in journalistic reporting, which is the one way I think an amateur could access this kind of information. I remember when Ken Lewis was touted as a great integrator who had a successful track record pre-CEO integrating some bank into BofA. Profiles of CEOs tend to be fairly glowing because no CEO would grant an interview to a journalist looking to expose how poorly they do their job.
Did I miss a quick 30% gain? Yes. Did I make a mistake? Maybe, but I'd lean closer to the no end of the spectrum. The acquisition angle is speculative, although BLUD had merit as an investment.
Does anyone have any other good or bad examples of a CEO change going unnoticed but being a catalyst to the up or downside? Ford comes to mind although there were serious survival issues when the company was trading at $2/share.
The CEO until last month was also the founder. He took this company from nothing to a $1.2bn company. It is hard to depart and it's hard to maybe affect the kind of change necessary when the company needs to put their shoulder to the wheel during hard times. This is a qualitative factor I hadn't really taken into account before, which is why I tend to shy away from a company like this. The Buffett's, Sequoia's, and Simpson's are just so much better at identifying the really good companies with a margin of safety than an amateur.
I identified BLUD as a good company, but I couldn't figure out the margin of safety. I'm not even positive it existed. A 30% premium is mostly a takeover premium and doesn't exactly reflect the idea that I missed some hidden value (this is just a gut feeling). I think noting that a founder/CEO with a decent inside ownership is not always a de facto sign that they are running the company really well, something to look out for with large cap tech as well. Obviously TPG sees room to better the operations and they aren't exactly paying a cheap price at 22x earnings. A new CEO can be a catalyst for public shareholders, although I'm reluctant to believe it's always a positive one.
The new CEO ran a company that was acquired. When I saw that Immucor had a new CEO, my interest was rekindled. A new CEO can mean tons of things. I saw that the new CEO was the former CEO of Mentor (the breast implant maker) that got acquired by JNJ a few years back. Could I interpret this as a sign that the CEO didn't have the typical CEO ego of wanting to not be his own boss? I could, but I don't have industry contacts or the scuttlebutt ability to figure out if that really was true. He did stay at Mentor for 2 years as a subsidiary company. I'm reluctant to read into this too much since it just confirms what I want to believe. It certainly meant that some change would occur at the company, although it's difficult to say it would be an acquisition without hindsight. Certainly the speed indicates that TPG probably was looking at the company before the CEO change, at least beyond preliminary stages. The CEO change probably gave them the courage to step forward with a bid. This is all back room kind of dealing though, which is not the basis of an investment process. It looks hard to do if you aren't a professional.
I can think of one good example of looking at a CEO change as a positive catalyst, although it clearly is based on a lot of research that is scuttlebutt. The hedge fund manager who had lunch with Warren Buffett after sending him stock research focused on a management change to make a profitable investment in Fiat (source):
"Sergio Marchionne, the new CEO, was a guy with a track record for creating value in Switzerland. He spent time in GE and made his mark at a Swiss quality control company. He came into a company [Fiat] whose reputation was tarnished and whose brand equity had been decimated. But philosophically smart people choose smart businesses. Marchionne saw the opportunity, and we saw Marchionne. We were likely the only investors outside Italy interested in Marchionne at the time. After some begging and pleading, he granted us a meeting. Marchionne joined Fiat with a mandate to do whatever was necessary to fix the company. We bought some shares. He confirmed what we surmised. He had full support of the board and its new chairman. If auto was worth more dead than alive, he'd kill it. Fiat was the biggest employer in Italy at the time. He took on the labor unions. He was fearless. He had real skin in the game and his incentives were aligned. Marchionne saved Fiat. He got $2.25 billion to cancel a legacy agreement that Fiat could "put" itself to GM. No one thought it could happen -- there's no way this debt-laden, cash strapped Italian company will win in an international court of law. But Marchionne walked away with $2.25 billion of cash and Rick Wagoner [then CEO of GM] was fired shortly thereafter. This was half of Fiat's market cap. We exited the position in the mid-teens and made a lot of money. It was the biggest profit generator in Brahman's history."
