Category: Featured

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

IFF Receives Approval for Dupont’s N&B Business: Waiting for the Right Entry Point $IFF

Reading Time: 4 minutes

When I first heard that IFF was buying Dupont’s Nutrition and Biosciences business, I gagged. I had known IFF from my time covering chemicals and knew it as a “secret SAAS business”, if you will.

For example, IFF provides scents and fragrances to perfume manufacturers. I like luxury brands, given “secular growth”, and IFF seems like an excellent “pick-and-shovel” play. In other words, I don’t have to pick the perfume that is going to win, I can just pick the underlying technology that should grow as the rest of the markets grow. A rising tide can lift all boats.

That’s not all IFF does – it also makes fragrances for household goods, detergents, and makes flavors as well. IFF used to be split ~50/50% between Flavors and Fragrances. IFF acquired Frutarom, which specialized more in the “natural” taste and scent market and also catered to small-to-mid sized companies, which also seemed to be a longer-term growth story (though in my view, this is really a GDP-ish business. I’d be buying for the stability + high ROIC).

I do view the ROIC here as “best-in-class” and like that IFF still seems underappreciated by the market. This isn’t a Sherwin Williams or something that is discussed everyday (yet).

As you can see below, to me, IFF had the “sexier” product portfolio as opposed to N&B.

I say this coming from experience covering Ashland. Ashland is a chemical producer that can be described as “specialty” (as opposed to “commodity”). Typically, this means high margins, limited capital intensity, lower volumes, and limited exposure to raw material changes like some commodities (e.g. ethylene).

But Ashland always had SOMETHING go wrong. They would spend several quarters talking about how great their personal care business is, and then next thing you know the profitability in that segment gets whacked and they’d have a big miss. And it turns out that Ashland’s components are certainly lower volume, higher margin business – but it is still highly competitive and subject to price cycles much like commodities are.

IFF’s core portfolio, especially fragrance, struck me as the better business. I recognize many of the Ashland constituents within the former Dupont’s business (cellulosics, guar). This is also clear through looking at gross margins (though not a perfect analysis), IFF’s historically 45% GMs compare to N&B with 36%.

That being said, from what I could glean from the proxy, N&B ROIC was still very good (they did ~$1.4BN of EBITDA on $3.6BN of tangible capital). N&B + IFF will also be way more diversified so a guar gum collapse wouldn’t kill them.

And that got me thinking that this deal could be much better than I expected. After all, N&B competes with Chr. Hansen (a beloved stock in the “compounder bro” universe) and it trades at 26.5x 2022 EBITDA at the time of writing… Chr. Hansen is a niche producer, though. N&B + IFF isn’t, so your company profile is “diluted” if you will… but scale matters too.

IFF & N&B just received approval to merge (its be a long, drawn-out process to get all the approvals). About a year ago in December 2019, the two announced they would be merging via a Reverse Morris Trust in a transaction that valued Dupont’s N&B business at 18.4x  2019 EBITDA, or 15.2x post synergies. This is a high multiple, but when you think about Chr. Hansen, the ROIC these businesses earn, and also think about the synergies between the two businesses, it makes sense.

While I like the business, the tough part will be integration. This is a massive transaction and sometimes analysts on Wall Street forget that pushing two huge companies together isn’t as easy as it looks on paper.  As I noted above, these companies kinda  operate in similar markets, but not really.

The interesting thing about the long, drawn out process is that the combined company has had to put out S-4s (which detail everything about the merger) along the way. We just got another S-4 on December 22, 2020. Unfortunately, both companies have reduced what they were expecting for 2021+ EBITDA. I don’t typically put much faith in these proxy projections anyway because they are typically inflated to get a deal done. In this case, I’d trust it more now that its come down and 2021 is closer to reality from a timing perspective.

IFF already had issues integrated Frutarom (and the latter had a bribery issue that had to be addressed), so it does concern me that they want to do a big deal again.  To emphasize the point, my take from the proxy was the IFF would do anything to acquire N&B. It just wanted to make sure it was the winner. That typically doesn’t work out well…

The concern is that N&B and IFF will be so distracted merging, that competitors can emerge and take share. This would not surprise me in the slightest.

