Apartment Development has a Big Lebowski Moment


By now, just about everyone knows the boiling frog metaphor. The business parable now sits among the regal pantheon of Vince Lombardi quotes, TedTalks about body postures, and the mystical epiphanies which occur when you gaze deeply in your Steve Jobs mirror. So let’s take the boiling frog story and give it a new level of sophistication. We’ll call it the Big Lebowski moment. This moment occurs when you are chilling out in your bathtub, just like The Dude. Your candles softly glow, the water is nice and warm, and you probably just had some help to induce your tranquil state.


The Dude Abides

For real estate developers, this can be like the construction phase of the project. You’ve done the heavy lifting of designing the building and gaining approvals from the city. You’ve negotiated the contracts and obtained your financing. You sit back a little and marvel as your dream leaps off the paper (or digital file) and becomes reality. This building is really happening. Sure, you will worry about the rogue subcontractor, the deadlines that may ebb and flow, and the weather, but if you’ve set yourself up with a well-planned project you will enjoy the next 18 months.

Once construction winds down, the stress starts kicking in. Will my glorious creature be the pony that every child wants to ride or do I have an old nag who buries its nose in clover when a rider approaches? Or, even worse, did I open one of those dodgy carnivals in a parking lot of a vacant retail strip center and my ponies just got quarantined by the Douglas County Health Department? Rents get adjusted, special lease incentives are offered, sweat beads appear on your brow and the pulse quickens. In Big Lebowski terms, The Nihilists have just arrived while you’re sitting in the tub, and they’ve started to break your stuff in the living room.

It gets worse. The Nihilists have brought a weasel with them (Hey, is that a marmot, man?). They throw the weasel in the bathtub. All hell breaks loose as the furry ferret turns into a screeching water snake keen on drawing blood from a sensitive region of the body. The tranquil tub becomes a frothing cauldron. For real estate developers, the angry weasel represents their debt. Real estate projects are highly dependent upon leverage. Most developers borrow 70% to 80% of their total project costs. Rising interest rates can threaten even the best developments.



Most construction loans have an interest-only period that terminate about 24 to 36 months after the start of construction. The end of the term is often referred to as the “conversion date”: the date at which the loan resets. On the conversion date, the interest rate adjusts to the current market level and the developer must begin paying some principal on the loan. For the past five years, rates have been in an innocuous range around 4%. Conversion dates came and went without much trepidation. Now, rates have risen dramatically. Many construction loans that were marked at LIBOR plus 3% two years ago will soon reset in a new and very weasel-ish world of 5% rates. One-year LIBOR sat at 1.73% in June of 2017, today it sits at 2.74%.

Well, that’s not so bad, you may say. After all it’s only 1% higher than it was a year ago. Yes, but the problem is exponential: your cost of money just went up by 20%. If you borrowed $10 million to build 100 apartments, you now face an additional $100,000 per year in interest expenses. On a per unit basis, that’s $83 per unit per month that you need to generate. From where I sit in Heartland, USA, $83 per month is a substantial amount of money. It’s probably a 10% increase on a one-bedroom apartment. My sister lives in San Francsco where they step over $100 dollar bills like soiled pennies, but here the number is the difference between two tanks of gas or an upper deck seat to see Kendrick Lamar. In other words, its a problem.

In a market facing over-supply, the pressure could become intense. Apartment construction has exceeded rates of household formation for the past six quarters. Higher interest rates will add to the challenges and pose a threat to developers in a way that has not been witnessed since 2007.

The interest rate environment places the Federal Reserve in a complicated position. The effective Federal Funds Rate is 1.75% and a 25 basis point increase is expected this week. Right now, markets place a probability of 41.7% on rates landing in the range of 2.25% to 2.5% by the December 2018 meeting.

Screenshot (1)

Source: CME Group

There are three problems with this outlook:

  1. The 10 Year Treasury Yield stands at 2.96%. A surge in short term rates would almost certainly invert the yield curve – a signal that portends most recessions. The 5 Year Treasury is already at 2.80% which demonstrates a flattening yield curve.
  2. LIBOR rates track short term Fed Funds rates. Most short term financing is set on LIBOR plus a spread. If you extrapolate my example above to the entire economy, I do no believe that borrowers can sustain rate rises over 1% without triggering defaults.
  3. Increased rates will draw capital to the US and strengthen the US Dollar. The foreshadowing of this momentum has already set central banks into a frenzy of currency market intervention in Turkey, Brazil and Argentina. If the Mexican Peso joins the crowd, you could have a full blown currency crisis like 1994 or 1998.


Screenshot (3)

The Mexican Peso (MXN) has fallen dramatically against the US Dollar (USD) since April. Source XE.com Currency Charts


Therefore, Jerome Powell must walk a tightrope. He must work to reduce inflation pressure and curb lending excesses, yet the risk of a recession rises with each quarter-point increase. He surely does not wish to create a lending crisis.

The intersection of interest rates, inflation and housing is even more complicated. Most measurements of the CPI show that housing costs are the major driver of inflation. I highly recommend reading the Bloomberg piece on the topic. There is some frustrating irony here: my industry, the one most susceptible to the risks of rising interest rates, is also the cause of the inflation which requires the Fed to raise rates. It’s a logical spiral that circles the drain like dirty water in a candlelit southern California bathtub.

Ultra Clean Holdings Can Rise 20%


This article originally appeared on Seeking Alpha on February 21, 2018.

