Monday, 15 April 2013

2013 Update

Well my big winner so far in 2013 has been the DF stand alone trade - DF Stand alone value now stands at $5.29/sh up from $3.80 at time of initial post. Making for a 39% return on net capital employed in the trade; not bad for a 6 week holding period. 

Unfortunately I was not able to execute the trade as a net trade due to employer restrictions on shorting, and therefore only realized the long DF upside of around 8%. 

Although I think there is plenty of upside left in this story and that DF stand alone profitability will be much higher in the future than where it stands right now; I may reduce my position in the trade to lower my portfolio concentration and pick up some other interesting opportunities arising. 

KLIC my other significant holding in 2013 has not fared as well and is down 7% from my initial purchase. The strong cash position, free cash flow generation ability of the business, and low level of competition in a niche market make me feel pretty safe about this holding.

New Ideas:
I have not had the time to post write-ups about other ideas recently, but I have been reading blogs and posts on sumzero, gurufocus, and the likes. Few ideas that tickled my fancy are:

1) Pinetree Capital ($0.40) - a publicly traded asset manager investing in junior (extremely junior) commodity developers. This is really the perfect opportunity for an activist investor to buy a dollar for 40 cents.
The goods: Cheap! 
  • Fund NAV as of March 31, 2013 was $1.20, stock is trading at $0.40 (57m mkt cap). $0.17 of NAV is deferred tax asset, rest is investments. Even excluding the deferred tax asset, it's trading at 0.39x NAV.
  • 91% of investments as of Dec 31, 2012 were in public companies - easy to liquidate
  • Extremely diversified, 400 odd positions; they don't take a majority stake in companies, so low liquidity concern. (175m fund, 25m is largest position)
  • Permanent capital, no risk of redemptions
The Bad: Management
  • A horrible way to invest. Diversifying between junior miners could be the worst possible way to deploy capital. Accordingly NAV has been shrinking at an alarming rate - Jan 11 - 4.68, Dec 11 - $2.61, Dec 12 - $1.55, and $1.20 as of March 31, 2013.
  • CEO bonus was $34mil in 2010; 10% of growth in BV of firm during year.
  • They continue to invest elsewhere - I don't understand how other investments can be more attractive from the management's point of view than repurchasing shares.

2) Bed Bath & Beyond ($65) - retailer of home, kitchen, and bath products. Possibly one of the best ways to play the US housing recovery.

The Good

  • Growth and Margins - 2003 to 2007 growth averaged over 15%, revenue growth remained positive throughout the housing crash, currently just under 10%. 
  • Gross margins over 40%
  • Reasonable valuation of 11.6x 2013 earnings. Even better, 12.6x 2013 FCF.
  • 0 debt
The Bad

  • Increasing competition from online retailers?

3) Skullcandy ($5.20) - producer of headphones facing stiff competition and slowing revenue growth of +21%. The company is refocusing business on mid-high range headphones in 2013 and exiting the lower price points. 

The Good

  • Market cap of $147mil and $100mil in working capital.
  • 2012 EPS of $0.92
The Bad

  • Little value-add industry, however a strong brand can help differentiate product. 
  • Competition forcing company to refocus strategy.
  • 2013 sales are expected to be lower due to the aforementioned change in strategy 
4) Leapfrog ($8.19) - maker of educational entertainment products for kids. Misunderstood competition of tablets and smartphones creating negative sentiment over the stock. Sales were up 16% y/y last quarter, and 28% LTM. 

The Good

  • Trading at <6x ex cash PE. 
  • Target market is kids from ages 3-9. This is not the target audience of smartphones, and you cannot replace toys with smartphones and tablets. 
  • Sales are growing still; Leapfrog makes good toys - 3 of the top 4 toys of 2012 according to NPD Group's Retail Tracking Service report.
  • Leapfrog has created a cheaper ($100) hardware to compete against the tablet insurgence. Also more durable.

The Bad

  • I may be underestimating the impact of tablets and smartphones on the toy industry.
  • Competition is the #1 destroyer of investment returns and should not be underestimated.

