Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

Candle in the Tailwinds: Bath & Body is “Secret SaaS” in Plain Sight $BBWI

Reading Time: 7 minutes

L Brands officially spun off Victoria Secret and now Bath & Body Works (BBWI) is an independent company. This is great news to me as I think BBWI is a “Secret SaaS” business, a topic which I discussed before and will get into here.

Why do I like BBWI?

  • High margin category with growth tailwinds (beauty, fragrance)
  • Fragrance has difficulty translating to online without trust – Brands matter
  • BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance
  • Like many other brick-and-mortar retail (B&M) businesses, discovered the power of omni-channel during COVID – I believe it will structurally benefit the business
    • Many focus on LTV / CAC as well as gross profit return on sales and marketing for SaaS and DTC businesses – the thinking being because it is a more variable cost business and you can tie the two
    • But strong B&M brands have high initial upfront investment (e.g. the stores), and then serves the customer and drives loyalty with more limited incremental spend. We shouldn’t forget this.
  • Business has been “trapped” inside L Brands
    • Not sure analysts gave BBWI its full consideration when it attached to VS – a brand that is facing significant competitive pressure and heavily dependent on malls.
  • Not as impacted by supply chain issues, but the “baby could get thrown out with the bathwater”
    • BBWI sources most products from their facility in Ohio, not China. 80% sourced from US. Broader sell-off in retail could create an opportunity

As an aside, the Victoria Secret spin may end up being like Joel Greenblatt spin-off: the market hates VS so much that it gets to an extremely attractive price as people sell the spin. Time will tell. Don’t get me wrong, I would probably be one of those dumping VS if I received it.


Business has been “trapped” inside L Brands

I’m going to start with the last point first because it is quick. If you listen to the latest BBWI call, it is clear to hear analysts are still a bit confused how to model BBWI – it hasn’t been standalone before. Things like normalized capex, SG&A, and others were frequently brought up. I had to do some digging to find long-term gross margins for BBWI. All this is to say – you have to do some work to learn the most you can about BBWI standalone.

Second, BBWI and VS fortunes have been the complete opposite. As such, if you just looked at L Brands as a whole, you might miss the success story within occurring at BBWI shown below:


High margin category with growth tailwinds (beauty, fragrance); Fragrance has difficulty translating to online without trust – Brands matter

BBWI has 28% operating income margins, which both shocked and didn’t shock me.

Granted, this is LTM, where they benefitted from more of a “DTC” model during COVID and less promotions, though their physical stores were closed for 90 days in 2020.

On one hand, the margins are top quartile. On the other, fragrance and beauty are notoriously high margin categories.

Why is fragrance a high margin category? The packaging and everything involved with fragrance related products are usually a small cost. What drives the sale is the actual smell – and that takes technical know-how that is hard to replicate.

It’s analogous to beauty – beauty products are high margin because it tends to be a tough category to replicate, it is tough to get good distribution, and there is a degree of customer trust and loyalty (“hey this worked for me, you should try it”) which is hard to break into. Oh – and obviously consumers will pay up for these products if they “work”.

BBWI is at the center of some of these trends. Clearly, you can see their growth in the numbers I posted previously as well.


BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance

I like the simple “razor, razor-blade” model from BBWI. They have “wallflowers” which consumers plug into the wall and dispenses the fragrance. These plugins can be simple or decorative, like seasonal ones shown below.

They  aren’t too cheap, as a razor is for the blade, but the scents offered are consistently refreshed and tend to be “optically” cheap. For example, 5 refills for $24 tends to be a consistent sale.

Compare that to one Yankee candle which is more than that for just one candle (which will burn longer, but the optics to a customer aren’t the same. I could dwell on this point, but to me, I don’t think consumers do that math).

I hate anec-data, but my wife and mother are consistent buyers here (thank you Peter Lynch for recognizing this investment thesis!).

Management has several slides that show they are thinking about this the right way. Find ways to increase retention rates and drive value.


If this is Secret SaaS, can we look at BBWI metrics with the lens of SaaS?

