Saturday, May 30, 2020
A few good investing websites
I honestly am trying to spend less time on "newsy" investing sites and focus more on fundamentals and thinking as we approach a "4th Turning" crisis period. Alas, crisis periods are nearly impossible to "invest" in in the normal sense - extrapolation and prediction are nearly impossible because there are so many macro factors that are likely to get resolved in one big cataclysm; the outcome of which is largely dispositive as it is really unknowable. Inflation or deflation? Empire or tributary dependency? Heavy industry, physical assets, or intellectual property? Legal, economic, environmental, political systems - all up for grabs.
Few strategies work well and unlike the later states of the prior crisis period, securities are not dirt cheap. The right strategy in 1937-1938 was to buy net nets, which were plentiful. Today, they are hens teeth, so the downside of being wrong is much much larger.
Anyway, some things you might want to check out:
- The writings of famous investors on Austin Value Capital
- The ideas on Clark Street Value
- The smart guys at Oddball Stocks
- The "cousins" at NoNameStocks
- Dave Waters at OTCAdventures
Not saying these are ways to invest, but they are places to think about the discipline AND get some stuff to sift through.
Recognize that most of the investors at Austin Value Cap were born in a fortuitous period from 1916-1930. Most of the great generation of post war investor-allocators were from this period, because you had your early career largely after the war and could accumulate significant assets cheaply from the 1940s to the mid sixties (Graham style investing) then buy compounders with strong yields in the 1970s and then sit back and let the twin tailwinds of lower taxes and lower yields drive the portfolio value into the stratosphere. Not saying these aren't smart people, just that Ben Graham, who was quite a bit older, did much less well because he was born at the wrong time to have the strategy truly work for him; he died before the really big revaluation could work it's magic.
Friday, May 29, 2020
What happens to Core Molding (CMT) from here?
Core Molding Technologies is an SME focused on plastics and structural foam molding that has emerged through a series of solid acquisitions, from the heavy trucking industry. Starting in 2018, the company was hit with twin challenges of operational weakness and balance sheet weakness. It has been fighting back ever since, but the stock price collapsed - barely exceeding $1 at the depths of the Covid-19 market panic in March. The price has bounced back since, what is likely to happen now?
I will spare you the suspense - I believe that the price is likely to rise, and sharply, from here. Why? Because of several cash generating levers that we are likely to see that will mitigate much of the "risk" to the lenders, who will therefore be likely willing to refinance the company, after they exact the pound of flesh that always attends distress guys.
Rarely do I take this view - almost always distress debt and NOLs lead to more distress and more NOLs until at some point, the business is sold, the assets or sold, or the whole thing is refinanced with debt being swapped with equity. For much of the past 12 months, it has been hard to see which way this was likely to play out, but several recent developments have indicated that the business is likely to survive intact with the equity surviving as the successful fulcrum security.
There are multiple reasons for this - the first is that the company competes as part of an oligopoly in its core market segment: plastic and lightweight composites for transports, particularly heavy trucking. The heavy trucking industry itself is quite concentrated - in North America there are four major players (Navistar/International, PACCAR, Volvo and Daimler Trucks); in Europe, you add Volkswagen/MAN and Fiat/Ivecco, but lose Navistar and in Asia you have a few other firms. However, each of these geographies is actually quite separate as are many of the supply networks, because the physical transport costs are significant. Sure, small parts like nuts and bolts are largely globally competitive, but air shields and panels and such are hugely expensive to ship if you have to pack them in containers and float them across an ocean; they take up too much space. It is far more efficient to ship raw materials to a factory co-located or at least near to the final production facility.
Companies being what they are, three competitors are essential to pricing and development strategies. Each of the four North American producers does business with each of the three suppliers (CMT and its competitors). The ecosystem is balanced in this way, and so everyone can earn ok profits and returns on capital over time; it would be unhelpful to the manufacturers to drive bargains that push prices below economic returns, because starving your suppliers means that they cannot invest in your future. This is how CMT managed to be profitable from 1996 to 2017 in all years except one (no credit for guessing that it was 2001, not 2008 or 2009 that was the unprofitable year). This sort of stable business that allows for very careful planning of capex is a source of competitive advantage and allows for very solid returns on equity and capital (high teens) over a cycle.
Moreover, we know that CMT has historically been a solid operator - a few years back, CMT landed a huge increase in business when a competitor irked one of the big four producers and had some programs shifted to CMT.
