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NN, Inc: Underfollowed stock, taking steps to improve the business mix. See solid upside to current levels. $NNBR

I enjoy finding stocks that fly under the radar. What does that mean? It typically means smaller companies that do not have good sell-side research coverage from large banks (e.g. Goldman, Morgan Stanley, JP Morgan, etc). Therefore, the large institutional money managers are not being pushed constant updates on the company, nor do they have in-depth “initiating coverage” reports on the company that are good for shortcutting the diligence process.

These companies can be very good businesses, yet sometimes are hidden gems (especially when they don’t show up well on equity screens too). In today’s data-driven environment, it is not hard to set up an easy screen to search for value (e.g. Find me companies that trade for a P/E of less than 7x; find me companies that have grown revenues 15% p.a. over the past 5 years). Therefore, if you do your homework and find companies before they are easily screened or picked up by a major bank, there is considerable alpha that can be generated. Today’s case, for example, is followed mainly by Keybank and Suntrust. No Goldman, Morgan Stanley, BAML, etc.

On to the company…


NN, Inc (ticker NNBR) is an industrial company that has undergone a significant portfolio transition. As background, NNBR was founded in 1980 and was mainly focused on the oil and gas industry. However, a recession in the 1980s drove the company into new markets, including automotive. The products the company sold to these markets were precision steel balls and rollers, which are critical moving parts of anti-friction bearings which, in turn, are integral parts of machinery with moving parts.

The company went public in 1994, and by 2000, the company had expanded into a variety of other industrial end markets. Through acquisitions, NN continued to expand into new products as well, including precision plastic products and bearings. The most significant acquisition was Autocam Precision Components in 2014, which created products for the  fuel systems, engines and transmissions, and other products in the automotive industry as well as HVAC and fluid power industries.

We will come back to this segment and discuss the opportunity driven by more stringent CAFE requirements in cars that will be a tailwind for NN.

The company also made acquisitions that expanded the business into the medical industry, including surgical knives, surgical staples, orthopedic system tools, laparoscopic devices, drug delivery devices among others. It also expanded into the aerospace and defense industry.

Next, in 2017, the company divested its Precision Bearing Components Group for $375MM, or 9.6x EBITDA, which they have since re-deployed in other highly attractive business. Importantly, PBC was a highly cyclical business (highly related to commodity auto OEM products) and that exposure came down significantly, from ~25% of sales to 8% of sales (CAFE was still 39% of sales).

NN Segment

One thing I like about this management team is that they have an eye on the cycle, which is important for an industrial business. As such, they try to have a balanced portfolio of cyclical (benefiting from the business cycle going up) and counter-cyclical (benefits when we are in a recession, or at least doesn’t go down).

Screenshot 2018-10-14 at 2.05.02 PM

The management team re-deployed that PBC cash into buying Paragon for $375MM, or 9.3x 2018e EBITDA. This filled out NNBR’s medical portfolio and was higher margin than NNBR’s core business.

As the CEO said at their recent investor day (though I do think it was embellished a bit… the company will still be cyclical):

“…in 2013… the majority of our end market, our revenues came from an automotive largely cyclical end market. As you look at where we are today, some 70% of our revenue comes from a non-auto, non-cyclical revenue base. When you think about our EBITDA, it’s the same story, obviously, it was heavy auto. When you look at it now, it is well distributed. So we’re a balanced organization and it’s distributed, again, across those counter-cyclical pieces within the economic cycle. And when you look at cash flow, it’s the same story. It’s even larger on the cash flow side. So I would submit to you that we are no longer an automotive company, we are diversified industrial that happens to have a CAFE technology interest. We are no longer a cyclical company, because we have the counter-cyclicality built in, and we are getting our revenues, our EBITDA, our cash from a variety of places. We are a transformed organization.

NN PF segments

In sum, through  lot of acquisitions and some divestitures, the NN business looks very little like the initial one started in the 1980s.

The key, long-term drivers going forward are:

  • Life Sciences: NN is highly exposed to orthopedics, surgical tools, endoscopy, finished medical devices, among others. As the population ages and the baby boomers move into the next stage of life, this segment should benefit.  NN expects this business to grow from $300MM to $750MM over the next 5 years, from organic growth as well as portfolio expansion (e.g. adjacent to their current platforms, such as expanding their cardiovascular business).
  • Power Solutions: This business is broken down into electrical power management (which will grow due to higher efficiency standards and demands as well as automation) and aerospace & defense (fuel efficiency, light weighting, etc) and is targeted to growth from $195MM to $450MM over the next 5 years. Similar to life sciences, they expect to get there from some organic growth in the base business, as well as growth in new areas
  • Mobile Solutions: The company is targeting transportation and general industrial products that are high precision and our core competencies. For context, the company said at its investor day that, “human hair, it’s about 88 microns in width. We’re manufacturing parts in the single-digit area, in some cases below 1 micron. We have a fuel system part, in China as an example that we manufacture, where the roundness requirement is 0.38 microns. We manufacturer that part in a climate-controlled room and each part is individually laser-gauged to make sure it meets our customers’ requirements.” The company is targeting a balanced portfolio with HVAC, off road, etc to also balance the portfolio.
  • CAFE Technology: While CAFE is technically is in mobile solutions, I wanted to break it out, given its an important growth driver for the company. Auto companies are driving out power from engines with less fuel. And part of this is regulatory mandated (i.e. CAFE standards). As the content of these devices increases, so will NN’s earnings.