The company will also be ~4.0x levered, which the market typically hates even if you’re a good business  (footnote: I don’t hate this).

The set-up here seems attractive… to wait for a better day. Right now, the stock is pretty richly valued. Results are coming down. And while this is a high ROIC business, I think there are too many “hiccups” post-merger that can come out and drive the stock down.

I say all this as a means of preparation for that buying day. I will be watching this one patiently for a good entry point.



New Home Company: Microcap Homebuilder Trading at Significant Discount $NWHM

Reading Time: 4 minutes

I’ve posted two recent “discount to NAV” plays recently, LADR and CET. I also had a disappointing call on CPLG, which thankfully I decided to exit. While I think those names are different than most stories, I am generally wary of “discount” plays and even sum of the parts.

As I stated in the LADR post:

“See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)”

However, exceptions are allowed. In this case, we have a homebuilder with a strong management team trading at a large discount to book value. Recent trends are really encouraging as well. Somewhat like LADR, homebuilders sell down inventory and recycle it into new inventory. Rinse and repeat. Therefore, I like that we will eventually realize book value at NWHM.

This will be a quick idea and I’m going to start with the punchline first: I think there’s 80% upside on NWHM.

Currently, the market cap is ~$86MM. I like to go to the balance sheet and take out any intangibles and look solely at what liquidation would look like (note, the company does have deferred tax assets to shield itself in a literal liquidation). The company just refinanced $290mm of bonds and reduced debt with the cash on hand.  As you can see, we could liquidate this company and easily earn more than where it is trading.

I’ll also note that the company just authorized a $10MM share repurchase plan, which ~11.5% of the company. They could easily do this will the cash on hand.


Background / Why did the stock get cheap?

NWHM started as an ultra-luxury builder (think $2MM+) in Northern and Southern California. That was a great market to be in just a few years ago, but with taxes increasing a few years ago for high net worth individuals (see state tax deduction limits, mortgage interest deduction limits) this hit the luxury market hard.

It also was the best market coming out of the housing crisis, so it has been strong for ~9-10 years. So recent weakening can be expected.

Lastly, we have COVID. While benefitting housing in general, it isn’t even across the country and there is concern that there will be an exodus from these high cost of living areas.

So you can get a general sense of what drove the stock down.

They also were levered and had bonds due in 2022 that people were concerned about (i.e. maturity wall into a slowing market). Therefore mgmt had been working down inventory, generating cash, and they bought back some stock and bonds at a discount.

With recent strength in the bond market, they were able to refinance those bonds and extend the maturity to 2025. They also have been opening lower-cost communities in Arizona, which is a hot market.  They are trying to get their average ASPs down (not by lowering prices, but by targeting lower cost areas).

While I mentioned luxury was moving slower in recent years, it appears mortgage rates coming down significantly is giving the company a nice bump as well. Take a look at recent absorptions for NWHM.

Why Buy NWHM Now?

First, recent results are improving materially. Q3 and Q4  are typically seasonally slow periods in the market, but the company noted on its latest call that sales are bucking those trends

Second, I think NWHM could be a take-out candidate. While luxury isn’t where most builders are focused, there is a struggle to obtain good lots right now. I think Toll Brothers (another luxury builder) could easily acquire the company and getting it at NAV would be a coup for TOL and for NWHM shareholders right now.

I’ll also mention the Chairman, Larry Webb, is known for selling out of his homebuilder (John Laing Homes) prior to the last downturn at a huge multiple (something like 3x BV).

Lastly, we have a lot more time than we did before now that the company refinanced its bonds.

Where could I be wrong?

Interest rates could move back up and slow home sales materially. We saw this at the end of 2018. Even modest move ups in rates tend to make people “pause” a home buying decision.

There could be impairments, which shoots the discount to NAV thesis in the foot. However, the threshold to actually impair something for a builder is really high. I’ll also say, NWHM has had some impairments, but they haven’t been “50% of book value” meaningful. Lastly, they wouldn’t be talking about moving up price if they were concerned about impairments.

