We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.
As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.
The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.
A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements. One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).
In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.
I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).
It’s always a pleasure to share these pages with like-minded people. Today’s post was written by a very smart, very diligent guy — who just so happens to be a long-time friend of mine. During COVID-19, he’s scrutinized one of the most “center of the storm” sectors: the cruise line stocks . I was thrilled when he accepted the invitation to share his thoughts and work on the blog. I know you will be, too.
With almost five months of lockdown behind us, logic would tell most that the outlook for the cruise industry has gone from bad to worse. As you’d expect, most cruise lines have spent the last few months pulling together survival dollars for what could be the worst storm to hit while not sailing. But even in the darkest of times, could there be light at the end of this tunnel? Article #Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus identified what I think is a very counterintuitive point – even when some of the most horrific events have hit cruise lines, their demand has been remarkably resilient in the following year(s).
For those who like bottom lines up front – I think CCL probably has best chance of survival, and a lot of assumptions used in this analysis are pretty conservative. This is a big gamble, and I’m not expecting any potential pay off until 2022 at the earliest (although reckless day traders may create some wild ups and downs along the way), but the payoff could be exceptional.
Who are these people making these bookings? Will these spikes in demand last? Even if there is strong demand, won’t governmental restriction stymie all chances for recovery here?
All great questions. The first two cannot really be answered definitively. If the past can be used to determine the future, it is fair to say that cruise demand has historically come back strong even after disastrous events. Further, many people seem to be of the mindset that Covid is here to stay, and are accepting its spread while hoping for a low death rate (whether this is an ethically acceptable position is an entirely different discussion and far out of the scope of this article’s analysis).
The last question is probably the most important here – where does governmental restriction fit in all of this? In my opinion, it is the most important final step in the recovery. If demand is there, but governments forbid sailing, then demand becomes irrelevant. Your guess is as good as mine here, but demand assumptions for the rest of this analysis are:
No more cruises will sail in 2020 – only revenue accumulated was Q1’20, with a complete halt to revenue for the remainder of the year.
Demand in 2021 is 50% of what it was in 2019.
2022 resembles normal operations – EBITDA falls somewhere between the min and max annual EBITDA generated in 2017, 2018, and 2019.
After diving into the financials of CCL, RCL, and NCLH (“The Big 3”), it looks like these three cruise lines have the ability to survive into next summerwith no cruise activity. While some of these may be able to last longer, failure to resume sailing in the peak season for cruises (i.e. the North American summer months) would likely be a final dagger for these businesses. CCL looks best poised to survive of the three, so more of the below will focus on them. Note that as of date of this post, cruises in the US will not resume until October for The Big 3; however, some European cruises are still scheduled to go ahead as planned.
Survival – what does liquidity look like over the next year?
Let’s start by getting perspective on what debt looked like on the balance sheet for The Big 3 pre-Covid. Looking at Net Debt to EBITDA and FCF as a % of Debt (avoid using equity in this kind of assessment, as companies can mess with it via share repurchases, dividends, etc):
CCL looks best capitalized coming into this mess, and has traded cheaper in comparison to the other two – EV/EBITDA ratio is ~20% less than the other two at the end of 2019.
As you’d expect, over the last few months The Big 3 have moved quickly to build up liquidity to survive this next year, drawing down revolvers and issuing new debt. Some of the debt issued at CCL and NCLH are convertible notes, so assuming these companies recover I think it’s important to factor dilution into any analysis that you run. NCLH also took in additional equity investment from both the public and via PIPE from L Catterton.
Now let’s put together some pro formas for CCL. What does a projected income statement look like?
As expected, these next couple years look rough, but I’d like to reemphasize that 2020 assumes no additional revenue, and 2021 assumes 50% demand – unless Covid goes from bad to worse than we could have ever expected, these feel conservative. This analysis also does not bake in the benefit of reduced fuel prices that may stick around these next couple years.
Where does this get my cashflows?
Using rough numbers here, analysis projects that $7.3bn of financing is needed over next couple years ($3bn in 2020 and $4.3bn in 2021). The good news (depending on how you look at it) is CCL pulled $3bn from revolvers in March and issued $5.75bn of new debt in April (some of which is convertible, and should be assumed converted if CCL recovers), meaning they’ve already achieved the financing needed based on these projections. My above cashflow projections also assumes all treasury shares are reissued at approx. 80% loss, and per the below, 62.5m of the 190m shares have already been reissued.