  • Ultra Clean Holdings is riding a semiconductor equipment boom.
  • 3D NAND chips will expand investments in new fabrication machinery.
  • Management has an optimistic outlook for sales.
  • An earnings power valuation demonstrates upside potential.
  • Industry cycles and the reliance on two customers adds risk. 

Ultra Clean Holdings (UCTT) is a manufacturer and supplier of critical components and engineering expertise to semiconductor capital equipment manufacturers. They also supply parts for fabricators of OLED display systems. UCTT was founded in 1991 as a division of Mitsubishi Metals. The company was eventually spun off and it went public in 2004.

Earnings are scheduled for release following market hours on Wednesday February 21. Shares surged 6% during Tuesday trading and closed at $20.36. On January 16, UCTT guided fourth quarter revenues towards $250 million and operating margins are predicted to be between 8 and 10%. Similar margins are forecast for the first quarter of 2018. When final 2017 results are tallied, sales will have exceeded $900 million, an increase of 62% over 2016. Sales will surpass the $1 billion mark in 2018.

I penned this article Monday when shares traded hands at just above $19, so my commentary has already burned through some of its analytical fuel. However, UCTT’s $780 million market capitalization continues to represent a discount to its intrinsic value. Using an earnings power valuation method indicates that Ultra Clean could easily fetch $27 per share as capital equipment manufacturers continue to expand.

Based in Hayward, CA, Ultra Clean has not been immune to the notorious cyclicality of the semiconductor industry. Sales dropped to $470 million in 2015 but recovered in 2016 to $563 million (see Appendix 2 for income statement history). The massive surge in sales expected for 2017 is a rapid departure from recent trends and does raise questions about the durability of future growth.

Management Optimism

Management is optimistic about 2018. CEO Jim Scholhamer praised his company’s prospects after exceeding $250 million in sales during 3Q 2017. During his answer session with analysts in October, Scholhamer confidently proclaimed the $300 million mark appears to be just around the corner. The team also believes that these additional sales can be generated by the existing asset base.

UCTT derived 48% of sales in international markets. The firm has major manufacturing facilities in Shanghai, Singapore, Hayward, and in the Philippines (through subsidiary AIT). Other major locations include South San Francisco, Chandler, AZ and the Czech Republic.

UCTT has a solid balance sheet. They carry various bank loans totaling $57 million with interest rates ranging between 3.75% and 4.25%. Cash on the balance sheet came to a total of $66 million at the end of September, 2017.

Risks: Cyclical Industry, Customer Concentration, Secondary Offerings

In an industry tasked with creating ever more sophisticated ways of packing circuit capacity on silicon wafers, UCTT operates in a rather mundane segment of the supply chain. They build gas and chemical delivery components as well as specially machined metal parts for chip fabrication equipment. They have strong expertise in the precision welding of parts in an industry that measures success in nanometers. Operating in the less glamorous world of being an outsourced supplier for companies like Lam Research (LRCX) and Applied Materials (AMAT) means that UCTT may be more susceptible to the wide swings in demand and supply that occur cyclically in the industry. Indeed, during the third quarter of 2017, 59% of sales went to Lam Research and Applied Materials accounted for 24.5%.

While UCTT’s components may be specialized (robotic parts are among their stable of products), they are not as technologically sophisticated when compared to the microscopic heroics of the semiconductor industry. Barriers to entry are lower at this end of the food chain. Major competitors include Flex, Foxsemicon, and Celestica (CLS). Ichor Systems (ICHR) is a major competitor in gas delivery systems. UCTT invests about $10 million in research and development annually and an additional $10 million in capital expenditures. Most of the competitive strengths of the company lie in the engineering talent and practices rather than intellectual properties and patents. In September, UCTT received a supplier excellence award from Lam Research.

Shareholder dilution is also a risk. Shares sold off 4.5% after the company announced a public offering of $100 million of stock in January. Funds will likely be used to invest in new manufacturing capacity and fund acquisitions. In 2015, the company acquired Marchi for $39 million and 1.5 million shares were issued to fund the purchase. So far, raising capital through equity markets to fund expansion has been beneficial for shareholders and another accretive acquisition may be in the offing.

Skyrocketing Fabrication Equipment Demand

When Lavi Lev, President of UCT Asia received the award from LAM, he referred to the current environment as “one of the greatest ramps in semiconductor equipment history.”

The rise of 3D NAND flash memory semiconductor technology will increase the need for future capital spending. An interview with Jim Feldhan at Semico Research conducted in late August of 2017 offers an insight into the growth trajectory at Lam Research and Applied Materials. According to Feldhan:

Blyler: Increasing the need for additional etching should be good news to the semiconductor capital equipment companies

Feldhan: Yes. With 3D NAND, you’ll have an array that is more like a cube or a three dimensional chess board with interconnections and wires going horizontally and vertically through the matrix. That is why companies like Applied Materials and Lam Research are thrilled since memory manufacturers will have to buy 5 or 10 times the amount of etch tools.

Wafer fabrication equipment spending will push towards $45 billion in 2018.

So what about the stock?

I employed an earnings power valuation method favored by Bruce Greenwald and the Columbia School of value investors, and I arrived at a valuation of $22.65 per share.

There are three critical assumptions in the model which present a reasonable margin of safety. First, I estimated 2018 sales of $1 billion, in line with the past quarter. Sales in the current year could be much higher. Second, I tempered the 10% operating margins from 2017 and management’s similar predictions for the coming year. Instead, I used the average operating margin for the past five years: 5.78%. Third, I used a weighted average cost of capital of 8.79% as the adjusted free cash flow denominator. An equity risk premium of 5.08% was added to UCTT’s current cost of debt to derive this factor.

