Category Archives: Company Analysis

Intel (INTC)

Key Statistics

EV/EBIT = 8.96x

FCF/Price = 7%

Debt/Equity = 49%

Return on Equity = 29.5%

Dividend Yield = 2.53%

The Company

Intel is the world’s dominant manufacturer of chips for PC’s and servers.

Intel was founded in 1968 by Gordon Moore and Robert Noyce. They left Fairchild Semiconductor to form their own company. They positioned themselves at the forefront of the new industry and sought to have the fastest chips in the market.

Gordon Moore coined “Moore’s law”: the number of transistors doubles on a chip every two years. The law became a target for the company and Intel has frequently had the fastest chip in the market. Intel itself has been the driving force behind Moore’s law becoming a reality. They have sometimes been outpaced by their competition, but they have always been able to regain their dominant position.

Over time, demand for chips has increased and Intel’s business grew with it. They developed close relationships with PC manufacturers, and this tight relationship along with strong R&D made them the dominant chip company.

Intel’s dominance has its roots in their development of x86 architecture, which was pioneered by Intel in 1978 and is still used by most PC’s and servers. Most PC software was written for the x86 architecture, giving Intel a sticky position in the PC market. AMD also makes x86 chips, but Intel remains the dominant player.

Below is the growth of Intel’s business over the last twenty years. In the last 10 years, EPS has grown at a 19.9% CAGR through a combination of growth in the business and buybacks.

Does this look like a falling knife?

My Take

Intel has high ROE, an incredible track record, secular growth prospects (we’re going to need more chips 10 years from now today than we do now). Why is it selling for a 8.96x EV/EBIT multiple?

The stock is cheap for two reasons: 1) Intel has recently fallen behind its rivals technologically. 2) The market prefers companies that outsource chip manufacturing and focuses more on chip design, a capital-light business.

Technological decline

In recent years, Intel has fallen behind the technological curve. I think this is temporary. The market seems to think it is permanent.

In July 2020, Intel announced that their 7-nanometer chips (nm – nanometer is a metric for measuring the size of transistors on the chip & smaller is better) were behind schedule and wouldn’t be released until 2022. In contrast, Samsung and TSMC have already transitioned to 5 nanometer manufacturing, making it clear that Intel is falling behind the curve. The delays mean that Intel will temporarily fall behind rivals AMD and Nvidia, who will likely gain more market share in the next couple of years. After the announcement, Intel shares fell by 9%.

Additionally, Apple announced that they are ending their reliance on Intel chips. Apple computers have used Intel chips since 2005. Apple is going to start using its own chips. Microsoft is making a similar move and announced that they are going to use their own chips in their products.

The perception in the market is that Intel is falling behind, squandering their cash flow on buybacks while they lose their competitive position, mirroring the similar decline of IBM.

Meanwhile, Intel spent $13.3 billion on research & development in 2019. This compares to $2.8 billion for Nvidia, $1.5 billion for AMD, and $3 billion for Taiwan semiconductor.

For all of the concerns over Intel’s loss of their competitive position, they still spend more on R&D than anyone else. They aren’t squandering their future to buy back stock and pay dividends, which is the popular narrative. This R&D spend has obviously been misspent – but the cash is available to make better chips.

Additionally, revenues, earnings, and cash flows have not declined. Through all of this, Intel has been consistently growing. 2020 was actually an excellent year for Intel, as lockdowns boosted demand for PC’s and Laptops.

Intel still has the dominant position in the PC market. Their revenues massively outpace that of any of their rivals.

They are pushing for faster and better chips. They aim to create 1.4 nanometer chips by 2029. Chip design & manufacture is an arms race and the key driver of that arms race is the money spent on R&D. I think that the company spending 375% more on R&D than the next rival will eventually be able to make a better chip.

In-house fabrication vs. a focus on design

Intel designs & fabricates computer chips.

The market prefers chip companies that don’t fabricate their own chips, like Nvidia, who outsources their manufacturing. Designing chips is a more profitable business than manufacturing them.

This is why Nvidia is rewarded with an EV/EBIT multiple of 86.2 and Intel with 8.96. This vast difference in valuation shows a simple narrative: Intel is a dying company and Nvidia will eventually dominate.

Even with the “bad” business of chip fabrication, Intel sports excellent margins. It currently has an operating margin of 32.8%, compared to Nvidia at 26.1%. With that said, Nvidia has significantly higher ROIC because chip design is more capital-light. Nvidia’s ROIC is 51.7% vs. Intel’s 21%.

This is why the market wants Intel to focus more on design.

Dan Loeb has recently announced a significant position in the stock and is pushing Intel to make strategic changes. This is why the stock went up 5% after Loeb’s activism was announced.

Management was already moving in the direction of outsourcing more production. Bob Swan is relatively new and is changing course from the management of the last decade, which oversaw the erosion of Intel’s competitive position. Management indicated recently that the “Ponte Vecchio” graphics chip may use outside factories, for instance. They also announced that they plan on outsourcing more manufacturing to TSM, another chip stock that has gone parabolic in 2020.

If that’s why they wanted to do, anyway – then I think Loeb’s activism will easily push them in a positive direction.

Prospects

I think it’s a fairly safe bet that Intel will pursue a strategic change, particularly considering that it was already considering going in a different direction.

It also seems unlikely to me that the company spending 375% more on R&D than its next competitor will remain behind the curve for long.

In addition to making faster chips for x86 style PC’s and servers, Intel is also acquiring smaller companies. Mobileye, for instance, is an important subsidiary. Mobileye is focused on self-driving car technology. Intel is also making significant investments in artificial intelligence, covered in this article by Fast Company. Nvidia has positioned itself as the AI leader, but I think Intel can catch up.

The incentives are strong to turn this situation around and Intel has the cash to make it happen.

They have fallen behind technologically and management has failed to execute over the last five years, but I don’t think that any of this is fatal or permanent.

Moat

Does Intel have a moat that defends it from competition?

I believe it has a moat. With that said, it isn’t as strong as other companies I have purchased recently like General Dynamics. The moat is also currently under attack, which is why the stock sells for a such a cheap price.

Intel’s moat is derived from its scale and tight relationships with the dominant manufacturers of PC’s.

Even with its recent manufacturing issues and the upcoming loss of Apple, it remains the top chip company. Intel did $71 billion in revenue last year. In contrast, AMD did $7.1 billion and Nvidia did $10.9 billion. TSM, which focuses on the manufacturing process, produces $35 billion in revenue. Intel is overwhelmingly the dominant player.

Competition is nothing new for Intel. It has battled AMD for decades. The sheer scale of Intel’s design & manufacturing capabilities gives it a cost advantage over its rivals and usually this results in Intel’s victory. Additionally, because x86 is the primary architecture for most PC’s, Intel’s dominance gives it a foothold there.

The recent worries over Intel losing customers is another major reason that the stock is down. Apple, for instance, used Intel chips in their PC’s and will use their own chip design in the future.

