Apartment Development has a Big Lebowski Moment


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


The Dude Abides

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

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

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



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

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

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

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

Screenshot (1)

Source: CME Group

There are three problems with this outlook:

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


Screenshot (3)

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


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

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

Cirrus Logic: The Apple Problem



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

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

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

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

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

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

Earnings Power Valuation

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

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

Research and Development: Hidden Assets

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

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

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

Share-Based Compensation is a Concern

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

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

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

WACC is a Tough Nut to Crack

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

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

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

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

A Final Thought on Profit Margins

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

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

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

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

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

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


Exhibit 1, Weighted Average Cost of Capital

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

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

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

Tredegar: Plastic Surgery



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

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

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

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

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

Family Pride

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

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

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

Revenues have started growing again, but beware the fine print

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

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


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

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

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

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

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

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

Earnings Power Valuation: $14.20 per share

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

Appendix: Tredegar Income Statements

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

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

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

Greenbrier: Rolling Stock


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

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

Insider sales and a JV partner raise questions.

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

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

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

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

Not everything is rosy in the City of Roses

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

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

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

CFO, Lorie Tekorius

CFO, Lorie Sekorius

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

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

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

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

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

Strong Margins

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

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

Valuation: The justification for GBX at $60

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

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

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

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

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

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


Balance Sheet

Income Statement

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

Pilgrim’s Pride: Recent Declines Present Opportunity


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

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

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

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

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

The Good

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

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

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

The Bad

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

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

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

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

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

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

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

The Mixed Bag

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

Earnings Power Value

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

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

Discounted Cash Flow

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

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

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

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

Disclosure: I am/we are long PPC.

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

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

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)