Full disclosure, I hate shopping at Bed, Bath and Beyond. It makes me angry. That has prevented me from actually acting on this investment. But I wanted to present it to others who may find it interesting and one I may act on:
At 54 cents on the dollar, BBBY bonds yield 12.3% to maturity. If they can do the bare minimum turning the biz around, or sell an asset like BuyBuyBaby, it is a much higher IRR. If they ever hit the goal from their 2020 investor day, it’s a home run (but low odds). But I also do think there’s a decent chance they don’t do any share repos near term and buy back discounted debt instead.
What’s the situation?
I highly encourage people to read Andrew Walker’s post on BBBY, which opened my eyes to (i) how much cash they have and (ii) the opportunity to improve earnings. He’s also opened my eyes to how much cash they’ve squandered…
Long story short (which is a story I probably should have shorted), BBBY had an investor day in 2020 and said they thought they could go from ~$450MM of EBITDA at the time to $950MM by 2023! Woa!
The way 2022 is going, there is no f*cking way there are getting there. Retail has been hard enough. With BBBY, you’ve got a turn around story, too.
And lo and behold – their guide was horrible for ’22.
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.
But I am always looking for a way to make money in nasty situations that no one wants to touch. Is there a place where maybe you can take a downside-protected position with solid return baked in and also some upside if things do go right?
BBBY 2034 bonds are trading at 54 cents on the dollar! Woo wee. And that foots to a ~930bps spread to treasuries and 12.3% YTM. And yes, these are registered (not 144a), so normal everyday joes can buy them (not investment advice lol).
How does the cap structure look?
With cash of $440mm and total debt of $1.2bn, I see total and net leverage of 6.2x and 3.9x, respectively. Total liquidity sits at $1.4bn.
I use the LTM EBITDA basically to acknowledge there are 1x factors in ’22 that I don’t think will crimp profitability in the future. I already mentioned $260MM is FY’23 estimate, that probably goes lower honestly, but I think $190MM actually isn’t a terrible mix between the next couple of years estimates. The market is forward looking after all
However, like I said, the BBBY bonds are at steep discounts to par. They have plenty of liquidity to take out the ’24s. Then its just the 2034s and 2044s – they have bought these back in the open market in the past!
Last but not least, they are currently marketing BuyBuyBaby, which actually grew comp sales in the latest Q (BBBY was -15%). I think equity holders are looking at a potential resumption of terribly timed buybacks like they’ve done historically, but I wonder if they buy back bonds. This would create equity value in itself, take BK risk off the table, and be at attractive IRRs.
You Don’t Have to Hold to Maturity
Let’s say they take-out the ’24s, which I think is a given. They turnaround the business somewhat and by Aug-2025, the market ascribes a 650bps spread (I think this is pretty conservative – single Bs right now have a spread of 480bps). That foots to an 18.5% IRR in the bonds!
If you are a real bull, you might look at those 2044s at 43 cents on the dollar instead!
My calls thus far on retail with BIG and BBWI have been terrible. So go at it with your own risk!
Quick idea today: I am looking at Service Properties Trust (SVC). I think the idea is interesting and there is a catalyst. Here’s the situation:
Company Overview: SVC is an externally managed REIT (managed by RMR – more on this later), owning 304 hotels and nearly 800 “service-oriented properties” which are net lease
Glance at the Opportunity:
$1.4BN market cap, $913MM in cash*, $7.14BN in Debt = $7.7BN EV
Tangible book $10.62 vs. stock at $8.61 = 19% discount to book value
Book value likely underestimates the net lease portfolio value
Book value is also depreciated – i.e. the assets bought many years ago likely didn’t go down in price from the price paid, but accounting is accounting. Depreciation is $3.5BN of value – think about that in the context of the market cap.
See Value Build table below. You could arrive at $40 implied stock price depending on what you want to believe. I used 7% cap rate for the net lease portfolio which is a decent discount to a recent comp.
You can also get to ~$12 stock using 12x EBITDA, which is 37% upside, and ignores a lot of other things I’ll mention. True value likely is somewhere in between these data points.
The cap structure is overlevered, they have a $500MM of bonds due Aug 2022 and the $1BN revolver is technically due as well.
*They have $1BN drawn on revolver. The rest of the debt is unsecured bonds.
The revolver draw isn’t all bad – they transitioned ~200 hotels to Sonesta in 2020/2021 and thought it had a chance of being disruptive, so they did it out of abundance of caution. It *was* disruptive when you add in COVID lock-downs, but both are looking like they are in the rear view mirror.