With that said, Intel still has relationships with the dominant sellers of PC’s. As of 2019, Apple represented only 7% of the PC market and is a relatively minor player. The big ones are Lenovo (24%), HP (22.2%), and Dell ( 16.8%). A bulk of all of these products run on Intel chips.

Of course, Intel can’t rest on that dominant position, as the world is subject to rapid technological change. Intel needs to use its scale and cash flow to solidify its future.

Recent manufacturing issues aside, I think that Intel is committed to maintaining its competitive position in the future. This is probably best reflected in its R&D budget.

The scale and vastly superior size of Intel’s R&D budget gives it an advantage over rivals. The stock is now selling for a cheap price because this is in question, but I fail to see how Intel’s overwhelming $13 billion annual spend on R&D won’t eventually result in them winning. This is a war and the company with the most troops (dollars) should ultimately win. Any innovation in this industry is going to be quickly commoditized. It’s a constant fight to develop the best and fastest chip. Intel’s R&D spend ought to get them there, even though they’re suffering temporary setbacks.

Intel’s acquisition of AI and self driving businesses also shows a commitment to their future: like Mobileye and Habana Labs.

This is not a company squandering its competitive position on buybacks, which seems to be the consensus view in the market.

Quantitative Considerations

Intel has a high degree of financial quality. The Z-Score is 3.54, implying that they have practically zero chance of going bankrupt in the near future. Debt/equity is only 49%. Return on equity is 29.5% despite the low leverage. With an M-Score of -2.88, there are no signs of earnings manipulation.

It seems unlikely that the stock will deliver negative returns over the next 10 years, unless they are completely overtaken by competitors.

Shareholder yield is high. The dividend yield is currently 2.53% and share count was reduced by 5% last year. They also have the margins and cash flow to sustain this yield that without ruining their business.

Intel isn’t operating in a declining industry. They are simply losing ground to rivals. It seems likely that semiconductor demand will be higher in 10 years than it is today.

Between EPS growth and shareholder yield, it seems likely that Intel stock could deliver a 10% CAGR over the next 10 years without any multiple appreciation.

With that said, at a 8.96 EV/EBIT multiple, I think a multiple re-rating is likely. Companies like Nvidia trades at 83x and AMD trades at 99x because they have temporarily leapt ahead. TSM trades at 27x. If the multiple re-rates, then the CAGR should be a lot higher than 10%. A 20x multiple seems reasonable for a high ROIC company with a dominant competitive position.

All of this said, I don’t have any special insight or knowledge into the chip industry. What I do understand is that 1) the incentives are there to turn this around (Bob Swan just became CEO in 2019 and seems determined to change course. The company is now attracting activists like Loeb), 2) the money is there to turn this around, 3) chip demand is not an industry in secular decline, 4) despite its trouble, Intel remains the dominant chip manufacturer with overwhelming financial resources to stay dominant.

Intel strikes me as a wonderful company at a wonderful price.

There is a leap of faith involved here. Faith is needed to believe that Intel will be able to turn around a deteriorating situation. I think they have the resources to do so. I think the incentives are there to do so. There is new management and activists are involved. The wonderful price is a result of the uncertainty. By the time that the uncertainty is gone, it will be 20x EV/EBIT and the opportunity to purchase a company of this quality will be gone.

Also, I think it’s worth noting that I looked at Intel back in October and I actually passed on it. Loeb’s involvement changed my mind. Now that it is attracting activists like Loeb (and Intel is listening), I think that the risk/reward is compelling. I think it’s a situation comparable to Microsoft in 2012 or Apple in 2013. It’s a strong company with a lot going for it, but it has been mismanaged for a few years and will benefit immensely from some activism & change. It has the resources & incentives to turn things around.

Checklist

  • Can the stock deliver a 10% CAGR for the next decade? The dividend yield is currently 2.5% and it is sustainable. Intel consistently buys back shares and share count is down 5% in the last year. Revenues grew over the last decade at a 7% rate. Even if that declines, a low growth rate combined with the shareholder yield could easily result in a 10% CAGR. Currently, the free cash flow yield is 7% and free cash flow is likely to grow in the future. At a P/E of 9, multiple appreciation on top of the growth & yield seems likely. It is easy to imagine how the stock could deliver a 10% CAGR for the next 10 years, if not more. Pass.
  • Has the business delivered consistent results over a long period of time? Despite the recent troubles, Intel has been able to consistently grow sales, cash flow, dividends, and earnings over the years. It is free cash flow generative. Pass.
  • Does return on equity consistently exceed 10% without the use of heavy leverage? Intel has averaged a 21.5% return on equity over the last decade with minimal leverage, passing my 10% hurdle. Pass.
  • Is management sketchy? Management has been transparent about the problems facing the company. The recent trouble has nothing to do with dishonesty or fraud. They aren’t shifty promoters or grifters. They aren’t obsessed with short sellers. Bob Swan strikes me as a competent and transparent leader who is committed to fixing the current situation. Pass.
  • Is the company financially healthy? Intel has a debt/equity ratio of 49%, which is low. The Altman Z-Score is 3.52, so no bankruptcy risk. M-Score is -2.88, so there are not any signs of earnings manipulation. Interest coverage is robust at 31. WACC is estimated at 4.5% and ROIC has averaged 19% for 10 years, so the company is not a net destroyer of capital. Pass.
  • Has the company consistently generated returns for shareholders? Is the industry in secular decline? The company has consistently generated positive returns for shareholders. Intel has generated a 11% CAGR since 2010. It returned only a 3% CAGR since 2000, but was in a bubble at that point. Chips are not an industry in secular decline. We will need more of them 10 years from now than we do today. Pass.
  • Has the company survived previous recessions? Intel did not report losses in earnings or negative free cash flow during the last two recessions. Cash & earnings declined slightly, but the company was never in any dire trouble. The stock drawdown was serious in the early 2000’s (80%), but this was due to the overvaluation of the stock, not the performance of the business. Pass.
  • Does the company have a moat? Intel has a moat in terms of its dominance of the still-dominant x86 architecture and tight relationships with PC manufacturers. Its scale also give it cost advantages over competitors. It has an overwhelmingly larger R&D budget than its competitors. However, Intel’s moat is under attack. With that said, I think that Intel has the financial resources to survive the current assault on its moat. With new management and activist involvement, it is likely that they shift their strategic direction. The current troubles are also a source of the compelling price. If I wait for the issues to be resolved, the “wonderful price” will likely be gone by that point. Pass, with reservations.
  • Is the stock cheap on an absolute and relative basis? EV/EBIT is currently 8.96, the P/E is 10, and the forward P/E is 11. The free cash flow yield is 7%. These metrics are cheap on an absolute and a relative basis. Pass.
  • If I was forced to hold the stock for 10 years, would I be terrified? I wouldn’t be terrified if I was forced to hold this company for 10 years. The industry isn’t in secular decline and the company is not a mall-retailer or Kodak-style melting ice cube. Intel is financially healthy, so I think the possibility of a bankruptcy in the next 10 years is approximately zero. They’ve shown resilience in past recessions, so I would be comfortable holding through a nasty recession. The stock isn’t expensive, so I don’t think it can be destroyed by multiple compression if interest rates go up or if the broader market embraces reason. While they could see their moat erode over the next decade, I don’t think that this is an investment which could result in a permanent loss of capital or suffer a catastrophic drawdown. Pass.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

General Dynamics (GD)

Key Stats

Price/Earnings = 12.6

Price/Sales = 1.1

EV/EBIT = 12.6

Debt/Equity = 119%

Return on Equity = 27.5%

Company

General Dynamics is a 121 year old defense contractor and private jet manufacturer. They have manufactured US military staples such as the M1 Abrams tank. They are also the original designer of the iconic F-16 fighter jet.

