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.
|Est’d FY 2016 NOPAT||78,374|
|Return on Capital||10.86%|
Returns on capital have been declining at MNRO:
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|
Balance sheet with adjustment for operating leases:
Questioner: When you try to arrive at the valuation number using the discount rate…
Munger: Your opportunity cost is so great. Considering everything else, you should forget about it. Most people don’t pay enough attention to opportunity cost. Bridge players know about opportunity cost. Poker players know about opportunity cost. American faculty members and other important people, they hardly know their ass from a plate of hot squash.
We don’t use numeric formulas that way. We take into account a whole lot of factors. It’s a multifactor thing. There are tradeoffs between factors. It’s just like a bridge hand. You have to think of a lot of different things at once.
There’s never going to be a formula that will make you rich just by going through some little process. If that were true, every mathematical nerd that gets A’s in algebra would be rich.
Atmel is being acquired by Microchip Technology. Shareholders can find evidence of the dubious quality of the acquisition quite easily.
Microchip Technology announced its pending acquisition of Atmel in January for $3.5 billion. I have doubts about the merits of the acquisition. Ironically, MCHP inadvertently flagged ATML as a dud while touting its own masterful abilities as an astute acquirer of other businesses during a December 1 slideshow.
In my homework on how MCHP’s other acquisitions have fared, I discovered an interesting nugget. Apparently, I am not the first person to question their prior acquisitions. On December 1, 2015, MCHP went so far as to release a slide show presentation of just how well its acquisitions have worked.
They show organic net sales have expanded at an 8.3% compounded rate for the past six years, and 6.3% for the past three years. Meanwhile, including acquisitions, net sales expanded at 17.3% per year for the six year period and 13.1% per year over three years.
In the next slide, MCHP takes a victory lap by showing itself atop a league table of other semiconductor companies. MCHP, with its acquisitions, grew net sales more than three times the industry average during the past six years. Who sits at the bottom of the list? None other than Atmel with a dismal -0.4%.
Just over six weeks later, MCHP decided ATML wasn’t so bad after all. MCHP claims that the acquisition will provide $170 million in “synergies”. But even that optimistic number represents a return on capital of less than 4.9%.
The downside risk is evident: Both companies have very high exposure to Asia (over 40% of sales), and revenues at ATML have dropped by almost 17% during 2015. Meanwhile, MCHP is enlarging its business by 47%, expanding debt from $2 billion to $2.8 billion, and expending nearly all of its $2 billion in cash to finalize the deal.
In fairness, MCHP generates over $500 million in operating cash each year, so replenishing the coffers won’t take long. The debt is growing, but can be easily serviced. But shareholders would be better served by a share buyback than the purchase of a business in decline.
Investors seeking ways to profit from the slow down in China may be tempted to seek short positions in semiconductor stocks. Many have exposure to China between 30 – 50% of revenues. Unfortunately (for bears), most are well-capitalized, and may not have the downside short sellers are seeking.
One microchip specialist that stands out for its relatively high leverage is Microchip Technology, Inc. (MCHP). Although the company is highly profitable, and sports cash of over $2 Billion, it has $2.7 Billion of debt vs book equity of $2.12 Billion. At February 3, MCH trades at $42 per share for a market cap of $8.54 Billion.
Two caution signs have emerged at MCHP. The questionable acquisition of Atmel and a rising level of inventories. I will focus on the ATML acquisition here, and leave the inventory question to a later post.
MCHP investors will be diasappointed to know that their company is spending massive amounts of capital on Atmel, a semiconductor firm with declining sales and strong headwinds in Asia. On January 9th, 2016, Atmel agreed to sell to MCHP for $3.5 billion, or $8.15 per share. This amount is funded from approximately $500 million in MCHP stock and $3 Billion ($7 per share) in cash. The deal represents a nice escape hatch for Atmel shareholders who have seen the stock languish between $5 – $10 per share for several years.
MCHP will spend $2.175 Billion in cash on hand (virtually its entire cash position at the end of 2015), issue $495 million of stock, and add $786 million in debt by drawing on a line of credit. What does MCHP get in return? According to investor presentations, ATML will provide $170 million in “synergies”. Even if this $170 million materializes, it represents a paltry 4.86% return on capital for MCHP shareholders.
The deterioration at ATML is clearly evident in the chart below. MCHP will struggle to achieve any meaningful return on its investment.
Interestingly, MCHP also had to pay a $137 m fee to Dialog Semiconductor plc to walk away from their proposed offer to purchase Atmel. Dialog is probably relieved to take their money and run.
ATML has been deteriorating along with the Chinese economy. With $1.43 Billion in revenue in 2012, the company will likely only post revenue of $1.173 Billion in 2015. In ATML’s defense, the company remains profitable and has shown consistent cash flow. The cash from operations less capital expenditures has declined from $165 million in 2012 to about $85 million in 2015.
The January 13 press release, prior to the acquisition announcement, shows ATML listing badly. Revenues are expected to come in between $261 and $262 million vs. expected revenue between $266 and $286 m. The company noted “weaker than expected billings, primarily in Asia”. ATML offered the limp excuse that the pending acquisition had caused orders to drop.
