Polaris Industries: The Wheels Didn’t Come Off, But A Tune-Up Is Needed

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This article was originally written on June 24, 2016 and appeared on Seeking Alpha

  • Polaris is a healthy company but has stumbled recently.
  • Declining revenues caused the stock to drop by nearly 50%.
  • Before investors jump in, quality control and inventory management issues must be resolved.

Polaris (PII) is a pretty cool company that has become famous for off road vehicles and snowmobiles. It has developed a commercial market and sell four-wheeled vehicles for rugged military use. The Slingshot, a sleek 3 wheel roadster, has garnered much enthusiasm and the Victory and Indian motorcycle brands have been immense sources of growth since 2011.

The Medina, Minnesota company generated $4.7 billion in sales during 2015, with operating income of $716 million and earnings of $455 million ($6.75 per share). Operating margins have consistently pushed above 15%. The stock has recently traded around $83.50 per share.

Polaris Industries receives many positive reviews on Seeking Alpha. Some of you may consider me a little late for the party. Rather than redundancy, I will strive to bring some context and color to the proceedings. As usual, my perspective is more bearish. I am not arguing for a share price decline, but my valuation only reaches $88.

If you want some excitement about Polaris, Alpha Investments offers an excellent article which includes a summary of the company’s aggressive and successful expansion of Indian and Victory motorcycles. Growth in the segment is over 15% and the reviews are stellar.

Unfortunately, management has acknowledged that 2016 revenues will decline by 2-3%. Gross margins will improve, but a lot of wind will be taken out of the sails by the effects of RZR recalls (explained below). Management expects earnings in the $6.50 range. The motorcycle segment has surged ahead, but sales are 19% of the overall picture at PII and they can’t completely compensate for ORV weakness.

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There are some recent developments at Polaris that require investors to trade carefully.

Warranty Issues

The April 21 conference call revealed some troubling news. CEO, Scott Wine announced, “This week, we announced a major recall of more than 160,000 RZR vehicles to address fire and other thermal risks in our global RZR business.”

The RZR 900 White Lightning starts around $12,800 MSRP. While the recalls are not catastrophic, they will cost money and risk damage to the brand.

Retirement of the COO

On May 16, President and COO Bennett Morgan announced his retirement after nearly 30 years. Morgan is a major player and owns over 1% of the stock. CEO Scott Wine is going to absorb Morgan’s role. I am not aware of the circumstances of Mr. Morgan’s departure. He is in his early 50s, so we hope his health is not a problem. However, one is left to speculate that some dissatisfaction was occurring behind the scenes since no search for a successor was announced. This retirement comes one year after the retirement of the CFO.

Inventory Levels

Polaris stock has declined by nearly 50% since 2015 and a look at the working capital items shows where problems arose.

Polaris may have been too aggressive with dealer shipments leading into 2013 and has been forced to pare back dealer inventories on a massive scale. COO Bennett Morgan acknowledged the problem, stating “Elevated Polaris and industry dealer inventory levels, along with our commitment to further drive any dealer inventory lower, will result in reduced model year 2017 shipments.” On the bright side, $160 million of inventory was culled in 2015. There should be opportunities for a return to supply/demand equilibrium as dealers re-stock the showrooms.

Taylor-Dunn

A grain of sand in my shoe is the treatment of the Taylor-Dunnacquisition for approximately $54 million in March 2016. The acquisition is described as “non-material.” This makes sense weighed against the $2.4 billion of Polaris assets.

However, I find it interesting that the guidance for 2016 included some comments about sales declines in off-road vehicles being mildly offset by Taylor-Dunn revenues. If a $54 million acquisition is worth touting as a source of growth, a pro forma should have been provided in the 10-Q. You may disagree. If that’s the case, I will make another argument: For a company like Polaris that has hailed itself as an active lifestyle brand, an acquisition of a staid industrial transport company seems like a diversion. Management argues that the acquisition will smooth the notorious seasonality of Polaris sales. The very notion that an acquisition makes sense because it smoothes earnings is not exactly a ringing endorsement of the purchase.

Financing

Investors also must be aware of the growing role of vehicle financing at PII. Income from financing has become a significant share of operating income. While the rise is not alarming, it does raise concerns about how much the company has artificially inflated sales through finance-based incentives. Sub-prime defaults in the auto sector have been flagged as a risk, so thoughts crossed my mind that Polaris my have some negative exposure if credit quality in the economy deteriorates.

