Author: DiligentDollar

I hope to share with my posts (i) investing opportunities that can arise from mismatches between short-term reactions to news and events compared to the long-term compounding of a business (ii) topics on portfolio theory (iii) general, topical macro discussions and (iv) some personal finance tips and discussions I tend to gravitate towards "ignore the headlines" type mantra. Often times, when something is going wrong with a company (typical in everyday business), the only headlines you will read is how bad things are and continue to be. This can also happen when things are going well. I think this, in turn, contributes to the mispricing of stocks, particularly as emotions get involved. In particular, I mainly cover small cap stocks that do not receive much attention by the headlines you typically see on CNBC. I believe there are plenty of opportunities in this realm to find mispriced stocks and I think by doing the homework and doing the proper diligence, you can outperform the general market.
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NXDT Update: What if Office is a Zero? $NXDT
Reading Time: 4 minutes

REITs have gotten clobbered over the past month. Vornado is down 32%, SL Green down 41%, and even apartment REITs like Mid-America Apartment is down 11%. There is a lot of concern with the banking crisis and interest rates that many of these properties are now underwater and financing has dried up.

For a newly-converted REIT like NXDT, it is obvious to see the headwinds. But NXDT already traded at a large discount to their reported (or purported) NAV. One could argue that should absorb some of this. One could also argue the discount is due to complexity and lack of a clear picture.

For background on NXDT, I would check out Clark Street Value’s posts  or Stocks Spinoff Investing. The latter has provided more detail to paid subscribers so you should definitely go check that out.

I bought NXDT after I sold HFRO as I mentioned here. I recently bought back into HFRO because the discount to NAV is now >30% and that is historically been a great time to add, but isn’t the topic here.

NXDT does have some office exposure. Their last presentation is from August and as of June 30, 2022 so it is completely stale as Timber and some of the CLO portfolio has been sold. But here is the NAV build:

I underlined CityPlace Tower as that represents ~10% of NAV. This is an asset Nexpoint acquired in 2018 with 7 hotel floors and 35 office floors.

As of 9/30, the latest filing we have, we know CityPlace gross value was marked at $214MM and had debt of $145MM, for a net value of $69MM. However, the company also has $34.5MM of restricted cash set aside, which adds up to $103.5MM.

I’m not sure why exactly that is up from 6/30 value of $99MM, but the property is in transition which is detailed below. You can see there is a large value ascribed to “construction in progress” on it in the filings. Perhaps they put more capital into it and marked it up:

However, you can also see CityPlace has hit its maturity wall. They did get an extension to May 2023, but that isn’t a great situation.

It looks like they are trying to rent it up, with reports of Neiman Marcus moving into part of the building. But looking at this site that has a bunch of listings, it seems like there are plenty of openings plus more coming in December 2023. It is tough to analyze and that is why I think to be ultraconservative, we could just mark it at zero.

So what if Nexpoint just tosses the lenders the keys? I am going to assume CityPlace is a zero. I’m going to mark down the rest of the portfolio, too.

I’m using the balance sheet they gave at 9/30 to do this. Many of the investments are marked using the equity method, so they do move around, but CityPlace is a clear line item I can mark to zero. Given the debt is non-recourse, we can also nix that with limited impact, though they will lose the restricted cash tied to it as well.

As for everything else, I tended to mark it down 15% from 9/30. The exception is NREF which isn’t actually down that much from then. The other pieces are their large other baskets of investments which I marked down 30%.

Lastly for markdowns, I took NexPoint Hospitality Trust down 100%. This probably isn’t a zero, but it is a tiny company that trades on the Toronto Venture exchange. It owns less than a dozen extended-stay hotels and has had some liquidity issues. NexPoint provided some additional capital and perhaps NexPoint takes the whole thing private, which would be interesting, but I digress.

The only other switch I did was move the perpetual preferred stock into the debt line item. I think of it as debt even if there is not maturity date.

As you can see, NXDT’s market cap at this point is $370MM. We can apply a huge haircut to the assets here, mark office as a zero and still come up with significant upside for the stock.

Honestly, what NXDT needs to do is have some portfolio rationalization or consolidation. Prove out more of their real estate marks are legit. The problem is the financing and M&A market stinks right now. Otherwise, time will tell.