This isn’t perfectly accurate, but I think it is instructive. If you assume 15% of SG&A is for attracting incremental customers, then the company has a ~3 year payback. Again, that is just a fixed assumption and hard to get a direct feedback response for a legacy B&M player.

However, this is extremely difficult to determine for B&M retail. Especially one where we have limited stand-alone detail… But as noted before, the investment in SG&A comes upfront and to some degree, it is a “build it so they come” model.

But Warby Parker put it well in their S-1:

“While we have the ability to track where our customers transact, we’re channel agnostic to where the transaction takes place and find that many of our customers engage with us across both digital and physical channels; for example, many customers who check out online visit a store throughout their customer journey, while others choose to browse online before visiting one of our stores.”

To me, it is clearly the other way around for fragrance. Once you get comfortable that BBWI isn’t going to sell you something awful in their fragrance line up, you are likely to buy online from them (and perhaps, not from a brand you don’t trust). Or, you find several fragrances you really like and consistently re-order them.

I think they are just too interlinked to derive anything useful from this analysis. Instead, we can just focus on margins and FCF to get a sense of health.

Omni-channel

On that B&M note, the company is 35% mall (says 99% are cash flow positive), 31% are off-mall (i.e. stand-alone stores, all cash flow positive) and 31% digital – super-enabled by COVID. They also have a small, international franchise business making up the balance.

I see a similar set-up longer term as Big Lots, which I wrote about how they can pivot their footprint. You can see in the table below that off-mall stores and Class A and B malls are clearly worth keeping. Class C and D? Less… And the Class D malls have the shortest lease terms remaining.

BBWI specifically called out closing stores in non-viable declining malls and remodeling others for an sales uplift.


BBWI Driving More Loyalty

While I’ve already stated why I think BBWI has a loyal customer base, BBWI is doing more. It makes sense – to create value from their existing customers, they need either more trips or for them to spend more in stores per trip.

Loyalty programs typically achieve this. For example, offering a 25% off coupon to loyal members typically gets them to either start an order they might not have done previously, or add one more thing… this incremental sale drives a lot of value for the retailer.

BBWI is testing that now: customers in the loyalty program spend 30% more than non-loyalty members.


A Quick Word on Value

BBWI is expected to generate $5.2BN in FCF between 2022-2025, or 30% of market cap. I even think that could be conservative. The company is returning significant amounts of cash to shareholders (continued the L Brands dividend, doing a $1.5BN share buyback) and I think the valuation is very reasonable at around 10x EBITDA.

However, they are earning high margins lapping a COVID bump. Essentially, the company saw a significant increase in sales, especially online, despite their stores being closed for 90 days during the pandemic. In the 2H of 2020, they were able to pull back on promotions which boosted margins.

I am not too concerned. This is a wide gap, but management targets $10BN in revenue (from $6.4BN in 2020) over the next 3-5 years. They assume some of this margin will be given back and EBIT margins will be in the low to mid-twenties. The stock is currently trading at 10x EV/EBIT on this forward number. Not too cheap, but not overly expensive given the business model either.

If I take the $6.4BN of revenue they did in 2020, apply a 22.5% margin to it I get $1.4BN of EBIT instead of $1.8BN. Based on their PF balance sheet for the spin, I calculate ~$910MM of tangible invested capital. This is true for most successful retailers thanks to leases (which can be a double edged sword), but that ROIC is fantastic.

Bottom line, I think BBWI deserves a premium multiple.

 

Entegris: Picks & Shovels on Secular Semiconductor Growth $ENTG

Reading Time: 5 minutes

I have a picks-and-shovels play on semiconductors. While it may not look “optically” cheap, I think Entegris can compound earnings at a very fast rate thanks to the secular growth in semiconductors as well as changes in semiconductor technology that will require more products from Entegris.

While I say Entegris stock is a “play” on semiconductors, I would underline that this isn’t a short-term trade for me. I am going to lock this name up in my coffee can portfolio and throw away the key. There actually is a second player as well I am reviewing, but haven’t gotten fully comfortable yet.


Why Entegris?