Other comments on cashflow:
2020 sales of ships– CCL plans to sell 13 ships in 2020 (approx. 10% of its fleet). I assumed $150m sale price per ship in my above cashflow estimates. I don’t think this is actually that alarming, as (1) these ships are probably older, and needed to go at some point anyway (who wants to ride an old cruise ship), and (2) 10% of fleet isn’t that bad given that they are the biggest cruise operator with ~45% market share. Competitors have also done and/or will probably do the same.
Cash outlays for ship orders- I’ve assumed that commitments for new ships will be wiped out over next few years. I think it’s fair to assume that CCL is probably under contract to take them, but in this environment they’ll probably tell the shipbuilders to pound sand the next couple years. It’s probably in the interest of the shipbuilders to suck it up as well if they do think CCL can recover – way worse trying to get paid if CCL gets forced into bankruptcy.
Credit vs cash refunds- so far, approx. 60% of customers have elected a to receive a future cruise credit rather than cash refund for their postponed cruises – definitely a positive sign for pent up demand
Breakeven point- the CCL Q220 earnings call transcript may be worth a read. David Bernstein (CCL CFO and CAO) notes that the breakeven point on an individual ship basis is generally 30-50% of capacity. He estimates that they’d need to run approx. 25 ships for cashflow to breakeven (approx. 25% of fleet). I view this as validation that my analysis is conservative, as I’m anticipating a cash shortfall in 2021 with 50% demand.
Debt covenants- I found some of the debt covenant specifics for RCL (net debt to capital ratio, fixed charge coverage ratio, min networth, etc); wasn’t able to find these for CCL and NCLH, but it looks pretty clear that The Big 3 will struggle to meet these. But similar to view on new ship orders, creditors will probably be willing to grant leniency if there is a light at the end of the tunnel – most lenders want to avoid seizure of assets and bankruptcy proceedings.
Bankruptcy- while I definitely see potential upside in an investment in CCL, it is definitely risky. If Covid continues to unfold in a horrific way into 2021, The Big 3 could be pushed into bankruptcies. But important to consider impact to CCL if RCL and/or NCLH go down while it stays afloat. RCL is the 2nd biggest behind CCL – if it files Chapter 11 and is relieved of some of its debt payments, it could suddenly have the opportunity to compete more aggressively. If RCL drives its prices down, it could force CCL to follow, driving CCL into bankruptcy. Takeaway here is that bad news for the other two could ironically lead to bad news for CCL.
NCLH differentiation- while NCLH’s balance sheet looked bad going into Covid, two points that I think help its survival case:
(1) It historically focused on cruise routes that the other two were not focused on. See snipit from 2019 10-k:
(2) its ships are significantly smaller (~30+%) than RCL and CCL. This could come in handy if governments put official caps on the number of people that can be on a cruise at a given time (regardless of ship size).
Cruises sailing in 2020– analysis assumes no cruises again until 2021, but if some of these carry on (unlikely in the US, but maybe more likely in Europe), it will be very important to track the outcomes and potential regulatory responses.
If betting on the survival and recovery of cruise lines is something that you’re interested in, I think CCL is the best bet. Back in March the market priced death into the Big 3 stock prices, and stock prices of these at the time of this post are not far from those March prices. Applying the lowest PE ratio from the last 10 years (excluding Covid) to this analysis’ EPS estimate shows a sizable ROI is in the cards. By no means should you view this as a real way to project the stock price, but point is that there’s a lot of potential upside here if you can handle the risk.
Now with the S&P back up to near highs, many are calling out Buffett and saying he’s lost his touch. “Maybe he’s too old now” and “maybe he doesn’t care anymore now that he’s approaching 90 and loaded” or “maybe the oracle has lost his touch”.
I don’t really think that’s the case and think the negative sentiment creates an opportunity in Berkshire Hathaway stock. People who argue that Buffett is too old and “lost it” could have easily argued the same thing when he was 65 going on 70, 75 going to 80… Buffett has that itch that can’t be scratched.