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The Fed Started Cutting Rates in November 2022, You Just Missed It
Reading Time: 3 minutes

The Fed cutting cycle began in November 2022. You just missed it. While you’ll hear a bunch of debate about whether the Fed will raise rates “25bps at the next meeting”, or “they’ll pause!”, or “25bps now and 25bps again at the next one!”…. It all misses the point.

And look, I just did a post on hating all the “Fed speak” predictions. I’m so done with all of it. But I’ll add one more thought to the cocktail party as I recognize it drives markets.

Yes, the Fed isn’t actually cutting rates (yet). But if you are confused by market reaction right now (equities are well off the bottom and credit markets are thawing each day), it is because the market is forward looking and already started to price cuts in. In fact, no matter how hawkish Fed officials have been, rates even at the short-end refuse to budge.

It all started when this happened:

October CPI came in weak. Weak enough to piece together inflation had clearly peaked.

In turn, we had a massive move in the market. The S&P closed up 5.5% that day, but more importantly, look at the yield curve:

The 10 year tightened nearly 30bps, as did the 3, 5 and 7 yr. Since then it has continued to be a dramatic difference, with the 10yr now 70bps inside.

But how else can we see this view changed exactly on that day?

The US Dollar also peaked: 

Homebuilders have ripped:

Here are 3 month SOFR Spreads, which is a way to look at market expectations of future Fed policy. Big change around November, huh?

It is no different when the Fed says it will, “likely raise rates 50-75bps at a meeting” like it did in 2022. The market priced that in largely at announcement. The Fed didn’t actually have to start raising rates yet for financial conditions to tighten to that level.

Likewise, the market understands inflation is now much more in control. In fact, as I have written due to the bullwhip effect, it could overshoot to the downside with inventory glut and lower demand.

We all like to believe the market is inefficient, and I have seen inefficiencies first hand. In some cases though, it is pretty good at sniffing out the truth. It’s pieced out inflation has peaked and now is time to focus on the second mandate, employment.

Columns, Earnings Recap

Quick Recap on $WDFC Q4: GMs +400bps sequentially. Europe main disappointment. No change to thesis.
Reading Time: 2 minutes

Quick update of WDFC, doubt I do this often, but they reported so soon after I wrote on it I thought I’d give some thoughts. We’re seeing the green shoots of recovery on margins, but EMEA was weak, much more than expected. All in all, nothing changed in my thesis, but I’ll expand.

Maintenance sales (their core product) declined about 30% in EMEA. That’s stark for a business that was resilient in 2008. It would have been just 15% FX-neutral and they did exit some Russian and Belarus business, but still. It was only down 1% in the Q ended Aug. They sell through distributors in the EU, so no surprise in the face of uncertainty, distributors are destocking.

As such, EBITDA missed my estimate by about $5MM ($23MM vs. $28MM) solely due to this. GMs even beat my estimate by about 50bps. And mgmt basically said they have no change to their expectations, which is a second-half story. Normally I take the under on any second-half story, but this one makes complete sense.

I reviewed the “cost of a can” to see what is really driving the margin erosion. Basically 65% of a WD-40 can is either related to oil or tin. While packaging doubled in $s, the real needle movers are the chemical inputs, can, and manufacturing fees. These manufacturing fees are essentially warehousing and freight costs.

I think all of these will be tailwinds in second half.

Plus, China sales grew 22% on the maintenance side and 32.5% in APAC-ex China. So that is a good sign and probably more room to run as China re-opens.

Outside of that, last thing I’ll highlight is they have way too much inventory. They should destock themselves. But anyway, I expect that’ll be a 2H cash source. Could be up to $85MM, honestly. That may seem small, but it ain’t nothing for a company I expect to recover to $120MM+ EBITDA plus have a cash release like that.

 

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Never a “good” time to own $WDFC, but now might be “OK”
Reading Time: 5 minutes

I wrote up WDFC stock in 2021. The inspiration was wanting to know why TF WDFC stock always traded at such a rich multiple. Persistantly. It would not have been a good short leading up to that time. Is everyone who hates it missing something in the numbers? At the time WDFC stock was trading around $300/share at 35x LTM EBITDA and 52x LTM EPS. Now it is more like $165, so if you could’ve top ticked it, good for you.

It was a good exercise. It’s easy to discard a stock simply by looking at the multiple and saying “nope too high”, when I think we can all agree we’ve bought companies with low P/E multiples and really regretted it, too.