One can argue that a lower cost of capital could be employed. Greenwald prefers not to use beta in the generation of estimated costs of equity, but choosing this route results in a lower weighted average cost of capital of 7.83%. The intrinsic value for this method would levitate the stock of UCTT towards $27 per share. In this latter exercise, I referred to the semiconductor supplier industry beta of .98 rather than the lower beta ascribed to UCTT itself (.82).

The price surge on Tuesday was an unexpected (and welcome) surprise, but it also took some chips off the table. My expected valuation of $22.65 seems less exciting than it did 48 hours ago, but I believe the current price continues to represent a discount and an attractive investment opportunity.

Appendix 1: Balance Sheet, with adjustments

Appendix 2: Historical income statements

Disclaimer: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing.

Disclosure: I am/we are long UCTT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Cirrus Logic: The Apple Problem



  • An Earnings Power Valuation indicates that CRUS is trading at a discount.
  • Massive investments in R&D have stimulated growth.
  • Revenues have doubled since 2013.
  • Unfortunately, dependence upon Apple raises red flags.

Cirrus Logic (NASDAQ:CRUS) dropped nearly 3% in Wednesday’s trading, and the price decline inspired me to investigate a potential buying opportunity.

Cirrus Logic certainly looks like a cheap stock cast adrift from frothy NASDAQ shores. The PE ratio for the Austin, Texas, company stands at 13 times 2017 earnings. The $3.26 billion market cap represents 2.72 times book value. CRUS has no debt and $329 million of cash on the books. There aren’t many high-quality technology companies that sport such reasonable metrics.

Two schools of thought have taken shape among recent discussions on Seeking Alpha: The bullish story emphasizes the company’s cutting edge semiconductor technology that provides the heavy lifting for audio and voice applications. The proliferation of sophisticated mobile devices has propelled growth at CRUS from $800 million in sales during 2013 to over $1.6 billion today. Operating profit margins have jumped from 25% to over 40% in three years. Returns on capital exceed 30%.

The skeptics believe that CRUS is far too dependent on a major customer: Apple (AAPL). The electronics giant accounts for nearly 80% of sales. There is probably no finer horse to hitch your wagon to than Apple. But Apple is no Clydesdale. It’s a thoroughbred. And even the finest champions have been known to change jockeys from race to race.

Although I am attracted to Cirrus Logic, I ultimately side with the skeptics. The Apple dependence is too much of a concern. I look at it in a very simplistic way: why would I own a company that has specialization in a critical segment of the market but is dependent upon a single customer when I can buy the customer itself? In Apple, I would be buying the thoroughbred with a far more diversified stable of products, millions of loyal customers, and perhaps the finest brand name in the world. Just buy Apple is my verdict.

Earnings Power Valuation

Nevertheless, attractive metrics merit further exploration. For my valuation exercise, I decided to employ the Earnings Power Valuation (EPV) model, championed by Bruce Greenwald at Columbia University. Greenwald’s method is fairly straightforward: Identify the stable free cash flow of the business and divide the number by the weighted average cost of capital to arrive at a value.

The company will produce revenues of over $1.6 billion in the fiscal year, which ends in March of 2018. Gross profits should come in around $830 million. Operating income was $317 million in 2017 and will likely exceed $366 million in FY 2018.

Research and Development: Hidden Assets

One number caught my eye: the company spends over $300 million per year on research and development. This amounts to over 49% of gross profit.

Accountants treat R&D as an expense. However, research and development is a critical driver of growth and is more closely akin to capital investment. The continuous enhancement of voice and audio technologies through large investments in R&D explains why the world’s most famous mobile device company partners with CRUS.

I capitalized recent research and development expenses at CRUS to produce an additional $750 million in assets. In the process of adjusting free cash flows for R&D, the annual expenditure is added back and a portion of amortization is subtracted. I gave the R&D asset a straight-line amortization of four years. The net effect is a $100 million boost to free cash flow. The amount of research and development invested by CRUS is a strong vote in the bullish column.

Share-Based Compensation is a Concern

Meanwhile, share-based compensation (SBC) posed a challenge for me. Like most tech companies, CRUS offers a large portion of compensation in the form of restricted stock units and options. The number paid in the form of non-cash stock benefits will exceed $40 million in 2018, or just over 10% of operating expenses. The customary process in the Greenwald model is to add back SBC because it is a non-cash expense. This effectively raises the value of the business. The model treats the value of the options and restricted stock much in the same way as debt, and it gets subtracted after the value is determined.

Buffett is a famous naysayer against the practice of removing share-based compensation when valuing a business. Compensation is an expense, pure and simple. I tend to agree, but I decided to add back SBC since grants and options are such a traditional means of paying employees in the technology industry.

So, if large share awards to employees are such a common occurrence, then why does it bother me? Probably because management has touted its recent share purchases of about $100 million. It indicated another $80 million in buybacks were forthcoming. Unfortunately, this amount merely seems to be keeping pace with the issuance of shares for options and grants. The share count has barely budged despite recent buybacks. In this case, the argument that share-based compensation is a non-cash item loses its validity. Real cash is being expended to keep the float from increasing.

WACC is a Tough Nut to Crack

Turning my attentions to the weighted average cost of capital was much more difficult. Greenwald prefers a calculation that takes an equity risk premium above the company’s cost of debt. Most other models employ beta to measure the risk associated with a particular stock. Greenwald argues that beta is a better measure of volatility than risk. In other words, just because a stock price fluctuates, it doesn’t necessarily mean the underlying business is riskier.