The US government is their biggest customer and most of their business is locked-in via long term contracts.

Not only do they have ongoing contracts to build new hardware for the United States government, but they are also responsible for the ongoing maintenance of the US arsenal. That’s about as steady a stream of business as you can get in this world.

The US government is their main customer, but it’s not their only customer. 66% of revenue is derived from the US government, 9% from foreign governments (they produce the British army’s AJAX armored fighting vehicle, for instance), and 25% is from their commercial aviation business (Gulfstream jets).

The commercial aviation segment (Gulfstream aerospace – which they purchased in the late ‘90s) is the cyclical part of the business, but it is only 25% of revenue. The cyclicality of that industry isn’t something that can sink the rest of the company. If this was the sole focus of General Dynamics, this would be a terrible business to own due to its cyclicality. With that said, when times are good, it’s a fine business to own with decent profit margins (operating margins were 17.6% in 2018 and 15.6% in 2019). Another nice aspect to this business is that the contracts to build the aircraft are often locked in, so the revenue doesn’t disappear overnight during a recession.

The defense segment is split up into Combat Systems, Information Tech, Mission Systems, and Marine Systems.

Combat Systems ($7 billion in revenue) mainly consists of land-based vehicles, such as tanks. They also produce arms, such as machine guns and grenade launchers. A key vehicle produced by this division is the Stryker armored personnel carrier.

Information tech ($8.4 billion) is primarily IT work for the United States government. They provide cyber security for the Pentagon and are migrating DoD applications to the cloud. They also provide services for the US government beyond defense, such as their $2 billion contract to manage the US state department’s supply chain.

Mission Systems ($4.9 billion) are navigations and communications equipment.

The marine unit ($9.1 billion) is a critical source of growth for the company. GD is the US government’s lead contractor in the production of the Columbia class submarine, the latest generation of nuclear subs. They also manufacture destroyers, support ships, along with many other vessels. They also provide ongoing maintenance and parts for the fleet.

Valuation & Financial Quality

General Dynamics generates high returns on capital and strong margins. This is because its biggest customer is the United States government and defense contractors are essentially an oligopoly.

Returns on capital are excellent. Return on invested capital was 18.8% last year. They have maintained high returns on capital consistently for a long period of time. Returns on invested capital have averaged 17.6% for the last 20 years. To put this in perspective: Facebook has a return on invested capital of 17.7% and Google has a return on invested capital of 18.7%. Of course, GD is never going to grow as fast as Facebook or Google, but I think the comparison gives perspective into how profitable their business is.

With the exception of the decline in 2011, operating profits experienced explosive growth during the 2000’s when the Iraq and Afghanistan wars began. They have remained elevated and grown slightly even as those wars have slowed.

Even though growth in operating profits has slowed a bit, earnings per share and free cash flow per share have continued to march higher thanks to share buybacks (share count is down roughly 25% over the last decade). They also return capital to shareholders via dividends. The stock currently has a 3% dividend yield, and dividends have steadily increased throughout its history (General Dynamics is a “dividend aristocrat”). The company has a good track record of returning capital to shareholders.

General Dynamics operates with a high degree of financial quality. Debt/equity is reasonable, at 119%. The Z-Score is 2.74, showing low bankruptcy risk. The M Score is 2.5, showing no signs of earnings manipulation.

The valuation for General Dynamics is extremely cheap for a company of this quality. Currently, it trades at a 12x P/E, 12x EV/EBIT, and a price/sales multiple of 1.1.

This valuation isn’t as cheap as it was during the debt showdowns of 2011 when the P/E fell to the single digits (back when people thought the US government found spending religion – lol). It’s nowhere near as cheap as it was during the generational buying opportunity after the fall of the Berlin Wall.

Even though it’s not as cheap as it was back then, I think the stock can still deliver totally satisfactory returns from current valuations. I think that the valuation got a bit silly after Trump was elected, and has since come back down to Earth, as seen on a raw price/sales basis.

From a pure price action standpoint, sentiment is currently poor against General Dynamics. It is in a nearly 40% drawdown from its early 2018 peak.

The Moat

Defense contractors have a pretty obvious moat, which is why they all enjoy high returns on invested capital that aren’t competed away.

This isn’t an industry where they have to worry about new competitors emerging to challenge their pricing power. A startup in San Francisco called Subr isn’t going to start up tomorrow and start burning cash for 10 years provided by VC gamblers to make nuclear submarines and ruin GD’s business.

Plus, weapons manufacturing is not an industry that would attract modern ESG-minded disruption capital. That is more drawn to things like vegan hot dogs, solar powered lawn mowers, subscription services telling people how to do a push up, and putting random stuff on a blockchain.

If the US government wants high grade military equipment, then it needs to deal with the defense contractor oligopoly. Even if a big company was willing to throw $100 billion into competing in this industry, they would have a tough time. If they wanted to play in this game, they wouldn’t have the deep knowledge and defense-specific engineering skills to enter it. They would also need to build the manufacturing capability from scratch. They also would need relationships in the US government, which run deep for a company like GD.

Defense contractors like General Dynamics also enjoy extremely long term, lucrative contracts.

A good example of this is the Columbia class submarine. General Dynamics is currently locked in for production of the Columbia submarine through 2042. The Columbia nuclear subs will replace the aging fleet of Ohio class nuclear subs, which started production in the 1970’s. The government is going to spend roughly $110 billion to produce these subs, and General Dynamics has the contract. The Columbia class will start construction in 2021, and General Dynamics will be making them for 20 years. How many other businesses in the world have that kind of visibility into future revenues?

Companies like General Dynamics are also needed for ongoing maintenance and parts. Considering they have manufactured so much of the US military arsenal, that ought to produce a steady stream of business, too.

Growth Prospects

Eisenhower talked about the growing military/industrial complex back in 1960, and he was not wrong. The defense industry has been a growth sector for decades, even during the tranquil period of the 1990’s after the fall of the Soviet Union. Defense stocks tanked after the Berlin Wall fell, but the dramatic cut in defense spending that the market was worried about never really materialized. That was a generational buying opportunity which Warren Buffett bought into.

With that said, I think defense spending is likely to increase in the next 20 years beyond normal levels.

I believe that General Dynamics has a strong source of growth in a growing Naval race with the Chinese.

After the end of the Cold War with the Soviets, the United States had almost total naval dominance of the planet. The US has mostly left this naval dominance of the world on auto-pilot since the USSR collapsed.

Meanwhile, China seems determined to challenge the United States as the world’s sole superpower.