Year Financing as a % of Sales
2012 1.06%
2013 1.22%
2014 1.38%
2015 1.47%

Now for the good stuff…

Indian and Victory Motorcycles have been star performers. I won’t dwell on this topic. Other authors have done a better job than I could exploring these exciting brand. Sales in the category were up by 18% year over year in the first quarter.

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Polaris has outstanding returns on capital. Even with the dismal 1st quarter sales numbers, Polaris will post pretax returns on capital above 50%. With $2.4 billion in assets and $463 million in debt, operating income is likely to be above $660 million in 2016. Net income will decline slightly to $430 million, or $6.50 per share. The P/E ratio at this level is 13.

Meanwhile, free cash flow excluding changes in working capital should be above $330 million. This leaves plenty of room to pay the $139 million of annual dividends. About $190 million could be allocated to other acquisitions or a purchase of shares. This could juice earnings per share to $6.65.

Polaris is also stronger than its peers. Alpha Investments already showed the comparison to Harley-Davidson (HOG), so I won’t dwell on it here. PII has much less debt and a pretax operating income “earnings yield” of 12.28% vs 8.92% for HOG. I also made a comparison to Yamaha (YAMHF). The yen conversion makes computations challenging. Yamaha does exhibit some good metrics: The company posts returns on capital of 16% and an operating income yield over 12%.

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I have attached my discounted cash flow analysis below. I welcome reader feedback on my assumptions. As per management guidance, I show sales declining in 2016 by nearly 3%. They begin to climb in 2017 and accelerate by 2019. This may be slightly conservative. Polaris invests heavily in R&D and capital expenditures that could lead to faster growth. I temper that with the belief that consumer spending and inflation in the US will continue to be mediocre at best.

PII has very inexpensive debt, but a beta of 1.28 raises the cost of capital for the firm to about 9%. I showed capital expenditures increasing in line with sales growth. I predict pretax returns on capital to be above 29% based on an adjusted 2015 balance sheet that capitalizes R&D expenditures.

In all, the DCF produces a value of $88.30

As an aside, I find Polaris to be a refreshing change from other companies I have reviewed due to its omission of non-GAAP financials. Every company I have looked at falls over itself to release numbers based on EBITDA that excludes many items that should be included. It is a smoke-and-mirrors game that Polaris chooses not to play. For example, Polaris has a fairly sizable chunk of non-cash employee compensation, but it doesn’t omit that from its earnings guidance. I wish I could say the same for a majority of other companies.

Could Polaris get snatched up by a foreign buyer?

Polaris might make a good acquisition target at this level. The stock is at a mild discount (and a major discount from 2015), and a buyer could move some production to cheaper locales as well as deepen access to more international markets.

I just wonder if a Chinese acquirer might come knocking. The supply of vehicles to the defense industry might cause some regulatory eyebrows to raise, but this would be a great company for Chinese

businesses to add to the dollar assets while the renminbi faces possible declines. The FT recently ran an interesting story about the role Chinese car companies like Chery, Lifan, and JAC Motors have played in (now struggling) Brazil. It’s only a matter of time before these folks target US consumers.

I am not going to purchase Polaris right now. I believe the company needs to post a few quarters of sales improvements and a resolution to its warranty issues before I go long. A safer choice may be the purchase of December $90 call options which hover around $6. For those of you who believe that a faster rebound in sales or a tender offer from a suitor lies just around the corner, call options could be a low cost way to play in the mud with Polaris.

Post Holdings Has Room To Run

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  • POST is up over 70% over the past year.
  • Acquisitions have rejuvenated the venerable food giant.
  • Amortization of intangibles unfairly weigh down POST.
  • Returns on capital will improve, but General Mills may be a healthier choice.

This article originally appeared on Seeking Alpha on May 27, 2016

Post Holdings (NYSE:POST) may be a 119 year-old company, but its recent transformation has been profound. In 2012, Post spun off the private label giant Ralcorp. Subsequently, ConAgra (CAG) nearly ruined itself through an acquisition of the hapless private label food manufacturer. Post looks incredibly wise in hindsight.

Impressive quarterly results seem to justify the 73% increase over the past year to $74 per share. Sporting a market cap of $4.73 billion and sales of $4.6 billion in 2015, the Post story has been based on a flurry of acquisitions.

