PBF Energy: Sophisticated Investors Have Doubled Down, Should You?


This article was originally posted on Seeking Alpha. Since the article was published, PBF has dropped 14% while VLO has fallen 2%.

  • Seth Klarman’s Baupost Group has recently increased holdings to 16%.
  • PBF has grown through skilled acquisitions but faces a tough refining market.
  • If you believe refined crude margins will recover, PBF is a solid value play.

PBF Energy (NYSE:PBF) is a New Jersey-based petroleum refiner with a throughput capacity of 884,000 barrels per day. As the owner of 5 facilities, the company has a market capitalization of $2.3 billion at the recent price of $22.65. PBF is less than half the size of industry giant Valero (NYSE:VLO), but the company has made two recent acquisitions that have vaulted the business up the league table of refiners. However, many recognize PBF not for its refining capacity, but for its largest shareholder: Seth Klarman’s Baupost Group.

Klarman is a disciplined value investor with one of the finest track records in the industry. Early in September, filings showed that Baupost had increased its stake to 16%. Klarman seems to be doubling down on his bets on PBF after the company’s shares have fallen by 35% since April. Notably, PBF’s CEO Tom Nimbley also added shares.

Following the moves of hedge fund wizards like Klarman can seem like sage advice, but is PBF right for your portfolio? The jury is mixed.

The case for investing in PBF rests upon its shrewd acquisition bets and a stock price that trades at net asset value. The case against PBF is largely an industry wide challenge: refining margins have been under pressure in 2016. While crude stocks have shown recent declines, gasoline inventories have increased. Finally, a comparison with industry giant Valero indicates that PBF needs to improve internal cost structures in order to gain market recognition.

The acquisition story

PBF was hatched from a private equity deal by Blackstone. Taken public at the height of the oil boom, Blackstone and other original private owners have reduced their LLC position to about 5% of the company through successive public offerings. As a fully-public enterprise, PBF spread its wings in 2015 with the acquisition of the Chalmette facility in Louisiana for $322 million. The transaction closed in November of 2015 and brought on board 189,000 bpd throughput capacity with a Nelson Complexity Index score of 12.7. PBF pounced on the opportunity as Exxon Mobil (NYSE:XOM) and Petroleos de Venezuela exited the business. The new capacity added to PBF’s facilities in Toledo, Delaware City and Paulsboro, New Jersey. Chalmette’s total price of $565 million included the acquisition of $245 million in inventory and working capital. Chalmette was a bargain purchase at $1,700 per barrel or less than $200 per complexity-barrel. The facility provided PBF with valuable exposure to the Gulf Coast.

PBF moved quickly to capitalize on another XOM divestiture late in 2015 by entering into an agreement to purchase the troubled Torrance, California refinery for $537 million. The transaction closed on July 1, 2016 and added 155,000 bpd capacity (14.9 NCI) in the critical West Coast Market. California has the most stringent environmental regulations but the Torrance refinery supplies 20% of the lucrative Southern California market.

Like Chalmette, PBF has taken advantage of XOM’s need to shed assets. The refinery was purchased for the inexpensive price of $3,500 per barrel or about $235 per complexity-barrel. What’s more, PBF has purchased a refinery which has undergone extensive capital improvements that enhances compliance with the strict California environmental laws. Torrance was infamous for an explosion in early 2015. Subsequently, XOM spent over $160 million to bring the facility back up to speed before selling to PBF.

The acquisitions have raised PBF’s throughput capacity to 884,000 bpd and they have earned a national reach with very reasonable allocations of capital.

The table below ranks major independent refiners by throughput. Using a metric of enterprise value divided by throughput indicates that PBF is much less expensive than its peers.