In some ways, this reminds me of CPLG, but sketchier – CPLG owned hotels and leverage got a bit too high. But CPLG sold poor-quality hotels at amazing levels, delevered and create value. Eventually they sold the whole business.
Bottom line: Given this is a levered equity, if you think the enterprise value is too low, that likely means the equity stub could have A LOT of upside. But also means A LOT of risk!
The Assets – Hotels and Service Properties:
The hotels are managed or operated by franchisees of Sonesta (261 hotels), Hyatt (17 hotels) or Marriott (16 hotels), etc.
About half of these are extended stay hotels, with the other being a mix of mid-level to some luxury. But luxury is in the eye of the hotel-er.
The hotels are recovering from COVID nicely, but no where near peak. The company did provide monthly operating stats in their deck which is nice.
The largest tenant in the net lease portfolio is TravelCenter of America (45% of minimum rent owed, but larger on a $ value basis – likely 60%)
TravelCenter is public (ticker: TA) and is a full-service truck stop.
TA is doing quite well fundamentally. Looks like EBITDA has doubled LTM 9/30/21 vs. 2018. Haven’t fully dug in, but seems like if trucking in America is doing well, TA is doing well.
Other tenants in the net lease portfolio include Shopping Centers (20%) AMC (2%), The Great Escape (2%), Life Time Fitness (~2%), and a tail of others. You can imagine many of these were battered by COVID, but mattered less compared to TA and Shopping Centers.
Either way, the company is collecting 100% of rents now and the portfolio is 98% occupied with well staggered maturities. I encourage you to check out the investor deck for more.
What else makes this interesting?
The situation is hairy: RMR involvement (I’ll get to it) and a levered equity. The latter tends to produce high returns if you get the entry point right and you think the B/S is fixable
Abandoned REIT: SVC had to cut its dividend during COVID. Went from 54 cents to a penny.
Catalyst: Currently marketing 68 hotels for sale ($579MM of carrying value). Mgmt stated they expect to get at least carrying value in Q1’22.
Mgmt said they have term sheets on all properties, though one is a bit more complicated. I suspect we will see staggered announcements to multiple buyers
Sales proceeds will first go to refi the bonds and likely downsize and extend the revolver
These assets for sale lag the rest of the portfolio in earnings or had deferred capex (read: bottom tier). It also reduces hotels vs. net lease portfolio. Net / net RemainCo should be valued higher.
Selling these assets and taking out the impending maturity can act as a cleansing event for investors to come back to the stock
Taking SVC’s annualized net lease rents of $396, 6% cap rate = $6.6BN. That’s 86% of the EV right there. 7% cap = ~75% of EV.
SVC owns 8% of TA equity and 34% of Sonesta Holdco. The former is worth about $51MM, the latter I am not sure as they are not public.
RMR earns fee on managing Sonesta. We can infer Sonesta makes about $750MM in revenue (0.6% fee on all revenue per RMR 10k)
We just saw CPLG get acquired for 2.8x revenue, which would imply $2.1BN EV here.
Assume 60% debt / cap (total guess) = $1.26BN of debt and $840MM of equity, implies about $285MM of value for SVC. This is all a wet finger in the air and the carrying value of the investment is $62MM. I use carrying value.
Here is the value build of what I have so far
There’s only one thing I haven’t talked about so far and that is the remaining 236 hotels.
The table below is how I got that number and it goes back to that depreciated book value discussion.
SVC’s lodging-REIT roots trace back to 1995. It isn’t out of the realm of possibility that many of those assets are depreciated considerably.
RMR / Intercompany Relationships:
RMR manages SVC. SVC owns a lot of Sonesta hotels and owns 34% of Sonesta. SVC owns a lot of TA properties and owns 8% of TA. RMR provides management services for Sonesta and TA!
Let me be clearer: RMR manages both sides.
I should also mention people have a lot of misgivings about RMR and the Portnoy’s who manage it.
Let me copy the statement straight from RMR’s 10-k:
Perhaps you can see the risk here. RMR might try to rob Peter to pay Paul. RMR makes more money from managing SVC than it does from Sonesta (like… a lot more. 10x more. $45MM vs. $4-5MM).
That said, the web of inter-ownership perversely provides some comfort (admittedly not a ton). Screwing part of the chain should ripple back through and solve nothing. And again, RMR makes more from SVC. If there is a transaction, it is to preserve value at SVC.
On the other hand, I will admit an outright sale of SVC isn’t likely. I doubt RMR does that.
Are there any signal of what RMR could do?
RMR also manages Diversified Healthcare Trust (DHC) which had some liquidity and covenant issues
RMR went out and found institutional investors for some assets, from my understanding not all core, which DHC contributed to a JV.