POST acquired Mom Brands in May of 2015 for $1.2 billion. Other FY 2015 purchases included Power Bar ($150 million) and American Blanching Company ($128 million). The firm was even busier in 2014: POST acquired pasta maker Dakota Growers for $370 million, protein bars and supplement maker Dymatize ($380 million), and peanut processor Golden Boy (CAD $320 million). But the biggest chunk of business that Post swallowed was Michael Foods for $2.45 billion. Michael Foods has offerings from egg and potato products to dairy brands.

Post management is very enthusiastic about this rejuvenated company despite its declining dry cereals sales. But does POST have the energy to justify its $74 price? For once, this author is landing in bullish territory. I believe the stock is worth in excess of $90 per share.

Attention shoppers: discount in aisle four

There are indications that Post is a relative bargain compared to Kellogg (NYSE:K) and General Mills (NYSE:GIS).

**POST return on capital is based on 2016 estimates. GIS and K are presented as 2015 results.

One may argue that the comparison between these cereal brands – turned – food giants is slightly misleading. After all, Kellogg and General Mills are much larger enterprises, $26 billion and $37.2 billion in market capitalization, respectively. Still, they offer decent benchmarks for relative value.

General Mills appears to be the best of the bunch and the author will be digging deeper into the GIS filings for proof of its relative investment merit in a future article. GIS has low debt, a healthy dividend yield, a reasonable price to EBITDA ratio, and a hefty 17.5% return on capital (pre-tax and excluding a one-time non-cash charge). Kellogg seems a little overpriced by comparison.

POST only trades at 1.6 times book value and 7.4 times EBITDA. It had a paltry 2.5% return on capital in 2015, but should exceed 9% in 2016. This is nowhere near as strong as GIS, but it’s a very positive move in the right direction. If you apply a 10 multiple to 2016 forecast EBITDA, the value exceeds $140.

If you’re reaching for your “buy” button right now expecting to double your money, hold on. There are reasons why a value below $100 is much more realistic.

POST has a heavy debt load as a result of the acquisition spree. POST also lags in its brand investments. Capital expenditures must rise significantly in the future. Meanwhile, a consistent level of performance remains to be proven. While 2016 looks like it will be a strong year with over 9% return on capital, 2.5% was the number posted in 2015. The jury, therefore, may still be out.

I also raise the caution flag about POST’s ability to match the performance of its peers due to the daunting task of integrating so many brands and facilities under one umbrella. The decision to unload RalCorp must still draw smug smiles of schadenfreude around the Post water cooler. Yet, as so many poorly executed acquisitions have shown, caveat emptor always applies. For example, I note that Michael Foods was purchased for $2.45 billion from Thomas H. Lee Partners. Private equity firms are rarely known for selling assets unless full value can be harvested. There is a chance that POST has overpaid.

So you’ve read the reasons why I temper my enthusiasm for POST. Let’s now look at the reasonable case for more upside.

The tangibility of intangibles

Post has some accounting hurdles that mask the company’s strengths. They are required to amortize a large amount of intangible assets (customer lists, trademarks, etc.) due to their massive acquisitions. These charges are non-cash items but directly hit earnings on a GAAP basis. They will also persist for many years to come. In fact, Post goes out of its way to highlight these charges as a separate line item on the income statement. In 2015, these charges totaled over $141 million. This was enough to drag corporate level operating margins down from 7.62% to 4.58%.

The treatment of intangible asset amortization at Post does seem to be an unfair burden when compared to K and GIS. These food giants also have massive levels of intangible assets on their balance sheet, yet unlike Post, they are not required to amortize the vast majority of this accounting item. As the chart below indicates, K and GIS are not required to amortize nearly 90% of intangible assets. Meanwhile, the polar opposite is required at POST.

Is Post being treated unfairly? Yes and no. Yes, operating income is actually much higher than accountants would lead you to believe. Unfortunately, there are no free lunches (or breakfasts) and the lack of investment shows up in the cash flow statement. In other words, Post may want you to give them the benefit of the doubt on their operating income, but their lack of brand investment tells a different story.

Intangibles may sound fuzzy, but they are very real drivers of value. In 2013, Professor Aswath Damodaran calculated Coca-Cola’s (NYSE:KO) brand equity was worth somewhere between $120 and $150 billion that was not on its balance sheet.