Throughput Capacity vs. Enterprise Value kbpd Enterprise Value EV/kbpd Op. Income from Refining
Valero 2,177 27,995 12.86 98%
Phillips 66 2,033 47,930 23.58 37%
Marathon 1,731 31,215 18.03 85%
PBF Energy 884 3,271 3.70 94%
Tesoro 850 13,310 15.66 72%
kbpd at 2Q 2016

Valero, with an enterprise value of $28 billion has 2,200 kbpd of throughput. Marathon (NYSE:MPC) has $31 billion of enterprise value for 1,731 kbpd of capacity. Meanwhile, PBF has an enterprise value of $3.27 billion for its 884 kbpd throughput. The chart shows that PBF sells for an inexpensive EV/kbpd ratio of 3.7. Admittedly, Marathon, Tesoro (NYSE:TSO), and especially Phillips 66 (NYSE:PSX) derive a larger portion of operating income from non-refining activities and make the comparison slightly less meaningful. Throughput capacity also doesn’t take into account the varying degrees of complexity indices and refining margins (as we will see later in a direct comparison with Valero). Still, the low multiple is hard to ignore.

PBF and the sum of its parts

PBF also attracts attention because it sells for a price that is in line with the value of its assets. Recently, LyondellBasell (NYSE:LYB) announced that it would sell its refinery in Houston with a 270,000 barrel per day capacity and an NCI of 12.5. Industry experts expect the transaction to reap as much as $1.375 billion using a metric of $5,000 per barrel. The leading candidate to purchase the Lyondell refinery is Saudi Aramco (AMRCO). Of course, one should apply the caveat that the Saudis may be on the verge of overpaying as they seem to be in a desperate mode to diversify assets away from the declining crude reserves at home.

Let’s take a broad swing of the axe at the PBF assets: If one employs a price of $4,250 per barrel for the 884,000 bpd refining capacity, the gross value is $3.76 billion. Now subtract the debt of approximately $1.83 billion. The net result is $1.93 billion of refining capacity value. Critically, PBF also owns approximately half of its pipeline and transport affiliate PBF Logistics (NYSE:PBFX). The market capitalization of PBFX is roughly $832 million. Adding the half of PBFX to PBF’s net asset value noted above, the sum of all parts equates to $2.35 billion – well in line with the current market price for PBF equity.

The case against PBF

Refiners produce profits by reaping the spread between crude oil inputs and refined outputs. “Cracking” hydrocarbons for gasoline, diesel and LPG generates a profit per barrel. The crack spread has trended downwards since early 2016 in fits and starts, and hovers around $12 today. In fact, the recent pop above $12 was only the result of a temporary pipeline leak at the beginning of September. Gasoline inventories have risen, while crude stocks have fallen. Crack spreads during the past four years have shown declines as peak driving season inventories are built. Spreads touched $43 in early 2013, $26 in early 2014, $33 in the first quarter of 2015, but only $22.50 early in 2016.

It’s tough to fall in love with a business with operating margins below 4%

A refiner has to pay overhead and operating expenses after it yields the crack spread. For PBF, operating income margins (before taxes) measured approximately 6% in 2015 (note: the author added back a $427 million inventory adjustment), but only 3.44% during the first half of 2016. The 2016 margin indicates the extent to which the petroleum industry faces pressure as it unwinds surplus inventory.

Cash Flow at PBF is not fantastic

In 2015, PBF received net income of $195 million. Adding back depreciation of $207 million and an inventory markdown of $427 million plus other adjustments provided $703 million of cash. The pressure on capital expenditures is high for refining facilities and the annual turnaround costs are immense. PBF required over $407 million in capital expenditures during 2015. The company also pays out 5% of cash flow to the non-public shareholders. This amount totaled $42.2 million. Out of the $254 million remaining, $106 million went to dividends. Unfortunately, PBF also had negative working capital of $338 million. While this may be excessively high due to inventory management related to the Chalmette acquisition, it also suggests that the dividend is not a certainty. PBF offers a robust 5.3% yield, but the elevated level reflects some inherent risk recognized by the market.

Finally, the refining industry faces a high degree of uncertainty related to environmental compliance regulations. The industry awaits final guidance from the EPA and additional capital expenditures may be required.