Foreign Buyer in California. This is kind of a “known unknown”. We know that foreign buyers have been scooping up US real estate and actually decreased purchases in 2019. But we don’t really know how much impact it would have if it evaporated. I think this is more of a tail risk.


Is it Time to Buy Big Oil Stocks? $XOM $CVX $BP $RDS

Reading Time: 4 minutes

The energy market is completely bombed out. If you tried to pitch an energy stock right now, I’m pretty sure no one would listen to you. Personally, I don’t know enough to pick a “winner” small cap energy stock, but I think buying a basket of the majors makes a lot of sense.

I know what you’re thinking: “Oh no… now Dilly D is falling for the value trap of big energy… there’s no hope.”

My thesis comes down to three points:

  1. Sector is completely bombed out. No one wants to invest in it. It’s almost toxic. Most people will likely skip this article because they have no interest. Oil prices going negative this year might have been the last straw.
  2. Supply is much tighter now. Shale, which was the growing marginal supply, now has rig count come way down. While COVID was a shock to demand this year too, demand likely will come back much faster than supply. This could lead to a price run-up.
  3. Oil is not going away. People think oil demand is going away due to electric vehicles, yet they don’t realize the chemicals and plastics we enjoy in everyday life are also derived from oil. Also, I don’t think an EV commercial jet will be made anytime soon… jet fuel will continue to be a large source of demand, not to mention emerging markets.

So the bottom line is that I think as the global economy recovers from COVID, supply will be much tighter than people expect. That tighter supply will lead to higher prices (not calling for anything crazy), and that will result in more focus on the sector again.

I’m not going to comment on how oil is now the lowest % of the S&P ever, because I don’t really think that’s relevant to me. It could be a contrarian indicator, or just a sign that the industries return on capital is only good when prices are high. I also think you can control for the risks in energy through position sizing (I don’t plan on having a big position here, but I also don’t want to have ZERO exposure anymore).

Let me work backwards from my three points.

Imagine a chart of global crude oil demand in your mindwhat does it look like? Is it something that flatlines around 2005? Maybe more fuel efficient cars have come and that’s crushed demand?

Up until COVID hit, that would be completely wrong. Yes, so far with COVID, oil demand has been crushed. But I’m not banking on people not flying, not driving to work for long.

With demand so low right now, plus the swath of bankruptcies in shale, US supply has come wayyyy down.

This chart clearly shows the “bubble” that was US shale, which eventually led to an oil collapse in 2014-2016. But now we’re talking about very low levels of supply. We’re talking lows of Great Financial Crisis. The lows of the early 2000s (or pre-Shale Revolution).

US Shale vs. the Majors

The energy sector is consistently called out for not ever generating FCF, but that’s more so related to US shale. I’m speaking more about the majors, where they do actually generate a lot of cash. The majors are also pretty diversified across upstream, midstream and downstream (e.g. chemicals).

But I think FCF in the industry could be much higher if they just stopped spending (re:drilling) every dollar they earn. If you think about having one well, once all the upfront costs are gone and the infrastructure is set up, the costs to keep it going are relatively low. However, you now have a declining asset.

A declining asset generating cash is still worth something. It’s the PV of a declining annuity. I just think the shale industry needs to prove they can generate FCF and have more discipline. I’m not banking on that, so I’m going for the majors.

The majors have the scale, the developed assets, and perhaps need to generate FCF to support the big dividends they’ve handcuffed themselves to. Yes, I still think Exxon should cut its dividend. It’s getting outrageous. But at the end of the day, I may be wrong, but at least I won’t have a ton of downside.

I kind of like this chart. It compares oil price (yellow), XLE price (energy stocks proxy in white), and Baker Hughes Oil rig count (orange). It helps me see “bubble” and then collapse in a classic cycle. For example, if I were to show you a chart of US Housing starts, you could see something very similar around 2005-2006 (around 2.1MM housing starts). Then a collapse and no one wanting to touch housing (around 500k housing starts)… how times change…

Clearly there are risks to this playing out.

The cure for high prices is high prices – meaning as soon as prices go up, shale is coming back.