  • Picks-and-shovel plays on semi growth (internet of things “IoT”) which should grow well in excess of GDP
  • Semiconductors are notoriously cyclical; there is a capex-exposed portion of the business (30%), but large chunk benefits from recurring revenue (70% of products are consumed in wafer production)
  • Best-in-class technology which sets them up well in changing landscape
  • Underfollowed name, but center of several long-term trends
  • Dry powder: <1x levered, $400MM of cash on hand to make M&A or investments

While semiconductor manufacturing is complex, I want this write-up to be simple. I think once you just understand the basics, it is easy to see how Entegris can be a winner for the long-run.

So I’m going to put the main drivers of why Entegris is a winner right here:

  • The number of production steps in semiconductors is increasing…increasing demand for Entegris’ materials
  • As the steps increase, yields tend to decline…also increasing the need for materials to improve yield (which Entegris provides)
  • Lastly, Entegris’ materials improve device performance. Performance demands are also increasing in smaller structures

Overview:

Entegris is a chemical / materials company that helps with the production of semiconductors.

Semiconductor production requires hundreds of highly complex and sensitive manufacturing steps. You’ve probably seen videos of semiconductor fabs where people need to dress in full radioactive-like suits to avoid contamination in the process.

Silicon wafers are the core building block for semiconductors, and during the manufacturing process, a variety of materials are applied to silicon wafer to build integrated circuits on the wafer surface.

I snagged this picture from an ASML page. If you don’t know ASML, they also are a picks-and-shovels play on semiconductor growth, particularly high value-add. But I thought this chart showed the processes well.

EUV beginners

Entegris is one of the companies providing these materials in each step. Here are some examples:

  • Etching
  • Deposition
  • Photolithography
  • Ion Implant
  • Chemical Mechanical Planarization (CMP)

I’m not going to explain each one to keep it simple, so please go read the 10-K for that (which I link to above).

Wafers are consuming more materials as the production process becomes more complex. Nodes in semiconductors are getting smaller, which requires more processes and yields potentially go down with each step. This requires new materials of increasing purity, quality, and stability to maximize yields.

For example, in memory chips, the industry is migrating to 3D NAND which requires 128 layers from 64 layers previously. In logic devices, there is a shift to 7 nanometer (nm) from 28nm. In both of these cases, there has been a 2x increase in material spending.

Fabs must reduce defects at each individual step in order to achieve the same final yield. I got this chart from this website which breaks down why the steps are increasing, but this reduction of the situation helps me understand it clearly.

Entegris noted, “by 2022, approximately 25% of the wafer produced in logic fabs will be at 20-nanometer technology or below. And in that same time frame, we expect almost all 90% of the 3D NAND chips to have 96 layers or more” – so that is very positive for Entegris.

Additionally, these materials play a role in performance of the chip. As the Entegris explains:

New materials have played a significant role in enabling improved device performance, and we expect this trend to continue. As dimensions get smaller, new materials will be required to enable transistor connectivity. For example, leading-edge semiconductor manufacturers are moving towards atomic layer scale, where the precision of the manufacturing process and purity of the materials used is vital to maintain device integrity. These materials need to be supplied and delivered at ever-increasing levels of purity and control, from point-of-production to point-of-dispense on the wafer.

So again, the boiled down, simple thesis:

  • The number of production steps is increasing, increasing demand for Entegris’ materials.
  • However, as the steps increase, yields tend to decline – also increasing the need for materials to improve yield.
  • Lastly, these materials also help improve device performance. Performance demands are also increasing in smaller and smaller structures

All of this paints the picture of Entegris compounding at a multiple of whatever semiconductor growth is.

Historically – you can see that is the case:


Quick Word on Value

Entegris valuation isn’t for the faint of heart (neither is ASML mentioned earlier), but the I think the dynamics outlined here, as well as M&A opportunities, makes me think the company can grow FCF/Share at double digits for a long-period of time.

The stock trades at 37x 2022 FCF, or <3% yield. So to get a 15% IRR, I somewhat need to expect a double-digit growth rate.

But here’s the thing that gives me comfort: a lot of capital is being put in to build new semiconductors.