This is most evident in their efforts to build up their Naval power. They have been ramping up the size of their Navy. China currently has a 335-ship Navy (the US has 293 ships), 55% bigger than the size of their Navy in 2005. Nor is their Navy small potatoes: it includes 2 aircraft carriers and 12 nuclear attack submarines.

While the Chinese have more ships, the US leads in tonnage and global reach. That said, I don’t think there is any question that China is making a strong push to replace the United States as the world’s superpower. The US needs to deal with that and will deal with that.

The path to superpower status is the oceans.

The Russians are also expanding their navy. Putin has committed to building 51 warships and 24 submarines, including eight vessels carrying nuclear weapons.

For the first time since the 1980’s, the United States has serious Naval threats to contend with.

I don’t think the United States is going to sit idly by and allow this trend to go on forever. My guess is that the US will eventually wake up and start ramping up its Navy.

A key aspect of the US military build up will be building more ships. There are only two Naval shipbuilders in the United States right now: General Dynamics and Huntington Ingalls Industries. Both of these companies should benefit when the US begins ramping up its Navy, but I think that General Dynamics is the higher quality of the two companies. General Dynamics is more diversified beyond shipbuilding, so it should continue to do well even if my thesis about a Naval ramp up is wrong.

In a more general sense, the world is not becoming a more peaceful place. I have no idea what conflicts will emerge in the coming decades, but it seems like wishful thinking to think there won’t be any in the future. Whatever happens, it’s hard to imagine that there won’t be wars in the future and that General Dynamics won’t benefit from those wars.

Risks

I don’t believe that there is a significant risk to owning a 121 year old company whose main customer is the United States government, but let’s dive into some potential risk factors.

The main risk to General Dynamics is if the United States government curtails spending. (Please, try not to laugh.)

This happened after the budget showdown of 2011 and lasted for approximately 5 minutes and the US government returned to spending-as-normal relatively quickly once the D’s and R’s stopped posturing.

Call me skeptical, but I think that the risk of the US government finding spending religion is about the same as Charlie Sheen joining a monastery.

The defense budget could be targeted if a very left wing President won an election. The kind of person who spent a lot of time in college reading Noam Chomsky and Howard Zinn, for instance. I see this as unlikely. Joe Biden isn’t exactly Ralph Nader.

It was feared that Bill Clinton and Barack Obama would cut the defense budget, but it never happened. If Joe Biden and Kamala Harris were to win (which looks likely), I don’t think that they would cut the Pentagon, either.

It also seems like the political left is more concerned over domestic issues (like taxes, UBI, etc.) than they are about foreign affairs.

Personally, I think that there is a reason that all Doves-on-the-campaign-trail become Hawks-in-office. Once the new President sits down and sees the intelligence briefings, they quickly realize that the world is a nasty, violent, and dangerous place (probably more dangerous than the American people are led to believe) and change their tune.

The fact that the defense budget was hardly cut in the 1990’s – after the US’s main global adversary was vanquished and during the tenure of a Democratic administration – is proof that defense spending is here to stay. I think US military spending is going to grow even stronger now that China and Russia are ramping up their military and the United States will not allow itself to fall behind.

The other risk is that the United States faces some type of debt crisis where the US can no longer run massive deficits or enjoy its reserve currency status to print cash and spend recklessly. If that were to happen, the global economy will likely be a horror show, and I’d rather be invested in a company like General Dynamics instead of a company dependent upon the vagaries of the economic cycle.

The business jet segment is the part of the company that I like the least and contains the most risk, because it is cyclical, but it should perform well during economic booms and won’t eat the rest of the company during busts.

Overall

Overall, General Dynamics checks all of the key items on my checklist: (1) statistically cheap, (2) positive long-term growth prospects, (3) strong returns on capital, (4) a moat insulating it from competition and protecting those strong returns on capital, (5) financially healthy with low leverage, (6) a strong long term operating track record, (7) a track record of returning capital to shareholders via dividends and buybacks, (8) Not highly cyclical, and (9) I wouldn’t be freaked out if I wasn’t allowed to sell it for 10 years.

Random

Rest in peace, Eddie Van Halen. I loved your music and it inspired me to make many bad life decisions.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Enterprise Product Partners (EPD)

Key Statistics

EV/EBIT = 11.27x

Dividend Yield = 11.12%

Earnings Yield = 12.5%

Price/Revenue = 1.23x

Debt/Equity = 117%

The Company

Enterprise Products Partners operates pipelines throughout North America. Their pipeline infrastructure moves natural gas, natural gas liquids, and crude oil. They are the biggest midstream operator in the US, with $29 billion in revenue. The next biggest operator is Kinder Morgan, with $12 billion in revenue.

The heart of their pipeline network is in Texas, where they connect suppliers (like drillers in Texas & shippers in the Gulf) to end-users via their vast pipeline network, which stretches throughout the United States. They also operate storage facilities and processing plants. Currently, they own approximately 50,000 miles of pipelines.

Natural gas and natural gas liquids are core aspects of their operations. Natural gas is critical to US energy needs, supplying 38% of US electricity generation. Natural gas is also essential for heating. The United States boasts the largest supply of natural gas in the world. We are the Saudi Arabia of natural gas.

Natural gas liquids – liquids separated from natural gas as it is processed – are also crucial to the US economy. Natural gas liquids include propane, ethane, and butane. These are critical to our agriculture needs. Additionally, natural gas liquids are inputs in everything from tires to diapers.

Enterprise is like a hub at the center of the energy needs of the United States.

In recent months, traders destroyed the stock and the rest of the energy sector after the COVID energy shock. I think this company’s stock was crushed via guilt by association.

A return to its 52-week high would be an 80% gain from the current price.

My Take

Despite ESG investors’ wishes, hydrocarbons are here to stay for the foreseeable future and are essential to life as we know it.

Without hydrocarbons, life would not be possible as we know it. I think that ESG investors are creating opportunities (via forced selling) for those who are willing to take the plunge into hydrocarbons. ESG investors are behaving like we’ve invented matter/antimatter reactors harnessed by dilithium crystals when no such innovation has actually taken place.

My views caused me to take a hard look at companies in the hydrocarbon sector. I looked at a lot of duds. Highly cyclical (and leveraged) frackers burning cash and going bust at the slightest energy blow up. Even large and respected companies had significant amounts of leverage and dicey track records. I looked at many companies with high dividend yields and wasn’t sure if they could sustain it if the economy rolled over.

Enterprise was different. Enterprise strikes me as the best available opportunity in the energy sector. It’s a fantastic company with substantial advantages and the stock was sold off via guilt by association. In my opinion, it’s a wonderful company at a wonderful price.

The recent decline in energy consumption is temporary. Ten years from now, with modest growth, we will need more natural gas and oil and it doesn’t matter if your ESG fund manager wants it or not.

Enterprise has a formidable moat. No one else is going to spend the money to compete with their vast nationwide network of pipelines. Even if a competitor wanted to match their network, they would need to overcome regulatory hurdles. Every pipeline has to be approved by the government, and no one wants a pipeline in their back yard. Pipelines also benefit from network effects – the more you own, the more valuable your network is. I imagine regulatory approval will grow even more difficult in the future, especially now that “hydrocarbon” is a dirty word. This further insulates them from competitors.