Unlike Coke, who largely built its brand through the compound efforts of decades of marketing and advertising, Post has essentially “bought” these brand assets. Yes, it’s unfortunate that Post has to charge off these intangibles. But they also need to be replacing them. Brands are nebulous concepts, but they are critical to consumer purchases. Unlike 2005, Power Bar no longer sits alone on the grocer’s shelf. It competes with Clif, Kind and every other protein-packed nutrition bar in the aisle. Post will have to spend millions to repackage and re-market this tired brand. As for their core breakfast cereals, when is the last time you were inspired to buy a box of Grape Nuts?

Compared with Kellogg and General Mills, investment and advertising are sorely behind schedule at Post. As the table above shows, advertising is much lower as a percentage of sales. Net capital expenditures are also much lower. A corporation cannot sustain growth if it doesn’t eventually replace depreciating assets at a comparable rate. Ultimately, the need for investments at Post will depress future cash flows.

Discounted cash flows indicate a $90 value

Let’s review. Returns on capital are going to start exceeding the cost of capital in a very strong manner during 2016. While they won’t exceed comparable food makers, they will create value. The strong performance is buried under the unfortunate accounting treatment of amortization charges on intangible assets. POST is relatively inexpensive but doesn’t deserve the same multiples as its peers until it shows consistent results and shows it can support its debt burden.

Presented below is my discounted cash flow analysis with a price of $90 per share. I indicate some consistent growth in the +5% arena, corporate-level operating margins slightly above 10% and a low weighted-average cost of capital of 4.54%. POST won’t pay much tax in the next few years due to some net operating loss carry-forwards.

This is a company with a 6.75% cost of debt that is about 49% leveraged. I applied Kellogg’s beta of .47 rather than the .21 shown on several finance sites. I gave Post the benefit of the doubt and showed depreciation and amortization add-backs in excess of capex for many years. As the years progress, I show depreciation and capex converging. Assets, both tangible and intangible, must still be replaced in order for growth to occur.

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A word about Pensions

The bullish argument for POST also includes the idea that the relatively small size of the business allows it to be more “nimble.” I’m not sure how nimble a 119-year-old company can be, but I take that compliment at face value.

POST is certainly not burdened by pension obligations. The big boys have big liabilities. Kellogg has $5.36 billion in pension obligations and a $732 million shortfall. GIS has $6.25 billion due with a shortfall of $493.6 million. POST has pension obligations less than $60 million.

Both K and GIS further obfuscate their hidden obligations through ridiculous pension investment return assumptions. Like most governments in the US, K and GIS are delusional in their projection that they can achieve 8.3% to 8.5% returns on plan assets in a world of sub-2% Treasuries. Taxpayers and corporate boards need to ask tougher questions and brace for future payments that are well beyond the scope of forecasts.

What does Post predict? 5.72%

Investing Sins: Confirmation Bias

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Without question, my short position in WMS was absolutely my worst decision (so far, I hope) in 2016. I covered yesterday morning. I had some put options as well. Huge loss.

Its a lesson for all investors: Do not take the opinions of pundits at face value. Do your own due diligence.

Second, the company had been viewed by many as a sinking ship because of a failure to file a revised 10k last year. However, I chose to ignore their preliminary estimates of earnings restatements. They were minimal charges and yet I still deluded myself that other shoes were ready to drop.

Beware confirmation bias. There is a huge tendency to form an opinion on a company and then seek to find ways to justify that belief. It is one of the biggest mistakes one can make in investing. I fell for it.

Finally, the other bias I am learning to filter is authority bias. Just because George Soros took a position in Barrick Gold in his last filing doesn’t necessarily mean I should rush out and buy gold. If Icahn says he’s going 140% short, that doesn’t mean he’s right.

Caveat emptor.

Why I disagree with Bill Gross about Carry Trades.

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Bill Gross

 

 

 

 

 

 

Bill Gross has issued a new message to investors in a letter entitled Bon Appetit! He is worried about yield spread compression and refers to the past forty years as a “Gray Swan” event. I disagree. The demise of the carry trade is greatly exaggerated.

I am going to go out on a limb here and offer a mild critique of Mr. Gross’ letter. Admittedly, I am on the thin limb – actually, its more like a leaf… I have never completed a “carry trade” myself, nor am I articulate in the fine points of duration. The one thing I do know is what a yield curve looks like, and I don’t think the shape of that curve will change for many years to come: Up and to the right… The demise of the carry trade is greatly exaggerated.