  • TSMC: Investing $100 billion over next 3 years to boost production capacity and R&D on advanced nodes and specialty technology equipment
  • Intel: Announced two new factories in Arizona at $20 billion
  • Samsung: Not disclosed, but analysts expect $37 billion in capex annually in 2021-2023, up from $32 billion in 2020

The current shortage in 2021 is going to leave a lasting impression on the industry and capital is cheap to add strategic capacity. Frankly, odds are several years down the road, we might be oversupplied (a classic cycle).

But the shortage today is here, giving companies comfort in putting new capital in the ground. And countries are looking at their production as increasingly strategic (US vs. China) which may lead to duplicative, but localized capacity. Bottom line: I think that might add even more capacity in the long run.

Again, Entegris is mostly tied to units sold. Semi fabs need to run at high utilization rates (because they are high fixed cost businesses) so maybe that pressure prices down the road, but I can comfortably bet more units will shipped than today.

I recently saw JPM estimate wafer shipments at growing double-digits in 2022, but then moderating to GDP-like growth in 2023+. That seems too conservative to me, but again, Entegris can likely outgrow this due to the factors mentioned previously.

Leaning into Value Traps that Everyone Hates… and a New Name, Strattec $STRT $AXL $ALSN $CATO $ANF

Reading Time: 5 minutes

There are certain businesses that investors have washed their hands of: Retailers, OEM auto suppliers, anything in the way of ESG… many others… And this trade probably worked well for the last 5 years. I recently wrote up at least three names that are counter to these trends, but there are many more.

I’m in the process of creating a “basket” of these names that I’m going to commit to buying and holding for at least 3 years.

I’m calling it: the Value-Trap Coffee Can portfolio.


Most of the time, a coffee can portfolio is set up of really good businesses that you should just set and forget. Let them compound.

In this case, the narrative around some stocks can be so toxic, you can convince yourself at any point to sell. But if find management teams that are very savvy, conducting effective turnarounds despite headwinds, and know how to drive shareholder value, sometimes you still want to align with them.

I fundamentally believe you can have bad industries, but great companies (driven by great management teams) and therefore great securities hidden within them. 

So I’m locking these stocks up and throwing away the key to see what happens.


So far, the Value-Trap Coffee Can (VTCC for short) portfolio includes Allison Transmission, Big Lots, and American Axle, but I am also adding Cato (recently discussed on Andrew Walker’s podcast with Mike Melby at Gate City Capital), and Abercrombie and Fitch (written up on VIC, but down nearly 20% since then). After looking into the latter two, I’m convinced they’ve earned their spot. They aren’t my ideas though, so I won’t be writing them up.

I am adding Strattec to the VTCC portfolio, which is an automotive supplier and I’ll get to at the bottom of this note.

Please reach out if you have any others I should be looking at!


Why the VTCC Portfolio Now?

At points in the past, this would’ve seemed nuts, but my response to that is these companies

  • have significant cash / FCF, especially compared to their market caps today
  • have a rising earnings path over next ~12+ months. Especially true now that we went through a downturn and are coming through on the other side of it, and
  • are completely unloved, so are still very cheap.

You can see it’s really more of a cycle + cheap call.


I cover cyclicals for my day job and cyclicals have been pretty much un-ownable since we had an industrial-recession scare back in 2015/2016. OK – they had a nice run when Trump first came in, tax cuts were implemented, and there was a brief sugar high – but after that, the stocks didn’t do well by comparison even if results were fine. I saw many companies I covered trade at super low multiples as everyone figured a cycle was inevitable.

I now think that since we may be entering a new cycle, permission to own is granted.

In other words, maybe value traps won’t be traps for too much longer. (Famous last words DillyD!) But seriously, you can mitigate this problem via position sizing.


A couple pushbacks to that simple thesis:

  • You could completely disagree with me that we are entering an upcycle – people are already saying what we went through in 2020 doesn’t count as a “normal” recession (whatever that means) and is more like a natural disaster. Semantics. Whatever. This is the theory I have and am going to bet that way.
  • Stocks already at all-time highs, too. So how can there be much of a recovery? Well… FANG is like 25% of the S&P500. None of these basket stocks are in tech.
  • Supply chains are a mess. This could derail the thesis, but I think it would be a temporary derailment vs. anything long-term.