As the biggest midstream pipeline operator in the US, it is also the best managed. This is best demonstrated by a comparison of profit margins. The moat gives it pricing power compared to the next biggest competitors.

Enterprise also establishes contracts with shippers when building a new pipeline, which can be for 15 years or more. They don’t build a new pipeline if the business isn’t already lined up and the existing pipelines have practically guaranteed streams of business.

The fact that no one can duplicate their network and they have long-term contracts with their clients creates a rock solid stream of business. Most importantly, it’s a rock solid stream of business that is resistant to competition.

The company is essentially an energy toll road, and as long as we continue to use natural gas, natural gas liquids, and oil – that toll road will continue to pay dividends.

Speaking of dividends, I was amazed when I looked at Enterprise’s dividend yield. It is currently 11%. I was more amazed when I realized it was sustainable and the company wasn’t employing significant leverage.

Usually, a very high dividend yield is a sign that something is wrong. It’s a sign of massive leverage, a dividend that will be cut, or a melting ice cube of a company. Enterprise is not a melting ice cube. This is a sustainable dividend yield that can continue even if cash flows decline significantly.

The durability of the dividend is best demonstrated by the track record. Enterprise has been able to increase the dividend each year for the last twenty years.

As for other metrics, the P/E is 8, and it trades at 5x cash flow.

Pre-COVID, Enterprise traded for a premium valuation due to its enviable position, strong management team, moat, returns on equity, and cash flow gushing assets. ROE has averaged 16% for the last 10 years. For most of the last ten years, it has usually sold in the 15-25x range, which seems right for a company of this quality. Currently, on an EV/EBIT basis, it trades at 11x.

Enterprise is also in healthy financial condition, with a debt/equity ratio of 117%. This is more than I typically go for (I prefer less than 50% for small caps, and less than 100% for large caps), but it’s conservative compared to the rest of the energy sector. The cash flows that Enterprise generates – even in recessionary years – are more than enough to sustain the company and the dividend.

At current prices, this is an opportunity to buy an 11% dividend yield that is sustainable and likely to grow in the future. The dividend is currently only 52% of EBITDA.

The main risk to Enterprise is a deterioration in the economy, which will reduce the demand of end users. Even if that were to occur, I doubt Enterprise would post actual losses. Even during the Great Recession, Enterprise continued to generate positive operating income with moderate losses in EPS. It continued to stay profitable during the energy bust of 2015-16. In Q2 2020 (the COVID quarter), they still posted earnings per share of $.47, suggesting that they will be able to handle further economic challenges.

In my opinion, this is a unique opportunity to buy a wonderful company at a wonderful price with limited downside risk, the potential for substantial multiple appreciation, and a fat sustainable dividend yield.

Of course, that doesn’t mean that there won’t be more short term pain. It’s possible that we’ll face further troubles in the economy. It’s possible that investors will continue to irrationally sell hydrocarbon stocks (while they sit in a home heated by natural gas, fly around in planes that guzzle fuel, use electricity generated by natural gas, eat food that was made possible by natural gas liquids, and have packages delivered to them via gasoline-powered trucks). There are a lot of short term potential troubles, but I think that this is a safe company to own for the long haul with favorable prospects. Even if pain occurs in the short run, an investor will continue to collect that nice dividend.

Random

Phil at at his best.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Charles Schwab Corporation (SCHW)

Key Statistics

Price/Book = 1.82x

Return on Equity = 14%

Earnings Yield = 6.67%

Debt/Equity = 38%

Summary

Charles Schwab has long been a financial industry powerhouse. With the merger with TD Ameritrade, it is going to become the dominant player in this market.

Schwab’s origins are as a discount brokerage. They offered cheap commissions for DIY investors. Perception around the stock is that this is what Schwab’s business still is. The truth is that brokerage commissions were a trivial component of Schwab’s business, which is why they were so quick to cut it to zero in an effort to clobber their competitors. They continue to make money on trading activity, via order flow. The financial media gets incensed about this, but I don’t think anyone really cares.

They cut commissions to zero to clobber their competition, which is rapidly disappearing. By merging with TD Ameritrade, the only serious challenger to their business is Vanguard. The sheer scale gives them the ability to cut costs and offer services at a lower fee. In my mind, this is a moat. They’re like Wal-Mart in 1990 taking on small mom and pop retailers, Clover, and Bradlee’s.

The stock is cheap for a simple reason: interest rates are low and investors think that will last forever. When clients leave cash in a brokerage account, Schwab offers the client little interest, and then they invest that cash in short duration fixed income products. With interest rates low, that income is reduced. There are also jitters about the merger with TD, but I think that the merger is only going to strengthen their competitive position.

My Take

I don’t think that the trend of investors cutting expensive mutual funds and expensive financial advisors is going to stop. There is a lot of money wrapped up in high fee financial services. As younger investors inherit that money, they’re going to invest it themselves and I think much of it is going to continue migrating to Schwab and Vanguard.

I don’t see how this trend stops. It’s hard to imagine how much of this money won’t migrate to Schwab one way or another.

There are challengers to Schwab, but I don’t see how they succeed.

There is Betterment, which offers robo-portfolios, but they’re a small player of an industry where scale matters more than anything. Additionally, an automated portfolio of asset classes tailored to age & risk tolerance isn’t an amazing innovation and it is easy to duplicate. In fact, Schwab already has automated investing portfolios of their own.

There is also E-Trade, but E-Trade is losing this war, which is why they sold to Morgan Stanley.

There is also Robinhood, but I think Robinhood’s emerging reputation as the home of Millennial and Gen-Z gun-slinging daytraders is not going to help them attract future capital, particularly after this insane market inevitably rolls over. It’s a reputation that they need to shed and I’m not sure if they will succeed.

I think Robinhood’s strategy is to lock in younger investors in now. Then, those investors will continue to accumulate assets as they save and inherit money – and they’ll keep it in Robinhood.

I don’t think it will work this way. My guess is that Millennial and Gen Z investors will see Robinhood as the wild person they dated when they were 23, but not the person that they’re going to marry.

The year is 2025. You’re 30 years old. Let’s say that you inherit $100,000 from a dead relative. Are you going to put it in Robinhood – where your 25 year old friend lost a bunch of money daytrading in 2020 and made a bunch of TikTok videos about it? No. You’re going to figure out a “serious” way to invest it. This isn’t $500 on an app that you’re fooling around with. This is $100,000. This is serious money. Your desire to invest “seriously” will probably lead you to Schwab or Vanguard.

If you don’t want to DIY it, then you’ll turn to Schwab or Vanguard for advice, which is a lot cheaper than hiring a traditional financial advisor. In fact, Schwab offers a flat consultation fee of $300 to set up your portfolio, and then they can roll it into one of their automated solutions for $30/month. This is where much of the Boomer & Silent money currently getting charged 1-2% of AUM in an ocean of high fee mutual funds is going to migrate to.