CMT has also historically been quite conservative in finance. I attribute much of this to the board - who are all old corporate operators with conservative corporate finance perspective. CMT was actually a spinoff of Navistar (in 1998). They have chosen to avoid balloon payments on debt (though the current debt does have a balloon, but it is many years out and CMT has adequate time to earn enough to meet the balloon).
Prior to COVID putting a hurt on operations, the company was earning solid returns; overall 1Q20 results were good, in spite of slow sales at the end of March. 2Q20 will be weaker, and yet, plants restarted in May and trucking has continued apace. Moreover, several new lines of business from the acquisitions of CPI and Horizon actually were up in 1Q20 over 1Q19; so there is some buoyancy in their end markets. (I estimate that heavy trucking clients actually represented only about 50% of sales in 1Q20, so diversification is happening).
In spite of what will be no doubt weaker sales and weaker profits from negative absorption of fixed assets and expenses, there might still be surprising cash generation in 2Q - lower sales in the past have been cash generative as receivables are collected and inventories are reduced. The strong paydown of payables in 1Q20 means that working capital actually expanded, providing more scope for reduction to align with lower sales levels going forward. If there is solid cash generation in 2Q, the receipt of $6m in tax refunds, it seems likely that the company can completely repay its $7.8m in revolver debt by 3Q20. The large tax refund is a benefit from the CARES act, which provided the company with a farther "look back" period for applying operating losses; usually these can be applied back one year and forward 20, under CARES, I believe they can look back 3 years. This allows the company to apply losses against profits from a period when corporate taxes were higher, as an added bonus.
Since it is clear that the company will be able to make its payments, there is little incentive for the lenders not to offer forbearance a bit longer, continue to benefit from a penalty default rate and get re-liquified in the inevitable refi, or agree to do the refi themselves and get the origination fees on top. I need to be clear, the issue is actually not the repayment; I don't believe anyone can expect that the company cannot repay. The issue is that the debt has covenants promising certain levels of profitabilty which, due to operating weakness, have been violated.
In any case, as I say, I expect that the debt will be refinanced and when an extension of the forebearance is announced, that the stock will rise further, and with a refi, that the stock will return to something approaching book value. I make this assessment, because of the solid profitability that the company generated on an operating basis with a much lower level of revenue in 1Q20. This is a strong sign that the operating improvements the new management have been putting in place are working, indeed, have worked, and that profitability in a normal operating environment, which should see revenue north of $70m a quarter will be incredibly strong. Gross margins were nearly 17% with $64m in revenue. With $72-75m they should exceed 19%. If SGA return to 2019 levels for similar levels of revenue, operating profit would be somewhere around $6.5m a quarter (with 7,778k shares out). Annualized, this is operating profit of around $26m, lower debt balances and lower interest rates could take interest costs down around 250 basis points, which could actually lower interest expense below $1m annually. Allow $1m and you still have PBT of $25m and income tax expense of 21% puts profits a shade below $20m, vs let's call it 8m shares out (it is less). $2.50 a share in profits. For a cyclical, is that worth 10x? 12x? As a firm with a solid history of good deals, increasing success at diversification from traditional verticals AND steady expansion of customers, products and manufacturing capabilities - could it be worth 15x? Maybe that is a bridge too far, but a stock price approaching $30, call it $28 seems like a 7x return from here in say, 18 months?
Management and the BoD have persistently made open market purchases throughout the last several months and quarters in spite of - nee, because of - the market weakness. They have been signalling, I think, that they are not worried about being able to be refinanced. This has continued into COVID. The CEO and COO filed form 4s earlier this month after 1Q earnings dropped and they had a window to make purchases.
There are risks, of course.
First off, there are the macro factors. COVID could lead to some sort of permanent shutdown. Also, I believe that we are likely to find tax rates being hiked to address the fiscal situation - a conflict, a military conflict, that is, likely with China, might be the proximate cause, but when it happens, it will be swift and sharp. That would certainly change expected yields.
Moreover, CMT, though an AMEX (NYSE MKT) stock and not a big board company, will still get hit. I am old enough to remember when the Wiltshire 5000 actually had 7800 stocks (to represent the "total [listed] market". Now I think it barely has 3300; so concentration in listed stocks has increased beta. Macro factors seem likely to persist. On the other hand, trucking might have certain tailwinds in a conflict and CMT might benefit.