It seems very hard to argue to me that any of the sectors I am going to buy a basket of are “overbid” territory. We can also reach new highs if FANG stocks stay flat and cyclicals have a really nice run, too, ya know?

I think retail is interesting because the consensus narrative was that they are dead, that we pulled forward a ton of e-commerce progress… and yet, if you actually looked at some of these player’s results, you’d see they either adapted very well (some did) or the buyer is coming back.

The anti-ESG trade is only interesting to me in names that can solve the problem – by buying back stock themselves at really attractive prices. Some names are in the ESG crosshairs, but either can’t or are unwilling to effect change in their share prices.


Why Strattec?

Strattec is an interesting little auto supplier that makes locks, power lift gates, latches, among other things. It was originally spun out of Briggs & Stratton in 1995. Here’s a [kinda hilarious] video of them trying to sell why people need a power lift tailgate.

They have their OEM concentration issues, like American Axle, but that is the name of the game. They actually have much better concentration than American Axle which you can go see in their 10-k.

Similar to my American Axle thesis, I think we are going to need a massive restocking of cars. Inventory days are ~22-23, compared to the normal 50. However, this cycle is going to take a long time to sort itself out.

Unfortunately, Strattec was impacted by plant shutdowns due to lack of semiconductors. This is disappointing as the company wasn’t able to sell as much, particularly in its award winning power tailgates in the Chevy Silverado and F-150 pick-ups.

But it’s a double-edged sword. The longer it takes to replenish inventories to “normal” the longer this auto upcycle will likely last. Yes, less sales today, but I think the tailwinds will be there for some time to come. Again, I wrote about all of this in my AXL post.

Even with these headwinds, Strattec still did $110MM in the latest FQ4 (ended June, reflecting the impact of the semi issue) and $485MM for the FY, down from $129MM in the quarter ending June 2019, but in-line for the FY $487MM. However, EBITDA increased by ~50%. Again, this was due to cost improvements and efficiencies in the business that the company says is structural.

Bottom line, I think Strettec will emerge more profitable than ever, and if permitted to run flat out (semi issue abates somewhat) then we will see awesome fixed cost leverage, too.


Strattec Valuation:

Strattec is only a $150MM market cap company, but an enterprise value of ~$147MM.

Over the past 12 months, they cut their dividend during the COVID panic and paid down $23MM in debt. If you fully count JV debt, they have $12MM in debt now, but $14.5MM in cash.

At the same time, let’s say you expect the top line to grow a bit, but they’ll give some margin back, the company is trading <3x EBITDA. And it isn’t like that EBITDA won’t convert into FCF: the company has guided to $12MM in capex, they’ll have no interest expense (basically) and taxes in the range of $8-10MM. That’s $35MM of FCF on a $150MM market cap company.

Not bad! Just last 4-5 more years and I’ll have my money back.

Why $BRK Should Buy $ALSN

Reading Time: 5 minutes

I wrote previously about companies Berkshire Hathaway could potentially buy. One of those options actually was acquired, just not by BRK. But I think Allison Transmission ($ALSN) is another strong candidate. Why do I say that?

  • ALSN is the market leader in fully automatic transmissions for medium-to-heavy duty commercial vehicles
    • They do not play in the super cyclical Class 8 truck market
  • Because of market dominance, they have great margins: ~35% EBITDA margins and spend 6% of sales on capex
  • Generates high ROIC (>20%) and even higher returns on tangible capital
  • It’s a classic industrial, but misunderstood, which has it trading in melting ice cube territory wayyy too early
  • Mgmt has been solid capital allocators, though the stock price doesn’t reflect this yet

I recently initiated a position in ALSN. It came up as I decided to update my model (right after I did some quick work on American Axle) and noticed that the share count had reduced from ~120mm to 106mm in a pretty short period of time… but the stock was actually lower than the last time I looked at it.

I think there are many reasons to own the stock now, not least of which is a cyclical upturn in their end markets, but wanted to frame it differently for this discussion. It’s a “small” company at ~$6.5BN EV, but I don’t think that would stop Buffett.