The table above indicates that pressure on operating cash flow continued in 2016. Free cash flow after capital items and dividends approached negative $80 million. Certainly, the Torrance facility will help these numbers during the second half of the year as well as the addition of a new storage tank at Chalmette.

One doesn’t have to look far to see the challenges facing the industry. The refining margins for the first half of 2016 dropped dramatically from $10.29 per barrel to $5.77. Management recently highlighted the constrained market and also noted that operating expenses will be at the $5 level for 2016. On the plus side, management also touted the benefits of the Torrance acquisition by emphasizing that it will add about $360 million of EBITDA. The chart below presents historical margins and actual numbers through June of 2016. The author made projections for the remainder of 2016 with an added column showing the accretive contribution from Torrance as will the addition of a new storage tank at Chalmette.

A comparison with Valero

Simply put, Valero has better gross margins.

Gross Refining Margin Per Barrel PBF VLO
2013 $ 8.16 $ 9.96
2014 $ 12.12 $ 11.28
2015 $ 10.29 $ 12.97
2016 1H $ 5.77 $ 8.44

Valero also has lower operating expenses.

Operating Expense Per Barrel PBF VLO
2013 $ 4.92 $ 3.79
2014 $ 5.34 $ 3.87
2015 $ 4.72 $ 3.71
2016 1H $ 4.63 $ 3.53

The following is a comparison of 2015 numbers between the two refiners. I added the Torrance EBITDA of $360 million at the bottom to make a comparison of enterprise value to EBITDA and price to EBITDA. Both measures show that PBF trades at a discount. However, given the margin advantage at Valero, perhaps the higher multiple is deserved.

2015 Income Statement, in millions PBF Valero
Revenues 13,124 87,804
Cost of Sales 11,482 74,651
Inventory Adjustment (427) (790)
Gross Profit 2,070 13,943
Operating Expenses
Operating Expenses 905 4,243
Gen & Admin 181 710
Depreciation 197 1,842
Other (1)
Total Operating Expenses 1,282 81,446
Operating Income 787 7,148
Operating Margin 6.00% 8.14%
EBITDA (with inventory adjust.) 994 8,990
Add EBITDA from Torrance 360
Total EBITDA 1,354
EV/EBITDA 3.06 3.11
Price/EBITDA 1.72 2.75

In all, PBF is probably the best option if you wish to add a refiner to your portfolio. Following Klarman is usually a productive bet. The refining capacity of the country has limited growth due to strong environmental opposition. Hence, PBF offers a proverbial “moat.” Miles driven by US consumers are steadily climbing after plummeting in the latter half of the last decade. Gasoline is also largely immune to foreign competition (unlike crude). PBF trades in line with net asset value and at a discount to Valero. If PBF can improve margins, Klarman’s wager will pay off handsomely.

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.

Ulta: Buyer Beware


This article was originally published on Seeking Alpha on August 17, 2016.

  • ULTA consistently posts annual sales growth of 20%, and the stock is up 175% in two years.
  • But the stock trades at 50 times earnings and a 30% premium over its intrinsic value.
  • Momentum seems unstoppable, but buyers must cautiously consider the downside risks.

Ulta Salon, Cosmetics & Fragrance (ULTA) has been a phenomenal investment. Trading around $266 per share, the stock has risen 178% over the past two years. Can Ulta continue its outstanding run? Yes.

However, there is a large difference between the words “can” and “should.” In this author’s opinion, Ulta is overvalued by more than 30%. Other authors agree. If you are new to Ulta, I recommend Vijar Kohli’s recent Seeking Alpha post for an understanding of the business. I will comment on valuation and leave the characteristics of the market and personnel largely out of this article.

Why Ulta can continue to rise

As one commenter boasted elsewhere, Ulta is a lot more likely to hit $300 than $200. The bullish sentiments are easily found among Ulta fans who have been downright contemptuous of bearish articles. And who can blame them? Shorting Ulta has been a sucker’s bet. The price chart is jaw-dropping.