It allowed DHC to get some liquidity, get a real bid on the assets, but not lose all economics
Why does this matter?
I think if your one hang-up is leverage, I think there are many solutions in addition to selling these non-core hotels in Q1.
If your one hang-up is RMR, then I think they’ve shown they are acting in the best interest of the company. RMR is aligned as they earn management fees on the enterprise values of the companies. They also manage the JVs in DHC’s case (lol)
Did RMR tip there hand to this??
That’s all for now – stay tuned for the asset sale announcements!
Vimeo stock collapsed following the spin from IAC. That caught my attention, I read some of their calls, but I never really dug in. Then, in early January, I tweeted there was an interesting cash-covered put trade you could do at $12.50 strike. As Vimeo stock has fallen more, I decided to do some “napkin” math on the stock.
Say Vimeo grows half the rate of management’s target, FCF margins end at 20%, and priced at 20x FCF. Discount that back at 10% and you get a market cap that isn’t too far off from today. These are all “finger in the air” numbers, but it showed me I should do more work.
If I had one takeaway from reviewing the company is that each Vimeo subscriber is not created equally! And when you break down the math, the targets become much more believable. If you want to cut to the chase, I’d suggest reading the “All Customers are Not Created Equal” section below as well as the model cut outs I have.
Is there risk? Of course. But I think many are likely saying, “eh, I’ll just wait” right now and that’s big time group think.
But first, I’ll go through a quick background, why the stock has gotten pummeled, and what you need to believe to make money from here. I’ve included a few screen shots of two of my models to emphasize this point.
Vimeo was spun out of IAC in May 2021. The spin followed strong 2020 results as Vimeo enabled many businesses to operate during the pandemic. No doubt, Barry Diller & Joey Levin at IAC recognized tech / SaaS multiples were high and a partial sale + spin would be best for shareholders.
Indeed, IAC sold a partial stake in Vimeo for $150MM which valued the company at $2.75BN in November 2020. Then in January 2021, another $300MM of equity was sold valuing Vimeo between $5.2BN – $5.7BN. In the first case, the valuation was a touch under 10x ’20 sales and then quickly moved to about 20x sales.
Today, we’re looking at Vimeo with a market cap of $2.3BN, or 6x ’21 sales (5x if you exclude cash, as Vimeo is FCF+, albeit from SBC & deferred revenue). Spun out at $57, the stock can now be purchased for under $14.
Ok with that background of “why Vimeo is even public” out of the way, we can explore why the stock is getting hammered, and then we can address why it’s a reasonable buy.
Why did Vimeo stock get pummeled?
Vimeo’s stock has gotten smoked for a variety of reasons.
Pandemic-enabled companies are coming home to roost (Peloton, Zoom, Docusign, Moderna are all down >50%)
Joey Levin straight up said it was expensive!
Growth is decelerating
Lost credibility: Vimeo will likely miss targets in its first year following an investor day that promised 30% growth for next 5 years
They are changing price strategy starting in ’22. A foundational change can lead to volatility
Spin dynamics, possibly
Investors are less enamored with tech / SaaS
I won’t go into all of these, but I think the first few are worth going through.
Pandemic-enabled and “a bit rich” at the spin:
In IAC’s Q3’20 letter, Levin stated that Vimeo was “a business that benefited meaningfully from the pandemic.” They also said, “we can’t be certain that the magnitude of the positive lift to Vimeo will persist when the virus’ effect on our lives becomes less pronounced…“
They went on to say, “Vimeo’s access to capital inside of IAC will be much more expensive than access to capital outside of IAC.” They decided to test the market by selling some shares (Nov ’20) and then some more (Jan ’21). They noted how the investors were willing to pay on a P/S multiple, almost besmirching the reputation of the buyers!
Read between the lines. They were saying others are willing to pay much more for Vimeo than we are.
Growth deceleration + Lost credibility
In that same IAC letter, they called out acceleration during the pandemic which was obvious.
Prior to the pandemic, we were steadily proving Vimeo’s fit in the market. Organic bookings growth consistently accelerated last year from 11% in Q1’19 to 27% in Q4’19 as we began to expand from our filmmaker roots to a broader audience of small businesses and large enterprises. Then the pandemic hit, and that acceleration exploded to 41% in Q1, 79% in Q2, and 56% in the most recent quarter.
If we look at the latest monthly metrics, we can see Vimeo is growing strongly, but at a slower pace. They actually face the worst comps in Q1’22 so it is likely this decelerates even more.
