Although there are no earnings updates or any particular newsworthy items on B&G Foods, I thought it would be a good time to update on the company as the stock has come under significant pressure. It also gives me time to gripe about the way dividends are viewed in the US.
You see, BGS’ stock is down
20.5% YTD (compared to SPY being up
14.5%). The dividend yield is now ~8.3%. However, all things considered, I’d
prefer the company to turn that dividend off and buyback shares at these
Companies typically establish dividends as a way of saying, “here you go, investors, I can’t invest this cash at levels that would create value for our company (i.e. in excess of our cost of capital), so I am giving it back to you.”
That’s all fine and good, but what about when things change (as they always do)? The way it works now is that dividends are viewed as sacrosanct. A company that cuts its dividend from the previous level will see its stock get crushed. It seems silly to me for that to be a rule. In some cases, the result is that CEOs/ CFOs initiate dividends to get into stock indices or attract incremental buyers. If I were CEO / CFO of a public company, the last thing I would do would be a regular dividend (even if it meant some funds couldn’t buy my stock). Special dividends, or dividends that are understood as non-recurring, seem much more prudent.
Anyway, back to B&G. It appears that private values of companies are now in excess of public companies. I also think that public investors are not valuing B&G’s platform as it should. As such, I wish B&G would (a) cut the dividend and buyback stock and (b) pursue a sale of itself. While the company would lose its public stock as currency to buy things, private markets are more comfortable with LBOs of highly cash generative companies.
What do I think B&G could sell itself for? Well, Ferrero just bought Kellogg’s cookies, fruit & fruit-flavored snacks, pie crusts and ice cream cones business for $1.3BN, or 12x EBITDA. Kellogg decided to sell this business because it had areas that it felt it could invest in for a higher return. Campell Soup, which is struggling with growth, trades for 11.5x. I think B&G should at least trade for that. Also recall that Campbell bought Snyder’s-Lance for 19.9x EBITDA pre-synergies and 12.8x post-synergies.
If B&G sold itself for 12x, that would imply a $31 price target (excluding any synergies or cost outs of no longer being a public company). I wouldn’t necessarily like that price, but it could be a catalyst for people to pay attention to the stock.
Does 12x make sense? Let’s look at the private equity math. I assume PE can carve out some costs and also the company should be lapping freight and other inflation costs. I also assume they use cash to pay down debt. It amounts to a ~16% IRR. Not a 20% winner, but not too shabby either.
As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2”, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures.
I came to the conclusion that Amazon was preparing for a split up of the company. The traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources.
For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources. This allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.
This led me to ask myself:
What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
Is AWS actually a good business?
Would splitting the company make sense?
I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:
Allow focus in areas of strength.
Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
Optimize capital allocation
AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
Better align incentives
Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
Wouldn’t it be better if your performance and the company’s performance were linked?
Is AWS a good business?
“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”
-Jeff Bezos, 2014 Letter to Shareholders
Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.
The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models.
As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.
AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.
Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.
The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers.
However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.
How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Jeff Bezos, 2016 Letter to Shareholders
In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns. In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…
Lastly, its no secret that building data centers to support growth is capital intensive (see AWS financial table above). They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.
Unfortunately, I DO think returns are going to come down materially over time. The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.
Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage. Think about commodity businesses that report utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.
As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.
Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.
I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?
How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far.
So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.
What do you think AWS is worth?
Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases. I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.
For the reasons stated above, I think this results in returns coming down over time. I still model goodreturns to be clear, but that the return on assets comes down meaningfully.
This may be hard to read, but I end up with a valuation of $164BN for AWS. Given the value of AMZN today is around $830BN even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately. However, I maintain that the business would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.
Because there are now less moving pieces, we can clearly arrive at a price target for the warrants. Based on my previous posts, you know that my price target for Univar is ~$32/share in the next 12 months. I think I am being reasonable in this analysis (though I admit, Univar is hosting its 2019 outlook call next week which could change things).
(March 4 Update: UNVR released 2019 guide of ~$750MM of EBITDA, which reflect 10 months of Nexeo and expectations of flat industrial demand. Seems relatively conservative. They also expect to generate $275MM of FCF, which is still a 7% FCF yield. Not too bad, but not amazing either).
appointed Equiniti as the successor warrant agent pursuant to the Nexeo Warrant
Agreement. This means they will now
handle the warrants being exercised. Unfortunately, in the meantime, this means
the warrants will be pretty illiquid.