Also, there are macro tailwinds in the form of autonomy. While the excitement and enthusiasm for self driving vehicles is overhyped, particularly in passenger cars, trucking is where much of the investment is among the majors. This makes sense - in the early days of autonomy, much monitoring will be required; planned routes and logistics infrastructure will provide the means of that monitoring and the economics of lower operating costs will provide much of the investment dollars needed. CMT doesn't have a huge spare parts business, but new truck programs and sustained high volumes as the fleet is turned over would provide a sustained tailwind enabling sustained high levels of utilization. The cash could be used to make further acquisitions that could provide diversification and reduced cyclicality when the secular tailwinds abate after say, a double long cycle.
The bigger risks are probably micro. As I have noted, the firm itself has certain protections from existential competition given the need of all four manufacturers to have a reliable local supply chain. It is possible that some Asian or European firms could make a transplant; buying a competitor, for instance and potentially driving down certain R&D costs, or leveraging global purchasing arrangements - given the fact that Daimler and Volvo are both Europe-based and between them represent a majority of NAFTA production, this is always at the back of my mind. On the other hand, if the economics of this were really that attractive, that sort of consolidation would likely have occurred. Management at CMT does not seem to believe that geographic expansion makes any sense, given their specialties.
A bigger risk, perhaps is in some of the newly acquired business, because some important revenue lines derive from cases where CMT is a tier 2 supplier and not only at risk for their own performance, but also for that of the tier 1. Horizon Plastics, the deal that nearly broke the company (in spite of a significant amount of equity used in the purchase in the form of cash on hand) has multiple business lines, among which are plastic fencing sold through big box home improvement stores. You know it - the white, plastic 1/2 in or so, lattice fencing that is used mostly for cosmetic purposes. This product is considered part of the "wood" category, so the category manager always has to find a supplier for it, as the category manager is sometimes booted from one of the stores. In fact, CMT/Horizon benefitted from just such a situation - where the competitor was ejected and 100% of the business was awarded to the tier 1. This situation is likely to reverse - given the situation there is considerably more tail risk that we might want. Better for a firm like CMT to know that you will get between 40 and 60% of the business than 0 or 100%.
Operations could continue to be a challenge - although these really seem worked out and I have personally been impressed with David Duvall and Eric Palomaki (CEO and COO, respectively). I believe they are earnest, hardworking and smart and full of integrity. Ironically, COVID may again be a tailwind here. The operational problems that were encountered late in 2018 stemmed from a set of misjudgments by management - misjudgments that were understandable. Trucking usually operates on a 7 year cycle, with five great years and two crappy ones. After what was a long up cycle into 2016 management and the industry anticipated weakness for 2-3 years. They were right in 2017 and had already made adjustments to hiring, staffing and capital investment, adjustments that saw profitability remain strong in a down year. They were caught off-guard when the truck market rebounded without sustained weakness, and, with unemployment at 20 years lows, were unable to recruit to staff up to meet demand, overtime and expensive contract labor were required, hurting margins. Previous management had compounded this error by PPAPing a part that could not be manufactured reliably, requiring considerable rework and overtime and even so, delivery delays hurt production and clients - one client in particular - assessed penalties for failure to deliver which compounded the losses.
That mercifully seems to all be in the past. But CMT's specialty is in developing custom solutions, as when a part requires a custom fit and the integration of say a metal rod or component into the plastic. Problems with manufacturing could happen again.
Another question mark remains the CFO. He is clearly not dumb, but I sometimes wonder if he is wise. Back when the company had an IR team, I was told that he was brought in with three objectives: reduce costs, improve IR and complete deals. He has achieved these things to some extent, but not always in the best way.
He certainly helped reduce costs and raise profitabilty in the 2014-2017 period. I was genuinely pleased with the level of cash generation, though much of that sat fallow for years only to still prove insufficient to his ambitions. Thing is, I ask myself if those cuts weren't the real reason the company found itself so unprepared in the rebound of 2018. Some of htis might have been poor operating decisions by the former CEO, but how much of that was finance pushing for particular margin targets and forcing corners to be cut?
IR has certainly improved in certain ways. There is a good investor presentation on the website (link here). Moreover, Zimmer has always responded to my inquiries, for which I am appreciative. Moreover, he managed, through the operating difficulties, to provoke shareholders to attend the annual meeting for the first time in years in 2019. But not sure if that is really a good thing. He prefers to have individual calls rather than investor meetings or conference calls. The company does not present at any major conferences. This is in spite of doing deals that should have investors looking at the company less as a heavy truck supplier and more as a custom lightweight composites solution provider.