ALSN is the Market Leader: 

This is a great slide covering ~50% of their sales, showing their dominance in “niches.” I love businesses like this.

Allison invented the automatic transmission for commercial applications and there’s been a long trend in the West away from manual transmissions.

It doesn’t matter as much in long haul, but constant starting and stopping can be annoying with a manual and Allison’s transmissions can also be more fuel efficient (lots of start and stop activity).

So who do they compete with? Well, their main customers are OEMs. Typically, their competition comes from OEMs who decide to do this in house, like Ford. Other competitors are smaller players that clearly don’t compete on the same scale.

This is mainly the North American market, so it should be noted Europe (13% of sales vs. 52% North America) has more vertically integrated players for these commercial vehicles, particularly the commercial trucks. So ALSN’s exposure in Europe is mostly garbage truck, emergency vehicles, bus and other markets.

ALSN, though, is viewed as the leader of technology and is often the most desired transmission.

I won’t dwell too much on their other markets (defense at 9% of sales, which is mostly tanks, or off-highway which is mostly construction and metals & mining exposed, but just 4% of sales).

I will say service, parts and equipment is the second largest part of sales (22%). I like this piece of business because aftermarket provides a nice, steady recurring revenue – driven by the large installed base of transmission already in existence.


ALSN has Great Margins

As mentioned, ALSN has ~35% EBITDA margins. That is actually down from peak due to (i) lower sales LTM, (ii) increase commodity costs, (iii) product mix, and (iv) a ramp in R&D expense. Given dominant share and a recovering market, I think they’ll work their way back up to high-30s EBITDA margins.

That said, the market is completely freaked out about EVs and lower margins in that category. For ALSN, it is the number one bear case. It was asked about 3 separate times on the latest earnings call, despite the existence of electric vehicles still being relatively nascent (I won’t hold my breath for the electric tank either).

This does tie into the misunderstood point, which I hash out below.


ALSN Generates a Great ROIC

Note, ROIC does get hit in cyclical downturns (2014-2016, 2020), but through cycle it is well above ALSN’s cost of capital and run-of-the-mill businesses. Enough said.


ALSN is a Classic Industrial, but Misunderstood

I think its pretty clear that ALSN is a classic industrial. An old school business. Maybe not classic given its high margins and dominant position in its market, and many, many industrials struggle to generate good returns without a lot of leverage.

ALSN does have many growth avenues, such as emerging markets which still have high manual transmission penetration. Second, there are underserved portions of the North American market it could enter, shown on the previous market share slide.

But the market is completely freaked out about EVs.

As I wrote about with Autozone, the penetration of EVs will take some time to work out in the passenger car market. The misperception with Autozone is that the market forgets how big the car parc of ICE engines is compared to new production.

It will, in my view, take even longer to happen in commercial. Add in the fact that these trucks consume so much energy from towing, it really will be tough to figure this out.

But why freak so much about EVs? Its because EVs don’t require a transmission and Tesla’s Class 8 truck doesn’t have a transmission. There. That’s the bear.

That said, ALSN is already the leader in hybrid transmissions (particularly hybrid buses), they have frequently highlighted examples where Allison transmissions have been used in electric trials over the past FIVE years, and there is a strong case that commercial EVs may benefit from a transmission (it could likely reduce the strain on electric motors, thereby reducing the need for larger, heavier batteries).

Is it a threat? Sure. I think EVs are inevitable. But will it take time? Yes. And the costs side has to be figured out so much more so on the commercial vehicle side than the passenger side (let’s not even talk about how we’re going to mine all these precious minerals for EVs…). And let’s not forget nearly a quarter of ALSN’s business is parts & services too, which will continue to benefit from a large installed base.

Maybe I’d be more concerned if ALSN had no position, had no experience, and the commercial vehicles were here and rapidly taking share. Maybe I’d be more concerned if ALSN wasn’t a FCF monster. But ALSN is priced as if this doomsday is already the case.


Mgmt has been excellent at capital allocation

It isn’t everyday that you come across a slide like this. First ALSN got their debt down after being PE owned. Then they continued to paydown debt after IPO’ing, but largely turned to share repurchases, dividends, and modest M&A. It’s pretty clear to me, that while the company is increasing spend on R&D, every dollar of FCF will be coming back to shareholders.