Yikes. No wonder the stock was down ~28% on the day. Being a contrarian investor though, do we buy now that there is blood (er, ketchup?) in the streets?
Unfortunately, I don’t quite yet think we are being compensated well enough for the risk. It is close, but the risk of rising inflation, new competition impacting CPG companies, and changing tastes has clearly impacted the business (and resulted in the miss and guide down).
Impairment and Financial Controls
The HUGE, but non-cash, impairment is something the headlines are grabbing. I’m less bothered by the impairment (is anyone actually shocked that Oscar Mayer cold cuts value has gone down?) and more bothered that this did not come up earlier. Each year, companies must test their assumptions on goodwill to see if it should be impaired. That test occurs in Q2 for Kraft which means they didn’t do it then and waited a couple more quarters to break the news. Perhaps they really didn’t change their assumptions until now, but more likely, I think some of their financial controls need improving.
Indeed, KHC has had issues in the past on this including issuing a non-reliance letter on its previously issued financials relating to the cash flow statement and maintained a material weakness in internal controls over financial reporting. This isn’t too rare, to be fair, but the CFO is a 29 year old so… do you feel comfortable with that? Especially with the new SEC investigation?
To be clear, I think Kraft Heinz is a good business and is supported by solid brands behind both companies. I would be a buyer KHC if it hits the right price. However, from a valuation standpoint, there’s not enough cushion built into the price today to weather more bad news. I generally use a 10% forward FCF yield to gauge this as a general proxy for when bad news is really priced in, though it can differ depending on the business. I would say given KHC is a strong business, I’d buy before it got to that level.
If the average S&P500 company trades at a 5% FCF yield, or 20x FCF, then you can see that KHC looks pretty good trading around 13x FCF. However, if you think you need a 10% FCF yield to buy the stock then that means it has further to fall — to $27 which is ~23% more downside.
Said another way, let’s say you think KHC should trade at a 6.5% FCF, a modest discount to the S&P500 especially when considering KHC is 4.3x levered. That is 18% upside from today’s levels, which is good, but not enough in my view for the risk.
There could be upside from improved sentiment and the sale of two businesses they announced on the call to pay down debt, but I think more likely than not, it will be bad news for the next two quarters. Without any positive catalysts, the stock likely drifts lower.
Alas, 2018 was a very tough year for Hudson (ticker HDSN). Based on my analysis below, however, I think the stock could be a multi-bagger. Currently trading around $1, with the rest of the street thinking the company is in trouble of bankruptcy, I think we could reasonably see it move up to $8/share over the next 2 years. Indeed, I think in a few years, the company will be doing $60MM of EBITDA compared to a $175MM EV today…
To recap a tough 2018:
The company, which supplies refrigerants for HVAC systems, just completed the acquisition of Air Products refrigerants business, ASPEN, when 2018 had two factors that pressured results:
Pricing on refrigerants in 2018 declined across the board
Customers left little inventory on the shelf, and moved to a just-in-time purchasing model. This was a consequence of pricing behavior
To give a picture of how bad it was, 1H’18 sales were up 22%, mainly from the ASPEN acquisition, but EBITDA was down 70%. Yikes. The company also took on only debt to fund its acquisition and was ~10x levered. Double yikes. The stock plummeted to around $1 after peaking around $9 in 2017.
These two negative factors that pressured results can be traced back to events of 2017.
Prices on refrigerants in that year were increasing rapidly, so customers bought early to get ahead of further increases in pricing.
As pricing leveled off coming into 2018, customers had to devalue their inventory to re-align with market pricing. As a result, buyers were much more cautious with their inventory levels in 2018.
This caused further pressure on pricing in a catch-22, circular fashion.
Pricing has since stabilized since Q2’18 and inventory in the channel remains relatively low.
What was going on with pricing?
Before I start, I should give some historical context that will provide a better picture of the market.