I can see how this process can work out well, but as you can see from the manager's explanation, it was based in part on meeting the guy. I'm unaware how an amateur investor could access the information pipeline to figure out what exactly Marchionne did at GE and the Swiss quality control company.
I'm not a fan of the anecdotal nuggets that get released in journalistic reporting, which is the one way I think an amateur could access this kind of information. I remember when Ken Lewis was touted as a great integrator who had a successful track record pre-CEO integrating some bank into BofA. Profiles of CEOs tend to be fairly glowing because no CEO would grant an interview to a journalist looking to expose how poorly they do their job.
Did I miss a quick 30% gain? Yes. Did I make a mistake? Maybe, but I'd lean closer to the no end of the spectrum. The acquisition angle is speculative, although BLUD had merit as an investment.
Does anyone have any other good or bad examples of a CEO change going unnoticed but being a catalyst to the up or downside? Ford comes to mind although there were serious survival issues when the company was trading at $2/share.
Monday, July 4, 2011
Is large cap tech really that cheap?
RIM, Google, Apple, Dell, HP, Cisco, Microsoft, Xerox etc. The list really goes on. The other list that goes on and on is of value investors going long these names. I think value investors are missing greater pitfalls than they perceive with some of these companies.
This is glaringly obvious to me, but technology is a much faster changing industry with more out of left field developments than value investors are traditionally accustomed. I don't see how people who traditionally trumpet their ignorance of these companies all of a sudden have the comprehension to make the investments in these companies. People seem to be papering over this in order to buy what would otherwise be considered cheap stocks.
Here is where I think many are going astray:
1. Ex cash PE ratios and financial strength - Typically a big net cash position attracts investors. It's a nice thing in a net-net stock and really any stock for that matter. The companies are financially strong, no doubt. The point of contention is that this strength is being applied to expanding the company in different directions (Dell, HP, Xerox, Microsoft, Google). Even where it isn't being spent poorly, the cash is overseas. I know what a dollar of overseas cash is worth to a US company - 65 cents. It is more nuanced than that, but dropping the cash balance right through the valuation doesn't reflect the underlying reality (neither does 65 cents).
2. Incentivized and intelligent managements - Maybe its heresy to say that someone with a multi billion dollar stake in a company isn't truly incentivized, but these guys aren't. These guys are egomaniacs for the most part focused on empires. Many of these companies have historically had such fantastic models too, that they can be run by morons. This is less the case when a business is acquiring businesses and entering new lines. Margins are going to be different in the future. Why should people trust Michael Dell to do the right thing for public shareholders? He can and is doing whatever he wants. Whereas large inside ownership is usually a good thing in the eyes of value investors, it is dangerous in almost all of these stocks.
3. Expanding into high margin areas - Everyone is seeking to enter high margin areas: search, services, switches, etc. Even if you agree with the acquisitions or overall strategy, everyone is moving into the same spaces. Not only does this drive up prices paid in the acquisitions and expansion, it drives up the level of competition in those fields. Dell wants to be IBM. HP wants to be Oracle, IBM, and Cisco. Microsoft wants to be Google. Google wants to be Facebook. Competition is bad for investors. It's the last thing you want. This is the absolute worst kind since people are paying these high prices to enter competitive fields. It is especially dangerous when these companies have seemingly unlimited resources relative to the markets they are trying to enter.
My criticisms don't all apply to all the companies that fall under the cheap large tech category, but I think investors are guilty of overlooking some of these things. I think Tweedy Browne articulates a reasonable case for Cisco while expressing some reservation. I'm sympathetic that Dell is being misperceived as a consumer PC manufacturer that is being beat by Apple, even though that doesn't reflect the sources of its profit. I'm staying away though since change is more rapid than people acknowledge and their attractiveness is overstated in my opinion.