I do think some of his methods are too old fashioned. I can’t actually confirm this is true, but he has said he won’t participate in auctions. What board would actually be able to justify selling to him without a second bid? Especially when times are good and they are a good business.
I’m taking Berkshire Hathaway’s current market cap and subtracting the market values of his equity holdings (note, I pulled this from Bloomberg, so it may not be 100% accurate). I then subtracted the cash to arrive at the value the market is ascribing to the “core Berkshire Hathaway” business.
I say core, but in reality there are so many subsidiaries within Berkshire Hathaway. You have GEICO, Berkshire Hathaway Energy, BNSF, Precision Castparts, just to name a few well known ones. If interested, I highly recommend perusing the list of subsidiaries on Wikipedia. I bet there are quite a few you didn’t realize he owned.
At the end of the day, you’re being asked to pay <8x earnings for the collection of businesses that Warren has acquired AND you have free upside from the cash if it is ever deployed.
Frankly, the real upside in the stock may be 5-10 years away when Berkshire Hathaway is broken up and people realize the sum of the parts is worth more than the whole.
Either way, look at the impact of Berkshire going out and deploying cash. Earnings could likely go up 30% from where they currently are and even deploying the cash at a worse multiple than where Berkshire trades today (i.e. dilutive), you’re still paying <9x earnings.
Unfortunately, if you want to read a 10-K to get better at investing or understanding how companies work, you can’t just read a 10-K in a vacuum. You must put the knowledge and information you glean into context.
If you were moving to a new city and needed to purchase a home, would you look at one home and determine you had enough information? Probably not. You’d probably want information on that home as well as several others and weigh the pros and cons of each (how are the schools, how much room am I getting for the price & is it a good trade off, do I need to pay city taxes, etc.).
Same is true for investing in companies. I want to read about this company, understand how it works, determine if I think it is good or not, and then go read about its competition. Is the competition even better? Maybe the customer is actually the better business or its supplier.
As you can probably tell, this creates a web of information you need to understand, but can be worth it in the end.
Also in the context of not reading a 10-K, I almost never open up a 10-K without opening up the company’s latest investor presentation (typically on their investor relations site), and then also typically plan on reading the latest earnings calls as I get more interested.
Ok – let’s dive into what I do when I first open a 10-K.
“How does this business actually make money” – Read the Business Overview Section and Understand How that Flows Through to the Income Statement
Nowadays, there are links upfront in a 10-K that can help you jump to the sections you want. First thing I do is click on the Business Overview section.
From there, I jump ahead to where the company has the opportunity to describe what it does.
I can’t tell you how much I respect companies that really take the time to help investors understand what they do. Sometimes companies leave it ambiguous which is super frustrating. Especially when covering small caps and I also look at private companies, the amount of times I’ve heard investors think an a company does one thing, when in reality they do not actually understand how they make money, is alarming.
As a quick aside, I once had a company describe themselves like this: “[Company’s] performance resins and surface overlays are ubiquitous in products used in residential and commercial applications and are increasingly displacing traditional building material through value-adding attributes. [Company] is a highly profitable, vertically integrated provider of these products.
Very hard to even determine what they were doing. Turned out, they would saturate paper with a formaldehyde-based resin and sell it into various building products. That’s the importance of diligence.
I have to commend Fastenal on how well they describe their business in 7 sentences. It gives some history, what customers they target, how many branches they have, and what their general strategy is.
So right off the bat, I can generally tell how Fastenal makes money. They sell fasteners. Their business description actually continues on for several pages, which I’ll let you read as opposed to pasting here. It’s a good read.
But as soon as I read this description, I start to have questions pop into my head. I’m trying to understand the value chain. Do manufacture themselves or buy from suppliers? What industries do they target? How do they differentiate themselves? The reason why I ask these is because the answers will start to tell me things about the business.
If they manufacture themselves, it’s probably a unique offering that they can charge a higher margin for, but it will be more capital intensive (need machines, plants as well as branches). If they just buy from China and sell in the US, maybe others can do the same so I’d expect their margins to be lower, but not much capital is really needed.