Bill Gross is a very wise man and a fixed income investor par excellence, but he has also been wrong from time to time.

A couple of general observations about the latest Bill Gross missive:

First, Mr. Gross doesn’t provide any Earth-shattering revelations here (pun intended). With the exception of life insurance and pension fund managers, I don’t think there is anyone left who doesn’t believe that a large measure of returns in the investment world have been the result of steadily declining interest rates post-Volcker.

Second, I don’t believe anyone disagrees that the low hanging fruit of a wide yield spread has been squeezed out due to the proliferation of liquidity. Therefore the probability of risk mis-pricing has risen significantly. Mr. Gross’ point about the danger of illiquid assets is very relevant. I am in the commercial real estate industry and the compression of yields has been breathtaking.

Third, I am very surprised to hear Bill Gross talk of the past 40 years as a one-off “Gray Swan” event. He usually has a fantastic sense of historical context which he seems to disregard in his letter. World capitalism has faced severe disruptions, panics, and most of all – deflation. The last decades of the 1800’s were marked by massive over-investment in railroads and steel (enabled by foreign capital) which caused multiple panics and a severe depression. The Great Depression itself was a period of deflation where the entire banking system ceased to operate because there was no ability to borrow short and lend long. The depositors simply refused to “lend” to the banks at all. The current period, in many ways, is not unprecedented.

grey-swan1

I’m really not that unusual! People confuse me and Alan Greenspan all the time.

Mr. Gross contradicts himself. He says that volatility is very likely in a market with compressed yield spreads, and yet he glosses over the disruptions of the past. He says you will rarely find a 12 month period where bonds had a negative performance. To make this statement assumes that the ebbs and flows of credit markets have been homogeneous. In fact, there have been pockets of massive volatility in credit markets: The 1974 IMF intervention in the UK bond market, the capitulation of New York City’s municipal bonds, the massive defaults of the central american debt crisis of the early 1980’s, Long-Term Capital Management, the Asian and Mexican currency crises, etc were all relatively recent events. Each one of them required highly coordinated international central bank intervention. Each one of them alone could have rendered the 40-year “Gray Swan” analogy useless. Indeed, if the past 40 years is a “Gray Swan”, it is one of artificial nature – entirely managed by central banking intervention. 2016 may be an extreme moment in time, but again, it is not unprecedented.

Here are some specific disagreements I have with Mr. Gross’ position:

1. The playing field of the post-Lehman era is littered with bond managers (including Bill Gross on occasion) who have bet against a reversal in yields, only to find themselves on the wrong side of the trade. Rates have continued to decline.

2. Gross has contradicted himself by recently recommending securities like Annaly Capital (NLY) and the Nuveen Preferred Income Opportunities Fund (JPC), both of which rely on short term leverage to juice long term yields. Are these not carry trades?

3. Three reasons for declining rates show little signs of reversal. Inflation has continued to decline. Indeed, we may well be on the cusp of a Japan-style 20-year+ deflation cycle. Next, the entire banking system relies on the ability to borrow short and lend long at higher rates. The Federal Reserve will do everything in its power to maintain this friendly arrangement for as long as it takes. Finally, the carry-trade referred to by Mr. Gross limits its perspective to the domestic environment. It ignores the other main trend of the past few decades – the demand for US Treasuries as a safe haven and/or the repatriation of export-based dollars. The argument also ignores the desire to borrow money in a currency that is depreciating to obtain stronger dollar yields.

4. To the extent that inflation has the very strong possibility of turning into deflation, holding Treasuries sounds like a decent investment to me. Real yields improve in a deflationary environment. Meanwhile, pricing power at US corporations evaporates. What would you rather own? A piece of paper that can produce a 3% real yield (2% nominal yield) or stock in a commodity-based company that has falsely improved earnings per share through debt-binges for stock repurchases?

You may have to go to Mars to repeat the last 40 years, but the carry trade is going to continue for several more years right here on Earth.

John Bean Technologies: Overpaying for Acquisitions

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Note: This article was published on Seeking Alpha on April 20,2016. JBT has declined from $60 to $53 since the article was published.

Summary

The Chicago-based company specializes in food processing equipment as well as airport services.

JBT has nearly doubled since September.

The stock price does not reflect declining returns on capital.