This is glaringly obvious to me, but technology is a much faster changing industry with more out of left field developments than value investors are traditionally accustomed. I don't see how people who traditionally trumpet their ignorance of these companies all of a sudden have the comprehension to make the investments in these companies. People seem to be papering over this in order to buy what would otherwise be considered cheap stocks.
Here is where I think many are going astray:
1. Ex cash PE ratios and financial strength - Typically a big net cash position attracts investors. It's a nice thing in a net-net stock and really any stock for that matter. The companies are financially strong, no doubt. The point of contention is that this strength is being applied to expanding the company in different directions (Dell, HP, Xerox, Microsoft, Google). Even where it isn't being spent poorly, the cash is overseas. I know what a dollar of overseas cash is worth to a US company - 65 cents. It is more nuanced than that, but dropping the cash balance right through the valuation doesn't reflect the underlying reality (neither does 65 cents).
2. Incentivized and intelligent managements - Maybe its heresy to say that someone with a multi billion dollar stake in a company isn't truly incentivized, but these guys aren't. These guys are egomaniacs for the most part focused on empires. Many of these companies have historically had such fantastic models too, that they can be run by morons. This is less the case when a business is acquiring businesses and entering new lines. Margins are going to be different in the future. Why should people trust Michael Dell to do the right thing for public shareholders? He can and is doing whatever he wants. Whereas large inside ownership is usually a good thing in the eyes of value investors, it is dangerous in almost all of these stocks.
3. Expanding into high margin areas - Everyone is seeking to enter high margin areas: search, services, switches, etc. Even if you agree with the acquisitions or overall strategy, everyone is moving into the same spaces. Not only does this drive up prices paid in the acquisitions and expansion, it drives up the level of competition in those fields. Dell wants to be IBM. HP wants to be Oracle, IBM, and Cisco. Microsoft wants to be Google. Google wants to be Facebook. Competition is bad for investors. It's the last thing you want. This is the absolute worst kind since people are paying these high prices to enter competitive fields. It is especially dangerous when these companies have seemingly unlimited resources relative to the markets they are trying to enter.
My criticisms don't all apply to all the companies that fall under the cheap large tech category, but I think investors are guilty of overlooking some of these things. I think Tweedy Browne articulates a reasonable case for Cisco while expressing some reservation. I'm sympathetic that Dell is being misperceived as a consumer PC manufacturer that is being beat by Apple, even though that doesn't reflect the sources of its profit. I'm staying away though since change is more rapid than people acknowledge and their attractiveness is overstated in my opinion.
Friday, July 1, 2011
Thoughts on bank stocks
I'm beginning to get really interested in bank stocks. I wanted to articulate what I'm thinking about when I look at bank stocks. The quality of a bank stock is easier to quantify*, although this ease can still cause mispricings since Mr. Market's recency bias cause him to sour on a bank's prospects beyond reason. It also helps that the pendulum of public opinion is swinging very hard to extreme dislike for all banks. In reality, a great bank is a really great business to own at the right price.
I recently finished The Most Important Thing by Howard Marks, which easily pushed its way to top of the list of my favorite books so far this year. One of the overarching themes is that of the cycle. Assets tend to become out of favor in their down cycles - homebuilders, banks, oil, chemicals - as a result of the pendulum really swinging to the negative extreme. People tend to extrapolate current events into the future, so they think that the down cycle will continue and the relevant firms will continue to do poorly. This is what creates a buying opportunity since the revulsion usually causes a bunch of selling which only encourages more selling, etc. I don't think banks are the buy of the century right now, but I think they are a fertile ground to look for value as they are in a down cycle with poor outlooks. I've been kicking around some ideas over the past week or two here and here, mainly focusing on mutual thrift conversion that have happened in the past few months.