A second factor is that credit is easy right now. At the time of writing, the yield to worst on the US high yield energy sector is just 6.4%. This was a factor that led to the shale uprising. If credit is too easy, it’s hard for these guys to just STOP F&CK!NG DRILLING. Especially because this was an industry that used to be rewarded solely by increasing production and never really generating FCF.

Obviously, there are a million other reasons why I could be wrong, not the least of which is OPEC. They just announced a small production increase, which seems crazy, but the OPEC countries’ economies are reeling. They need to pump volume at the expense of price sometimes. I still think longer term, they realize what needs to be done and shale (in a way) has already responded.

affirm S-1 Break down: Lessons on Customer Concentration $PTON

Reading Time: 4 minutes

I’m sure you’ve seen it by now. You’re checking out online and you see a notification that says, “Why pay $180 now when you can pay 6 payments of $30…”. I’ve been very tempted to use this, but actually never have. I get tempted because I view it as managing my working capital (pushing my payables), but figure there must be a catch. Most often, I see it offered by a firm called affirm (I guess, like, affirmative covenant). And affirm is out with its S-1 to go public.

If I jump straight to the punchline: a buy on affirm is really a buy on Peloton, too.

If you know Peloton’s exercise bikes, you know they retail for $2,000 to $2,500 for the new bike. You may also know that this pill becomes easier to swallow with the interest free payments. This is actually powered by affirm (see the fine print at the bottom of Peloton’s page).

affirm argues this helps merchants sell at higher price points because the sticker shock is less severe (makes sense).

I’m not buying a $2,500 exercise bike, where cheaper copycats are plentiful, I’m paying a low, low price of $64/month for 39 months!

This is what affirm calls “Merchant Network” revenue. The loans are 0% interest, so there’s not really any interest income, but affirm charges the merchant a fee for conducting a transaction on their platform.

Here’s the thing: You’re buying at what they think will be a $10 billion valuation or 18x core revenue. You’re banking on a lot of growth. With the surge of e-commerce in a year impacted by COVID, people more cautious on liquidity, it should be a major growth year. Affirm did grow revenue 98%, with merchant network revenue up 157% in the Q ended Sept.

But wait – look at affirm’s Peloton exposure. It grew faster than merchant sales. It also grew with Peloton faster than Peloton’s “Connected Fitness Product” sales. This means they are converting more of PTON’s customers. But it also means it accounted for ~70% of affirm’s growth. And if they didn’t convert a higher percentage of PTON’s customers, PTON still would’ve accounted for 60% of merchant revenue growth.

This all begs the question: is that worth paying for? The biggest pushback will be “it is early days for affirm, they’ll convert more and more merchants” but clearly consumers are using the product heavily for Pelotons and mainly for high ticket price items. And there are other competitors in the space (which I discuss at the end of this post).

Let me put it this way: non-Peloton merchant revenue, by my estimate, is just $131MM in the LTM. Is the Peloton business + this worth $10BN?

Oh, and by the way (yes – this is true for Peloton too):

I can imagine in 2023 investors watching on bated breath what will happen to this contract…

What I love about affirm is that they say,

“we believe that companies… that peddle toxic financial products and derive profit from their consumers missteps – like credit cards and other products with deferred interest – will find themselves in the shrinking minority before too long.”

Look, we have usury laws for a reason. I think that is important to protect consumers, especially those that have limited alternatives and can be taken advantage.

But it’s almost as if affirm is calling out earning interest… taking a risk for a return… when in fact, they do this as well… They better not expand into earning higher rates of interest in the future or I’ll call them out.

But isn’t affirm also kind of in this “predatory” boat? You may not be charging high interest, but you are coaxing consumers into making a big purchase they may not be able to resist.

Quick aside here: people tend to have a lot of issues with Credit Acceptance Corp, a name that makes subprime loans to people needing to buy a car. On one hand, Credit Acceptance makes high interest loans – think a 20% interest rate which seems crazy. On the other, these are predominantly loans to people with FICOs below 550. This is an area of the market that no other lender dares go. And Credit Acceptance usually doesn’t collect on ~25% of these loans, too. So yes, they charge a high rate, but without them – a lot of Americans wouldn’t have cars. In other words, if Credit Acceptance was “regulated away” tomorrow to crack down on high interest loans, would that actually make things better?