Screenshot 2018-10-14 at 2.54.07 PM

Put all this growth together and the company is targeting being a $1.6bn in sales company in 5 years, up from $860MM today. And importantly, they expect EBITDA margins to expand to 25%, which would be top-quartile.

Screenshot 2018-10-14 at 3.00.03 PM


As you can see, this business has some serious moving parts and that provides an opportunity for analysts willing to do their homework.  I think NN, for those who know anything about it, relegate the company to just an Auto OEM supplier, when in reality, medical sales are a higher component of EBITDA and cash flow today. The company also has carried a higher leverage profile, which is risky on a more cyclical business, but medical tends to be more stable.

The company did recently issue equity to pay down some second lien debt. The stock sold off on the news, but I think it helps eliminate negative headlines.

Let’s move on to the price target…

I think NN has been beaten up too much in the context of the cash flow I expect the business to generate, not to mention the possibility of  re-rating in the longer term if the business does reach its EBITDA margin targets.

At an 8% FCF yield (the average S&P500 company trades at less than 5%), I see over 35% upside on the stock over the next 12 months and much higher thereafter for long-term investors.

NNBR FCF yield

Summit will have to guide down earnings, but that’s largely priced in and the stock is too cheap to ignore $SUM $VMC $MLM

Welp, Barron’s this week beat me to it, but instead of focusing on the industry in aggregate (no pun intended) I will focus my post on Summit Materials, the aggregates, ready-mix, and cement player.

Summit has taken a beating this year and is down nearly 40% YTD. It’s been a challenging year due to weather and higher material costs which have pressured the company’s earnings. Q1 is a small quarter for the company, but consensus was calling for $11MM of EBITDA and SUM printed $5MM. Q2 is more important and consensus was calling for $150MM of EBITDA. SUM printed $135MM, about a 10% miss.

SUM_chart.png

Then this week, the company posted this slide calling out more weather concerns for 2018.

SUm1

Wichita makes up ~12% of company sales, Houston is ~10%, and the Mississippi river and the Carolina’s are also important regions for the company.

SUM 2

Essentially, when you look at the company’s EBITDA bridge, there seems to be a lot of risk related to the “2H Price / Volume Acceleration” the company is calling for.

Sum 3

While the company didn’t officially lower guidance, this deck basically does. It also called out cement pricing as more competitive, whereas on previous calls they’ve pointed to that being an area of growth for them.

All that being said, I think part of this is already priced into the stock. SUM was down another 8% or so when this deck came out. Also, consensus already lowered estimates to ~$460MM, so they are already saying results will come in below guidance.

I should also say that Aggregates companies are great businesses. They literally sell rocks used for residential, commercial, and infrastructure construction. You can’t ship rocks very far so that creates opportunities for limited competition (e.g. China isn’t going to be a low-cost rock producer and ship them into the US). Also, the quarries where these aggregates are pulled from need to be nearby where the construction is occurring, but far enough away due to NIMBY issues (Not in my back yard!). That creates regional oligopolies for producers and gives strong pricing power.

When you look at the comps, Vulcan and Martin Marrietta have historically traded at well over 10x EBITDA. Which is why I was shocked to learn the SUM trades at 6.5x consensus 2020 estimates!

VMC_MLM_chart

Fine, consensus estimates need to come down in the short-term, but over the next 3 years, the fundamentals still look favorable for building products companies. I just made a post about different case studies of when the market is too short sighted and I think this is another case of that.

So I am going to haircut 2018 estimates even more, but I still believe there is demand for the work. So while it will be delayed, it’s not business gone forever. One other thing I should mention is that SUM is a roll-up — it acquires smaller aggregates producers for attractive prices and bolts them on to their network. Because Summit is so acquisitive and since they just issued a bond recently to prefund acquisitions, I do include acquisitions in my assumptions, which is consistent with the street.

SUM 4.JPG

As you can see, even with my lower estimates, Summit is too cheap to ignore trading at   < 6.5x.

For conservatism, let’s say SUM should trade at 10x (you could argue 12x due to where comps are trading).  I see over 115% upside to current levels.