Finally, there are the deals. I actually liked both deals he did at the time he did them. CPI was a deal that was entirely debt financed, though, I am not sure that it earns an equity rate of return. It is hard to say because much of the margin there (quite a bit of the revenue for Bombardier - BRP - is from CPI but some is also from Horizon) is hard to estimate. Moreover, that goodwill was impaired a few years later when management had to review goodwill as part of their normal process of looking at low P/B in market multiples. At least it was conservatively financed. At $15m, the purchase price was small relative to the cash generation of the legacy business. Moreover, the legacy business was largely unencumbered by the time of that acquisition and so cash built up. It brought them not only new customers and new verticals, it brought them manufacturing processes that were - we have been told - helpful in expanding significance with customers of the legacy firm.
That cash may have burned a hole in their pocket, because the Horizon deal seems now to have been a bit expensive. It achieved several objectives, but also left no balance sheet flexibility. I have a sense that having failed to do small deals in the three years between CPI and Horizon, management and the board felt a need to do something "big" and almost sank the firm in the process.
So, if we evaluate them as operators, investors and financiers, we can say that the old management turned out to be poor operators, but the new crew seems top notch, EXCEPT that perhaps the CFO also was to aggressive in optimizing cost aspects of operations and investment, both internal and from acquisition seem to have been either too parsimonious or two generous. Finally, as financiers, he has not been great. The folks who ran the company for the first two decades, who were holdovers from the corporate parent that spun the company, approached finance like typical corporate guys - conservatively. Wanting full amortization each month. One could argue that this was "aggressive" in the sense that it is inflexible to have monthly principal payments (as compared with balloons) but, it is disciplined and avoids the need to refinance or to keep large amounts of cash on hand waiting for the payoff date and earning returns well below the interest cost of the debt that the cash offsets.
But in the Horizon deal, management should have demanded a different structure - knowing that the owner who built Horizon was selling to retire, they should have demanded that he take at least some of his payment in equity in the new business. This would have reduced the debt load and made it easier to meet covenants and would have made the former owner more invested in the success of the merged firm. CMT could have repurchased shares to offset dilution over time.
They might have also considered some preferred or convertible debt. Rates were low, conversion provisions could have been set to ensure a premium to book and again, they would have had much more financial flexiblity. In the end, the CFO failed to imagine how bad the situation could be.
On the other hand - he has managed, so far, to avoid issuing additional equity as they have worked through this, which is actually fairly impressive, tho it probably has been a reason the problems have gone on for so long. Will he get wiser? Who knows? The BoD is turning over some, and I expect that there will be a more muscular and aggressive board more focused on accountability. We shall see, but I believe that this firm has some great characteristics and offers a superior risk / return.
I will spare you the suspense - I believe that the price is likely to rise, and sharply, from here. Why? Because of several cash generating levers that we are likely to see that will mitigate much of the "risk" to the lenders, who will therefore be likely willing to refinance the company, after they exact the pound of flesh that always attends distress guys.
Rarely do I take this view - almost always distress debt and NOLs lead to more distress and more NOLs until at some point, the business is sold, the assets or sold, or the whole thing is refinanced with debt being swapped with equity. For much of the past 12 months, it has been hard to see which way this was likely to play out, but several recent developments have indicated that the business is likely to survive intact with the equity surviving as the successful fulcrum security.
There are multiple reasons for this - the first is that the company competes as part of an oligopoly in its core market segment: plastic and lightweight composites for transports, particularly heavy trucking. The heavy trucking industry itself is quite concentrated - in North America there are four major players (Navistar/International, PACCAR, Volvo and Daimler Trucks); in Europe, you add Volkswagen/MAN and Fiat/Ivecco, but lose Navistar and in Asia you have a few other firms. However, each of these geographies is actually quite separate as are many of the supply networks, because the physical transport costs are significant. Sure, small parts like nuts and bolts are largely globally competitive, but air shields and panels and such are hugely expensive to ship if you have to pack them in containers and float them across an ocean; they take up too much space. It is far more efficient to ship raw materials to a factory co-located or at least near to the final production facility.
Companies being what they are, three competitors are essential to pricing and development strategies. Each of the four North American producers does business with each of the three suppliers (CMT and its competitors). The ecosystem is balanced in this way, and so everyone can earn ok profits and returns on capital over time; it would be unhelpful to the manufacturers to drive bargains that push prices below economic returns, because starving your suppliers means that they cannot invest in your future. This is how CMT managed to be profitable from 1996 to 2017 in all years except one (no credit for guessing that it was 2001, not 2008 or 2009 that was the unprofitable year). This sort of stable business that allows for very careful planning of capex is a source of competitive advantage and allows for very solid returns on equity and capital (high teens) over a cycle.