Here is another scenario. Let’s say you worked for a company for 10 years, you get a new job, and have a nice amount stashed in a 401-k. Let’s ask the same question: where are you going to roll over that 401-k into? Chances are it will go to two places: Schwab or Vanguard.

Are you going to entrust this money with a financial advisor at a bank? Boomers might have done this in 1989, but Millennials hate banks. They’ve had an adversarial relationship with banks for most of their adult lives. Banks are the institutions that charged them 30% on their credit cards and a $35 fee when they accidentally went over in a checking account because the Netflix renewal hit before payday. They hate banks and don’t trust them.

The irony is that Schwab is structurally a bank (they take deposits and earn interest on it), but that’s not how they are perceived, and they’re not an institution that most people have had a negative experience with. They’re not engaged in the risky behavior that many banks routinely find themselves making headlines for (trading scandals, risky loans, stupid nonsense with derivatives, clashes with regulators, breakdowns in risk & controls, aggressive practices). They’re not a bank that set up a fake account or that charged you a crazy rate on a credit card. As a result, Schwab is more reputationally sound than most banks.

The main worry with Schwab is over interest rates – which is the concern hanging over the entire financial sector. I see this as a temporary problem. Investors seem to think that interest rates will be low forever. They think this because of what the Fed tells them. In my opinion, the Fed’s word is worth very little. If inflation emerges as a problem, the Fed will be forced to raise interest rates. It’s hard for modern investors to fathom this because most living investors have invested during a 40 year period of declining rates.

Interest rates are obviously something out of Schwab’s control. Schwab should simply focus on increasing the size of the assets that it manages, which is something that will continue to happen naturally due to its size and reputation.

Over time, interest rates are going to do their own thing. Schwab should focus on what it can control: increasing the assets that it manages and scaling up the business. This lowers prices and eliminates competitors. This is exactly what management is doing.

Schwab is incredibly cheap relative to its history due to the interest rate worries and jitters over the merger.

For the last decade, it usually trades in a range of 2-4x book value. It currently trades at 1.8x book. Meanwhile, I think the book value will continue to grow. In terms of multiple appreciation, I could see this easily returning to 4x book value if interest rates increase even a little bit.

Meanwhile, over time, I think that secular trends will make that book value continue to grow regardless of what happens to rates.

Schwab has earned 10-17% on equity for the last decade (a decade of low interest rates), and I don’t see how that doesn’t continue in the future. If interest rates remain low, it will earn the low end of that ROE, while the equity will continue to grow organically.

This means that even without multiple appreciation, Schwab should offer a satisfactory rate of return over the next 5-10 years via increasing book value and strong ROE. With multiple appreciation, it will offer a fantastic rate of return.

I also look at the size, reputation, rock solid balance sheet, and strong management as factors that will prevent a permanent loss of capital and make this a safe long-term holding.

Random

I’ve been listening to a lot of Prince lately. 1984’s Purple Rain has to be one of the best albums of all time.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Biogen

Key Statistics

Enterprise Value = $48.05 billiion

Operating Income = $6.301 billion

EV/Operating Income = 7.62x

Earnings Yield = 12%

Price/Revenue = 3.49x

Debt/Equity = 53%

Free Cash Flow/EV = 13%

The Company

Biogen is a biotech firm. They sell high-margin drugs that treat a variety of different illnesses. Much of their pipeline is acquired through research & development and they also achieve growth through acquisitions.

They run a phenomenal business. Their gross margins are presently 87% and their operating margin is is 48%. Revenues & profits consistently grow every year.

Each of their blockbuster high-margin drugs has a similar lifecycle. Massive amounts of money will be spend for years attempting to develop a new drug. It’s uncertain if the drug will be successful. It’s also unknown if it will be approved. Eventually, if the drug is approved and it is successful, it will experience explosive growth. Eventually, generics will come along, and that will eat into the profit margins, and revenues will decline.

A good example of this product life cycle is evident in TYSABRI. TYSABRI is a drug that treats multiple sclerosis and Crohn’s disease.

TYSABRI’s life cycle is typical for that of many blockbuster drugs. It experiences explosive growth in the beginning. It may be approved for use in one country, then expands to others. As generics are released, revenues decline and revenues & margins start to fade away.

Therefore, a firm like Biogen must constantly invest in R&D to develop new blockbuster drugs that can serve as new sources of revenue.

Fortunately, Biogen accomplishes this. They have a rich research pipeline and are constantly developing new drugs and new sources of revenue, resulting in strong growth in revenue and earnings per share.

Due to Biogen’s rapid growth from 2010-2015 thanks to drugs like TYSABRI, the stock price and valuation experienced rapid growth in the mid-2010’s. In 2014, the company traded at an absurd multiple of 60x EV/EBIT.

Since those lofty heights, the multiple has contracted even while the company continued to grow. The stock price has mostly remained stuck in a trading range while revenues, cash flow, and earnings have grown.

My Take

Biotech stocks in the mid-2010’s went through a bubble. Thanks to their rapid growth and high margins, investors relished these stocks and bid them up to absurd valuations.

It is much like what occurred in the 2000’s to companies like Microsoft. At the peak of the internet bubble, Microsoft traded at a EV/EBIT multiple of 50. Throughout the 2000’s, Microsoft’s stock went nowhere even while the business continued to grow. The multiples continued to decline as the business grew into the valuation. By 2012, Microsoft traded at an absurdly cheap multiple of 7x EV/EBIT.

I think the same thing is happening with Biogen. Biogen was bid up into an absurd bubble. As growth began to wane for a bit, investors dumped the stock, but the business continued to execute. Now, it trades for a bargain basement multiple.

Biogen has multiple drugs at different stages of their lifecycle and they have a robust research pipeline, with multiple drugs in development. Drugs like TYSABRI are waning, but there are also drugs in earlier stages of their product lifecycle that are still growing.

Current drugs that are still growing are:

SPINRAZA (treats spinal muscular atrophy)

BENEPALI (treats arthritis), IMRALDI (treats psoriasis), and FLIXABI (anti-inflammatory, treats arthritis).

Biogen trades like it is never going to develop another blockbuster drug again. Fortunately, they have drugs that are currently in their growth phase of their development. They also have a rich research pipeline, shown below, with multiple drugs at various stages of their development.

One of the most promising drugs in development is Aducanumab, a novel treatment for Alzheimer’s disease. It has shown tremendous promise in clinical trials, which you can read about here. The FDA recently accepted Biogen’s application on August 7th and expects to reach a decision in the first quater of next year. You can read about this here.

If approved next year, Aducanumab is a potential catalyst for the valuation to rise again.

Even if that doesn’t happen, Biogen is a strong company at an absurdly cheap valuation with many different drugs in the research pipeline so that it can continue growing.

7.62x EV/EBIT seems like an absurd valuation for such a high quality company. There are retail stocks in secular decline that trade at this type of multiple. Meanwhile, the balance sheet is safe and there is a high degree of financial quality, limiting the downside risk. Debt/equity is 53% and the Altman Z-Score is 4.24, implying practically zero bankruptcy risk.

