Category: Featured

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

The Fed Started Cutting Rates in November 2022, You Just Missed It

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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.

Never a “good” time to own $WDFC, but now might be “OK”

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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.

Interesting (Hated) Spin-out – Masterbrand Cabinets Stock $MBC

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Intentionally or not, Fortune Brands has created a Good Co, Bad Co with their spin-out of Masterbrand Cabinets stock. It is very easy to be cautious on 2023 and say, cabinets are F’d. Instead, cling to your Fortune Brands shares which sell into plumbing, security products, and decking.

Cabinets are a super cyclical business. I tend to think a cabinet sale occurs during new construction… or when they fall off the wall. But really they are also replaced when there is heavy remodeling work done. All require some discretionary income.

The cabinet business proved its cyclicality back in the financial crisis. Featured below is Masco’s (since divested) cabinets business operating income. It took until 2016 to get back to Op income profitability! Woof.

Now, of course we were in a housing bubble back then… Masco also added in a ton of capacity right before the market turned. This number includes some impairments and restructuring charges. In addition, China started to nip at the heels of the industry by competing in the really commoditized, “stock”, low-end product (ready-to-assemble cabinets).

American Woodmark’s EBITDA perhaps is a better example:

Typically, competition is pretty localized in cabinets as shipping costs can be really expensive. That’s still true, but the industry had to flush out losing some of that lower-end business.

Fast forward a bit to today, American Woodmark (AMWD), Masterbands (MBC) and Cabinetworks (private, but bought the former Armstrong and Masco cabinet businesses along with Elkay), now dominate the industry. Definitely flip through Masterbrands investor day deck if you want more background

It is still a tough business, no question.

In 2021, they were hit by labor costs (building cabinets is labor intensive), freight, as well as hardwood costs. It’s a high fixed cost business too, so when operational issues occurred (omnicron absenteeism for example), it really hit them on the chin as throughput suffered.

As such, the industry has been trying to get price to recover this. Backlogs have been huge, but that wasn’t necessarily a good thing as the price on the backlog didn’t match the new input-cost reality.

The industry is doing better to recover margin. As you can see from American Woodmark’s EBITDA margin, they are slowly but surely getting back to a reasonable margin level.

We’re talking big price increases rolling through now.

Volumes for the industry are pretty flat lately, but price increases are 15-20%. That will help margins going forward. KCMA publishes data and in October, volumes fell 2.6%, but price was up 17%

AMWD’s FQ2’23 (ended Oct’23), showed EBITDA margins expanding from 6.8% to 12.0% Y/Y. And therefore EBITDA $ more than doubled.

Taking a step back, I think this tends to surprise people – demand was so strong for cabinets that it hurt profitability. And as demand has cooled a bit now, that’s helping? WEIRD.

Back to Masterbrand – Fortune Brands decided to spin the company out. My guess is for a re-rating. Get rid of the more cyclical, lower margin business. Heck, that’s what Masco did (though it didn’t really re-rate).

But my guess is everyone is thinking the same thing on MBC. “Get away”

Masterbrand, I will say, has outperformed its peers on maintaining margin. They have a long history of that. I believe they are THE best run cabinet player in the space. Even so, they think they can get to 16% EBITDA margins over time.

I like low hurdles to jump over. So I did some rough math. I used their estimate for “high-single digit” sales decline next year, 25% decremental. But then I basically say no growth from there. I give no credit for W/C being a benefit either, after a couple years of a large build. Maybe that’s too aggressive? I don’t know, I think expectations for Masterbrand Cabinets stock are probably pretty low…

That looks like a lot of cash…. And when I compare it to the current market cap, we’re talking nearly a 20% FCF yield for Masterbrand Cabinets stock.

Historically, cabinets businesses have traded for 6-8x, in some cases higher for private M&A. It intuitively makes sense given what we’ve discussed. But I think this valuation, IF YOU HAVE A LONG TIME HORIZON, makes a lot of sense.

Obviously there are risks. The cycle could be a nasty one. The spin could have some stutter-steps (though MBC was a separate segment for a long time). But I like the risk-reward here and the forced selling.

The other major risk is I am writing this the day of the spin! That’s a no no. Wait for it to bleed out, Dilly D! This is a $1BN market cap and hated industry right now!

Ehhhhhhh whatever. AMWD is trading at 7.3x ’23 and in my view, has performed worse. Capital intensity is also higher there. I like the risk reward.


More Signs of the Bullwhip Effect (part 2)

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I wrote a post at the beginning of the year that the bullwhip effect was what kept me up at night. It actually was one of my most-read posts thanks to a bump from Andrew Walker (thank you sir, if you are reading). To summarize, it was a fear that while everyone else is focused on inflation, I was thinking about the after effects of a bullwhip. That is, on the way up, customers tend to see strong demand, prices are going up, and they realize they don’t want to be caught short and also want to get ahead of price increases, so they pre-buy.

Once demand tops out or reaches a tipping point, prices start to fall, customers say, “eh, I’ll just wait to buy when it is cheaper” and it is a destocking downcycle. It isn’t quite intuitive because sometimes  prices of inputs can really overshoot to the downside yet buyers are still reluctant to step in. But that is the point. The bullwhip overshoots on the way up and down.