Moreover, we know that CMT has historically been a solid operator - a few years back, CMT landed a huge increase in business when a competitor irked one of the big four producers and had some programs shifted to CMT.
CMT has also historically been quite conservative in finance. I attribute much of this to the board - who are all old corporate operators with conservative corporate finance perspective. CMT was actually a spinoff of Navistar (in 1998). They have chosen to avoid balloon payments on debt (though the current debt does have a balloon, but it is many years out and CMT has adequate time to earn enough to meet the balloon).
Prior to COVID putting a hurt on operations, the company was earning solid returns; overall 1Q20 results were good, in spite of slow sales at the end of March. 2Q20 will be weaker, and yet, plants restarted in May and trucking has continued apace. Moreover, several new lines of business from the acquisitions of CPI and Horizon actually were up in 1Q20 over 1Q19; so there is some buoyancy in their end markets. (I estimate that heavy trucking clients actually represented only about 50% of sales in 1Q20, so diversification is happening).
In spite of what will be no doubt weaker sales and weaker profits from negative absorption of fixed assets and expenses, there might still be surprising cash generation in 2Q - lower sales in the past have been cash generative as receivables are collected and inventories are reduced. The strong paydown of payables in 1Q20 means that working capital actually expanded, providing more scope for reduction to align with lower sales levels going forward. If there is solid cash generation in 2Q, the receipt of $6m in tax refunds, it seems likely that the company can completely repay its $7.8m in revolver debt by 3Q20. The large tax refund is a benefit from the CARES act, which provided the company with a farther "look back" period for applying operating losses; usually these can be applied back one year and forward 20, under CARES, I believe they can look back 3 years. This allows the company to apply losses against profits from a period when corporate taxes were higher, as an added bonus.
Since it is clear that the company will be able to make its payments, there is little incentive for the lenders not to offer forbearance a bit longer, continue to benefit from a penalty default rate and get re-liquified in the inevitable refi, or agree to do the refi themselves and get the origination fees on top. I need to be clear, the issue is actually not the repayment; I don't believe anyone can expect that the company cannot repay. The issue is that the debt has covenants promising certain levels of profitabilty which, due to operating weakness, have been violated.
In any case, as I say, I expect that the debt will be refinanced and when an extension of the forebearance is announced, that the stock will rise further, and with a refi, that the stock will return to something approaching book value. I make this assessment, because of the solid profitability that the company generated on an operating basis with a much lower level of revenue in 1Q20. This is a strong sign that the operating improvements the new management have been putting in place are working, indeed, have worked, and that profitability in a normal operating environment, which should see revenue north of $70m a quarter will be incredibly strong. Gross margins were nearly 17% with $64m in revenue. With $72-75m they should exceed 19%. If SGA return to 2019 levels for similar levels of revenue, operating profit would be somewhere around $6.5m a quarter (with 7,778k shares out). Annualized, this is operating profit of around $26m, lower debt balances and lower interest rates could take interest costs down around 250 basis points, which could actually lower interest expense below $1m annually. Allow $1m and you still have PBT of $25m and income tax expense of 21% puts profits a shade below $20m, vs let's call it 8m shares out (it is less). $2.50 a share in profits. For a cyclical, is that worth 10x? 12x? As a firm with a solid history of good deals, increasing success at diversification from traditional verticals AND steady expansion of customers, products and manufacturing capabilities - could it be worth 15x? Maybe that is a bridge too far, but a stock price approaching $30, call it $28 seems like a 7x return from here in say, 18 months?
Management and the BoD have persistently made open market purchases throughout the last several months and quarters in spite of - nee, because of - the market weakness. They have been signalling, I think, that they are not worried about being able to be refinanced. This has continued into COVID. The CEO and COO filed form 4s earlier this month after 1Q earnings dropped and they had a window to make purchases.
There are risks, of course.
First off, there are the macro factors. COVID could lead to some sort of permanent shutdown. Also, I believe that we are likely to find tax rates being hiked to address the fiscal situation - a conflict, a military conflict, that is, likely with China, might be the proximate cause, but when it happens, it will be swift and sharp. That would certainly change expected yields.
Moreover, CMT, though an AMEX (NYSE MKT) stock and not a big board company, will still get hit. I am old enough to remember when the Wiltshire 5000 actually had 7800 stocks (to represent the "total [listed] market". Now I think it barely has 3300; so concentration in listed stocks has increased beta. Macro factors seem likely to persist. On the other hand, trucking might have certain tailwinds in a conflict and CMT might benefit.