5) ORIG ($15.32) - a leveraged deep underwater drill ship owner/operator. Currently has 3 ships under construction paid for using debt, which are due in the second half of 2013, and hence the current debt position seems unreasonably high. 
The Good

  • Post delivery of vessels, ORIG is trading at a 4.6x EV/EBITDA multiple with one of the youngest fleets of its competitors. New vessels are already contracted along with the remaining fleet; 90% of the vessels are contracted into 2014 as well. ORIG is also trading at a discount to book and significantly below asset replacement value.

The Bad

  • The company has a leveraged balance sheet, $2.3b net debt.
  • Shipping is one of the businesses with very little value-add, differentiation, and barrier to entry. It is extremely vulnerable to cycles, and current attractive rates on deep water vessels probably mean oversupply is due in the future.

Saturday, 2 March 2013

Dean Foods Spin-off Opportunity

Charlie Munger once provided 3 simple tips on becoming a successful investor:
1) Follow the great investors
2) Look at the cannibals (companies aggressively buying back shares)
3) Carefully study spinoffs 

So, here is an analysis of a recent spinoff by Dean Foods in which David Tepper of Appaloosa management had been an active shareholder. At the start of 2011, Appaloosa held close to 7% of the total shares outstanding, however has since reduced its position to ~1%, taking profits on the way. The analysis below is for the Fresh Dairy business of DF and involves shorting the illiquid IPO of WWAV, which is a trade someone of Appaloosa's size cannot execute.

Dean Foods (NYSE: DF) recently spun-off it's high growth business, "WhiteWave" (NYSE: WWAV) through an IPO. This presents an interesting opportunity to buy the remaining Fresh Dairy Direct (FDD) business on its own through a long-short trade. Dean Foods currently retains 86.7% ownership of WWAV, however it will distribute majority of its stake on April 23, 2013, retaining 19.9% , after the IPO lock-up period expires. DF plans to distribute or sell the remaining stake at a later date as suitable per tax issues.

Dean Foods stand-alone (DF Stub) is currently trading at a Fwd P/E of 7.6x, P/FCF of 5.2x, and an EV/EBITDA multiple of 5.2x. The DF Stub currently has a price of $3.80/sh ($710m mkt cap, calculation below), however I believe it's fair value is closer to $6.23/sh (67.3% upside) even based on the company's relatively weak 2013 guidance (will discuss later); and a upside value of ~$9.95 in a normalized margin scenario combined with further capital structure savings.

DF Stub Capital Structure

*the stand alone debt includes debt reductions from the Morningstar sale completed on Jan 3, 2013

The Business
Dean Foods is a leading food and beverage company and the largest processor and distributor of milk and other fluid dairy products in the United States. The company has two business segments: Fresh Dairy Direct and The WhiteWave Foods Company ("WhiteWave"), which is it spun out through an IPO. After the spin-off and distribution, DF holders will be left with just FDD.

Fresh Dairy Direct is the largest processor and distributor of fluid milk in the United States, and Fresh Dairy Direct also processes and distributes other dairy products ice cream, cultured dairy products, creamers, ice cream mix and other dairy products. Dean Foods sold it's longer shelf-life business, Morningstar, to Saputo in December 2012, leaving milk as 75% of the remaining FDD business. DF is the largest and only national player in the fragmented industry and maintains a 40% market share.

DF's size doesn't provide it the supply-side economies of scale you would expect from a dominant industry player. DF sources milk from fragmented local farmers, however milk prices are set by the US government on a monthly basis to provide farmers the ability to earn reasonable profits and pass-through inflation of their inputs costs (corn). 

DF also doesn't have any demand-side economies of scale. Its customers are retailers, and like other middle of the supply chain businesses, DF competes largely on price. With low switching costs, no product differentiation, and numerous local providers of milk; DF also has little power over its customers as well. 