A short candidate, but caution is required.

 

John Bean Technologies (NYSE:JBT) has been one of the hottest stocks of the past twelve months, surging from $32 at the beginning of September to $60 today. Those who joined the party last fall have reaped the enviable reward of 100%.

JBT has a market capitalization of $1.7 billion with 2015 sales of $1.1 billion. The Chicago-based company is a leading food processing technology company which offers specialized equipment and systems for protein and liquid foods. JBT Food Tech supplies 65% of revenues. Curiously, JBT also has a sizable business servicing airlines and airports, including passenger and cargo loading equipment. Based upon recent acquisitions, it’s clear that John Bean is focusing on growth in the food industry.

Markets have rewarded the company for 15% revenue growth projections in 2016. Operating income is forecast to increase by 30% as some restructuring charges burn off. Operating income projections imply an operating margin of slightly over 8% with minimal debt service. JBT should earn $58.6 million after taxes, or $1.97 per share. This is a hefty 30x future earnings and it raises questions about the ability to live up to these lofty expectations.

Note: restructuring charges are highlighted above.

On a comparison basis, JBT seems reasonably priced. However, a discounted cash flow exercise shows that the price could be much closer to $41 per share.

First the comparison.

A quick glance of Middleby Corporation (NASDAQ:MIDD) offers comfort to JBT shareholders. The $6.2 billion food processing equipment business had sales of $1.82 billion in 2015. Operating income was $331 million, or a margin of 18%. Price to EBITDA stands at 16 for MIDD and 14 for JBT. EV/EBITDA is 18 at MIDD and 16 at John Bean. The much higher operating margin at Middleby is the outlier, and it would seem that the company is deserving of a higher value than JBT. Nevertheless, for arguments sake, we’ll say that on a couple of metrics JBT is priced in line with a major food industry player.

Discounted Cash flow implies 25% Downside

My discounted cash flow analysis shows that JBT is overpriced by more than 25%. A declining return on capital from acquisitions is the main culprit. An acquisitive company can often look more profitable in the near term, while struggling to reap rewards in the future. Revenues get booked early while expenses can be deferred and capitalized. As long as the game continues, revenues jump upwards while expenses lag. I don’t accuse JBT of shenanigans. However, I do believe JBT is not going to repeat its recent impressive string of over 19% returns on capital.

Note: The author has capitalized operating leases and R&D for an “adjusted” 2015 balance sheet

JBT has presented a clear growth strategy through acquisitions. Indeed, management guidance for 2016 outlined growth in revenues of 15% with 5% from organic sources and 12% from acquisitions.

Excluding restructuring charges (highlighted in yellow above), JBT had an operating margin of 8.04% in 2015. Forecasts of EBITDA and net earnings imply a similar margin of 8.05% for 2016. Revenues for 2016 are forecasted at $1.273 billion. It appears that roughly 83% of revenues are from continuing operations and $204 million from acquisitions. The March 2016 Investor Presentation concurs with my $200+ million revenue figure from acquisitions.

The recent string of purchases includes the following food processing businesses:

Date Target Price
July 2014 ICS Solutions, Form-Cook $ 37.7 m
Dec 2014 Wolf-tec $ 53.7 m
July 2015 Stork Food & Dairy $ 50.7 m
Oct 2015 A & B Process Systems $ 102.9 m
Jan 2016 Novus undisc.
Total $ 243 m

Interpreting the performance of the acquisitions is a frustrating exercise. JBT offers no pro forma information in its reports, nor does it break out prior results for the acquired businesses. This leaves one with the task of extrapolating growth segments.

Comments about the purchase of protein processor Wolf-tec in December of 2014 reveal an acquisition that seems less than stellar. Management indicated that Wolf-tec would provide $30 million in revenues in 2016, but its EPS contribution estimate contrasts with its optimistic tone.

The acquisition of Wolf-tec is expected to generate over $30 million of revenue in 2015 with EBITDA margins higher than our core FoodTech business. In 2015 we expect a $0.12 EPS contribution before integration and purchase accounting impact. This translates to $0.06 EPS contribution on a GAAP basis…

Wolf-tec’s 6 cents per share in net income translates into $1.7 million. If you back into the revenue number using a margin of 8.7%, the net operating income after taxes is $1.88 million, for a disappointing 3.5% return on capital.