Turns out, Fastenal mostly buys from third-party suppliers, but as you’ll see later, its margins are surprisingly high. Fastenal is a rare company where it actually provides some detail on this. As I said in my competitive strategy series, looking just at the numbers doesn’t tell the whole story. We need to understand why a company may have high margins or not and if that is OK.
To understand a business and get better at investing, you have to know how a business works. If the above snippet doesn’t make a ton of sense to you, then you need to map it out.
Here is a quick snapshot of what I typically do. I first just try to make a made-up model of the company. I just say, “Hey, I understand selling fasteners, widgets, what-have-you, means buying fasteners in inventory and selling them for a profit. Let’s assume I sell 100k fasteners for $5 – how does that look here for Fastenal?” Note, these numbers are made-up, but the margins are about what Fastenal has.
Hopefully from the notes above, you can see I’ve also made attempts on how the cost structure of the business works. Is this a highly variable cost business or not? I would say it is highly variable. If my sales go down, I’m not just going to keep buying fasteners and keep paying bonuses to sales staff (I’m going to incentivize them to get sales up).
Contrast that to an automotive company like Ford or GM. They typically have unionized workforce, so I’m not sure how many people they can actually cut in a downturn. They also have huge manufacturing plants that are hard to just turn off and turn back on without expenses associated with it. Contrast that to Fastenal, whose branches are very basic stores with shelves. That’s one reason why automotive companies and airlines go bankrupt so often. They are highly competitive, highly cyclical, highly fixed cost businesses – demand going down hurts the bottom line a lot more.
I digress. Back to Fastenal.
Let’s now see an impact of what happens with more fasteners being sold – what impact does that have on the bottom line (using EBITDA here for now)?
As you can see, a 4% increase in fastener sales actually leads to a ~7% increase in EBITDA. The main reason is that, while COGS went up by a similar amount to sales, SG&A stayed relatively flat. This is important to understand because you may say, “Ok Fastenal is a mature business. Maybe it should only grow with growth in industrial production, manufacturing, or GDP in the long term. Well if that is 2-3% growth, earnings probably will grow at a faster clip than that, which is important for valuation.
This is a simplistic example and view (for example, more detailed models will have store branches modeled out, how many fasteners each branch sells, what the sales impact and cost impact will be of adding a new branch) but hopefully shows in more detail of how I examine a business and how it makes money.
“Show me the money!” or, uh, Free Cash Flow – Examine the Cash Flow Statement; Understand Drivers
First, the income statement doesn’t capture everything. Net income does not equal free cash flow that we use to value a business. It may capture depreciation which can be used as a proxy for capex in a mature business, but for a fast growing business, capex will likely exceed depreciation. The income statement doesn’t capture the working capital investment needed to grow the business. It also doesn’t tell us where the free cash flow is going (M&A, dividends, share buybacks, debt paydown, just sitting on the balance sheet?).
I also focus on the cash flow statement next because frankly I am trying to find good businesses. If after examining the business overview and parts of the income statement, I see that the cash flow statement is a mess, I may or may not decide whether or not it’s worth my time. Sometimes I like to dig into a messy cash flow statement because people who do simple stock screens will miss opportunities. Other times I’ll decide it’s best to drive on.
To find the cash flow statement, I typically search the document for “Operating activities” which will allow me to jump to “Cash Flow from Operating Activities” part of the cash flow statement. If you don’t know, free cash flow = cash flow from ops minus capital expenditures. This is typically the cash leftover to the business that it can use for other discretionary items.
So I do some quick math and try to determine FCF for Fastenal.
They generated around $600MM of FCF last year, which was a nice jump from $500MM the year before despite what clearly was a big increase in capex. You probably want to figure out why to see if it is sustainably higher. Very quickly, I can see that net income increased (+$39MM), depreciation & amortization increased slightly (+$11MM) which is non-cash so added back, and I have to do some math, but I can see changes in working capital also benefited them in that it looks like they didn’t need to invest as much there, as you can see the increases in inventory and accounts receivable are down a lot Y/Y (total W/C benefit +$141MM Y/Y).
After figuring this out, you need to understand why these occurred. Does the company say anything in its earnings calls about this? Investor presentations? Why is capex up so much? New branches? Is that what drove net income higher? But if they opened new branches, why didn’t working capital increase? Is it a new type of branch that doesn’t require as much of an upfront investment?
