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Disappointing Q, but asset sales will help close value disconnect $CPLG

Clearly a challenging Q and guide down from CPLG. To recap earnings, RevPAR decreased 6.1%, but adjusted EBITDA came in ahead of expectations at $46MM and street estimates of $36MM. However, due to an issue discussed more in detail below, as well as pressure on oil markets, the company reduced EBITDA guide to $155MM (down 13% from prior) and expects RevPAR to decline from -4.5% to -2.5% (from +1%).

This guidance assumes that disruptions that occurred in 2Q continue through the balance of the year (mgmt noted RevPAR was already down 5.1% Y/Y in July).

Disruption Event

From the call, it sounds like the company had issues with its “revenue management tools, customer interfaces and the administration of corporate and group bookings” which had an adverse impact on the business. This is run by Wyndham, which is technically the property manager on CPLG’s properties. CPLG noted because of this disruption, “there are several events of default under the management agreements relating to all of our wholly owned properties.” This also seemed to be the main driver of the guide reduction.

For the second quarter, total U.S. industry RevPAR grew 1.1%, and RevPAR performance in the upper midscale, midscale and economy chain scales in the quarter was 0%, down 0.7% and up 1.7%, respectively.

As a result of our 6.1% decline in comparable RevPAR for the second quarter, our comparable RevPAR Index declined 455 basis points.

We believe this underperformance is well outside normal expectations and reflects the impact of an adverse disruption to our business.

It remains to be seen what remedies will occur under this. Wyndham likely will fight these claims, but considering the disruption at CPLG one could envision that it is owed monetary damages from the lost earnings (and not to mention stock price).

For now, it will continue to pressure earnings… but I continue to think that misses the point of the whole story behind CPLG….

Asset Sales

The company’s asset sale program continues to go very well. To highlight some data points from the call:

  • Sold 3 hotels in May for $16MM
  • Sold 1 hotel in Illinois that was non-operational for $3MM
  • Sold 7 non-core hotels in July and August for $29MM, the average hotel-level EBITDA was 1,200bps below the company average
  • “We have 27 hotels under contract with qualified buyers, expected to generate over $100 million of gross proceeds at pricing in line with our initial expectations, which we expect to close by the end of the year”

Let’s recap what they’ve sold and announced thus far then:

This is clearly accretive to the equity, whether they pay down debt or buyback stock. A dollar of debt paid down is a dollar to the equity. 

So two questions we can ask ourselves is: What will the rest of the ~36 hotels be sold for?  And two, why don’t they find more hotels to sell?

Well, to answer question number two, it seems like mgmt is open to that:

“Given the early success we’ve seen in our noncore asset sales, we will continue to evaluate the composition of our portfolio in order to drive long-term shareholder value.”

If the rest of the hotels are sold at 20x EBITDA, we know they generate ~$5MM of EBITDA based on the presentation posted. That would be another $100MM in proceeds. This foots to management’s quasi-guide: 

“These hotels typically trade on revenue, and we’ve targeted a range of generally 1.5x to 2.5x revenue. To date, we have been well within that range, which could translate to potential gross proceeds of at least $250 million, if we are successful in disposing of the noncore portfolio in its entirety. “

Valuation

Given the fact that the asset sales have gone so well, I would strongly encourage more or a sale of the whole company at this point. We know from this chart there are a lot of hotels that have less than 25% EBITDA margins and those could be added to the list. 

In the meantime, I think the valuation on CPLG is fine, not overly compelling when solely looking on EV/EBITDA. Again, the real story is selling assets well above BV and closing the gap. Book value remains above $20/share. I think mgmt should focus on more sales to realize value.

B&G stock pressures continue. Starting to think the company should pursue a sale of itself, either to a strategic or sponsor (supported by back-of-the-envelope LBO math). $BGS

Although there are no earnings updates or any particular newsworthy items on B&G Foods, I thought it would be a good time to update on the company as the stock has come under significant pressure. It also gives me time to gripe about the way dividends are viewed in the US.

You see, BGS’ stock is down 20.5% YTD (compared to SPY being up 14.5%). The dividend yield is now ~8.3%. However, all things considered, I’d prefer the company to turn that dividend off and buyback shares at these levels.  

Companies typically establish dividends as a way of saying, “here you go, investors, I can’t invest this cash at levels that would create value for our company (i.e. in excess of our cost of capital), so I am giving it back to you.”