I modeled the components of 2016 growth below utilizing Wolf-tec as a proxy for the other acquisitions. In order to generate a forecast 8.05% operating margin (per management), the organic business were shown at 5% growth and a 7.7% margin. Meanwhile, the other acquisitions were given an extra point of margin, while a hypothetical acquisition was given a 14% margin. The acquisitions were given a 5% revenue boost as well.

The author assumed that 8.05% margin translates into approximately 7.7% for continuing operations and 8.7% for stabilized recent acquisitions. 2016 acquisitions (Novus, et al.) are modeled to have a margin of 14%.

Indeed the $243 million (and more to be added in 2016) spent on acquired businesses will generate about $20 million in net operating profit after taxes, or a 6.4% return. This amount is less than JBT’s 8.32% weighted average cost of capital.

John Bean enthusiasts may beg to differ, and I welcome your input. You may offer me guidance on how I am misunderstanding the acquisition strategy, what kind of synergies are available, and how well management executes. I am happy to revise my numbers to reflect new insights. However, I am certain that a company forecasting revenue growth from acquisitions of 12% during 2016 is in no way earning a return in excess of its cost of capital for the $243 million spent on new businesses.

My model incorporates the following assumptions:

  • A weighted average cost of capital of 8.32% using a beta of 1.3.
  • Three years of 15% revenue growth followed by a 10% increase in year 4, and tapering off from there.
  • An operating margin of 8.05% tapering to 7% in year 10.
  • $484 million in acquisitions from 2016 to 2018, employing a $435 million line of credit that is paid down in subsequent years.

I also gave JBT a boost to free cash flow by capitalizing R&D and operating leases.

In the end, the acquisition strategy is where the rubber meets the road, if strong growth in earnings and revenue are to continue. Applying a 6.4% return on capital for the $484 million in acquisitions weighs heavily on the future with little upside.

In alternative scenarios, the value remains lower than the current market price. Using a 12% return on capital assumption brings the investment requirement down to $232 million and justifies a share price of $48. Meanwhile, investing at the cost of capital of 8.32% justifies a price of $46. Finally, a return on capital of 16% implies acquisition requirements of only $178 million and justifies a $50 share price.

Ignorance breeds caveats…

I have entered a short position in JBT at slightly above $60.

However, I would like to purchase some long-dated out-of-the-money calls to hedge the trade. I have to assume that, in spite of the confidence in my analysis, the market is smarter than me. The game is rarely kind to the novice analyst and speculator. Messrs Buffett and Munger always evaluate intrinsic value, but disdain the machinations of spreadsheet jockeys. Unfortunately, the highest contract strike price available is $65 and the price is prohibitively expensive.

I do believe JBT has a strong management team and a lot of board expertise. JBT has an impressive roster of diverse and sophisticated customers. It has recognized that food processing, particularly in liquids and proteins, is a growth market that is increasing as consumers around the world demand better nutrition. It has hitched its train to this industry and I believe the airport services business should be sold when a willing buyer emerges. Most of all, the biggest risk I see to a short position is the possibility of a sale of the entire business. If I opened Seeking Alpha one day to find that a Chinese buyer had emerged, it probably wouldn’t surprise me.

I have attached my DCF as an exhibit. As I noted above, comments and input are always welcome.

Disclosure: I am/we are short JBT.

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.

Monro Has Unrealistic Ambitions

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Summary

  • MNRO wants to grow revenues by 15% per year for the next five years.
  • Icahn’s acquisition of Pep Boys indicates MNRO is overvalued by 20%.
  • Future returns on capital imply a value of $61 per share.

Monro Muffler Brake, Inc. (NASDAQ:MNRO) has grown to 1,000 stores primarily through acquisitions. In March of 2013, shares traded for about 40. Today, the price has pushed beyond the $73 level (note: since this article was published, MNRO has dropped to $68.50). This impressive price surge overestimates the value of future business growth by as much as 20%.

The Pep Boys Comparison

Comparing Monro to Pep Boys (NYSE:PBY) offers the first clue that price has outpaced value. Carl Icahn formalized the acquisition of PBY last December for just over $1 billion, or $18 per share. PBY is more than twice the size of MNRO. While MNRO will exceed $950 million in sales when its fiscal year closes this month, PBY had nearly $2.1 billion in revenues for 2015. Icahn’s purchase represents an EBITDA multiple of 11.67 and an EV/EBITDA multiple of 13.08. In contrast, MNRO trades at 14.44x EBITDA and 16.90 EV/EBITDA. Applying a 12 multiple to EBITDA implies the stock is 20% overvalued.

