Investing Sins: Confirmation Bias

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

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

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

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

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

Caveat emptor.

Why I disagree with Bill Gross about Carry Trades.

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Bill Gross

 

 

 

 

 

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

John Bean Technologies: Overpaying for Acquisitions

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

Summary

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

JBT has nearly doubled since September.

The stock price does not reflect declining returns on capital.

A short candidate, but caution is required.

 

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

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

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

Note: restructuring charges are highlighted above.

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

First the comparison.

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

Discounted Cash flow implies 25% Downside

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

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

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

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

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

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

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

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

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

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

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

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

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

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

My model incorporates the following assumptions:

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

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

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

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

Ignorance breeds caveats…

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

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

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

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

Disclosure: I am/we are short JBT.

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

Monro Has Unrealistic Ambitions

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Summary

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

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

The Pep Boys Comparison

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

Growing faster than they’ve ever grown before

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

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

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

The only way to grow: reinvesting capital effectively

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

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

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

Returns on capital have been declining at MNRO:

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

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

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

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

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

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

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

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

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

Discounted cash flow projection

Explanation of assumptions

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

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

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

Debt cost is calculated as follows:

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

Balance sheet with adjustment for operating leases:

The perils of student loans

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

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

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

Federal-Loans-to-Students-Q3-2015

College-versus-Medical-Care-or-New-Car

Munger on the Proper Discount Rate

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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.

charlie-mungerThere’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.

Charlie Munger

Thanks to Farnam Street
(C) 2016 FARNAM STREET MEDIA INC.

MCHP: Time to Move On, Find Other Short Opportunities

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Summary

  • My parting views on MCHP’s pending acquisition of ATML.
  • The $3.5 billion acquisition offers a return on capital in the low-single digits.
  • ATML has rapidly shrinking revenues.
  • However, MCHP has plenty of cash.

In spite of the lukewarm return projections, the ATML acquisition has little downside.

I have written two articles questioning the decision by Microchip Technology (NASDAQ:MCHP) to acquire Atmel (NASDAQ:ATML). In those articles, I argued that the $3.5 billion acquisition represents a return on capital below 4%. I remain skeptical of the MCHP investor presentation, projecting upside synergies of over $170 million annually. However, because MCHP has over $2 billion in cash on its balance sheet and consistently churns out over $500 million in cash flow after capital expenditures, I have concluded that the downside risk of the acquisition is limited. If the proposed synergies do materialize, there is upside potential for shareholders. At $42 per share, the market has assigned virtually zero value to the accretive nature of ATML’s $100 million of additional cash flow.

Let me refresh readers on my journey: I have followed the remarks by Kyle Bass, George Soros, Jim Chanos, and others who are convinced that China faces a massive debt crisis. Looking for ways to short China, I noted that the semiconductor industry has significant exposure to the Chinese economy. However, I was astounded by the massive profitability of the sector and the lack of debt as I sifted through the numbers. MCHP stood out with its $1 billion in debt to $2.35 billion in equity, so I decided to wade in.

When MCHP announced the ATML acquisition in January, it struck me as a risky play. It is set to expand the company by over 50% (based on my estimate of combined revenues). The purchase price of $8.15 per share is approximately 100 times ATML earnings. Moreover, ATML has indicated that it will suffer a decline in revenues of 17% once 2015 numbers are tallied due to a sales slowdown in China. Finally, I showed that MCHP has been a successful acquirer of businesses in recent years, but not quite as good as it may lead investors to believe. My view of the MCHP acquisition of Standard Microsystems (NASDAQ:SMSC) in August of 2012 showed that R&D and amortization expenses were probably understated by $95 million due to maneuvers on the balance sheet.

I am moving on in my search for short opportunities. While the debt levels of MCHP are higher than its peers, the acquisition of ATML offers little downside to a company generating over $500 million in cash annually and can boast a treasure chest that is more than adequate to cover the $2 billion cash portion of the ATML purchase. The additional 13 million shares to be issued will not be dilutive, and the additional $765 million in debt should be rapidly paid off.

Here’s how the merged balance sheet should look on a pro-forma basis:

Here’s a pro forma estimate of operating free cash flow:

Using this definition of operating free cash flow, the projected return on capital for MCHP drops from 13.20% to 9.30% after the acquisition. However, if the proposed merger “synergies” enhance the cash flow, the return rises to nearly 12%.

While I maintain my argument that this acquisition is not a stellar use of capital, commenters have reminded me that MCHP is effectively removing a major competitor from the market. This alone may be worth the price of admission.

The final point (and, yes, this really is the final point!): Anyone wishing to short the semiconductor sector based on a Chinese slowdown may run into the risk of a floor on valuations effectively put in place by none other than the Chinese themselves.

Seeing the healthy margins on semiconductors (over 40%) and the need to move capital into profitable industries quickly, the Chinese have been on an acquisitive spree. The province of Guizhou set up a JV with Qualcomm (NASDAQ:QCOM) in January in which the Chinese state will own 55%. The Taiwanese firm Powertech sold a 25% stake to Tsinghua Unigroup. Portions of STATS ChipPAC (OTC:SCIPF), NXP (NASDAQ:NXPI) and Fairchild Semiconductor (NASDAQ:FCS) have also been sold to the Chinese recently. Many more will follow. Could MCHP be a target?

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: This is my third post on MCHP. Your comments, corrections, and input, and feedback are valued and encouraged. I am not a professional analyst and the projections enclosed represent my own interpretation of available press releases, SEC filings and other articles in the public domain. My measurements of operating cash flow and returns may differ from conventional metrics. Please do your own due diligence before making any decisions about taking a position in MCHP. Thank you.