I’d like to believe affirm is lending to higher quality borrowers that can afford a $2,000 exercise bike and just want the convenience of deferring the payment.

But if you think about it, Peloton is seeing an uptick in customers using affirm. You could argue Pelton wouldn’t have the same sales without a firm like affirm offering a 0% APR loan for nearly 4 years. Aren’t you essentially admitting you know your price gouging customers?

Off the soap box. I see a lot of issues with this business. No question that its growing and I think it will continue to grow in the near term. But thinking 5-10 years out, and bracketing some of the risks, I’m not so sure its worth it.

It seems to me every tech company wants to insource payments / expand into “fintech”. Do you feel comfortable Shopify and Square aren’t coming for this space? What about when you checkout using Google sign-in or more importantly, Facebook, who is clearly targeting payments?

What is the actual TAM here for affirm specifically? Putting aside the other competitors like Afterpay, Klarna, and Quadpay — Does the number one e-commerce player do this or have they partnered with Visa for their credit card and offer equal payments at 0% APR? Hmmm… Surely they affirm is attacking those sleepy incumbents… Maybe Amazon wants to keep that “merchant revenue” for themselves.

Hear Me Out: Lots to Like about Big Lots Stock $BIG

Reading Time: 6 minutes

What if I told you there was a company with an average ROE > 22% over the past 10 years… It also earns a double-digit ROIC… What if I told you that this company was a beneficiary of COVID, and the cash flow greatly increased its future optionality for years to come? What if I told you this company also has been a consumer of its own shares – especially in market volatility (i.e. when you want it to be buying shares). The title gives it away, but I am talking about Big Lots stock.

Yes, I’m sorry readers. This is a value stock (vs. some SaaS-y growth stock). Brick and mortar retail, no less. 

The stock is now down ~14% after posting Q3’20 results.  While the company posted 17.8% SSS comp (a record), they noted some deceleration (perhaps too much pull forward of Holiday shopping into Black Friday + they closed early on Thanksgiving).  Even so, the deceleration meant Q4 was looking like a +Double-digit Q, and their gross margin guidance seemed conservative, so I thought I’d take a deeper look. 

There are several reasons why I think there is significant upside to the stock with reasonable downside protection — including some things to assuage the B&M concerns.  

The quick and dirty background on Big Lots is its a discount retailer with its foundation in the south and south west, mainly opening up in strip malls (typically an “anchor” tenant). They have ~1,400 locations today, but if you haven’t heard of them it’s because you aren’t in a location they target (more suburban and rural and where the ~30% discounts to other retail they offer are appealing to the price conscious).   

There’s a debate over whether companies that have strongly benefitted from COVID will give back all of the gains they’ve seen this year. In some cases, like in SaaS, investors see a sticky business with low attrition. So it appears investors are saying SaaS will give no sales back  post-COVID. In fact, the street is saying they’ll continue to grow. I’m not saying that is wrong, but for retailers, they are saying the opposite.

For example, people are stuck at home. They aren’t traveling, not going to restaurants, so they’re spending on making the home better. Dollars have shifted from some sectors and into other sectors. As COVID ends, people travel more and go to restaurants, there will be less dollars to go around and they’ll cut back on the beneficiary-of-COVID sectors.

I agree with this generally. Clearly Big Lots is making more sales than ever. These comps it is posting are unsustainable and it will likely post sales declines comps next year.

However, this also didn’t come for free. On BIG’s Q1 call, they noted they canceled their annual Friends &  Family event, gave their employees Easter off (which is typically a big sales event), gave a temporary $2-hr wage increase, provided an additional 30% employee discount, and additional bonus pay. So looking forward, its not just so easy to say the sales comps will reverse. 