They repurchased 5% of their stake in the 1H’21… they’ve repurchased 50% of their shares outstanding since 2012! All while delevering, not levering up.

ALSN IPO’d in 2012, so you can see they clearly turned cash to repurchases

Back to Berkshire – look, if this cash is better spent on other businesses, let Buffett make the call. But at this point, the market is just not giving them credit for the cash!


Why Now?

Why buy the stock now? You make your own call, but for me, we are witnessing a cyclical upswing. ALSN will be growing sales and EBITDA for at least the next 3 years just to get back to a baseline.

Using consensus FCF numbers, ALSN currently trades at 14.5% FCF yield on 2022 FCF estimates and 15.7% on 2023. This likely means they’ll be buying ~12% or so of the stock back + the dividend. With that much buying pressure, plus a cyclical upswing, I think it is very hard for a stock to NOT work.

On EV / EBITDA, ALSN trades at 6.5x ’22 EBITDA. I regularly see paper companies trade for around that. That seems too cheap to me.

Sponsors have owned the business before and they may own it again. It can support a lot of leverage…Or, Mr. Buffett might give it a look.

American Axle: Play the Auto Restocking Cycle $AXL

Reading Time: 3 minutes

American Axle is a crappy company. But I currently view that we are going to see a large increase in auto production to (i) meet demand which we are unable to do right now and (ii) restock to baseline inventory levels. So with the stock at a ~40% FCF yield, I’m interested.

This could be a value trap, but my thesis is simple:

  • SAAR came way down during COVID, but demand held in
  • Semiconductor shortages have limited production to catch up, which will sort itself out over time. But it will take time. And this will result in a prolonged auto upcycle
  • Credit is cheap + average age of vehicles has continued to tick up which tells me there’s room for even more restocking.
  • US personal savings averaged $3.5 trillion during first 5 months of 2021, nearly 3x the level seen in 2019. We could see a decline in the average age of vehicles in the car parc for the first time in many, many years
  • Inventory continues to decline. Days supply of autos is now around 20 days compared to long-term averages of 60 days. Auto producers need to meet current demand + restock inventories to some sort of normal level

Add this all together, I think the next 3+ years will need to see above average production to catch up.

Here is SAAR, auto inventories and the average age of cars on one chart:

What is a levered bet on this? Shitty auto suppliers. And that is where American Axle comes in to play (and I’m open / reviewing others). AXL trades for ~4x EBITDA for a reason – when auto production collapses, they get crushed. But on the other side, they can generate great FCF when the cycle is in their favor.

How often do you see sell side pointing out the FCF yield is ~40%?. That is also an appeal here – the FCF yield to equity is quite high and I don’t think expectations are high for this company. At the very least, there is a lot of doubt in this cyclical name that the cycle will be short-lived.

$AXL used to have “a balance sheet problem.” While it might’ve only been 3x levered, it was on a business worth 4x, so it mattered. That’s a 75% LTV, which is pretty high. But they generate cash flow now and will definitely in this market.

I should go ahead and point out why they are not great:

  • AXL is a Tier 1 auto supplier, which is a tough business and cycles hard
  • ~40% of sales are to GM. If GM needs to take a plant down, like in the case of no semi’s, that won’t be ideal. This also means GM has significant power of AXL. Fiat Chrysler is another ~20%
  • Pretty capital intensive, as 6-7% of sales is spent on capex in normal times.
  • Investors view anything related to powertrain parts as secularly challenged from EVs (however, AXL did note it is quoting $1.5bn of new & incremental work, with 80% related to hybrids / EVs). In an EV world, perhaps there is less AXL content needed

So there lies the main risks. The other hard part is where this company should trade. I am not calling for a re-rating. I just think earnings / FCF will likely be much higher than consensus expects for the next 3 years. Leverage is down to 2.5x and once they get to 2.0x or less, I think that FCF will really start accruing to the equity.

If this stock underperforms – I’ll know why. I bought a value trap.