David Tepper bought bank stocks at the brink, which turned out to be a phenomenal call. He has since sold them and moved into homebuilders, probably not multibaggers in a matter of months like the banks were in 2009, but definitely an area where people are revolted and maybe not giving the stocks their fair value. Bruce Berkowitz loaded up on financials about this time last year, although they seem to be around the same price +/- 15% depending on the name. His reasoning:
1. Essential service - Banks provide an essential service that will be difficult to change in the grand scheme. Any type of financing allows people to purchase goods that would otherwise require huge upfront cash payments that don't match an individuals cash flow. This is an essential service for people looking to own homes, cars, or for businesses wanting to expand faster without dilution. Compared to other financing vehicles, banks are the low cost providers since their cost of funding is very low. Even with financing consisting mostly of certificates of deposit, a bank's interest payments still fall below an equivalent financing vehicle without the same funding options. This obviously changes in a credit bubble and banks can get sloppy as the lending environment becomes more competitive.
2. Commodity business - There is no real superiority of a 6% plain vanilla loan from Bank A versus Bank B or even a nonbank financing entity. For an investor though, behind the loan will be a difference in cost structure (efficiency ratio, net interest margin) as well as managerial competence (loan to value, non-performing loans, capital allocation) that are for the most part easily quantifiable. Buffett's favorite bank, Wells Fargo, combines a low cost structure with managerial competence. Its price goes down in bad times, but the bank never loses its enduring competitive advantage or normalized profitability. This is no different from broad investing principles, but I find it easier to quantify these characteristics in a bank. Banks are more susceptible to the depressive episodes of Mr. Market since a bad economy depresses loan growth and causes loans to sour. The recency bias causes Mr. Market to really extrapolate out the bad times, but a calm investor can identify the cyclicality and wait for an attractive price (Berkowitz style).
3. Compounding machines - A good bank is compounding machine. If a bank has a low cost structure and managerial competence, an investor can earn a lot of money if they purchase at the right price. If you buy a bank that earns a normalized 12% ROE at 80% of book value, then you can earn a 15% return. The bank can either reinvest the profits in its loan book to continue to grow profits at a 12% ROE or it can return it to shareholders via dividends and share repurchases. This can happen year after year if the bank has the right management at the helm. The market for banking services is so huge that opportunities for reinvestment are a lot greater than say home builders or oil companies.
I think the ability to compound is what makes banks so interesting. Most banks can't do it and the ones that have in the past are easily identified and rewarded with high multiples most of the time. The smaller banks though are victims of the same inefficiencies of small cap stocks in general though, so it makes for an interesting space to look. A small bank beyond a minimum threshold is better suited to compounding too simply due to the law of large numbers. Geographic concentration can expose you to specific risks, but it can also allow you to apply local knowledge if you live in the area. You can also coattail on a better local economy (Dallas vs. Detroit) so it works both ways.
*It is easy, but still requires work. It's certainly easier than figuring out the competitive advantage of a semiconductor company. I like that I can go on the FDIC website and pull tons of figures and metrics into excel on an annual and quarterly basis and really dig into how the business has looked over a 10 year period. You can overlay this with economic data to get a good feel on the performance of the bank, which is a lot easier than devoting hours to understand the product cycle of PC makers or really industry specific trends. These posts on Value Uncovered do a good job in highlighting the specific investment process here and here and are well worth the time.
I recently finished The Most Important Thing by Howard Marks, which easily pushed its way to top of the list of my favorite books so far this year. One of the overarching themes is that of the cycle. Assets tend to become out of favor in their down cycles - homebuilders, banks, oil, chemicals - as a result of the pendulum really swinging to the negative extreme. People tend to extrapolate current events into the future, so they think that the down cycle will continue and the relevant firms will continue to do poorly. This is what creates a buying opportunity since the revulsion usually causes a bunch of selling which only encourages more selling, etc. I don't think banks are the buy of the century right now, but I think they are a fertile ground to look for value as they are in a down cycle with poor outlooks. I've been kicking around some ideas over the past week or two here and here, mainly focusing on mutual thrift conversion that have happened in the past few months.