Refrigerants go through phase-down cycles due to environmental regulations. Chlorofluorocarbons (CFCs) were used from the 1930s through the 1990s. But with awareness on their ozone depleting effects, the Montreal Protocol introduced the phase down of CFCs. We then moved to HCFCs and then HFCs and then HFOs and I am sure there will be many more acronyms to come. The point is, as concern over global warming and depletion of the ozone advances, new regulations (across the globe) and new refrigerants are introduced.
R-22 refrigerants, a type of hydrochlorofluorocarbon or HCFC, has been one of the most widely used refrigerant, but is being phased out. Pricing had been increasing in 2017 as customers wanted to get ahead of the phase out of new production, which limits new supply in the market.
As such, no new production of R-22 can be produced by 2020. To be clear, this does NOT mean you can’t use R-22 anymore. Many HVAC machines have 20+ year lifespans and often would require retrofitting for the new refrigerant types to work, which is more expensive than just using the same refrigerant.
Looking forward, though one could see a re-stocking event occuring in 2019. Pricing should also increase for the refrigerants they sell, which I will touch on below.
Why is pricing going up?
Demand for the old types of refrigerants remains relatively steady, but supply goes down dramatically (i.e. to zero). Given the offset, pricing moves up as well. Only 4MM pounds can be produced in 2019 and then moves to 0 in 2020+. The EPA projects that aftermarket demand will be ~50MM pounds by 2020. As a result, the company expects that R-22 will move like other previous refrigerants. It thinks that pricing will move from $10-11/lbs to $30/lbs.
To state the obvious, pricing on Hudson’s products should improve. First from the lack of new supply and second if demand increases as customers re-stock inventory. This should also drastically improve margins, as price increases drop to the bottom line.
Hudson is also the largest provider of reclamation services, summarized in the graphic below. These reclaimed refrigerants can and will replace/displace virgin production. Reclaimers will provide 100% of R-22 following 2020. There are over 50 million residential and light commercial systems using R-22 in 2018. This should bode well for Hudson, who has 35% market share.
What happens when R-22 is phased out?
A question you have to ask yourself is whether or not Hudson has a business following the eventual phase-out of R-22. Obviously, the terminal value of the company has a lot to do with its valuation.
In 2016, the Montreal Protocol reached an agreement to phasedown HFC compounds by 85% between bow and 2047. HFCs are the next generation compounds, meant to phase-out HCFCs (like R-22) and CFCs. While these HFCs were designed to have zero impact on the ozone layer, they have determined that HFCs still have a high global warming effect. Lo and behold, we have a new product (and acronym) coming out, called HFOs that will reduce both global warming impact and ozone depletion.
But for the next few decades, HDSN will not only work to reclaim R-22, but then will switch to reclaiming the HFCs providing a long-lead time to the business. In addition, emerging market countries tend to ratify global warming protocols at later dates and use older refrigerant types for longer. As such, these markets will likely continue using older technology for longer.
Reclamation is not all the HDSN does. I should also take a step back here to also note that you can think of Hudson like a distributor of virgin product. It also sells refrigerants to customers from its suppliers. For example, in 2016, Hudson was awarded a $400MM contract to the Department of Defense to supply refrigerants, gases, and other related items to the military. This is a 5 year contract with a 5 year renewal option. As an aside, the value of this contract does not appear to be factored into the stock price today.
What do we think the company is worth?
On a PF basis, Hudson and ASPEN generated $255MM of sales in 2017. Given changes in pricing plus volume improvement from JIT ordering patterns unwinding, I think it’s not unreasonable to see sales move past $300MM in 2020. Remember, R-22 will move from $11/lbs to $30/lbs over time, which is a huge uplift.
The company has stated this will result in 20% margins (though I think that’s conservative given pricing). Assuming the business is worth 8x, I think the stock is worth $8/share, which is significant upside from today’s levels.
Why am I not concerned with the leverage?
As of today, HDSN remains highly levered (~9x) and it was required to get a waiver from its banks on its covenants. Banks typically are willing to do this if they view the challenges the business is facing as 1x in nature. At the end of the day, they don’t want to take the keys and run the business themselves. Most of the time in bankruptcy, the company haircuts its debts in Ch.11 and continues operating.
Hudson is still able to manage its debts and paid down $37MM of debt in Q3’18. The term loans also does not come due until 2022, a point at which HDSN (hopefully) is rocking and rolling again.