They are also aggressively returning capital to shareholders. Total share count has declined by 12% in the last year.

Random

I’ve been listening to a lot of Ladytron.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Friedman Industries (FRD)

deer

Key Statistics

Market Capitalization = $37.02 million

Current Assets = $69.29 million

Cash & Equivalents = $22.33 million

Total Liabilities = 12.68 million

Net Current Asset Value = $56.61 million

Operating Cash Flow = $3.47 million

Price/Tangible Book = 53%

Altman Z-Score = 4.66

Summary

Friedman is a steel company that has been around since 1965.

Their business is split up into two segments: coil products and tubular steel. Coil products account for 67% of revenue and tubular steel accounts for 33% of revenue.

Coiled steel is basically a form of sheet metal used in a wide variety of different industries. It can be used in the manufacture of automobiles, refrigerators, or roof gutters.

Tubular steel is used for a wide variety of applications. It can be used in the medical industry for stethoscopes or wheelchairs. Engines require tubular steel, which can be used in aircraft or automobiles. Steel tubing is also used in the manufacturing industry, to transport liquids throughout the process. It is also used heavily in the construction industry, for things like structural support or railings.

Friedman is a smaller player in an industry dominated by giants, but it has managed over the decades to continue to survive in a tough industry. Its plants are located throughout the Southern United States. The plants operate in Texas, Arkansas, and Alabama.

My Take

Friedman’s stock has been beaten up. It started to decline last year as a recession and reduced steel demand became more apparent. It hit a low of $3.72 during the depths of the COVID decline. I bought it yesterday at $4.9899. It has gone up significantly since the lows, but I still think it is relatively cheap. A return to the 52-week high would take the stock up to $7.01.

The stock trades below net current asset value, so I don’t expect it to be an outstanding business that is growing fast with high returns on invested capital.

With that said, in the universe of net-net’s (a world of reverse mergers and biotech science experiments), Friedman strikes me as a high quality net-net. In the last year, it has posted positive operating cash flow, so it is a viable business. The Altman Z-Score of 4.66 also shows a high degree of financial quality and limited bankruptcy risk. I’m confident based on the operating history and high level of financial quality that Friedman isn’t going to annihilate its current asset value, which can’t be said for many net-net’s.

The situation currently appears bleak for the steel industry. The customers for steel products are hitting hard times as a result of the recession. Construction and manufacturing activity are likely to slow down.

I think the hard times are already reflected in the stock price. At 53% of tangible book, this is near the lowest level that it has traded in the last 20 years. In the last five years, the stock usually trades in a range of 80%-100% of tangible book. When the steel industry was hot in the mid-2000s, Friedman traded at double tangible book value. I think it’s a reasonable assumption that this can return to 80%-100% range of tangible book, at which point I will sell.

If the economy returns to some semblance of normal, then construction and manufacturing activity will get back to normal. Coiled and tubular steel are essential for a number of uses that aren’t going away.

Meanwhile, steel plants are being shut down and steel production is down for the industry. This means that if demand returns back to normal, Friedman will be well positioned to take advantage of it.

If that doesn’t happen, then Friedman has the balance sheet and discipline to survive. It already trades at a price which indicates that there won’t be a recovery in the steel industry.

For those reasons, I think the risk/reward makes sense, so I purchased a position.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Village Super Market (VLGEA)

grocery

Key Statistics

Enterprise Value = $240 million

Operating Income = $20.8 million

EV/Operating Income = 11.52x

Price/Book = .99x

Earnings Yield = 5%

Price/Revenue = .25x

Debt/Equity = 33%

Summary

Village Super Market is a chain of grocery stores trading at book value and located primarily throughout New Jersey and with other locations in Pennsylvania, New York, and Maryland. The company has been operating since 1937.

They are a part of the chain where I buy most of groceries: Shop Rite. Peter Lynch advocated “buy what you know,” so I hope this works out for me.

The Shop Rite that I go to is owned by a different operator and not a part of Village, but Shop Rite is a well known grocery brand around New Jersey, Pennsylvania, Delaware, and Maryland.

Shop Rite is known throughout the region as having the best prices. I used to shop at one of their rivals and was able to reduce my grocery bill by 30% when I switched.

My Take

For the last few years, Village’s earnings and cash flow have been in decline. This is why the EV/EBIT multiple is higher than I typically pay and the earnings yield is lower.

However, the stock is cheap on a price/book basis in comparison to its history. It currently trades at book value. As recently as 2014, Village traded at 2x book value on a lower equity level. Back then, shareholder equity was around $250 million and it is $321 million today.

The decline in valuation has been during this period of declining operating income. It also experienced declines during the recent sell-off.

Why have earnings been in decline? I think this is due to the trend towards Americans eating out more. Recently, Americans spent more money eating out than they did buying groceries.

With the rise of COVID-19, this has now completely reversed and spending on groceries is surging. I suspect this is a trend that will continue. Americans will continue to purchase large orders of groceries to ensure that they have enough food if there is another lockdown.

I also think that Americans are likely to see the financial benefits of eating out less. During a time of recession and financial stress, they are going to gravitate more towards the grocery store than the restaurant.

Another factor that has been hurting Village is Costco. Personally, I used to exclusively shop at Shop Rite. In the last couple of years, I have bought more bulk items at Costco. I’ll buy things like bread and eggs at Shop Rite every week, and then make a monthly trip to Costco and load up on things like meat that I store in my freezer.

Lately, I stopped going to Costco completely. With the COVID-19 panic, Costco is so crowded that it isn’t worth the trouble. I’m willing to pay a little extra and just go to the grocery store and not have to deal with as insane of a crowd.

While I think the competition with Costco is likely to continue, I don’t think that they can replace the grocery store. For me, Costco is out of the way and is a bit more of an “event,” while going to my neighborhood grocery store is a quicker ordeal.

Additionally, I believe that COVID-19 is going to break the trend towards restaurant eating.  I don’t think that Americans are going to go full-throttle back into their old routine.

Meanwhile, I suspect that grocery stores are about to experience a significant boost in sales and earnings, which should justify a higher multiple. Here is an image from my Shop Rite a couple weeks ago:

aisle

It seems to me like this kind of sales volume should justify a better multiple of sales and book value.

Moreover, no matter how bad this crisis gets, grocery stores are going to remain open. They’re as essential as you can get.

In short, Village is a company whose business has been positively affected by COVID-19 and yet it still trades at a very low multiple of sales and book value.

Additionally, even if this thesis is incorrect, the company has a strong and liquid balance sheet. Debt/equity is only 30%. They have $75 million of cash on hand. The Z-score shows a low probability of bankruptcy at 4.36. The Beneish M-Score shows a low probability of earnings manipulation at -3.5. I also take comfort in the company’s long 83 year history of operation.

Random

This is a New Jersey stock, so it’s only appropriate that I post a New Jersey song from the Boss.