Anyway, my conclusion was it was a really good brand, great business with super high ROIC, long-growth runway that required little capital. Pristine balance sheet… too pristine if you ask me….

Plus, its been highlighted before, that WDFC stock has some particular things going for it.

Setting all that aside, I couldn’t make the numbers work to meet my return threshold. In other words, a business can have a high return on its capital, but if I pay too much for that invested capital, my return will suck. the company has some long-term targets I thought they had really low chance of hitting based on their trajectory. I still think that’s the case, but the company has started to talk those down.

So it wasn’t a good time to buy. But I also pointed out WDFC stock never looked great to buy, but somehow you could’ve earned a >10% return buying at many points in the past when it looked expensive.

I’ll re-post that chart here – red line is where you could buy it 3 years before the current date, dotted orange is where it needed to be for 10% CAGR. Blue line is where it was. In other words, you could buy it below that price much of the time and it ended up being much higher in the end. 

Now with the stock at ~$165, I think it is actually an OK time to buy. I won’t rehash everything I did in the first post. This time it comes down to a 3 basic ideas:

  • Earnings are depressed from a price / raw material mismatch (this is true for many specialty chemical companies, such as Sherwin-Williams, PPG, etc). Price is flowing through now at the same time raw materials are collapsing. Earnings estimates look too low, in my opinion.
  • China is a growth story LT. It is still a small segment. Re-opening will help drive higher growth perhaps faster than people expect.
  • Last but not least, it is a great business and you have to pay up for quality. I’ve quibbled with execution in the past, but it does have a long growth trajectory (how is China only $20MM of revenue??).

I’m not sure what is exactly in WD-40, but I know it is a lot of oil derivatives.

Here is how true specialty chemicals typically work (and footnote- this is kinda what caused Sherwin Williams to re-rate, among other things).

  1. They are typically resilient businesses with pricing power and their customer doesn’t keep track of their raw materials and keep an index of inputs to change price (i.e. not a commodity)
  2.  In an benign environment, should grow volumes GDP+ and get price too
  3. However, if oil spikes, there can be a mismatch in raws and price, compressing margins
  4. BUT what specialty chem players do is they get MORE price to cover raws and when they fall again, they never lower price.

So what happens? True specialty chemical players may realize some compressed margins short-term in an oil spike, but long-term they reset higher. 

You can kind of see that play out for WDFC gross margins over time. It tends to move inverse with oil, but then reset higher:

In their fiscal year 2022 (ended August) they realized nearly 500bps of gross margin compression. Their long-term target is >55% gross margins, and they did 49% in ’22 when they had just done 54% in ’21. They break down more of the headwinds here, but keep in mind each of these have turned to tailwinds now and the company likely won’t be lowering price.

They go on to say they have implemented significant price increases that will recover margins over time. And yet, when you look at street expectations, they don’t have them getting back to slightly-below 54% gross margins until 2024. To be fair, 2023 guidance from management is wide – anywhere from 51%-53%.

The low end doesn’t seem right to me and is meaningfully different outcome. The low end doesn’t seem right based on their comment that a ~25% price increased went into effect late-2022. They also already had some margin benefits from price coming through, though they were masked.

They also say they will be implementing these across geographies.

So you’ve got all this price coming through, right when raw materials are falling. Sure, we may be in a recession in 2023, but that’s a big maybe too. I’m at ~$6.85 of EPS and the company guided to $5.15 for 2023… I only model 5% volume growth (big price increases result in some elasticity plus weaker market).

Again, history shows they regain this margin and then some…

Moving on to keep this short.

The other thing about this company is China. APAC in total for WDFC is <$75MM. I don’t see why this geography couldn’t be well above $200MM (Europe and North America are $200MM and $240MM).

There’s a lot of squeaky, rusty stuff in Asia too.

So I can’t say when, but that seems inevitable if they can get the branding and distribution right. Which they clearly haven’t so far.

But the CEO who had been there for forever just retired. They brought up an insider so not totally optimistic, but at least you know things won’t be shooken up too much.

In sum, I think at we’re at a much more reasonable point optically on valuation (24x my 2023 EPS), but again EPS doesn’t matter. What does matter is FCF per share is likely going to go grow double-digits for essentially a consumer staple where estimates are too low and the required capital to grow is very limited.

That seems like the set-up for a winner. I fully accept being “early” on this one.