Total revenue is coming down from high-50s to 60% to 40s, high-twenties and now around 23% in December. Look at Q1’21 figures and we can probably conclude comps will be tough. Perhaps the company grows “just” high-teens / low twenties.
This is problematic as management set out much more lofty 5 year goals at their investor day in March 2021. A few quarters in and it looks like we will be under the goal.
Vimeo hasn’t reported Q4 yet, but investors can look at the reported monthly metrics as a guide. Even before they reported December metrics, they were guiding investors down at conferences:
[Regarding Q4]. What we have said is that revenue growth to be about 25% year-over-year. And if you think about that, we are lapping a very strong growth rate in the fourth quarter of last year, which was about 54%. So on a 2-year stack basis, we are significantly higher even compared to Q3 of this year. We haven’t talked specifically about 2022 and what the growth rates would be there. We are still in the planning process and for all the reasons that you talked about, the visibility being harder. We’ll provide more guidance as we get through this year and into early next year.
But what we have said is that the 30% growth rate is unlikely next year. And we also believe the first half of next year and the growth rates will be muted for the same comp reasons that we talked about earlier, and we expect the growth rate to be accelerated in the second half of the year. So if you think about our growth rates coming down in the second half of this year, that would continue through the first half and then we expect it to reaccelerate sometime in the second half of the year.
My emphasis added.
But let me say one heuristic I have learned over time.Anytime a company says that “we’ll make it up in the second half”, it is a SHORT for me.
“But Dilly D – if that is the case, how can you possibly buy the stock now?”
I think a lot is priced in at this point (also dangerous words as making it up in the second half). But after studying the business model, strategy, and thinking about the TAM, I do think this business can continue to grow at high rates.
Ok enough depressing talk, let’s talk about why Vimeo now looks cheap!
Why Does Vimeo Stock Look Cheap?
Vimeo is a more focused company, post-spin. They are free to operate the way they want & invest where they want. Focus on a singular goal is important.
End of the day, Vimeo is a good business
Classic “freemium” model converts users to paid in highly efficient manner. That said, enterprise customers (where decent amount of S&M is dedicated) are worth way more than typical “Pro” subscriber.
Enterprise 1% of subscribers, but 25% of revenue.
50% of paid customers started off with the free plan (i.e. freemium model)
Vimeo is an alternative to YouTube for business
Pandemic likely pulled forward sales, but also accelerated market growth and adoption.
Decent amount of growth is “locked in”
I’d gamble some things from the pandemic will stay (e.g. virtual “town halls” for companies, more video options for live events, etc.)
Brand value is worth something (I won’t dive in here, but something to think about)
The “What do I need to believe?” case seems reasonable
First, I think a focused, small company can really do wonders. Investors worry big tech will squash the “little guy.” See online dating, industrial distribution, media content, marketplaces, among many others. But Vimeo lives and dies by this “niche.” They come into the office everyday thinking about this one thing.
Steve Jobs said with “focus and simplicity you can move mountains.” To me: stand alone company = more focus, though maybe Vimeo requires more investment short-term.
I think we started the year with about 75 quota-carrying sales headcount, and we would end the year at about 150, so almost doubling. We have opened offices, at least in 4 or 5 new geographies that we didn’t have at the beginning of this year, so significant expansion
Seems like they are investing for growth.
End of Day, Vimeo is a good business
On the Self-Serve segment of our revenue (meaning, a customer begins to pay Vimeo without having spoken to a salesperson), we’re seeing about $5 in profit for every $1 we spend in marketing. That ratio has continued to steadily improve and we haven’t yet found the limit on our ability to spend on marketing with those returns
IAC also mentioned during the pandemic that Vimeo “accidentally” went EBITDA positive as the growth resulted in a lot of operating leverage.
Go back to the 2020 summary results with long-term goals below. Look at that operating leverage on the gross margin line and EBITDA. Pretty impeccable. This has been true over time when you spread the financials as well and look back to 2018 and 2019. I do think a SaaS company like Vimeo should be able to reach 20%+ EBITDA margins, which we can get into in the model later.
All Customers are Not Created Equal
As mentioned, Enterprise is just 1% of subscribers, but 25% of revenue. This checks out with their other disclosures:
As of December 31, 2020, we had over 3,800 enterprise customers, who, as of the quarter ended December 31, 2020, pay us over $22,000 per year, on average. We define “enterprise customers” as those who purchase plans through contact with our sales force. Our enterprise customers grew 87% year-over-year for the quarter ended December 31, 2020, and these customers now represent nearly 25% of our total revenue for the same period.
The goal is to increase Enterprise exposure. In fact, as of Q3’21, it was 30% of revenue.