Cirrus Logic, however, has no debt. I reluctantly decided to calculate the cost of equity using the capital asset pricing model which employs beta. In the case of CRUS, the beta is .85 vs. a market beta of 1.0. This has the overall effect of reducing the company’s cost of equity to 6.84%. This results in an earnings power value of $78 per share. Cirrus Logic appears to be selling for a discount of 34% to its current market price.

But wait – not so fast. It made no sense to me that CRUS should have a lower cost of equity than the customer that makes up 80% of its revenues. What is the beta for Apple? 1.21. Applying Apple’s beta to the cost of equity raises the cost of capital for CRUS to 8.67%. The result is a share value of $62. A share price of $62 is more sensible on a P/E multiple basis than the $78 value I initially modeled. If the company earns $4.30 on a diluted basis in FY 2018, the P/E will be 14.4. The $78 per share number produced by the .85 beta pushes the P/E to the dubious level of 18. Yet, $62 does indicate that there is potential for 17% upside. Is that enough of a discount to entice me into the water?

I am tempted to purchase CRUS, but the dependence on Apple is far too heavy. In fact, one could easily argue that the cost of equity for Cirrus Logic should be much higher than Apple. If I saw that CRUS was available below $45, I would purchase shares. I desire a 30% discount to the earnings power valuation to provide a sufficient margin of safety.

A Final Thought on Profit Margins

I have painted a picture of some kind of giant axe emblazoned with the Apple logo poised to strike. This fear is overblown. Cirrus Logic has proven technology and investments for the future are consistently growing. The balance sheet is pristine, and management is not complacent.

As much as Cirrus depends on Apple, Apple needs Cirrus and its robust audio and microphone technology. Barring a catastrophic failure, it seems unlikely that Apple would dump Cirrus in one fell swoop. A day of reckoning is probably years in the distance. In the meantime, leaders at Cirrus can focus their energy on increasing the quality of their wares, diversifying the customer base, and making skillful acquisitions. With $0 debt and over $400 million in annual cash flow, CRUS has a lot of strengths to work with.

My concern is therefore less about the sudden death of a customer relationship than the slow loss of breath from such a tight embrace.

I recall those famous stories of Wal-Mart (NYSE:WMT) when they would invite all of their suppliers to an arena in Bentonville for a big showroom display and price negotiation. They would literally turn up the heat in the building while negotiating the contracts. Wal-Mart always had the leverage. The beads of sweat on the brows of the suppliers just hastened their capitulation.

What seems more likely to me is that, in the event of a slowdown in handset sales, Apple could hungrily eye Cirrus Logic’s 40% operating margins, fat share compensation packages, and a paucity of other customers as an opportunity to negotiate price concessions.

If there’s a slowdown in the handset market, CRUS will start to sweat.


Exhibit 1, Weighted Average Cost of Capital

Exhibit 2, Balance Sheet Adjusted for R&D and Leases

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Tredegar: Plastic Surgery



  • Tredegar has recovered from lows, but upside is limited.
  • Family owners have returned to management and steadied the ship.
  • Plastic hygiene products are under competitive pressure.
  • Aluminum extrusion is growing but cyclical.
  • An earnings power valuation places the stock price in the low teens.

Tredegar (TG) is a Richmond, Va.-based company that operates in two major business segments: plastics used for consumer products and aluminum extrusion deployed in the construction and automotive sectors. The company was badly shaken by Procter & Gamble’s (NYSE:PG) decision to diversify its sources of hygienic plastic films used primarily for sanitary products like diapers. Tredegar forecasts net sales could decline in the plastics business related to personal hygiene for the next several years by $5 million to $10 million annually.

The stock plummeted to $14.65 in July from an all-time high of $30 per share in 2013. TG has recently rebounded to $17. Unfortunately, my analysis shows Tredegar to be fairly valued with limited upside. My earnings power valuation yields a stock price below the $15 level.

Tredegar has a market capitalization of $560 million and a debt balance of $187 million. Revenues have fallen from $961 million in 2013 to $830 million in 2016. Enthusiasm for TG revived after second quarter results showed revenues stabilizing in the plastics segment and growing in the aluminum extrusion business.

Note: The balance sheet for June 2017 has been adjusted by capitalizing R&D investments and operating leases.

Family Pride

There is much to like about Tredegar. Family owners Bill and John Gottwald returned to leadership positions in the company after the customer defections during 2015. They have 22% ownership and a clear desire to restore growth. They have recognized the need for urgent transformation. The plastics business is consolidating redundant facilities, and significant dollars have been invested in capital improvements and research and development.

The aluminum extrusion business, Bonnell Aluminum, is more promising. The production of specialty products and components for the construction and automotive industry has grown as demand for lightweight materials increases. The recent acquisition of Futura Industries will be accretive to earnings in 2017.

Yet, reading of the 2016 CEO letter by John Gottwald leaves one feeling underwhelmed. The CEO admitted his struggle to outline a clear vision for the company. Is this humble candidness or a shell-shocked owner grasping for a future in a family business that was believed to be in transition to a new generation of leadership?

Revenues have started growing again, but beware the fine print

Tredegar has posted revenue declines for the past three years ended December 2016. Gross profit peaked in 2012 at $187 million but slumped to $162 million in 2016. Operating income hit $32 million last year, a decline of over half from 2012. Earnings per share were 75 cents for 2016. At $16.75 per share, the P/E stands at 22. With a dividend of 11 cents, the yield is north of 2.6%. Tredegar had $29.5 million in cash at YE 2016 with $95 million borrowed on a line of credit.