In The Hour Between Dog and Wolf, John Coates explains how chemicals within the body interact with the brain. The surges of dopamine during pleasure, testosterone during aggression, and cortisol under stress, are not only triggered by the brain, they have a reciprocal effect on thought and consciousness.
John Coates is a senior research fellow in neuroscience and finance at the University of Cambridge. Coates was also a successful manager of a Goldman Sachs trading department for over a decade. His observations of trading behavior led him to the conclusion that more than rational thought was involved in the execution of trades. He saw the emotional surges of adrenaline inflate markets into bubbles. He also saw the depths of despair cloud judgement to the point of paralysis.
However, no other chemical in the body seemed to affect the cognitive behavior of the Wall Street trader more than the hormone testosterone. The wolf – in Coates’ metaphor – lurks just beneath the surface. When challenged, the testosterone surges and aggression takes over. It is the basis of the “fight” instinct when the opposite choice is flight. In the world of the trader, too much testosterone can lead to aggressive trades that miscalculate risk.
Coates also examines the role of the body’s “second brain” known as the enteric system that contains approximately 100 million neurons and produces the same neurotransmitters as the brain. The vagus nerve – the main connection between the brain and enteric nervous system forms a direct link to the chemicals in the stomach and digestive tract. “Trusting your gut” can be taken in its most literal sense.
The enteric nervous system forms the basis of preconscious thought – It registers biological feedback before the conscious mind can compute it. The most frequent human example is the instantaneous recognition of facial expressions. Even the smallest change in the face of can be identified as worry or anger milliseconds before the analytical mind fully recognizes the emotion.
While Coates observed Wall Street through the lens of chemical surges, I thought about its applications in major historical events. I had recently read Bernard Cornwell’s book on Waterloo and thought about how the fateful battle was shaped by both rational analysis and the chemicals surging through the body.
Waterloo, in southern Belgium, was the site of Napoleon Bonaparte’s final defeat in 1815.
In a stunning turn of events, the ink had barely dried on the peace agreement from the previous Napoleonic wars when Napoleon returned as Emperor. In a caper that rivals the fictional tales of Captain Jack Sparrow, Napoleon escaped exile on the island of Elba while the British ship patrolling the harbor departed for Italy where the British captain could enjoy a tryst with his mistress.
Upon reaching France, he found a population that was already disenchanted with the restored monarchy in 1815. As Napoleon marched from southern France to the capital his small band of partisans grew into a formidable force of thousands as the French army deserted their posts and rejoined their once-exiled leader. Napoleon marched to Paris where he received a hero’s welcome: literally carried on the shoulders of cheering crowds. Women wore violets, a symbol of his previous reign. The effect on Napoleon must have been intoxicating.
With Napoleon in power again as Emperor, the British, Dutch and Prussians were determined to remove him once and for all. They immediately declared war on L’Empereur.
Napoleon surely did not lack testosterone.
Rather than adopt a defensive tactic and digging in defenses at the French border, Napoleon advanced on positions held by British and Dutch forces in southern Belgium. After some of the bloodiest fighting in recorded history, France was routed. Napoleon was once again banished, this time to the remote island of St. Helena.
The Battle of Waterloo began as a tactical chess match filled with strategy and intrigue, but it ultimately degenerated into capitulation and chaos as French lines panicked and fled. Prussian and British cavalry slaughtered the fleeing French. The battle between bodily chemicals and rational thought were well and truly on full display.
Napoleon’s mere presence at the front of his lines, it has often been written, was worth an additional 40,000 men. While Napoleon was a genius of military strategy and logistics, it was his aggressive charisma that whipped his soldiers into a frenzy of fearlessness. But one certainly has to ask: Was the surge in chemicals affecting his brain so powerful that he lost a sense of proportion and judgment while at Waterloo? John Coates would probably say yes.
The decision to attack on foreign ground rather than defend French territory, in hindsight, registers as a poor decision. Napoleon was riding high on his restored status as Emperor, and he was brimming with over-confidence.
The Duke of Wellington strikes a contrast as a force of calm in a sea of chaos. He is seen dispatching orders while using the front of his saddle as an improvised desk.
Wellington deployed his troops beyond the top of a ridge to camouflage the exact locations and number of soldiers. Napoleon’s powerful artillery columns were less effective against these positions. The British army formed disciplined “squares” to defend against the feared French Cuirassiers on horseback. And while Napoleon organized his troops masterfully, he ignored poor weather conditions and his advancing armies became hopelessly bogged down in thick mud.
While Wellington’s correspondence was direct and clear, Napoleon’s orders could be vague and allowed for misinterpretation. In one of the most infamous incidents at Waterloo, Napoleon instructed one of his generals to engage the British on their southern flank. Before they encountered the enemy, another order called the army back to the main concentration of forces. In the end, thousands of French troops spent the battle of Waterloo in the woods. They neither engaged the British at the south flank, nor were they in the time to reinforce the main French forces.