David Tepper bought bank stocks at the brink, which turned out to be a phenomenal call. He has since sold them and moved into homebuilders, probably not multibaggers in a matter of months like the banks were in 2009, but definitely an area where people are revolted and maybe not giving the stocks their fair value. Bruce Berkowitz loaded up on financials about this time last year, although they seem to be around the same price +/- 15% depending on the name. His reasoning:
We bought at prices reflecting pessimism in the economy. I do not believe that we are going to lose money at the prices we paid. If the economy just sputters along, we’ll do fine. If the economy recovers, we should do reasonably well. Absent a severe double-dip recession, I don’t see how our shareholders can get hurt.When you buy something this out of favor, even the slightest bit of not bad news can be good news. He is also focusing on the price, not nitpicking over credit card fee legislation. This is a sensible outlook. At least in my head, the cyclical forces that drive the banking business are very clear since it tends to mirror the broader economic cycle of the geography it serves. Banks possess some identifiable characteristics that make for interesting investments in their own right.
1. Essential service - Banks provide an essential service that will be difficult to change in the grand scheme. Any type of financing allows people to purchase goods that would otherwise require huge upfront cash payments that don't match an individuals cash flow. This is an essential service for people looking to own homes, cars, or for businesses wanting to expand faster without dilution. Compared to other financing vehicles, banks are the low cost providers since their cost of funding is very low. Even with financing consisting mostly of certificates of deposit, a bank's interest payments still fall below an equivalent financing vehicle without the same funding options. This obviously changes in a credit bubble and banks can get sloppy as the lending environment becomes more competitive.
2. Commodity business - There is no real superiority of a 6% plain vanilla loan from Bank A versus Bank B or even a nonbank financing entity. For an investor though, behind the loan will be a difference in cost structure (efficiency ratio, net interest margin) as well as managerial competence (loan to value, non-performing loans, capital allocation) that are for the most part easily quantifiable. Buffett's favorite bank, Wells Fargo, combines a low cost structure with managerial competence. Its price goes down in bad times, but the bank never loses its enduring competitive advantage or normalized profitability. This is no different from broad investing principles, but I find it easier to quantify these characteristics in a bank. Banks are more susceptible to the depressive episodes of Mr. Market since a bad economy depresses loan growth and causes loans to sour. The recency bias causes Mr. Market to really extrapolate out the bad times, but a calm investor can identify the cyclicality and wait for an attractive price (Berkowitz style).
3. Compounding machines - A good bank is compounding machine. If a bank has a low cost structure and managerial competence, an investor can earn a lot of money if they purchase at the right price. If you buy a bank that earns a normalized 12% ROE at 80% of book value, then you can earn a 15% return. The bank can either reinvest the profits in its loan book to continue to grow profits at a 12% ROE or it can return it to shareholders via dividends and share repurchases. This can happen year after year if the bank has the right management at the helm. The market for banking services is so huge that opportunities for reinvestment are a lot greater than say home builders or oil companies.
I think the ability to compound is what makes banks so interesting. Most banks can't do it and the ones that have in the past are easily identified and rewarded with high multiples most of the time. The smaller banks though are victims of the same inefficiencies of small cap stocks in general though, so it makes for an interesting space to look. A small bank beyond a minimum threshold is better suited to compounding too simply due to the law of large numbers. Geographic concentration can expose you to specific risks, but it can also allow you to apply local knowledge if you live in the area. You can also coattail on a better local economy (Dallas vs. Detroit) so it works both ways.
*It is easy, but still requires work. It's certainly easier than figuring out the competitive advantage of a semiconductor company. I like that I can go on the FDIC website and pull tons of figures and metrics into excel on an annual and quarterly basis and really dig into how the business has looked over a 10 year period. You can overlay this with economic data to get a good feel on the performance of the bank, which is a lot easier than devoting hours to understand the product cycle of PC makers or really industry specific trends. These posts on Value Uncovered do a good job in highlighting the specific investment process here and here and are well worth the time.
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