The second quarter of 2017 brought better news. Revenues expanded by over $90 million from the prior period in 2016. Operating income expanded by $50 million. Unfortunately, $38 million in revenue growth is attributable to one-off recognition of increased values of ownership stakes in subsidiary businesses. The value of Kaleo, a specialty pharmaceutical company was boosted by about $25 million. Although the re-valuation is welcome, it begs the question of why Tredegar owns part of a pharma company. The results at Kaleo seem to justify the value increase as revenues for the business increased by over $75 million for the first six months of 2017. Another one-time boost came from an $11 million escrow adjustment related to the Terphane acquisition of 2011.


The remainder of the revenue increase does hold merit as a sign of growth at Tredegar. The acquisition of Futura Industries, a Utah-based aluminum extrusion company, closed in February. Futura generated revenues of $53 million since February and $6.6 million in operating profit through June 30. Unfortunately, growth didn’t come for free. Debt expanded from $95 million to $187 million during the first half of 2017 due to the $92 million Futura acquisition.

Although returns on capital have been in the mid-single digits for several years, TG is committed to research and development that may boost sales in the future. R&D expenditures have been ramped up from $16 million in 2015 to $19 million in 2016. R&D is expected to be the same in 2017. Capital expenditures for plant closings and upgrades are welcome, but they have forced TG into negative free cash flow during recent quarters. The dividend may be at risk.

Unfortunately, it is also worth noting that Tredegar has pension liabilities of over $90 million.

Evaluating Tredegar is difficult without in-depth knowledge of the thin-film plastic market and aluminum extrusion industries. The author lacks this education and is, therefore, limited to parsing numbers and corporate risk factors. I have assembled an earnings power valuation using the method advocated by Bruce Greenwald. The results are presented below. Think of this article as a “first pass” look at Tredegar. If there is appeal beyond the numbers as presented, then investigate further. Your comments are welcome, and I am happy to revise my analysis if better information is available.

Certainly, the world of thin film plastics has potential. Food safety is a big opportunity as people worldwide choose more convenient packaged options. But the business seems highly competitive. The Procter & Gamble loss shows that a search for cost effective suppliers is well under way as brand name profits come under increasing pressure. Investments in technology will help, but can they drive growth or merely prolong a business facing secular headwinds? Aluminum extrusion has much potential, but the reliance on highly cyclical businesses raises significant concerns. It is late in this economic expansion, and headwinds have appeared in vehicle manufacturing.

For me, Tredegar shall remain on the sidelines. The stock appears to be fully valued at this time. A sustainable growth trajectory in the plastics business would need to appear before I consider an investment.

Earnings Power Valuation: $14.20 per share

Revenues – The valuation writeup in Kaleo as well as the Terphane adjustment have been excluded from revenues. However, the value of Kaleo (cited in the 10-Q) has been added to the net value computation. Beta has been used to calculate the cost of equity. Many would consider the use of beta as distorting the typical Greenwald methodology. However, the author believes a weighted cost of capital at 10.68% is reasonable. Due to one-time tax write-offs, the effective tax rate for 2017 is only 9.9% vs. 29.8% in 2016. For purposes of valuation, a tax rate of 30% is assumed. R&D as an adjusted balance sheet item with expenses reflecting a reimbursement of current expenditures less an allowance for amortization over a four-year period.

Appendix: Tredegar Income Statements

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Greenbrier: Rolling Stock


This article originally appeared on the website Seeking Alpha on May 5, 2017. 

  • The railcar manufacturer has surged 52% since the election.
  • Three years of industry pain have cleared the way for new growth.
  • International acquisitions can push GBX forward.

Insider sales and a JV partner raise questions.

I feel like I’ve missed the train. Greenbrier (NYSE:GBX) was beaten up during the meltdown in commodities. The stock fell from nearly $80 at its 2014 peak to $22.30 in early 2016. The Portland, Oregon company surged over 50% after the election and has been north of $40 for several months leaving the enterprise with a market cap of $1.2 billion.

Although I am reluctant to jump aboard anything moving faster than an airport escalator, GBX appears to have further upside potential. An earnings power valuation and discounted cashflow analysis indicate a share price headed towards $60.

Greenbrier has made big acquisition moves in recent weeks. The ownership stake in Brazil’s Amsted-Maxion has been increased from 19.5% to 60%. 2017 will also mark the closing of the agreement with Astra Rail Management GmbH to form a new company known as Greenbrier-Astra Rail. By the end of the year, GBX will be the largest freight railcar manufacturer in South America and Europe, and number two in North America.

Management has indicated that earnings per share will be between $3.25 and $3.75 at the end of FY 2017 (2Q FY 2017 results through February were released on April 5th). The Greenbrier-Astra benefit will be another $0.15 to $0.35 per share. Using these figures, GBX trades around 11 times FY 2017 earnings. GBX has also consistently posted returns on capital well above 15%.

Not everything is rosy in the City of Roses

Greenbrier’s FY 2017 revenues will decline by 15.5% largely resulting from a drop in the order backlog from 41,300 railcars at the end of 2015 to 27,500 at the end of 2016. Early 2017 numbers show a backlog of 22,600 units. The order book has certainly dried up and will need to be replenished.