That’s all fine and good, but what about when things change (as they always do)? The way it works now is that dividends are viewed as sacrosanct. A company that cuts its dividend from the previous level will see its stock get crushed. It seems silly to me for that to be a rule. In some cases, the result is that CEOs/ CFOs initiate dividends to get into stock indices or attract incremental buyers. If I were CEO / CFO of a public company, the last thing I would do would be a regular dividend (even if it meant some funds couldn’t buy my stock). Special dividends, or dividends that are understood as non-recurring, seem much more prudent.

Anyway, back to B&G. It appears that private values of companies are now in excess of public companies. I also think that public investors are not valuing B&G’s platform as it should. As such, I wish B&G would (a) cut the dividend and buyback stock and (b) pursue a sale of itself. While the company would lose its public stock as currency to buy things, private markets are more comfortable with LBOs of highly cash generative companies.

What do I think B&G could sell itself for? Well, Ferrero just bought Kellogg’s cookies, fruit & fruit-flavored snacks, pie crusts and ice cream cones business for $1.3BN, or 12x EBITDA. Kellogg decided to sell this business because it had areas that it felt it could invest in for a higher return.  Campell Soup, which is struggling with growth, trades for 11.5x. I think B&G should at least trade for that. Also recall that Campbell bought Snyder’s-Lance for 19.9x EBITDA pre-synergies and 12.8x post-synergies.

If B&G sold itself for 12x, that would imply a $31 price target (excluding any synergies or cost outs of no longer being a public company). I wouldn’t necessarily like that price, but it could be a catalyst for people to pay attention to the stock.

Does 12x make sense? Let’s look at the private equity math. I assume PE can carve out some costs and also the company should be lapping freight and other inflation costs. I also assume they use cash to pay down debt. It amounts to a ~16% IRR. Not a 20% winner, but not too shabby either.

Why I like to invest in good companies with bad balance sheets $PAH

If you take a look at my investment recommendations over 2018, you might notice a lot of the companies I target have poor balance sheets (as measured by debt / EBITDA or debt / total capitalization). Why do I target these companies?

  1. The Equity market clearly overreacts to highly levered names (which provides opportunity to nab good businesses)
  2. Patience is rewarded
  3. As the company pays down debt, every dollar of debt paid down is a dollar gained to the equity

It may be best to walk through a few examples. And to be clear, in most cases, I am discussing names that don’t have near-term maturity issues as it is hard to bank on the capital markets always being open. That is my one important disclaimer.

The company I will be discussing today is Platform Specialty Products, a specialty chemical company that originated as a SPAC formed by Martin Franklin. Franklin is a serial deal maker, known for a strong track record at Jarden where he conducted dozens (maybe even hundreds) of bolt-on acquisitions. According to Fortune, Jarden’s 10 yr annualized return was 17.9%. Not too shabby.

Anyway, Franklin’s strategy with Platform was to buy “Asset light, high tough” business. That is, those with limited capital intensity, but high margins because of the service the businesses provided to its customers. Essentially, it was targeting really strong businesses. It also would have a target leverage range of 4.5x, which is on the higher end of companies, but if you assumed the companies were worth 12.0x together, it wasn’t that big on a debt to cap basis.

Long story short, after a series of frenzied acquisitions (mostly funded via debt), Platform got over its skis, fundamentals for its Agriculture chemicals business got burned by the Brazil real devaluation, and the company was 7.0x levered. The stock fell from $28 to slightly below $6, valuing the company at ~8.0x EBITDA (when comps were trading at double-digits), plus a high-teens FCF yield to equity, and a portfolio of strong businesses.

pah_chart

The headlines and chatter at the time were ridiculous. The company’s nearest maturity was >5 years out and people were concerned about Platform tripping a covenant (it had no covenants other than on its revolver, which would only spring into play if it was drawn down a significant amount. Even still, revolver lenders roll over on these covenants pretty customarily as they do not want to own the business).

As the company addressed some of its debt problems, the stock moved up to $15/share ~1 year later for ~150% return.

This to me is a clear example of the 2/3 items I noted above (except for number 3, which I’ll show more below). The problem for some investors is that the volatility in share price can pick up because of this, but as Warren Buffet likes to say, if your neighbor shouted a price to buy your home everyday, would you panic and sell if the number he shouted began to go down? Certainly not.