With COVID, I think we saw this on steroids. Where customers saw strong demand, cost increases, but also supply chain challenges that made them consider having safety stocks. You can imagine why I have a fear of this upcycle-on-steroids turning into a down-cycle-on-steroids. Anything with steroids isn’t good, except for professional baseball, football…

I won’t rehash Target or Wal-Mart‘s earnings, or Bed, Bad & Beyond, which all seem to be experiencing excessive inventory in some fashion. In the latter case it completely sapped their liquidity. This could be true of Big Lots as well, we shall see but the tea leaves are not good.

But now, we have chip companies – center of the storm for supply chain challenges – calling out the bullwhip. Nvidia, which is a top 10 S&P500 company, recently came out and said,

Second quarter results are expected to include approximately $1.32 billion of charges, primarily for inventory and related reserves, based on revised expectations of future demand.
“Our gaming product sell-through projections declined significantly as the quarter progressed,” said Jensen Huang, founder and CEO of NVIDIA. “As we expect the macroeconomic conditions affecting sell-through to continue, we took actions with our Gaming partners to adjust channel prices and inventory.

Not only did they get demand completely wrong, they actually are taking an impairment charge on inventory! That is quite a change from 2021.

Here is Micron as well. They don’t just describe the bullwhip, they talk about its financial impact (demand down, but they also need to throttle back production. Doing so leads to bad decremental margins).

But they aren’t the only ones. Check out what Armstrong (a ceilings company) said about what they are seeing. I think they describe the bullwhip effect beautifully! I know it is a lot of text, but at least read the second half.

Low and behold, many other building products companies are reporting similar impacts. Here is Trex, a composite decking company, which typically viewed as a compounder, long reinvestment runway company (but also decking benefitted from the home being a sanctuary).

Their competitor Azek also mentioned similar things.

Here is Ryerson, a metal distributor:

And here is Stanley Black & Decker

So you get the point. There has been a swift change in what companies have seen and we look to have a destocking cycle on our hands. The last time we saw this was around 2015-2016, when there were similar fears of a recession, prices were correcting lower, inventory was fine so it was a perpetual down cycle.

It didn’t last long though. But you can probably guess why I was recommending municipal bonds a month ago when the 10 year treasury got to 3.5%. My bet was we actually have a disinflation problem coming, and that is starting to prove itself.

My advice would be to continue to avoid things with too-good-to-be true “demand.” Especially those that experienced strong bumps during COVID. That seems like it could unravel quite quickly. On the positive side though, I think the Fed will accomplish its goal on tamping down inflation! At least on the goods side.

Bed, Bath & BeBOND? (part 2)

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We all knew it was going to be bad, but it was worse. Bed, Bath & Beyond’s earnings were terrible, their cash got sucked up, and the CEO is out. The CEO’s credibility was already toast, but I want to pile on: their share buybacks might go down as some of the worst timed in history. Their investor day targets were laughable and I feel sorry for anyone who believed them. They also might be the fastest “great liquidity situation doing ill timed buybacks” to bankruptcy I have seen in awhile.

In my last Bed, Bath and BeyBOND post  I said,

I calculate LTM EBITDA of $190mm as the turnaround plan ran up against snarled supply-chains. Now we have changing consumer trends, which Target called out. So expectations are just $51MM in EBITDA for FY’22 (ended Feb ’23) and then going to $260MM in ’23.

This all sounds pretty bad compared to their investor day goals of $950MM. Management credibility is bad. And with everything else going on, I’m not sure many have appetite to invest in retail right now.

So we knew it would be bad, but it was Bed, Bath & BeREALLyBAD. EBITDA was negative $225MM. Woof. Expectations were negative $85MM.

As a result, their liquidity got zapped pretty quickly and they burned almost $500MM of cash. Good thing they were still buying back stock this quarter (what a clown show).

As a result, the bonds have cratered. In my last post, I mentioned I was interested in the 2034s at 50 cents. However, since that post the 2024s cratered from about 75 cents on the dollar at the beginning of June 2022 to 42 cents.

Ok – call me crazy, but I am taking a small flier on the 2024’s. The company is clearly in a distress scenario, but they also still have $900MM of liquidity. We could still see a fire sale of BuyBuyBaby (a big if), but there is value here to someone to loan-to-own, in my view.

BBBY still has $1.1bn of book value of real estate and $258MM of net working capital. I think they will start to sell down their $1.7BN of inventory over this year to generate cash and get over the 2024 maturity wall and they have room for mark downs of inventory to generate cash.

On the flip side, they still have $1.4BN of debt, but about $1.2BN of it is trading for less than 50 cents on the dollar!  So $1.3BN of real estate and NWC vs. $600MM of market value of debt (it is actually less) and $200MM of ABL. That leaves a gap of about $500MM to work with.

My pre-mortem expectation is they try to do a distressed exchange with the 2024s. They may generate enough liquidity to tender a portion of them (it is less than $150mm market value today – theoretically could use the ABL). My guess is liquidity worsens further next Q before they start to see some inflows from working capital.

One thing I know for sure – expect some coupons in the mail soon!