I created a hypothetical scenario where Vimeo had 100 paid customers, 99 on a “Plus, Pro, or Premium” contract and 1 enterprise customer. Let’s assume nothing changes other than their ability to gain one more enterprise customers. Note, I somewhat made up numbers to back into an ARPU roughly around today’s levels.
The other subs can be flat, ARPU can be flat, but the mix effectcan drive significant results.
And assuming ARPU is flat is pretty conservative. They stated in their S-1 that Net Revenue Retention was 110% and in Q3’21 they stated:
“Our enterprise net revenue retention remains healthy with our sixth consecutive quarter of NRR above 100%.”
Pricing Strategy Change
Let me also say they are changing their pricing strategy. As I said, foundational changes can cause a lot of turmoil. Currently, this is in “beta” but they are moving from a storage-based model to a “per seat” model. In other words, they are going to try to base payment tiers off of customer success. You host a webinar, Vimeo will charge off of registrants. If you have an internal library of content, it will be based off of admin seats.
This may turn off some people. But Vimeo is doing it now because they feel they’ve expanded the product platform enough to make it enticing. Plus, aligned payoffs makes a lot of sense. Think about Facebook ads where the company buying the ad only pays when someone clicks – that is high ROI and easy to tie which increases lock in.
This is no doubt a big project and scary, but they have been talking about it for at least a year. If it works, they’ll move customers up in pricing tiers (e.g. from the self-serve model to a higher tier). For what it is worth, most SaaS companies are on a per seat model.
Here is Vimeo talking about converting customers and retaining them, as well as bringing up per-seat pricing. This is from March-21, but they also spoke about this in 2020.
In terms of the conversion and upgrade mechanisms, so I think of it in two ways. One of the biggest features that we see help unlock our free users to convert in the first place is being able to create content. The creation of content is a big barrier. So things like our Create app or Vimeo Create app, being able to record your screen and send a video message, those actions are really the things that we found activate a free user to get them to be paid.
From there, the way we tend to move our users and subscribers up tiers is unlocking more advanced functionality. Some examples would be livestreaming, advanced marketing tools, the ability to capture e-mails within a player, put your customization and branding, add calls to action, privately and securely share content or create a video portal, those are all the mechanisms today. Tomorrow, we see even more mechanisms. You’ll see us do things as we expand our product suite. You’ll see us look at per-seat pricing, for example, so that we can actually use the number of seats or the size of your team as a way to move people up tiers. But even what we have today, we see, I think, about 25% of our self-serve subscribers move up tiers from those other features I just mentioned.
Vimeo has >200 million free users today and they have a good history of converting them to paid. I think about Dropbox: it is much easier said than done converting free users, but when you are actually able to bring them up the chain, it is a beautiful thing.
If you go back to the S-1, it seems like this isn’t a “new” change, but something thought about for awhile now:
Over 65% of our new enterprise contracts came from customers who were existing free users or self-serve subscribers first
We seek to employ a “land and expand” strategy where we inspire our existing subscribers to increase video adoption and usage and upgrade to higher-priced plans over time. For enterprise customers, we seek to expand the number of employees, teams and departments using our platform and increase contract value organization-wide.
What about YouTube?
All of this can be a disconnect for people who quickly think of YouTube as a competitor. I’d say a lot of YouTube is B2C, ad-driven revenue.
Most people today probably still think of us as the sort of indie smaller version of YouTube. And for most of our history, that’s what we were. We were a viewing destination and a place to watch a video, like YouTube.
And 3 years ago, we pivoted away from that strategy to really being a B2B video SaaS company…today, we enable any business of any size to connect with their customers and their employees with video…we do this by providing a very simple, high-quality, end-to-end solution for those businesses and professionals. So SMBs and marketers will use us to make social media videos, post them all over the web and drive traffic back to their business or store. Fitness studios and churches will use us to live stream their classes and their sermons. And yes, we have Fortune 500 companies using us to host virtual town halls and conferences and events
Video is a big market and there are a lot of different use cases (read: niches). To head off the “YouTube vs. Vimeo” argument, let me pause and offer a few reasons why someone would choose Vimeo.
YouTube is quantity over quality: Vimeo can offer higher quality videos with more customization
No ads: there is a component of control here, such as no control over what ad plays in front of your video. Plus, an ad is inherently trying to drive traffic away from the site. That is NOT what a Vimeo customer wants.
Make money with pay per view: Back to that fitness class example, a small business can set up a “pay per view” using Vimeo
Password / privacy protection: Can create company specific vids or those for customers without sharing with the world
It’s reasons like these that the NYSE does live stream of opening and closing bell on Vimeo, or why Starbucks does workforce training on the platform. From a quality perspective, a lot of music videos are now on Vimeo as well as short-films where the filmmakers care about their videos not being compressed.