Also, there are macro tailwinds in the form of autonomy. While the excitement and enthusiasm for self driving vehicles is overhyped, particularly in passenger cars, trucking is where much of the investment is among the majors. This makes sense - in the early days of autonomy, much monitoring will be required; planned routes and logistics infrastructure will provide the means of that monitoring and the economics of lower operating costs will provide much of the investment dollars needed. CMT doesn't have a huge spare parts business, but new truck programs and sustained high volumes as the fleet is turned over would provide a sustained tailwind enabling sustained high levels of utilization. The cash could be used to make further acquisitions that could provide diversification and reduced cyclicality when the secular tailwinds abate after say, a double long cycle.
The bigger risks are probably micro. As I have noted, the firm itself has certain protections from existential competition given the need of all four manufacturers to have a reliable local supply chain. It is possible that some Asian or European firms could make a transplant; buying a competitor, for instance and potentially driving down certain R&D costs, or leveraging global purchasing arrangements - given the fact that Daimler and Volvo are both Europe-based and between them represent a majority of NAFTA production, this is always at the back of my mind. On the other hand, if the economics of this were really that attractive, that sort of consolidation would likely have occurred. Management at CMT does not seem to believe that geographic expansion makes any sense, given their specialties.
A bigger risk, perhaps is in some of the newly acquired business, because some important revenue lines derive from cases where CMT is a tier 2 supplier and not only at risk for their own performance, but also for that of the tier 1. Horizon Plastics, the deal that nearly broke the company (in spite of a significant amount of equity used in the purchase in the form of cash on hand) has multiple business lines, among which are plastic fencing sold through big box home improvement stores. You know it - the white, plastic 1/2 in or so, lattice fencing that is used mostly for cosmetic purposes. This product is considered part of the "wood" category, so the category manager always has to find a supplier for it, as the category manager is sometimes booted from one of the stores. In fact, CMT/Horizon benefitted from just such a situation - where the competitor was ejected and 100% of the business was awarded to the tier 1. This situation is likely to reverse - given the situation there is considerably more tail risk that we might want. Better for a firm like CMT to know that you will get between 40 and 60% of the business than 0 or 100%.
Operations could continue to be a challenge - although these really seem worked out and I have personally been impressed with David Duvall and Eric Palomaki (CEO and COO, respectively). I believe they are earnest, hardworking and smart and full of integrity. Ironically, COVID may again be a tailwind here. The operational problems that were encountered late in 2018 stemmed from a set of misjudgments by management - misjudgments that were understandable. Trucking usually operates on a 7 year cycle, with five great years and two crappy ones. After what was a long up cycle into 2016 management and the industry anticipated weakness for 2-3 years. They were right in 2017 and had already made adjustments to hiring, staffing and capital investment, adjustments that saw profitability remain strong in a down year. They were caught off-guard when the truck market rebounded without sustained weakness, and, with unemployment at 20 years lows, were unable to recruit to staff up to meet demand, overtime and expensive contract labor were required, hurting margins. Previous management had compounded this error by PPAPing a part that could not be manufactured reliably, requiring considerable rework and overtime and even so, delivery delays hurt production and clients - one client in particular - assessed penalties for failure to deliver which compounded the losses.
That mercifully seems to all be in the past. But CMT's specialty is in developing custom solutions, as when a part requires a custom fit and the integration of say a metal rod or component into the plastic. Problems with manufacturing could happen again.
Another question mark remains the CFO. He is clearly not dumb, but I sometimes wonder if he is wise. Back when the company had an IR team, I was told that he was brought in with three objectives: reduce costs, improve IR and complete deals. He has achieved these things to some extent, but not always in the best way.
He certainly helped reduce costs and raise profitabilty in the 2014-2017 period. I was genuinely pleased with the level of cash generation, though much of that sat fallow for years only to still prove insufficient to his ambitions. Thing is, I ask myself if those cuts weren't the real reason the company found itself so unprepared in the rebound of 2018. Some of htis might have been poor operating decisions by the former CEO, but how much of that was finance pushing for particular margin targets and forcing corners to be cut?
IR has certainly improved in certain ways. There is a good investor presentation on the website (link here). Moreover, Zimmer has always responded to my inquiries, for which I am appreciative. Moreover, he managed, through the operating difficulties, to provoke shareholders to attend the annual meeting for the first time in years in 2019. But not sure if that is really a good thing. He prefers to have individual calls rather than investor meetings or conference calls. The company does not present at any major conferences. This is in spite of doing deals that should have investors looking at the company less as a heavy truck supplier and more as a custom lightweight composites solution provider.