Where DF does have an advantage is in its distribution network and economic scale. The company continues to look for cost efficiencies in it's distribution network, capital structure, and overhead costs. Over the last 2 years, DF has reduced its operating leverage through deleveraging its capital structure (reduced debt burden from $3.4b to $1.4b) and seeking efficiencies in its distributions network and overhead expenses ($300m or ~3% cost reduction). Management expects to achieve another $100m to $150m per year over the next two years through debt refinancing and further distribution savings). Dean Foods transformation over the last two years has unlocked significant value for its share holders, the market value of the company has responded increasing from 2b at the start of 2012 to 3.5b currently (DF + WWAV, excluding DF ownership of WWAV). However, this is a thesis on DF FDD Stub, which remains undervalued. 
FDD has a gross profit margin of 20-25% and operating margin ~2.5%; management is expecting 2013 to be another tough year because of high projected milk prices. However even with the lower gross margins, DF will be able to achieve higher profitability through improved SG&A margins and a substantially lower interest expense. Management also sees debt refinancing as an avenue for further cost savings into 2014 as DF has substantially improved its leverage and credit position and will be able to secure financing at much lower interest rates (most recent senior notes were issued at 9.75%).
The upside scenario represents a normal gross margin year, combined with further interest expense savings. The downside scenario simulates an ever tougher margin environment than 2011, when DF experienced what management calls "irrational competition".

Below are valuations based on the above profitability scenarios. I believe the base case represents a fairly conservative scenario of compressed gross margins and leaving the low-hanging fruit of reducing financing expenses on the table. As mentioned earlier, the base scenario represents a 67% upside with fairly conservative profitability and multiples scenario. 

    The upside scenario is definitely not out of reach. Management has shown great diligence over the last two   years in reducing costs. If milk margins normalize and management continues to find ways to improve margins, upside scenario is a definite possibility. 

More impressive than the cost reductions has been the managements efforts to unlock shareholder value through deleveraging and separating the parts of Dean Foods. Post WWAV distribution, DF stand alone will be a cash-cow (pun intended) with strong profitability and low capital intensity for an industrial business. Management plans to continue shareholder friendly capital allocation practices in the future through dividends or share-repurchases, which could help target multiples as well.

Risks/Downside scenario: like any other industrial business, DF doesn't have control over its input costs and has little power over its customers as well. Periods of intense competition from smaller, local competitors, could lead to decreased profitability. However the deleveraged capital structure and improved SG&A margins should allow DF to use its scale to out-compete in the longrun. 

Executing FDD Stub
This is an analysis of the FDD business alone, therefore execution must be done such that you are purchasing FDD only and hedging out the embedded WWAV ownership. To execute FDD Stub you should use a long DF 125 shares to short WWAV 100 shares ratio.

Disclaimer: I do not have a position in DF or WWAV, however may initiate a position within 72 hours.

Thursday, 14 February 2013

Apple Apple Apple

3 great articles on Apple:

Understanding Apple requires an analysis of Fundamentals and Psychology
Apple has created 3 groundbreaking products over the last 10 years and in the process have created a moat for the company - huge economies of scale, unmatched buying power, ecosystem of products, and a brand associated with quality.

Why David Einhorn Is Wrong About Apple
Ecosystems are overrated (switching costs are low), every product company disaster has had superfans, the moat is narrow.

Apple Versus the Strategy Professors

Wednesday, 13 February 2013

Kulicke & Soffa $11.41 - Long term target around $18.20

Incorporated in 1951, Kulicke & Soffa (NASDAQ: KLIC) is a global leader in the design and manufacturing of semiconductor assembly equipment. KLIC specializes in the production of ball, wedge and die bonders for the integrated circuit (IC) and light emitting diode (LED) end-markets. The company’s primary customers are outsourced assembly and test manufacturers (OSAT) and integrated device manufacturers (IDM); largest customers include Advance Semiconductor Engineering, Siliconware Percision Industries, and Haoseng Industrial.

Industry Overview: KLIC operates in two industries, Equipment (wire, ball, & die bonders) and Expendable Tools (10% of revenues). Equipment business (90% of revenues) is inherently cyclical as it depends on capital investment cycles of its customers (OSATs). However, the growth trend of the end products created with KLIC equipment, integrated circuits, has been positive because of technological innovations (better performance) and price declines (new applications). The list of end-use products for wire-bonded integrated circuits continues to grow and includes: smartphones, tablets, laptops, memory, computers, cameras, TVs, automotive electronics, others.