Napoleon’s aggressive attack on the British and Dutch positions left his right flank dangerously exposed to Von Blucher’s Prussian forces advancing from the north. Early in the battle, Napoleon believed that the Prussians were in full retreat after some early skirmishes. In reality, Von Blucher had regrouped his troops for a powerful counter-attack that shattered the French right flank.
To say that the greatest victory in British military history turned on the tide of human chemical interactions is perhaps an exaggeration, but it offers one a new lens through which to analyze historical events.
Coates offers remedies to balance the conflict between the rational mind and the chemical surges in the body:
Aside from the occasional plague and peasant uprising, Europe during the early 1500’s was an exciting and prosperous place to be. New worlds were being discovered, art and technology flourished in the Renaissance, nations emerged from fiefdoms, and religion was undergoing a massive reformation.
The strongest financier during this period was a German by the name of Jacob Fugger (rhymes with cougar) who hailed from Augsburg, in present day Austria. He transformed his family’s textile business into a massive empire of banking, mining, and trade. Fugger was wealthier than the famous Medici clan who received much more historical attention. As a percentage of GDP, his wealth would dwarf Rockefeller, Gates and Buffett.
Fugger financed the Habsburg dynasty and the expansion of the Holy Roman Empire – an empire that ruled the core of Europe for four hundred years until World War I swept aside Austria-Hungary. He was a shrewd operative who financed the Vatican (indulgences aren’t free, you know), and obtained the ownership of entire villages when debtors defaulted on their loans.
Greg Steinmetz’s book “The Richest Man Who Ever Lived” is the latest book to revive the legend of Jacob Fugger. The book is a business biography, but it is also a geographical instruction manual.
The story of Jacob Fugger illuminates the importance of cities in the development of commerce. Augsburg, Rome, Venice, Antwerp, and Mombasa are the supporting cast of characters in the book. The evolution of these cities provides insights into our own urban areas. For me, the book provides a lens through which to look at he challenges faced by Omaha as it tries to surge past 1 million people and reach the second tier of US cities.
Fugger maintained his home in Augsburg, but he located important business centers in Venice and, later, Antwerp. He chose to locate in Venice early in his career because the Venetians were the leaders in big business at the turn of the century. Their fleets traded goods from all over the world and their management skills were second to none. Most importantly, the Venetians mastered the system of accounting. Double-entry book-keeping was a new science, and Fugger used his mastery of accounts to centralize his far-flung empire. Later, Antwerp became popular as shipments from the New World increased. It’s massive port and access to the European heartland drew Fugger.
This process of city and regional emergence is on display today as ConAgra considers moving its executives to Chicago. Omaha has a strong infrastructure in place to serve the agricultural industry, but Chicago has what it takes to reach consumers: It has a core group of companies like McDonalds, Kraft, Mondelez, ADM, and Ingredion all sharing resources. Chicago has thousands of well-educated people, young folks who can identify with a growing millenial target market, and dozens of advertising and marketing firms. Chicago, with its high cost of living and pension problems, trumps Omaha when it comes to innovation and sales. Like Silicon Valley, the costs of living are far outweighed by the opportunity to rapidly gain from networks of people. Omaha lacks the talent needed to reach rapidly-evolving consumer tastes.
Omaha also suffers from its peripheral location on the Great Plains.
One of the most fascinating stories in the Fugger biography is the rise of Portugal. Once a European backwater, the Portuguese decided to punch above their weight. They spotted their opportunity in pepper.
Pepper was essential for the bland European diet. Spoiled meat was a frequent entree and it needed a little, ahem, flavor. At the time, the Venetians controlled the pepper trade from India. They had a direct route but it required an overland trans-shipment at Suez. The Portuguese made the bold move of sending ships around the Horn of Africa to the Indian Ocean. While the route was dangerous, it was much faster than the Venetians could manage.
One of the most exciting chapters in the book is the siege of Mombasa in present day Kenya. Only a few cannon blasts allowed the Portuguese to take over the trade hub. From there, it was a direct route to India. The galleons returned to Portugal loaded with pepper. They reaped a fortune from the trade. Fugger, as their investor, took his handsome share as well. Steinmetz argues that the loss of the pepper trade is what directly led to the demise of the Venetians.
The story illuminates the role of trading hubs and transportation centers to the growth of an economy. It seems fairly obvious, but it is remarkable that a city or region can grow exponentially without having a local industry. Singapore and Hong Kong are certainly modern examples of this phenomenon. Closer to home, Louisville and Memphis show how modern transport hubs have emerged in the jet travel era as the hosts of UPS and FedEx respectively.
Omaha may have lost it’s stockyards, but it remains an important commodities trader with firms like Scoular and Gavilon. Trucking is big here. But at the periphery, Omaha will probably never emerge as a transportation and market hub. Alas, it does not have a fleet of galleons to lay siege to The Loop.
Remaining a lower tier City is not all bad. Cost of living does matter when it comes to location selections. Nice people and good education systems do add value. By all accounts, Augsburg remains a pretty nice place to live even though the banking capital of Germany moved to Frankfurt centuries ago.