Finally, there are the deals. I actually liked both deals he did at the time he did them. CPI was a deal that was entirely debt financed, though, I am not sure that it earns an equity rate of return. It is hard to say because much of the margin there (quite a bit of the revenue for Bombardier - BRP - is from CPI but some is also from Horizon) is hard to estimate. Moreover, that goodwill was impaired a few years later when management had to review goodwill as part of their normal process of looking at low P/B in market multiples. At least it was conservatively financed. At $15m, the purchase price was small relative to the cash generation of the legacy business. Moreover, the legacy business was largely unencumbered by the time of that acquisition and so cash built up. It brought them not only new customers and new verticals, it brought them manufacturing processes that were - we have been told - helpful in expanding significance with customers of the legacy firm.
That cash may have burned a hole in their pocket, because the Horizon deal seems now to have been a bit expensive. It achieved several objectives, but also left no balance sheet flexibility. I have a sense that having failed to do small deals in the three years between CPI and Horizon, management and the board felt a need to do something "big" and almost sank the firm in the process.
So, if we evaluate them as operators, investors and financiers, we can say that the old management turned out to be poor operators, but the new crew seems top notch, EXCEPT that perhaps the CFO also was to aggressive in optimizing cost aspects of operations and investment, both internal and from acquisition seem to have been either too parsimonious or two generous. Finally, as financiers, he has not been great. The folks who ran the company for the first two decades, who were holdovers from the corporate parent that spun the company, approached finance like typical corporate guys - conservatively. Wanting full amortization each month. One could argue that this was "aggressive" in the sense that it is inflexible to have monthly principal payments (as compared with balloons) but, it is disciplined and avoids the need to refinance or to keep large amounts of cash on hand waiting for the payoff date and earning returns well below the interest cost of the debt that the cash offsets.
But in the Horizon deal, management should have demanded a different structure - knowing that the owner who built Horizon was selling to retire, they should have demanded that he take at least some of his payment in equity in the new business. This would have reduced the debt load and made it easier to meet covenants and would have made the former owner more invested in the success of the merged firm. CMT could have repurchased shares to offset dilution over time.
They might have also considered some preferred or convertible debt. Rates were low, conversion provisions could have been set to ensure a premium to book and again, they would have had much more financial flexiblity. In the end, the CFO failed to imagine how bad the situation could be.
On the other hand - he has managed, so far, to avoid issuing additional equity as they have worked through this, which is actually fairly impressive, tho it probably has been a reason the problems have gone on for so long. Will he get wiser? Who knows? The BoD is turning over some, and I expect that there will be a more muscular and aggressive board more focused on accountability. We shall see, but I believe that this firm has some great characteristics and offers a superior risk / return.
Thursday, May 21, 2020
Two types of Value Investors and Why Value has Underperformed
The structure of the modern company – indeed of modern business
operations – represents a big challenge in the frameworks that value investors use
to think about company values and in particular risk, reward and safety. Two structural factors: the impact of
intangible assets – and asset-light business and operating models - on business
value and quality AND the consolidation of industries into global players, are
making the calculus more difficult, particularly for one type of value
investor.
Value investing, properly understood, is an approach to taking
financial risks that seeks to minimize the risk of loss while allowing for reasonable
expectations of upside gains at rates of return that allow you to get rich (and
not just stay rich. “Get rich” returns have to be MUCH higher). Value investing
therefore is primarily focused on “safety first”. That safety is usually thought about through
looking at worst case scenarios and trying to buy at a price so low that it
offers a positive return even if that outcome occurs, or at least, only a very
low probability of loss, and near certainty that the loss cannot be very large,
not more than a few percentage points of the capital at risk.
Value investing as a mindset comes in two flavors: quality
and cheapness. Both concerns are
important. Quality matters, because crappy
assets, or even decent assets trapped inside of a crappy operation, tend to diffuse
over time and become impaired. They don’t
compound – or do so at very low rates - and so even if they are distributed at
some point in the future, the returns over time are modest. Worse, distribution
often happens at times of stress when the assets yield the lowest values.
Without quality there can be very limited expectation of upside, unless the
investor can wrest control of the assets and force some sort of asset conversion
– a liquidation, a merger, a recap, a new line of operation or business.
But paying too much for even a quality asset can produce the
same outcome. Needing an asset to “grow”
into its valuation embeds years of low or modest INTERNAL returns (market returns
can be robust) while waiting for the value to catch up to the price paid.