Anyway, it is a difficult question for many of the 800lbs gorilla squashing Vimeo’s niche, but I go back to how big the video market is. To me, the analogy is similar to an Etsy vs. Amazon – both can exist.
I think this conversation on Vimeo will not die down. It will likely continue to “dog” the company for some time, especially when reports of other video players adding new features (like Zoom) emerge. Unfortunately, I can’t “prove” Vimeo will win in every case. That’s the bet.
Summary Model Scenarios
For the first model summary, I wanted to show a “management case” and have ’22 at subs and ARPU growing 9-10%, for 20% revenue growth, followed by re-acceleration. I assume some modest leverage on COGS, but they are already at their goal, and some fixed cost leverage (mostly coming from G&A – where I assume ~70% of G&A is fixed).
Yes, I do assume SBC is added back to EBITDA for Adj. EBITDA.
I assume, because they’ll be generating so much cash and already have a lot of cash on hand, that they start buybacks in 2023 = FCF. They likely do acquisitions instead, such as the two at the end of 2021, but those assumptions are too hard. Buybacks start at $20/share and stock price increases 15% p.a.
Bottom line: If you think this is reasonable and want to buy the mgmt case, then we are buying the business for 3.7x 2026 EBITDA and the company will be generating a lot of the current market cap in FCF.
In this case, the company will be doing $4.35/share in FCF in 2026 (remember, stock today is <$14). 20x that figure gets you an $87 stock price.
What about the scenario where they were *just* a COVID winner?
I think that’s interesting. The truth might be somewhere in between.
Let’s say subs slow to just 3% a year but ARPU decelerates meaningfully. NOTE: This is in full contrast to the Enterprise customer math we did above! In reality “what I think will happen” is subs could slow, but ARPU accelerates.
But anyway, you can see the results here:
Given I still assume buybacks (at the same prices in the first case) I have Vimeo doing $1.20 in FCF/share by 2026. If you put 20x on that, that’s a $24 stock. That may not seem like much, but that’s 60% over 5 years and foots to a 10% CAGR.
If the truth is somewhere in between, the risk / reward looks pretty attractive now.
I tweeted this in the beginning of the year, because I saw it as an interesting way to play Vimeo and wait for a better price:
Full disclosure, I did do that trade. At the time of writing you can get $2.25 for this contract! That’s an 18% unannualized “yield!” And I also have done that. Worst case, I am buying Vimeo stock at $10.25, or $1.7BN. I am comfortable owning there, too!
Selling cash-covered puts is more conservative than buying the stock. BUT it has less long-term upside. Sentiment seems pretty low, and definitely can get worse, but there is risk you miss out owning a great, little business with a long runway ahead.
We saw a massive “destocking” of inventories occur in 2020 (the initial response to the pandemic). Then, a massive “restocking” occurred as demand returned with limited inventories. But on the other side of that is typically another “destocking” cycle as supply chains tend to under and over shoot.
What we saw in 2020-2021 appears to be a bullwhip effect on steroids.
In other words, today’s shortages become tomorrow’s gluts. What appears to be endless demand may be simply pulling forward purchases to replenish inventories, leading to oversupply.
I was listening to Joe Weisenthal on the Notes from the Crises podcast and he put it well. He said something like:
A pork producer does everything to prepare the pork, but then he doesn’t have styrofoam trays to put it on. He can’t deliver the meat despite solid demand and the customer’s shelves go empty. The customer thinks supply can’t be met due to unexpectedly strong demand, so they double order to make sure they have it. The pork supplier says he won’t be caught short again too… so he triple orders styrofoam. On and on…
As you go further and further upstream (that is, further away from the customer), these swings are more pronounced (that’s why it’s called the bullwhip effect – the handle of the whip barely moves, but the end of the whip – the upstream producer – swings massively up and down). Demand information has to travel up the chain, like the telephone game, before it arrives at the upstream supplier.
Is it any wonder we’ve seen a lot of these shocks and surges in pricing commodities?
To further explain, we had a massive, but short lived, demand shock in 2020. Companies halted purchases and decided to sell down inventory to better match demand in what they thought could be a depression or GFC 2.0.
Here’s an example from Atkore, a company that sells conduits around electrical cords for buildings, talking about this in May 2020. They are essentially saying they think demand is going down a lot so they are destocking in the channel.