GBX posted FY 2016 sales of $2.68 billion. Operating profit landed just north of $408 million and earnings per share stood at $5.64. The deterioration in earnings per share to slightly less than $4 on revenues of $2.3 billion will be a marked departure from past trends.

Insiders have recently sold shares. William Furman, the CEO, sold $5.8 million of stock at $44.50 in a filing posted on April 25th. The CEO has over $71 million in value remaining in the company, but the sale is not insignificant.

CFO, Lorie Tekorius

CFO, Lorie Sekorius

The company also faces possible dilution in 2024 when convertible bonds mature. The issue was completed in February and raised $275 million at a coupon rate of 2.875%. The notes are convertible at a price of $60.16 per share or a 37% premium. The conversion ratio of 16.234 shares per $1,000 of face value represents a 13% dilution to current shareholders.

Convertible bonds are a wonderful way to receive low cost funds, but do they provide a telling glimpse into where management sees the upper limits of growth? Is $60 the top? I question the decision to issue convertibles in a low-rate environment. Why place any future dilution risk onto owners if you can borrow funds cheaply today? Shareholders deserve to reap the upside if more risk is added to the balance sheet.

My biggest complaint with GBX is a lack of disclosure on the 50/50 joint venture with Mexican manufacturer Grupo Industrial Monclova, S.A. (GIMSA). GBX generated $408.5 million in operating profits in FY2016, and $282.7 million in net income. Unfortunately, a whopping $101.6 million was subtracted below the line because it is attributable to GIMSA. The distortion in performance metrics is significant: Instead of an impressive 15.25% operating margin, GBX shareholders only receive the equivalent of something closer to a 10% operating margin when the subtraction for income attributable to GIMSA is factored in.

The GIMSA venture may very well be a profitable one for GBX, but the lack of clarity at the operating level is a huge gap for investors performing due diligence. It’s virtually impossible to discover the true contribution of GIMSA to top lines when little information is provided. Fortunately, as GBX grows the joint venture will be a diminishing factor.

Lastly, I wouldn’t be doing my job if I did not at least mention potential liability for superfund cleanups in the Willamette River. The EPA study was concluded in late 2016 and final remediation costs are yet to be determined. However, GBX has certain exposure to the environmental damage. Estimates disclosed in the report vary widely, but could be as high as $1 billion.

Strong Margins

GBX derives 80% of revenues from railcar manufacturing and orders have begun to pick up after 3 years of declines. Gross margins have consistently been above 20%. The leasing business has been a good contributor to growth and boasts 34% margins but it only accounts for 6% of revenues. The repair business looks lackluster as revenues have declined from $495 million in 2014 to $322 million in 2016. Recent deals with Mitsubishi UFJ Lease & Finance could help solidify the repair business going forward.

Meanwhile, operating margins have held up well. They were north of 15% in 2016 and seem to be headed towards 14% in 2017.

Valuation: The justification for GBX at $60

I performed two valuation exercises: An earnings power valuation and a discounted cash flow analysis. The EPV resulted in a value of about $50 per share while the DCF arrived just below $60.

For both exercises, I utilized a revenue number of $2.277 billion for FY 2017 (slightly lower than the midpoint management guidance number). I assumed the GIMSA joint venture subtracts about 3.25% of revenue (lower than the 3.78% level of 2016). I employed an operating margin of 14.12%.

The EPV analysis employed a weighted average cost of capital number of 8.915%. I calculated a yield-to-call interest rate on the convertible notes at a 37% premium to arrive at a debt cost of 7.05%. Some may question this number when the coupon is below 3%. As you will read below, the justification lies partially in attempt to reconcile the cost of capital with GBX’s high beta.

Management presented growth capital expenditures at $60 million in 2017. So I used capex equal to depreciation for a steady-state analysis assuming zero-growth cash flows.

The DCF model utilized a weighted average cost of capital at a much higher level of 12.04%. The broad divergence owes to a high beta of 2.14. Capital expenditures are initiated in 2017 at $125 million reflecting both growth and maintenance requirements.

Readers are likely to take issue with my analysis of convertible debt and the rate I have employed, so I welcome any feedback about perceived costs of capital.


Balance Sheet

Income Statement

Disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Pilgrim’s Pride: Recent Declines Present Opportunity


This article originally appeared on Seeking Alpha on February 7, 2017. PPC traded at $18.68. I exited my long position on April 25 at $25.50.

  • PPC boasts a hefty return on capital and a recent acquisition will boost sales.
  • Earnings power valuation indicates a stock with 15% upside potential.
  • Buyers should be wary of declining margins.

Pilgrim’s Pride (NYSE:PPC) is the second largest poultry producer in the world. The Greely, Colorado corporation boasts that it supplies 1 out of every 5 chickens in the US. The company has a market capitalization of nearly $4.6 billion.

I have decided to focus on two valuation metrics: an earnings power valuation favored by the Columbia School of value investors, as well as a discounted cash flow model. In both instances, my computations show a company capable of producing share price returns of 15-25%.

PPC stock has been cut in half since the heady days of 2014. The stock peaked in December of that year at $37 per share and has fallen to $18.66. It briefly touched $17 in early December 2016. The decline represents a buying opportunity.

The Good

PPC completed the acquisition of GNP on January 6th. The addition of the premium poultry producer is set to boost sales by $460 million annually. This represents a 5.2% increase over the projected $8.05 billion in 2016 sales. Poultry is growing as a primary source of lean protein among consumers. The macroeconomic, dietary and demographic trends favor the business on the whole. (Note: Recent income statements are posted below.)