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Re-examining Big Lots Stock – Case for Optimism? $BIG
Reading Time: 4 minutes

It’s a start of the new year, and the end of a year where the S&P500 was down nearly 20%. Some may focus on what worked, I’ll look at an idea that did not go well. Big Lots stock, down 68% in 2022, it’s market cap is just ~$425MM.

I think there’s still room for optimism (even if its just a “dogs of the Dow” type of viewpoint). This bagholder just won’t quit. Mainly because I think the stock is trading at ~3x FY’24 EBITDA, 8% dividend yield, with some upside if they continue to sell some assets.

Don’t get me wrong. Don’t take this as “Big Lots stock is my largest position.” Far, far from it. Could we go into a recession? Sure. Am I happy that FCF may be mediocre despite the low EBITDA multiple? Of course not. That’s why position sizing is important.

That said, from here the stock looks interesting (even if that means when I first wrote it up was much too high). This could be one to add to the radar at the very least. I’m also looking out to 2024. So if you’re someone who is looking for something that will definitely do well this year, not sure this is the place. Especially because if under this new lens it just looks “interesting”, then it probably has a bit more downside before the upside arrives (just my experience).

I think my biggest mistakes in 2022 were buying low-quality business that seemed like they had tailwinds. Things can quickly change, tailwinds can evaporate, and you’re left with a low-quality business! It worked for awhile and then it really did not work…

Retail is a tough business. That’s apparent right now where many are caught with too much inventory (in the face of destocking), mark downs are evaporating profits and working capital has eaten liquidity. Freight and labor have also been challenging.

What makes this a particularly bad pick for me is I’ve been calling for the bull whip to play out for some time now and this is a clear example (here and here).

But I really liked what Big Lots was doing – pivoting store formats, bought brands with staying power (Broyhill), improving cost structure and growing stores to help absorb fixed cost leverage. I still think all of those are true. But as I’ll show below, they really got hit with freight, promotional activity, and labor costs.

Theoretically, the challenges mentioned above should be “one time” in nature, or at least cyclical problems, not secular. And they are all known now, at least I think they are…

I built a waterfall chart from 2019 to show the pressures Big Lots has seen. But just to rehash in FY2022 (which will end Jan’23, so Q4 is still an estimate).

  • Sales will have declined ~11%
  • GMs down >400bps
  • Opex up as a % of sales >350bps

Big Lots ended 2019 with ~6.5% EBITDA margins, so no surprise it is now negative.

But when you break down the reasons, Big Lots has called out freight being 400-500bps of operating margin pressure via GM and Opex. And they said that has peaked at this point. Promotional activity has peaked, too.

Looking forward, Big Lots has already faced destocking as mentioned. If we assume modest sales growth to 2024 and some of these headwinds abating, I could see Big Lots easily getting back to $255MM of EBITDA in FY’24 with some reasonable assumptions.

Bridging Big Lot’s EBITDA from 2019 to the current year to my expectation a couple years from now

With a ~$425MM market cap and ~$825MM Enterprise Value, that means Big Lots stock is trading at 3.2x EBITDA!

Is it the cheapest retailer I have ever seen? No. But I think that multiple could look even lower given more asset sales are on the come:

I have no idea what these assets could sell for. Back in 2020, they did a sale leaseback of 4 distribution centers for a gross amount of $725MM (net proceeds was more like $575mm after taxes and such). That’s not really a comp, but was interesting how low book value was compared to the actual proceeds (recorded a $463MM gain on sale).

I did find several listings of Big Lots stores that ranged anywhere from $2.5-$4.5MM (honestly averages in the middle). If it could sell 25 stores for $2MM a piece, that is $50MM gross. There’d probably be $3.5MM of incremental rent expense as a result, but that’d still be a win in my book given where the market cap is.

Big Lots has nearly $720MM of PP&E on its balance sheet. Selling assets at better than a 10% cap rate is accretive given Big Lots stock is trading at such a low multiple. It helps liquidity and can help pay down debt. I’ll take it.

While dangerous to anchor on, let’s not forget book value is $27/share.

As I mentioned at the top, a big concern here is $255MM of EBITDA may not generate much FCF. They’ll probably spend $170MM on capex per year (albeit to grow stores). I think with interest the stock is probably trading at a 10% FCF yield at best.

So one to watch. I still think this business and brand are underappreciated long-term. But alas, buying low-quality businesses even at cheap prices can be a dangerous game.