Industry/Company Strategy: KLIC has focused on producing the best bonding equipment (95% of equipment revenue) and continues to spend consistently on R&D ($50-$60 mln) even during economic and cyclical downturns.
All figures in $US 000s
  Net Revenues
Gross Margin
SG&A Margin
R&D Margin
Operating Margin
Operating Income
  Interest Expense
  Earnings before Taxes
Adjusted Earnings
Cashflow to D+E
 FCF to D+E
Traditionally, semiconductor bonds were formed using gold; however with gold prices rising ~5x over the last decade, alternatives were required. Various materials were considered to replace gold, such as copper and aluminum, each with their own set of pros and cons. KLIC was first to provide a viable alternative in 2010 with their copper bonding specialized equipment, copper bonding requires the use of nitrogen gas in order to prevent copper oxidation in the process. KLIC’s main competitor, ASM Pacific Technologies, has been focusing its R&D on LED bonding (LED is one of the fastest growing markets). With customers shifting to copper enabled bonders and ASM focusing on LED, KLIC emerged as the clear leader in the IC bonding market. This is evident in the company’s #1 market share position in all types of IC bonders and in its healthy operational margins and return on invested capital. Overall penetration of copper capable bonders still remains low at under 35%, suggesting there is still room for increasing market share.

Cash Flows: KLIC is not a part of a capital intensive business but rather a R&D led industry; the company’s PPE, cap-ex, and depreciation are extremely low. Cumulatively from 2008-2012 the company has spent just $34m on PPE representing a mere 7% of the $470m in after-tax cash flows generated during the period. For 2013 the company is forecasting $30-31m in capital expenditures due to $15m in facility improvements at their Singapore facility.

Investment Thesis: Being conscious of the fact that the IC capital investment business is cyclical and technology moats vanish over night; I use a 10x free cash flow multiple to the last 5 year cycle for a value of $11.62/sh, slightly higher than the current price of $11.45. However, this overlooks the free call option imbedded in KLIC. The company is debt free and has $494m or $6.52/sh in cash. Not only does the cash provide downside protection, but at its current price you are getting that cash for free. If used for an accretive acquisition or returned to shareholders, this free cash option will end in-the-money. There are not many businesses that trade at under 10x free cash flow and KLIC does have a number attractive qualities like its industry leading technology, broad market shift to copper, high growth end-market, low capital intensity, and industry duopoly. I arrive at my target price using a 10x free cash flow multiple to the previous 5 year cycle $11.62 + cash $6.52 = $18.20. This assumes the management can find a 10% FCF yielding investment.

Investment killers checklist (checks out 5/5)

1) Bad management
Management has shown caution or restrain towards acquisitions even with their enormous cash-pile. They also issued convertible-bonds at incredibly low interest rates securing extremely cheap financing.

2) Intense competition
Low competition - duopoly industry structure and both companies are growing and profitable, significant R&D, unsexy cyclical industry. However KLIC does boast high margins during cycle booms .

3) Too high of a price
5.5x trailing p/e, 2.0x ev/ebitda and still a number of underweight recommendations, the stock is definitely not a darling

4) Debt 
No debt

5) Complexity 
The business model itself definitely isn't complex but the technology to make copper bonding feasible is.

Disclaimer: I am long KLIC and may exit my position at any point

Sunday, 20 January 2013

The peculiar case of Lennar

Idea: Buy Len.B, Sell Len.A (Currently 23.5% profit potential)
Decision: No trade, monitor spread

Lennar Dual Class Common Shares
The information below will show that Lennar Class B shares have greater voting rights, tightly controlled issuance, and extreme alignment of interest with management; and therefore should trade at a premium to Class A shares. However Lennar Class B shares currently trade at a 24% discount to Class A! And during the financial crisis the spread was over 50%!! I am obviously extremely disappointed I did not discover this spread between the two classes at a more opportune time; however the trade is still worth examining with a 24% profit potential and limited downside. Really the only thing that would suggest that this spread would remain this high is the fact that it has done so for the last five years.