Strong returns on capital make PPC an attractive investment. Returns on total capital will exceed 25% again in 2016. Returns on equity have consistently been above 30%. The addition of leverage is set to boost the equity returns even higher.

Note: The adjusted balance sheet adds approximately $86 million in capitalized operating leases to fixed assets as well as an offsetting addition to debt. For simplicity purposes, The $350 million GNP acquisition is added entirely to goodwill on the asset side and debt (line of credit) on the liability side.

The Bad

I was going to wait to post an article on Pilgrim’s Pride until after they announce quarterly earnings on the 9th of February, but the dramatic 4% drop Tuesday inspired me to rush to press in spite of the risk that my numbers may prove to be off-base by the end of the week. Notably, Wednesday morning, the price has rebounded above $19.

This volatility reflects recent news from Tyson Foods (NYSE:TSN) as well as a fear of higher trade barriers. The Financial Times reported that Tyson has faced headwinds in their poultry business due to a variety of factors, including margin pressure due to the recent rise in the price of soybeans. More disconcerting is the revelation that the company is under investigation for chicken price collusion. If other industry leaders like PPC are shown to be involved, speculation about hefty fines and ethical challenges could place the stock under pressure.

Like Tyson, operating margins have been declining. Following a peak of 14% in 2014, they dropped below 13% in 2015 and look set to barely surpass 9% in 2016. The recent decline in corn prices should help margins going forward, but soybean prices have not been as cooperative.

The most striking aspect of poultry-related stock prices over the past three years has been the failure of markets to properly assess the benefits of the avian-flu outbreak. Poultry-related firms like Sanderson Farms (NASDAQ:SAFM) and Cal-Maine (NASDAQ:CALM) are but two examples where markets wildly overestimated the sustainability of conditions during 2014 and 2015. In fact, these years appear to be an aberration rather the norm. Margins and revenue levels were elevated to unsustainable levels in hindsight.

Meanwhile, The Economist writes that talk of NAFTA renegotiation would have an adverse effect on PPC. Tariffs on chicken would render the white meat less competitive in the Mexican market if Mexico were to exit NAFTA. Agricultural states that rely heavily on exports to Mexico are worried about the potential loss of free trade.

Mexico is certainly a concern. The decline in the peso is well-documented and PPC is facing adverse currency conditions. 18% of revenues are generated in Mexico, so unraveling NAFTA and continued dollar strength could weigh heavily on the business.

The company has already paid out some big cash dividends on a one-off basis. In 2015, the company paid shareholders $1.5 billion, and then followed with another $700 million gift in 2016. PPC increased debt from virtually zero to over $1 billion during 2015 as a result. Borrowing to pay dividends is not necessarily cause for alarm for a company set to generate nearly $500 million in cash flow after capital expenditures, but it leaves a balance sheet that is slightly more risky. Indeed, free cash flow has dropped from a peak of $840 million in 2014.

The Mixed Bag

PPC is owned largely by JBS S.A. of Brazil. The world’s largest protein producer, JBS holds 75.5% ownership. Getting on board with a minority shareholding position presents the risks of potentially hazy corporate governance issues and the possible divestiture of stock by the Brazilian giant. On the other hand, a massive international player offers worldwide growth opportunities as well as the possibility of an outright acquisition.

Earnings Power Value

The weighted average cost of capital I employed for this EPV model is 6.94%. The cost of equity is 8.31% and the weighted average cost of debt on a post-tax basis is 2.20%. Debt represents less than 24% of capital.

Earnings before interest and taxes will be around $742 million in 2016. Using a 35% tax rate, subtracting $220m of capital expenses and adding $168 million of depreciation leaves a net free cash flow of $439 m. I added another $40 million of working capital to derive a steady-state free cash number of $475 million. Taken at the rate of 6.94%, the EPV is slightly less than $6.9 billion. Subtracting debt of $1.4 billion, but adding cash of $86 million, leaves a net equity value of $5.55 billion or $21.77 per share.

Discounted Cash Flow

Here the upside is much higher. I employed a beta of .80 and the weighted average cost of capital drops to 6.17%. I held operating margins flat at 10% and showed the revenue growth at the 2.45% 10-year treasury bond level. I show capital expenditures ramping up at a fairly aggressive pace. The end result is a value of $24.25 per share. This represents a 30% premium.

DCF valuations are subject to so many variables that they are often decried as meaningless in so far as the modeler makes assumptions about a variety of future outcomes. However, it provides the author with another layer of confidence.

The Pilgrim’s Pride story is a good one in spite of recent challenges. Ultimately, I believe the consistently high returns on capital and the growth of poultry in most diets will reward shareholders in the future.

Appendix: Historical income statements, with the author’s estimate for 2016 and 2017.

Disclosure: I am/we are long PPC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Verisk Analytics: Big Data At A Fair Price


This article originally appeared on Seeking Alpha on October 27, 2016.

  • Verisk Analytics provides insurers and businesses with sophisticated risk analysis services and software.
  • Aggregating and interpreting massive amounts of data is on the leading edge of technological innovation.
  • A foray into the energy industry and challenges in the property & casualty markets present headwinds.

Economies of scale and an entrenched user base ultimately present long-term rewards for investors.

I struggle to justify current market valuations, and my articles have been mostly bearish. It’s unusual for me to recommend an investment, but I believe Verisk Analytics (NASDAQ:VRSK) has a business model which is too good to be ignored.