What happened with Atkore? Well, demand held in very well. Pricing surged as they have commodity pass-throughs, so Atkore is going to do $900MM of EBITDA in ’21. Normally they’d do ~$300MM. They even are telling the street that it isn’t sustainable, yet street estimates still have them at $600MM of EBITDA in ’23 (likely a wet finger in the air)…
Here is another great one from Louisiana Pacific, which sells OSB (a type of plywood into buildings) as well as siding in May 2020:
Neither these companies, nor their customers, knew that demand would actually come roaring back. Inventories, in turn, would be *too* depleted, caught short, and prices surge.
Winter Storms and Hurricanes of 2021 Exacerbated Normalization
Let me add another piece into the mix. Chemicals. You know, the upstream products that go into everything?
PPG had a great comment on how much the Winter Storm Uri impacted 2021 in getting supply chains back to normal:
Yes, 95 plants (!!!) in Q1 2021. That surely can cause a disruption, tighten inventories, causing key input prices to surge… which they did for key plastics.
What are two key end markets for plastics and chemicals? Autos and housing.
Lyondell, another major chemical producer, but very upstream, noted in one of their earnings calls that they weren’t actually sure what demand is!
“We really don’t know where the real level of demand is because we’re so supply constrained.”
Now, Lyondell spun that as a positive, but that’s concerning to me.
In hindsight, it is obvious to see how that rippled through supply chains. But many smart investors are saying, “too much stimulus, so that has resulted in inflation.” That is way too simple. As prices rose, that had to be passed down the chain in a market desperate for supply. What does this mean for when supply relaxes?
Shipping Adds in Another Layer of Complexity
Another thing you can point to rippling through the chain is simply global shipping is normally deflationary (the more containers per ship, from low cost areas, the lower the cost per each individual unit). But bottlenecks prevented that.
In addition, in a globalized economy,high shipping costs can keep low-cost producers OUT of the market, driving up prices. If this happened in many industries, but you think shipping normalizes, why do you think those prices won’t normalize?
I bring up shipping because the constraints there caused further scrambling for orders, which again makes me think the bullwhip effect is on steroids – it is on a global scale.
No auto dealer likes having nothing to sell. No retailer wants to be the one without seasonal items for the holidays.
In fact, in an Odd Lots podcast, Joe Weisenthal and Tracy Alloway discussed how a small-fry customer can be booted from the container ship in favor of a large customer (a la Walmart). Companies are doubling ordering there too so they don’t get kicked from the boat. All this double ordering leads to very strong backlogs, but is it “real” demand?
Inflation in my mind right now is very much being caused by a supply chain issue and that will be resolved. It is inter-relatedly tied to these inventory & shipping issues.
I am actually very bullish for the next few years. I think we are operating in a very exciting time for investments. At the same time, I am highly cautious underwriting things right now that say they have amazing backlogs. The market is forward looking. As some companies burn through insane 1x earnings, I don’t think they will perform well.
I also think despite some podcasts and WSJ articles, investors are impatient and may ignore the bullwhip reality until they see it with their own eyes. If they don’t see the market “normalize” in 6 months, they tend to think we are in a “new paradigm.” I’m cautious saying much actually structurally changed post-COVID.
I’ve written up some things that still look cheap, like select retailers, but I would much prefer something like auto suppliers in the cyclical space where I think I have a high degree of likelihood of where production is going.
Oh, and by the way, this isn’t the first time we’ve seen something like this. Arguably post-GFC with China stimulus was similar (go back and look at what happened to commodities then), but that didn’t last. That said, this is on steroids…
When do you have recession levels of production, but demand has already improved drastically? Even if demand slows, production has to be elevated to restock the channel.
Investors are always worried about demand and production levels in autos given high fixed costs, but the visibility of go-forward production levels is obvious: UP!
I want to lay that thesis out a bit more and highlight a basket idea I have. I already have American Axle and Strattec in my recs, but I am adding Magna International, Lear and Ingevity to the mix. I discuss others below as well.
Let me also state I know auto supplier stocks are value traps – they trade at low multiples for a REASON. Many reasons. But let’s lay out the bull case.
Why am I so confidant in auto restocking?
First, here is annual SAAR, or the number of units sold each year. We typically ran 15-17.5MM units in the US:
Domestic production is running at just 12.5mm units. Here’s inventories, in units
And here is inventory to sales ratio. Normally I don’t prefer this, because a 1x elevated pace can make it look bullish at the top of the cycle. But that isn’t what happened here.
It is no wonder why used car prices have surged – we are short cars. As I put in my prior posts, many dealers I follow have less that 25 days of inventory on hand compared to 60+ days pre-COVID.