Value investors debate these two poles frequently – and often
bitterly. I often find myself debating
with other investors (and sometimes with myself) about the relative merits of
the two in the case of a potential investment, or in comparison of a few investments.
At issue is really a question of margin of safety, which, I believe is the true
hallmark of value investing (the estimation of which I am working hard at
improving). A big part of this divide
now, I think, is tied to the dominance of intangible assets in (post)modern
business: they have much greater tail outcomes than physical assets do.
Low price seems to offer a much more straightforward route.
It has a lot of appeal, in part because it is so quantitative. You can look at the market values of the
assets of the firm and if you can purchase them at a significant discount, then
even if they are producing modest, perhaps non-economic returns or just barely
earning their costs of capital, you still feel you have a margin of safety. In the event of liquidation, the securities/interests
you hold expect to receive a payout sufficient to at least return the capital
invested if not more. That is having a
margin of safety.
Consider, tho, what sort of things this investor wants to
buy – if the focus is on liquidation value, then the investor wants many,
ideally liquid, SEVERABLE assets. These
are the sorts of things that are easy to auction to many bidders: receivables
and rights to payment, inventories (in some cases, quick inventories at least),
assignable leases, real estate (esp cash flow real estate), even property plant
and equipment has value, especially to strategic buyers who may take a portion
of the operations and may pay for some of that business value.
This investor likes things like banks, old line industrial
firms, asset heavy companies with lots of liquidation value. His problem is
that in a world heavy on intangible, asset light models, what does he have on
liquidation? Often not much in the way
of safety. Intangible assets have much
fatter tails. If they retain their quality;
then the strong operating characteristics of the business – which often require
little or no reinvestment – mean that returns on capital will be genuinely
wealth creating, but in the event of impairment, they are often worth next to
nothing. These assets can be goodwill,
which is great while it is in place, but often worth nothing if customers flee.
Even the most “severable” of intangible assets, brand names, can often have
huge tail risks. Other intangibles, like
tax NOLs, are impaired upon transfer – by rule!
You can see the dilemma this poses for the value investor:
he sees a Facebook and can only think about MySpace and he is not wrong to
think this way. But – at least in my
case – I think the tendency is to *assume* no moat for Facebook; that it can
fall out of fashion and be yesterdays news in a matter of months. The implosions can be spectacular.
In cutting himself off from that left side of the distribution,
though, our price and liquidation value focused investor is cutting himself off
from many investments on the right side of the distribution set. These businesses produce a very
disproportionate amount of the value and so he underperforms. Constantly. As he waits for asset heavy
models to return to favor.
Worse, in a world with fewer competitors, the liquidation value
of many of the assets is also lower.
There are simply fewer strategic buyers in nearly any traditional
business line to purchase the operating assets AS OPERATIONS, which always
command a higher price. So the discount that
has to be applied is larger.
Instead, the value investor has to focus more on paying up
for quality – which is harder and more “qualitative” which is also more
subjective. It requires thinking differently about what value means – that it
is possible for a person and a webcam to generate some incredible content and a
following that produces (if it remains topical) the potential for residual
income streams in the form of the modern form of “syndication” – the YouTube
suggestion set. These residuals can go
on for years. They can also disappear either from audience preference changes,
or from decisions by the platforms on which many of these businesses depend.
Quality – and being able to assess that quality – is more
important. Moreover, it may be necessary
to think differently about “quality” – that it is not always a permanent annuity. Perhaps it is something in which the investor
can realistically get a significant return in the near term – and thinking differently
about how manage that position (he will need a market outcome in most cases,
and will have to manage the position to capture and retain that gain. This, tho, might be thought of as sepcuatlive
and not value investing at all), in order to earn a solid return. Is it so bad to know that you are “guaranteed”
a solid return – enough to recover your capital and more – over a two to three
year cycle, so long as you make sure to sell, because the long term prospect is
the business is a $0. This might be like
investing in newspapers.
I think this paradigm really is a tough one for value. Value works because of cheapness and protection,
but it also assumed that financial capital would have considerable power in the
structure of the firm – that financial capital controlled the purse. But in an asset light world – very little financial
capital is required. Financial capital
is going cap in hand and begging entrepreneurs to let them put money into their
ventures. What is the likelihood that
this changes? The value investor is going to need to rethink the frameworks for investment, I think. To find a different way of seeing margin of safety and perhaps to change thinking around how to provide / ensure that margin of safety.
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