After figuring out FCF and whether the past few years look sustainable, I take a look at where the cash is going. It looks like from above Fastenal paid down some debt (as payments are larger than issuance of debt) and paid a big dividend, which has been consistent in size.
However, one red flag I immediately see is that 2019’s dividend is nearly identical to 2018’s FCF… do they have enough FCF to cover the dividend? Yet ANOTHER reason why focusing on net income and payout ratios that are thrown around never makes much sense to me.
Anyway, looking at the cash flow statement provides a lot of clues as to how good the business is. Frankly, I only really need to Income Statement and Cash Flow statement to get an idea if the business generates a good return on capital.
Management’s Discussion & Analysis
This section of the 10-K is when management teams can really explain what drove business results over the past few years. Look at how much detail Fastenal provides in just one section. This doesn’t even really get into cost of goods or operating expenses.
This section really should help an investor with the detective work needed to understand the business. It certainly helps me model companies and think about drivers for the future.
Obviously, there are many more things to study when evaluating an investment, but wanted to share my starting point for how I read a 10-K.
I think the bank stocks look cheap, as I highlighted with a few in a recent post. But there are issues with lending right now — and I am not even including the wave of defaults & impairments people expect or forbearance.
In the article in the WSJ titled, The Day Coronavirus Nearly Broke the Financial Markets, there is this scoop on what was going on in the market. Essentially, banks held interest rate hedges on it books and when rates went down, the hedges swung in the banks favor and out of companies favor who decided to hedge.
What is funny is that this was seemingly good thing for banks — they had a gain on their books — but actually restricted their ability to deploy capital:
So when Mr. Rao called senior executives for an explanation on why they wouldn’t trade, they had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets.
One senior bank executive leveled with him: “We can’t bid on anything that adds to the balance sheet right now.
The Fed stepped in and said that, temporarily, they would ease these restrictions through March 2021:
Liquidity conditions in Treasury markets have deteriorated rapidly, and financial institutions are receiving significant inflows of customer deposits along with increased reserve levels. The regulatory restrictions that accompany this balance sheet growth may constrain the firms’ ability to continue to serve as financial intermediaries and to provide credit to households and businesses. The change to the supplementary leverage ratio will mitigate the effects of those restrictions and better enable firms to support the economy.
This is good and as I showed in my last post on banks, the amount of capital banks hold now is insane compared to what they had going into the Great Financial Crisis. The Fed agrees:
Financial institutions have more than doubled their capital and liquidity levels over the past decade and are encouraged to use that strength to support households and businesses. The Board is providing the temporary exclusion in the interim final rule to allow banking organizations to expand their balance sheets as appropriate to continue to serve as financial intermediaries, rather than to allow banking organizations to increase capital distributions, and will administer the interim final rule accordingly
Why did we tell banks after the GFC that they needed to increase their reserve requirements? So that they would be able to provide support in a crisis, not be a source of weakness. That is what is happening now.
I think we need to go a step further and actually lower the capital requirements for the foreseeable future. When you crimp credit, you crimp the economy. Lowering reserve requirements for some time would unleash significant amounts of capital into the system. So far the Fed has just said certain assets won’t count against the risk-weighted assets. With the rule expiring in 2021, it doesn’t really help banks feel super confident.
Here is the chart again of what banks capital levels look like – exiting 2019 with a median level of 12.8%.
Tier 1 Capital represents core equity capital to risk weighted assets and essentially represents the capital not committed to meeting the banks liabilities. The reason you have excess capital is to prepare for unforeseen events, which is why regulators require a minimum of 4%, but higher (6%) for large banks. Investors typically want to see 150% above the minimum. That foots to 6% and 9% respectively… And the big banks were near 13%. The excess capital allowed banks to invest, conduct share buybacks or dividends.
But its clear to me that banks learned their lesson from the last crisis – they did not want to buy the cause again so they carried significant amounts of capital.
I think the Fed / Govt should lower the reserve requirement to unleash more capital into the system from banks, not just central banks. They clearly have excess capital, they just need to be encouraged to deploy it. Imagine how much capital would be deployed if banks went from 12% or 10% to 6%? We then could say they have to get back to 9% in 5 years.