Let’s then look at a home and the math of it being funded more with leverage and assume the mortgage will be covered by rent. As you can see, putting 20% down on a house and assuming no growth in rent or home price appreciation provides a nice little IRR. Notice each dollar of debt paid down accretes to the the equity. The reason being that you are essentially LBO’ing your home in America.

(Note, I assumed a 5% mortgage rate here)

home 80_20

Now that is pretty good, but what if you were looking at an investment of solid property, same assumptions. This will be an investment for you that you plan to dump in 5 years, but you have to pay a 5.5% mortgage rate to compensate for higher risk (i.e. putting less cash down).

home 90_10

As a result, you get a 70% return on your money (vs. 40% in the first example) and put less down which frees up capital to put elsewhere.

Levered bond?

Said another way, if you view a high quality company as a stream of cash flows, then levering those cash flows can help boost returns.

Let’s say you bought a 5% coupon bond trading at 95 with 100% equity. If you held it to five years to maturity and sold it at par (or 100) your IRR or yield to maturity would be ~6.2%.

Bond IRR_Equity.PNG

Now lets say you bought that bond by borrowing half of the purchase price with debt, funded at 3.5% (which Interactive Brokers actually offers, so I’m not being crazy). The IRR then boosts to 8.8%.

Bond IRR_debt.PNG

There’s clearly risk here if the bond does not return par, since leverage cuts both ways. If the bond only paid back 90 cents on the dollar, you’d be down ~10% instead of only 5%.

All in all, this is no different than private equity. They have tremendous returns partially because they don’t have to mark-to-market every day like public equity fund managers do. That’s why I like these scenarios as a long-term investor. In the case that something goes right for these levered assets, that obviously provides even more upside.

As I result, I have invested in past in names that were levered 8x when I thought the business was worth 6x when I thought the fundamentals were moving in the right direction and EBITDA growth would help the leverage scenario. I’ve also bought into companies that were in the middle of negotiating covenant relief with banks, as banks typically will provide relief if it is a result of 1x issues or even a cyclical issue that is expected to pass in the longer term and the company can still make payments.

 

Catching Falling Knives amid Headline Risk $FB $AAPL $MSFT

Here we go again. Facebook’s stock has hit another pocket weakness and was down to $132/share as I write this piece (-5.5% on the day). New articles have been posted in the media about Facebook having a morale problem and there has been in-fighting and finger-pointing during this time of “chaos” in the company…

All of this sounds eerily familiar to an article entitled “Apple’s Employee Morale Problem”, published in 2013, another which pointed to its top execs leaving, published in 2012, or the plethora of articles written about how Apple can no longer innovate (published first in 2013 and again in 2015).

If you recall, these articles were being published at a time when it was not fun to be a shareholder of Apple. It was absolutely a falling knife and the headlines everyday were only negative. Although we have hindsight to help us, we now know what those headlines ended up being worthy of…

You can’t blame the media for publishing on large cap names that have been under selling pressure. If you own the stock, you’re definitely going to search around and see what the hell is going on. Is there something I am missing? “If key employees are leaving, how will the business stay on top?” Selling begets selling and articles get clicks.Apple

What I love about the stock market is that we can come back to real data in our analysis to see what is priced in. As of this writing, Facebook trades at 7.7x 2020e EBITDA… by comparison Microsoft trades at 13x. Apple trades at 9.1x. Visa, no question a good business, trades at 17.6x EBITDA… The S&P in aggregate trades at 12.6x LTM.

Facebook looks way too cheap me today, especially when you look at sales growing at 20%+ CAGR at least over the next 3 years (and they haven’t even truly monetized WhatsApp yet). The business also earns extremely high returns on capital, which supports the multiple. In other words, Facebook is worth more than the average S&P500 company…

I cant help but think this is another case of Apple. Can I say when the slide will stop? No. But I can look at the numbers to help realize the market is pricing in much worse case than I think will be the reality.

S&P Correction Doesn’t Tell the Whole Story: Housing-related Stocks Look Attractive After Decimation $FBHS $MHK $MAS $BECN $ITB $XHB $TOL $LEN

If you’ve only been reading the headlines, you would know that the S&P has entered into a correction (defined as contracting ~10% from the high). This is still much better than a bear market, down 20%.