After much deliberation, I decided not to execute the trade and wait until the spread provides a 30-35% profit potential; at a 30% profit potential Class B is trading at 77% of Class A. Not quite the 70% NCAV Graham threshold, however this is a much less riskier trade than owning shares in a company.

Purpose of Dual Class:
In April 2003, Lennar Corporation adopted a dual share structure. The purpose is to maintain the managements control over corporation without compromising its ability to raise equity for acquisitions. The voting rights, share dividend policy, and the termination of Class B shares are all created in a manner to allow management to maintain control over the organization and avoid dilution. Both shares are traded publicly. Differences in the two classes are listed below:
Class A
Class B
·    1 vote per share
·         10 votes per share
·         Class B votes together 
·    When voting without regard to class, must be approved by majority of the Class A shareholders.
·         Equal cash dividend payout
·        Share dividend may be distributed in Class A shares as determined by the BOD.
·         Equal cash dividend payout
·         Share dividend may be distributed in Class B shares as determined by the BOD.
·         Class B shares will be converted into Class A if:
            I.        Number of Class B shares outstanding is less than 10% of all Class A shares.
            II.        Majority of Class B share holders vote to convert shares to Class A
·         Equal rights in event of a liquidation
·         Equal rights in event of a liquidation

Stuart Miller (CEO) Ownership:

# of Shares Held Miller
# of Shares Total
% of Class Held Miller
# of Votes Held Miller
% of Total Votes Miller
Market Value ($millions)



Rarely can you see this kind of alignment of interest with management in a possible trade. The 68% holding of total Class B shares by Miller represent 90% of his ownership in the company and likely his net worth. If the Len.B shares began to trade at parity with Len.A, Miller’s net worth would increase by $171 million. Likewise, if the remaining Len.B shares not owned by Miller were allowed to convert to Len.A, Miller’s voting power would increase to 58% of total votes.

There is really no scenario I can think of where in the long-run Miller would allow this spread to increase or even stay at its current level. Nor can I think of any fundamental reason why the spread between the two classes to be so large, and in favor of Class A shares; Class B shares have 10 to 1 voting rights and their issuance is tightly controlled.

Spread Analysis:

1) On an absolute $ basis, the spread is near its all time high. However on a % basis, the spread has come down from its recent highs of 32%.
2) The spread was much narrower until Lennar’s dividend deteriorated in 2008.

· The extremely low volume of Class B shares traded help explain

Potential Catalysts:
1.      A number of shareholders of Class B shares have put forward the proposal of allowing conversion to Class A shares; a one way conversion. Remember that Class B shares can be converted to Class A if majority of the Class B shareholders vote to do so; however, Miller controls the Class B vote with his 68% ownership of the class.

2.     Currently Lennar’s dividend yield is 0.4%; not providing a big income incentive in owning the shares. However if Lennar provided a 3.0% cash dividend yield, Class B shares would be yielding 3.7% due to their current price discount, providing a clear incentive in owning Class B shares (along with their higher voting rights).

On a side note, from looking at Lennar’s dividend history, I am once again in awe of the recent enthusiasm in housing stocks. Even during the remarkable housing bubble of the early 2000’s, which was fueled by overbuilding and over investment, Lennar’s dividend yield ranged from 1-3%. This was followed by a five year housing slump and hefty deterioration in shareholder value. Even after failing to receive any meaningful cash flows during the most exuberant housing bubble in U.S. history, investors are jumping back into the sector in hopes that a gradual recovery to the natural rate of demand will result in enormous profitability.

Housing is remains an extremely competitive business with gross margins near 20% and little value add from builders. Therefore, it will always be tough to generate meaningful profits from the business aside of periods of overbuilding and over-investment. However the future of housing does not affect this trade in any way!

Even with no fundamental reason for this spread to exist in favor of Class A shares, I am not entering the trade at this moment and will be monitoring the spread for a better entry point or any news on the proposal put forward by Class B shareholders.

Sadly the historical performance of this spread has deterred me from entering this trade and thus also provided the basic explanation for why it exists. The combined psychology of other traders monitoring this trade is likely similar and again shows that the market tend to be backward looking.