I really like the option value of Big Lots. The boost from COVID has done 3 things. And if the term wasn’t overused, I’d say it’s a flywheel – each of the factors reinforces the others:

  1. Improved comps, therefore operating leverage, allowing them to generate a ton of cash flow
    • Big lots YTD has produced about 3x as much FCF as it did last year ($267MM vs. $80MM PY). It also did a sale & leaseback transaction in Q2 to generate $587MM of cash.
    • Q3 is a working capital investment Q ahead of the holidays, but I could see them ending the year with >$700MM of cash
    • Big Lots is also coming off of a capex spend, so future cash flow should also look better
  2. Accelerated competitiveness of Big Lots and its strategic plan
    • Without COVID, I wonder if Big Lots would have accelerated as quickly with Buy Online, Pickup in Store… or E-Commerce (which is probably small, but up 50% in the Q)
    • They also now have >20MM people on their rewards database
    • Sure, a lot of retailers have had to adapt, but there could be something to the theory that struggling retailers (both big and small) will close some locations and post-COVID, the playing field may be altered
  3. Introduced new buyers to the concept
    • With COIVD impacting so many businesses, and a lot of them shutting down, there’s no question that Big Lots benefitted from increased traffic. The question is – can they convert some of those new buyers into repeat buyers?
    • As of right now, the market doesn’t appear to be giving Big Lots much credit for this. In fact, it seems to be getting the least credit out of the few comps I looked at
    • However, as I noted, Big Lots actually does have really good deals. And they are focusing on a market with tailwinds (furniture, home decor, which I speak about later). Couple this will more rewards customers and I think its unfair to say they can’t retain much business

These are intertwined. But the issue with Big Lots, and why its multiple has been halved over the past few years, is that people view the company as being in secular decline

The WHOLE POINT of this post is to say, I think that may be too pessimistic

But take a look at what mgmt is saying it is investing in and able to do right now. I ask myself, “is this company getting better or worse in the future?” and “is my downside well protected?”

In fact, I can’t think of a better strategy to adopt pre-COVID – mgmt’s strategy has been focused on increased home furnishings. Mgmt is probably thinking “I’d rather be lucky than good” — targeting the home was a good idea.

For more background, Big Lots had basically grown nominally the past 12 years. They got a new CEO in 2018 which helped oversee a refresh of the stores, put the best categories up front, and accelerated online investments.

Furniture is a high margin category and they purchased Broyhill, which allows them to offer indoor and outdoor discount furniture (note: Broyhill is on track to do $400MM of sales this year – this is an asset they acquired at the end of 2018 for $15.8MM). Food is fiercely competitive, so they are deprioritizing that. 

The issue with this original plan is how they will inform buyers they offer / are expanding in core categories – it is clear traffic was up this year, so perhaps that will help going forward.

The other factor is that we clearly had a major recession. Big Lots is a discount retailer, typically trying to offer goods at a sizeable discount. These sort of end markets tend to have tailwinds after a recession (see my AZO post), albeit this recession may be brief. 

If you’re thinking, “ok this is good. I just hate the legacy brick and mortar exposure.”

The good news is 684 leases expire through 2022. That is almost half of their locations. In my view, BIG is in a much stronger negotiating position since the strip malls they tend to sit in may have been hit hard (i.e. anchor tenant leverage).

Second, if they need to “right size” their footprint, BIG can walk away, liquidate inventory, and invest elsewhere…. Including locations it thinks may be more profitable.

I don’t think Big Lots is in a bad position and I think the stock is cheap. There are upside to my numbers here below, yet the stock trades at just 5.8x 2022 EPS. For context, Dollar General trades at 22x, AZO trades at 13x, Home Depot at 20x, Ross Stores at 22x. Maybe the best comp is Bed, Bath and Beyond trading at 10x ’22 EPS and they’ve had much worse performance than BIG… the list goes on.

Ok – so some of those comps have performed better and earn a higher ROIC than Big Lots. But BIG also has the lowest expectations priced against the lowest multiple. And I view the downside risk as pretty limited.

For example, based on my estimates, the company trades at just 5.8x EPS. If it were to trade at 10x EPS, you’d have a $78 stock, or ~65% upside from today’s levels. 

You can also tell the company gobbles up its shares and I expect that to continue. The company repurchased $100MM of stock and has $400MM of remaining authorization (that’s around 25% of its market cap – which it could do given the cash). That eventually will grind EPS back up to the peak we may have seen this year, especially if the stock price doesn’t react.