Growing faster than they’ve ever grown before

CEO John Van Heel touted an ambitious plan during the January 26 conference call:

Our 5-year plan remains unchanged and continues to call for on average 15% annual top line growth, including 10% growth through acquisitions, 3% comp and a 2% increase from greenfield stores.

In a highly competitive environment where inflation runs below 2% and consumer whims are subject to the variances in weather, comp sales will not grow faster than the economy – 3% is a stretch. Acquisitions will clearly have to carry the load. MNRO has a solid acquisition track record. They integrate stores well and margins and earnings have responded accordingly. However, Monro has grown revenue below 10% for the past four years. Running up the score by 15% annually for five years into the future sounds like a moonshot by comparison.

The only way to grow: reinvesting capital effectively

In evaluating investments, my primary question is the following: Can the company earn a return on capital that exceeds its cost of capital by a margin sufficient to achieve the growth necessary to sustain its value?

FY 2016 return on capital will be around 11% for MNRO.

FY 2015
Cash 7,730
Capital Leases 133,145
Debt 122,543
Equity 434,183
Total Capital 721,569
Est’d FY 2016 NOPAT 78,374
Return on Capital 10.86%

Returns on capital have been declining at MNRO:

Year Capital Return
FY 2012 319,569 18.59%
FY 2013 375,406 12.76%
FY 2014 550,325 11.26%
FY 2015 601,819 11.86%
FY 2016 721,569 10.86%

Given these trends, how will MNRO hit 15% revenue growth going forward? Let’s start with the base FY 2016 estimate shown above and use a forecast return on capital of 11%.

Since 3% of growth will come from comp sales, it is the 12% growth needed from acquisitions and “greenfield” stores that deserve our attention.

Indeed, CEO Van Heel outlined some progress they’ve made negotiating new purchases:

With more than 10 NDAs currently signed, we remain very optimistic about the attractive acquisition opportunities we see in the marketplace… These NDAs represent chains of between 5 and 40 stores located within our 25 state footprint.

Let’s work backward. A return on capital of 11% implies that for every dollar the company invests, it will yield 11 cents in operating income less taxes. Assuming a 35% tax rate implies an operating income level of 17 cents. An operating margin of 12.65% translates into $1.34 of revenues. Therefore, every dollar of investment generates $1.34 in revenue.

If forecast revenue needs to increase by $143 million to slightly less than $1.1 billion to hit the 15% target, MNRO will have to invest about $107 million. In FY 2016, MNRO had approximately $109 million in operating cash flow. This amount was mostly sufficient to pay $20 million in dividends, $48 million in acquisitions and $38 million in capital improvements.

An acquisition and construction budget of $107 million will require only between $20 and $30 million in additional long term debt. This is a very manageable amount of leverage. I have presented below a discounted cash flow analysis that utilizes the aforementioned sales-to-capital ratio of 1.35.

Unfortunately, the 11% return on capital is merely sufficient to justify a price around $60 per share.

Discounted cash flow projection

Explanation of assumptions

The CEO’s revenue growth target of 15% for five consecutive years was utilized. The growth trails off for the following five years.

An operating margin of 15% was employed instead of 12.65%. The reason for the additional margin is the result of the exercise I went through to capitalize operating leases. MNRO has capital lease obligations on the balance sheet and I added the operating leases to both sides of the balance sheet. The amortization of the asset is shown as a benefit to EBIT.

The cost of capital employed as a discount rate is 6.76%. This was derived from a leveraged beta of .85 for equity and 5.38% for the cost of debt.

Debt cost is calculated as follows:

Long Term Debt 1.75% $127,359
Capitalized Leases 7.15% $138,680
Operating Leases 7.15% $123,362
Weighted Average 5.38% $389,481

Balance sheet with adjustment for operating leases:

The perils of student loans

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As high school seniors and their parents fill out those dreaded FAFSA forms, I thought it would be instructive to point out just how wacked out the world of student loan debt has become.

Since the 2008-09 recession, student loan debt has risen 665%. That is not a typographical error.

As always, the folks at Advisor Perspectives do a masterful job charting the ebbs and flows of markets and the economy.

Federal-Loans-to-Students-Q3-2015

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