 

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

American Outdoor Brands (AOBC)

Key Statistics

Enterprise Value = $670 million

Operating Income = $32.3 million

EV/Operating Income = 20.74x

Price/Book = 1.06x

Earnings Yield = 3%

Price/Revenue = .77x

Debt/Equity = 53%

The Company

American Outdoor Brands is a firearms manufacturer. They sell handguns, long guns, handcuffs, suppressors, and other firearm-related products.

Brands include: Smith & Wesson, M&P, Performance Center, Thompson/Center Arms, and Gemtech brands.

My Take

AOBC is not cheap on an earnings yield or EV/EBIT basis. This is because earnings are at a cyclical trough. Gun sales have been very poor for the last few years, and gun manufacturers have been punished accordingly.

The Obama Presidency was very good for gun sales. Gun enthusiasts bought up guns like crazy because they were worried about Obama imposing new gun regulations. Of course, the regulations never happened. This created a bonanza of earnings, cash flow, and sales for the industry.

At the peak in 2016, AOBC traded at a price/book ratio of 6x. Price/sales was 2x.

Then, the Trump Presidency came along and gun enthusiasts were no longer scared of regulation. Gun sales slowed.

Meanwhile, in the face of slowing gun sales and the recent bear market, AOBC shares were crushed down to below book value. Recently, all stocks have been dumped regardless of their prospects. The stock has also been punished in recent years due to the ESG fad, in which ESG investors don’t want to have exposure to an ugly industry like firearms manufacturing.

Unlike most of the economy, the firearms market now has excellent prospects. Last month, there was a 41% increase in background checks. Due to the Coronavirus panic, firearms sales are surging. I believe they are going to surge beyond the extremes experienced during the Obama Presidency.

This suggests higher multiples for AOBC. I don’t see why the multiple can’t expand back up to a price/book of 6x from its current 1x multiple. It could also expand up to its 2x price/sales multiple, on likely higher sales. I think there is potentially a 200% upside to the stock from current levels. The market seems to be catching onto this quickly. The stock is already up 15% from my purchase price while the rest of the market is going down this week. I expect this to continue.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

RMR Group (RMR)

winter

Key Statistics

Enterprise Value = $634.49 million

Operating Income = $205.54 million

EV/Operating Income = 3.08x

Earnings Yield = 10%

Price/Revenue = 1.04x

Debt/Equity = 0%

Free Cash Flow/EV = 27%

The Company

RMR Group is a property management company. They manage properties for REIT’s and and other real estate companies. They have been operating since 1986 (under a different name – REIT Management & Research) and manage properties in 48 states throughout the continental US.

Four of RMR’s REIT clients are: Industrial Logistics Property Trust (ILPT), Office Properties Income Trust (OPI), Senior Housing Property Trust (SNH), and Service Properties Trust (SVC). ILPT manages industrial & logistics properties, SNH manages elder care facilities (a growth industry based on US demographic makeup), SVC manages hotels.

Other clients include Travel Centers of America, a company with $6 billion in revenue operating truck stops throughout the United States. Five Star Senior Living is another client which operates elder care facilities.

My Take

The nice thing about all of RMR’s clients is that they are unlikely to be disrupted. The elder population is growing in the United States and they are all going to need medical care and housing, no matter what happens to the US economy. Truck stops and industrial parks might decline with an economic downturn, but they aren’t going away. Office properties are probably the most prone to disruption with the expansion of remote work, but that’s not going away entirely.

Not only are RMR’s clients unlikely to be disrupted, but RMR has *20-year contracts* in place to manage them. I believe a 20 year contract can be categorized as a moat. The key base management fee that they earn is .5%, which is based on market cap plus the value of the real estate. On top of that, RMR earns an incentive fee which is tied to the 3-year stock performance of the companies that it services. The management fee is steady and isn’t going anywhere. Meanwhile, when the stocks of the underlying REITs outperform, RMR earns an incentive fee on top of that.

Quantitatively, this is as good as it gets and it checks all of my boxes. It’s selling at an EV multiple of 3x, a 27% free cash flow yield, and at annual sales. The operating cash flow is $198 million, which compares favorably to the enterprise value of $635 million.

They post high returns on capital. The return on equity is 28%, and that appears to be sustainable based on the consistency of the management fees.

The balance sheet is in impeccable shape. Out of the current $46 price, $22.20 is cash. They have zero long term debt. The Altman Z-Score is 6.4, which implies a zero chance of bankruptcy.

The base case is that RMR itself has 20-year contracts in place with their key clients and they will continue to earn the base management fee. The potential upside is that the stocks of the managed companies wind up outperforming. In this situation, RMR earns more incentive fees.

The stock is currently cheap due to concerns about the REITs that it manages. The REITs have a lot of debt. OPI has a debt/equity ratio of 164%, SNH is 127%, SVC is 180%, ILPT is 97%. A few of these companies lost money in the last year and the stocks underperformed. Leverage isn’t uncommon in the REIT industry and cash flows are fairly predictable, so I am not overly concerned.Meanwhile, much of RMR’s earnings are tied up in the performance of these stocks. When those stocks underperform, it weighs down RMR with it.

Something else that probably weighs down the stock is the control of a single individual, Adam Portnoy, who controls a majority of the company’s voting stock. Not only does Adam Portnoy have total control over the company, he also serves as managing director and CEO. Investors can look at this in two ways: you have an owner-operator committed to increasing the stock price as much as possible, or you have an owner-operator who has more power than shareholders. The concerns likely weigh on the stock.

RMR has only been trading since 2015, but it is at a discount to its history and its competitors. It is currently the cheapest it has ever been. As recently as 2018, the stock traded at 3.5x sales and it currently trades at 1x sales.

Overall, this looks to me like a compelling bargain with a predictable business. The potential upside far outweighs the downside, which I think is further limited by the company’s strong balance sheet.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Principal Financial Group (PFG)

iowa

Key Statistics

Enterprise Value = $13.1 billion

Operating Income = $1.725 billion

EV/Operating Income = 7.59x

Earnings Yield = 9%

Price/Revenue = .95x

Debt/Equity = 28%

Price/Book = 1.02x

The Company

Principal Financial Group is an Iowa based asset manager and insurance company. Their current AUM is over $700 million. They company has grown premiums and AUM (along with fee income) rapidly over the last decade, with revenue rising from $8 billion in 2009 to $14 billion today.

The company is global in scope and operates all over the world. The business is split up into four segments: (1) Retirement & income solutions, (2) Principal Global Investors, (3) Principal International, and (4) US Insurance (life insurance is a key focus).

The valuation is likely depressed over concerns about fee income, along with the general gloom around the financial industry as the market expects interest rates to decline and there are jitters about a recession which I wrote about here.

My Take

PFG currently has a dividend yield of 4.1% and the share count has declined by 2.67% in the last year.

PFG is cheap relative to its history and its peers. It currently trades slightly below sales, which is where it was around nadirs in the valuation such as when it was emerging from the financial crisis. It is also trading at book value for the first time since 2013. The 5-year average price/book ratio for the stock is 1.41 and the average price/sales ratio is 1.25.

Like the other financials that I own, my expectation is that the valuation gap will eventually close and while I wait for that to happen, I’ll earn a decent shareholder yield.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.