The story at Ulta has been a rollout of about 100 new stores per year since 2012. The chain reached 874 stores at the end of 2015 and plans to push towards 975 by year-end 2016. Unlike many expansion plays in retail where new store growth masks flat same-store sales, Ulta has posted some massive comparables in the 10% range for over 5 years. The new stores have pushed total sales growth in excess of 20% per year. A 35% gross margin and 12.9% operating margins have netted substantial gains.

The chart below shows the growth trajectory. More importantly, I have compiled a return on invested capital by taking annual capital improvements, new store start-up expenses and the annual change in capitalized leases. 20% returns on capital (pre-tax) have been posted, on average, annually. For a company with no debt (if you exclude capitalized operating leases of $1.5 billion), the returns are fantastic. Sales per square foot have reflected improved customer loyalty programs and the introduction of more luxury cosmetic brands. Ulta has been a buyer of its own shares and paid surplus cash as dividends in 2015. Ulta will announce earnings on August 25th and should extend its streak of stellar quarters.

(click to enlarge)

The Bear Case

I have read comments by Ulta bulls calling for bearish authors to back up their sentiments with a short position. To my bullish friends, I confess that I count myself among the chickens. To go against a momentum stock that has no apparent speed bumps on the horizon would be a fool’s errand. The largest threat to Ulta is a dramatic slowdown in consumer spending, but improving job reports and expanding wage growth paint a positive macroeconomic picture.

Therefore, I offer my valuation as a caution flag to those who may be interested in entering a new position at Ulta or the lucky ones who have been on a one-way ticket to riches and may be considering a removal of chips on the table.

I present below a discounted cash flow analysis that results in a valuation of $207 per share.

Let’s talk about the base of the model: management expects comparable sales growth between 10-12%. I add about $360 million from new stores to arrive at overall 2016 sales growth of 20%. Operating margins are expected to be slightly lower but still above 12.50%, and earnings will grow 20-22% to over $6.15 per share. Looking forward, the model assumes consistent margins above 12.50% at the operating level and growth on the top line slowly tapering from its heady 20% annual rate. I give Ulta the benefit of the doubt with a very low weighted average cost of capital of 5.36%.

(click to enlarge)

Three yellow flags

I have also given Ulta a generous assumption that working capital will be positive in the future. The company has wisely expanded through relatively low capital investments – stores are all leased. However, each new store requires a large investment in inventory. In this regard, working capital turned significantly negative in 2015. Failure to move product efficiently could prove to be a drag on future cash flow. For purposes of my model, I do incorporate a positive working capital trend in Ulta’s favor.

A second word of caution can be found within the capital improvements line item. Management has announced that capital improvements will exceed $390 million for 2016 – up from an original projection of $300 million. The company has embarked on a plan to showcase the introduction of new luxury brands. Not surprisingly, higher-end cosmetic brands have a desire to be presented as a distinct upgrade from the typical fare that can be bought at your neighborhood CVS (CVS), Walgreens (WBA), or Target (TGT). The buildout of exclusive store displays has become a necessity. Investors should be vigilant about future capital expenditures.

Third, competitors aren’t going to sit back and relax. Macy’s (M) may be derided as a dinosaur, but it won’t go down without a fight. As Ulta pushes into the luxury categories, Sephora will push back. Finally, Ulta has built its brand on the back of less expensive and widely available cosmetics, by offering better service and a dynamic sales environment. But for the busy shoppers, it’s very easy to pick up an inexpensive eyeliner brush while picking up a carton of milk.

Buyer Beware

Finally, to those of you who scoff at DCFs and their widely variable inputs, I offer more mundane estimates of value (or over-value as the case may be): Ulta trades at 44 times 2016 earnings and 25x forward EBITDA, and it offers a pre-tax earnings yield of 3.09%. By any measure, these metrics are in the stratosphere. Tread carefully.

Exhibit: ULTA Income Statements with author’s 2016 estimate.

(click to enlarge)

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


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.

(click to enlarge)

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.


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.


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.

(click to enlarge)

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%.

(click to enlarge)

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

  • 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.

(click to enlarge)

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


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.


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.


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


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


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.