In spite of vast improvements in mobility, connectivity and automation, economists have been puzzled by the lack of productivity growth over the past 10 years. The naysayers point to social media as nothing more than a distraction. The optimists believe the innovations of the recent past will soon appear in productivity statistics as the benefits proliferate. One of the key sources of projected growth is the ability of technology to analyze streams of vast amounts of information in order to detect patterns or hidden anomalies that may lead to better decisions and efficiency. From human genetic material to battlefield simulations, big data is becoming big business.

An investment in Verisk could be one way to participate in the profit opportunities buried in the sophisticated analysis of mountains of data. Verisk Analytics, based in Jersey City, operates in markets throughout the world. At the recent price of $82 per share, Verisk has a market capitalization of $2.27 billion on $2.0 billion in revenue. The company was formed in 1971 to provide as a resource for insurance companies and regulatory bodies to provide and share information on property and casualty insurance claims. Insurance companies were the initial stakeholders in VRSK, and a 2009 IPO allowed them to liquidate their holdings. Interestingly, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is one of the few insurers that have retained their position.

Verisk is a key provider of risk analysis solutions. Property and casualty insurers confidentially share their data and Verisk aggregates the information. In turn, VRSK provides complex models on weather patterns, building losses, catastrophic scenarios and other hazards. Verisk also provides risk analysis solutions and software to the financial services, defense, entertainment, retail and food industries. Importantly, the company entered the energy industry in a big way during 2015 when it acquired Wood Mackenzie, a UK-based provider of analysis tools for the hydrocarbon industry.

The positive story

Verisk has grown revenues and EBITDA by double digits on a compounded basis over the past five years. With over 7,000 employees, it has a global reach. Most importantly, it has a treasure trove of data that is continually updated and expanded. The economies of scale are immense. Risk analysis is becoming more essential as volatile political, macroeconomic, and geological challenges become increasingly complex. For example, the host of cataclysmic meteorological impacts upon lives and property will continue to increase as global warming persists. Does your company need to know the possible effects of a pandemic or terrorist attack? Verisk will tell you. VRSK lists 29 of the largest 30 insurers as clients.

Verisk recently expanded into the energy data business with its Wood Mackenzie acquisition. It purchased the business during the lowest points of the oil market collapse in 2015, leaving the company poised to benefit from a rebound in crude exploration. Not only is the science of oil discovery evaluated, but also its expertise extends to geopolitical risk assessment. The company also divested its healthcare analytics business in order to profit from its primary expertise in the physical environment.

Leadership has recently been solidified: Mark Anquillare was named as COO and Eva Huston was promoted to CFO in May of 2016. Management is proud to mention the strong profitability at VRSK, with EBITDA margins over 49%. Free cash flow has consistently risen and will allow VRSK to pay down debt and continue to expand through future acquisitions.

The risk factors

VRSK has some hurdles. Property & casualty insurance markets are under pressure. Loss ratios have been rising and investment income has dwindled. Verisk earns about 75% of its revenues under long-term contracts, so it does not face a sudden loss of business. However, insurers will likely seek to reduce costs in the years ahead and service vendor contracts will certainly be vetted. On the other hand, a challenging underwriting environment may only reinforce Verisk’s position by providing insurers with a competitive advantage. Any tool to help mitigate losses should be welcomed by the casualty insurance sector.

VRSK is now highly exposed to the UK pound sterling through its Wood Mackenzie energy subsidiary. The 15% decline in the pound since the referendum vote will be a drag on revenues. Energy clients may ebb and flow more quickly than others as the price of crude fluctuates. Verisk’s steady stream of growth may be more volatile in the future. Slightly less than 20% of revenues come from Wood Mackenzie.

VRSK does have a debt level in excess of 2.2 times EBITDA. At the end of June, VRSK had $2.27 billion on the books, an increase of $1.2 billion from 2014 following the Wood Mackenzie acquisition. Debt levels would have been higher but for the sale of the healthcare analytics business during the second quarter which allowed VRSK to pay down its revolver line by about $600 million. Management is determined to hold the line on debt at a steady state level of 2.5 times EBITDA. VRSK will continue its acquisitive ways and liquidity is essential for growth.

After growing 18% in 2015, revenues will likely decline in 2016 by about 3%. This excludes the six months of revenue from the healthcare segment that will post “below the line” as income from discontinued operations. With the British pound flattened, it will be 2017 before meaningful top-line growth is restored. Analysts are projecting a 6% increase to $2.1 billion next year. Still, the company should generate over $500 million in free cash flow next year.

Verisk has a high price because it is a great business

The valuation looks a little high right now. VRSK trades at 27 times earnings and 9.5 times book value. The pretax operating earnings yield from continuing operations is a paltry 4%. However, returns on capital are in the mid-teens and operating margins are above 35%. I ran a discounted cash flow analysis and arrived at a value of $75. It’s more than I’d like to pay, but not out of the realm of reason if considered as a long-term holding.

Would I rather over-pay for a great business or try to wait for a lower price? I will admit to a “fear of missing out” mentality, but I tend to lean towards the side of investing in spite of some downside risk. I believe the long-term value will emerge as cash flow improves and future acquisitions appear. I am going to wait until after the November 1 earnings announcement. I do believe there may be some disappointing numbers as a result of dollar/pound strength that may chase away some bulls. Ultimately, though, Verisk is an investment that will prove to be profitable.

I have attached my discounted cash flow analysis for your consideration. I use a weighted average cost of capital of 5.46% and a revenue growth rate projection between 6% and 8% over the next several years. Operating margins of 35% are employed – consistent with recent performance.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VRSK over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.