With no production issues in 2022, I think it likely takes until 2023 for passenger and truck inventories to normalize.
Here are some comments on that:
So I think what you’ll find is that, as you look through 2022, the first half, we’ll have less supply than through the second half. And as I said earlier, we see this mitigating over time. It may extend into 2023. But I would say that we should be back up and running based on what we’re seeing today, a run rate, the end of next year into ’23. And then in 2023, we’d start to rebuild our inventories.
-John Lawler, CFO of Ford
As we indicated, we see a very bright future and a very strong demand for the various platforms that we support for years to come, especially because of where the inventory levels are and because of the consumer demand that exists in the marketplace. And as I said, as fast as the OEMs can build them, the consumers are buying them.
So I think it’s going to take an extended period of time to rebuild the inventory levels. That’s going to put us in a very healthy position to generate a lot of cash for our business. We’ll use that cash as we always have to continue to support our organic growth, a big shift in our organic growth is towards electrification.
We think it will take a minimum of 24 months to replenish the value chain. And therefore, we see some bright days ahead of us as it relates to our ability to generate cash, pay down debt and fund our electrification growth in the future.
–David Dauch., CEO of American Axle
I think if you look at ’21 versus ’22…the biggest impact on decrementals/incrementals is really the start-stop and the inefficiencies that we have in our facilities. And I expect that’s going to go away as we work through ’22. And that’s the biggest item order of magnitude against some of the inflationary pressures are — will have — I expect will have an impact.
-Vince Galifi, Magna International CFO
What are the best plays?
I may not know the best plays, but this is what I am doing. I’ve already written up $AXL and $STRT and those are my top ideas for this.
Here are some other thoughts. Note, a lot of my estimates tend to be higher than consensus, because sell side tends to stink at modeling fixed-cost absorption. I should also say I am looking for cheap names I don’t think will underperform for some other reason (e.g. EV risk) and that’s why I exclude a Garret Motion or a BorgWarner – I just want exposure to my thesis. I do like those too and full disclosure am long the GTX prefs in my PA.
Magna International ($MGNA) should benefit from increased production plus. Valuation is undemanding at ~5.5x 2023 EBITDA. This is generally a “safe” auto supplier name as they have less exposure to “EV risk”, in that some suppliers products may be disrupted. MGNA is “drivetrain agnostic” as they say, but also pretty diversified across exterior parts, drivetrains, seats, etc. There was this report stating Magna was involved in the powertrain for an Apple car. Who knows, but MGNA really does have its hand in a lot of EV related things, but also is generally tied to auto production.
Lear ($LEA): Lear is dominant in seats (Lear and Adient each control about 22% of the market, followed by Magna at 7%, and then other small players). Lear doesn’t really have EV risk in my view with seats. They are also a leader in wiring components. With EVs and ICEs having higher electrical content per vehicle, Lear is a long-term winner. I do think the street may be underestimating Lear’s profitability when it is running flat out, though if I am wrong, Lear’s upside is admittedly capped. But assume 10% EBITDA margins on ’22 consensus sales, it trades for ~5.75x EBITDA. Lear last earned these margins back in 2013-2014 when they were running really strong. Lear used to buyback a lot of stock – back in 2013, they bought back $1bn, or 16% of shares. I love it when companies buy back huge slugs of stock at one time
Adient ($ADNT): A possible play, but turnaround story (former spin from Johnson Controls, margins well below Lear). I think I am a pass here, but bring it up for those who want the highest beta. The hardest part is they generate basically no FCF. If you buy the turnaround story (mgmt says 500bps of margin improvement was disguised by inflation in ’21) it could make a lot of sense. An improving ROIC + Growth = winner stock. And their growth is near 1:1 with production.
I know, I know – there are a ton of suppliers and so I don’t have to cover them all. Here are some other tertiary ideas, though:
Cars.com et al ($CARS): With tight inventories, dealers and OEMs have been able to cut incentives as well as advertising. When inventories normalize, so should incentives and ads. Up to you on this one. Cars.com does look optically cheap, but I don’t know it well enough.
Ingevity ($NGVT): Under-discussed name and likely requires its own post as it is a fascinating business. This is a chemical business attached to an auto-component business. A former spin-out of Westrock, the chemical business uses pine-based chemicals to make certain resins used in paving, inks, O&G, etc. The auto component is basically a vapor control system in cars that utilizes activated carbon. While I said “no EV risk,” this truly is a great business as they essentially have a monopoly on the business (and it has 56% EBITDA margins in good times! Alas – because of lower auto production, Q3 margins were down >800bps. Guess what happens when that reverses?). >10% fwd FCF yield is too cheap.