However, the S&P does not tell the whole story. As shown by the iShares sector ETFs below, you can see that the S&P is down 9.8% from the high. Housing stocks, however, are down ~34% from the high.

IShares Sectors

Obviously, one headline related to housing is interest rates. As interest rates go up, mortgage rates will follow and that will make housing more expensive. It is very tough to own housing stocks while rates are going up, so the old playbook goes. And that certainly has proven true this year, even if mortgage rates are still quite low.

10 yr and mortgage rate

However, in addition to rates rising, there has been some pretty disappointing data as well. Housing starts, new home sales, permits, and so forth have come in below expectations of mid-to-high single digit growth it was previously growing at.

US Housing Data - Octo

This has investors worried that the combination of rising rates, increased labor costs, inflation in raw materials plus tight supply of housing will result in an affordability issue.

However, I think this is just a “pause” in housing’s recovery. To recap, much of housing’s story over the past couple of years has been a tightening of the months supply of homes (number of listed homes divided by monthly sales volume), which has started to unwind very recently. Note, 6 months supply is typically seen as “balanced.” This tight housing supply has led to an increase in housing prices.

Months supply housingCase Shiller housing prices

So if investors are concerned about affordability of housing (though by many metrics, the mortgage rate moving to 5%+ still makes housing historically affordable)… one thing that will slow home price appreciation is new supply of homes. We’ll lets take a look at the supply of new single family homes over time. As you can see, the inventory situation has relaxed much more recently.

Months supply new single family

In addition, builders are focused on increasing community count in 2H’18 and in 2019. I believe that this increased supply, although it may come with softer pricing, should help ease the price problems that new buyers are faced with. Higher pricing is good for home-builders, but it doesn’t help if they don’t have the volume to support it.

KBH: We were able to raise prices in over 60% of our communities and still maintain accessible price points for first-time buyers….. During the quarter, we reinvested $600 million in land acquisition and development, driving our owned and controlled lot count to 53,400, a sequential increase of more than 3,800 lots, further supporting our future community count growth.

WLH: Our average community count for the second quarter was 107, up from the 88 average communities during the second quarter of 2017. As of June 30, we were selling out of 110 active sales locations. We expect to open approximately 42 communities during the second half of 2018 and continue to expect to be selling out of approximately 125 new home communities by the end of the year.

TPH: Our operations in [Washington] will get a boost in the second half of the year with the expected opening of 6 new communities…In Phoenix, where we are at the tail end of a number of communities, but we’re poised to open approximately 10 communities over the next 9 months….We look forward to opening over 30 new communities in the second half of 2018, building a strong foundation for the future

TOL: Our community count grew from 283 at second quarter end to 301 at third quarter end, but still lagged fiscal year 2017’s 312 at third quarter end. We expect to reach approximately 315 selling communities by fiscal year-end 2018, which should give us a strong start to fiscal year ’19. And without giving specific guidance on community count for 2019, we already own or control enough communities we plan to open next fiscal year to project growth in community count by fiscal year-end 2019

If you’re wondering if all this new supply echoes the terror of the last crisis, I’m sorry it doesn’t. As you can see, housing starts remain well-depressed from their long-term averages. I like to use the recession of the early 1980s as a baseline for the low in starts to see what it looked like outside of the obvious bubble we had. Recall, back then inflation moved up to 13.5%. During that time, housing starts were around 650k.

The current rate of ~850-900k starts does not seem that out of the realm now, especially when you consider household formation has gone up since the crisis (meaning more people will need more homes than 10 years ago).

US housing Starts - Oct

I remain positive on the housing cycle, despite all the negative headlines and share price performance. I’ll admit, I forgot the rules of the playbook – don’t buy housing stocks when rates are going up!

But at this point, a lot of building products stocks have been the babies thrown out with the bath water. I have never really liked homebuilders’ business model, but many building products names are exposed not only to new construction, but many have exposure to repair and remodel. R&R is much less cyclical (it was down less than 10% during the great recession) which means earnings can be more stable.

I would consider taking a look at Beacon Roofing, HD Supply, Masco, and Fortune Brands and Security, which have sold off this year (some more than others) and look attractive relative to the rest of the market.

BECN HDS MAS FBHS.JPG

BECN HDS MAS FBHS PE ratio