SUM 5

 

 

 

Case Studies of Overreaction in the Market $AAPL $FB $IPI $LULU

Investors are notoriously short sighted. But how often have you capitulated at the wrong time on an investment simply because (a) the headlines get worse and worse and/or (b) your losses are mounting (or your gains are shrinking)?

Any experienced investor has these cases. Equally as bad is not acting when your diligence and work suggests the value of the company is not impaired or that the news is bad, but they will make it through.

I wanted to highlight a few examples I’ve taken note of over the years and are hopefully recent enough to be relevant. My goal is for us to remind ourselves of these cases and to profit from similar cases if they are to occur again in the future, which they always do.


Case Study 1: Facebook IPO

I remember the Facebook IPO well. Mostly because it was one of those where I knew the business would be fine and had large run way ahead of it, but yours truly talked themselves out of buying it.

It was 2012, so not too long ago, and this was going to be one of the largest IPOs in recent history of a large tech company.  The IPO was also extremely over-hyped. Yelp had IPO’d just recently and popped 64% on the first day of trading. Everyone I talked to that was outside of the finance realm was going to buy into Facebook (which scared me, since if everyone is a buyer, what value is there to be had) and they knew nothing about how the company made money (which scared me again). The stock IPO’d at $38 (after a technical snafu delayed trading). The stock traded poorly and the underwriters on the deal actually downgraded their growth estimates for the company.

Then, the lock-up period on the stock ended a few months later that released 133MM shares, which was a large increase in float compared to the 180MM that had been sold in the IPO. Fear began to build around this “technical” factor, as 1.2BN shares were going to free up thereafter. With so much supply and tepid demand, who would support the stock??

People were concerned about these short term factors, but completely missed the point. FB filed the IPO with $4BN in LTM Revenue and actually was very profitable – with 24% net income margins. The stock bottomed at $19 / share, which foots 9.5x estimates of EBITDA over the next 12 months. The thing about that multiple is that FB would go on to grow EBITDA from ~$1.2BN to $27.4BN in the LTM period.

Let’s say you bout in the IPO and sat through the pain… you would have experienced a ~50% loss, but would’ve turned into a 325% gain up to now.

FB_chart


Case Study 2: Apple and the death of Steve Jobs

This one will be quick because I think everyone knows the story. Apple had essentially made a comeback  of a life time when Steve Jobs came back, after being on the verge of bankruptcy. Now, everyone knows it as the $1 trillion dollar company that has a well entrenched customer base that refuse to change phones, even when the prices exceed $1,000 per phone.

But there were several times in which people thought that the death of Steve Jobs would again impair Apple’s business model. What people forget is that men and women can have lasting impacts on firm culture, even after their deaths or departures.

AAPL_chart

Steve Jobs dies in late 2011, but it wasn’t until 2013 really that people became concerned about innovation. The company was still launching iPhones and iPods, but it wasn’t launching the NEXT thing (I guess people were expecting microchips in their heads). And that brought about serious fear in the company’s outlook and led people to anchor on quotes like this one from Larry Ellison, the CEO of Oracle.

“Well, we already know. We saw — we conducted the experiment. I mean, it’s been done. We saw Apple with Steve Jobs. We saw Apple without Steve Jobs. We saw Apple with Steve Jobs. Now, we’re gonna see Apple without Steve Jobs.”

As shown in the chart above, the stock fell 40% from its highs. But you already know what happened next. Customers didn’t frantically leave, Apple kept improving and innovating, and is still a dominant player in the space.

What actually came to be was an interesting cycle. Apple had an upgrade cycle that was becoming evident every 2 or so years. In the lulls of those cycles (i.e. the low periods when less people decided to upgrade), the headlines would be overly negative. Again, we would hear about the lack of innovation in the company and actually, despite seeing a rebound in 2014-2015, the headlines came back in 2016 and Apple’s stock got crushed again. Articles like these, appropriately titled, “Apple’s Core Problem Is That It Can No Longer Innovate“, were so proliferate it was hard not to buy in.

AAPL_chart (1)

Again, that turned out to be a lot of noise and Apple’s stock today sits at ~$230 a share.

The question is, now that we are in the next lull cycle, will the market learn from these last mistakes?


Case Study 3: Intrepid Potash

I wanted to provide another example of overly negative sentiment, but this time related to cyclical downturn + headlines of bankruptcy risk. There were plenty of examples of this with the 2016 oil downturn and there are actually even a few I had the choice from related to just overly concerned bankruptcy risk, but I wanted an example that maybe you haven’t heard about.

Intrepid Potash (ticker:IPI) is a US potash producer, which is used as a fertilizer for crops. IPI’s capacity was relatively high on the cost curve, meaning there were mines in the world out there that could produce the same commodity for cheaper, giving those producers an advantage if prices fell.

Well, prices did indeed fall. By a lot. Back when corn was $8/bushel in 2010/2011 time frame, fertilizer prices also benefited. Farmer incomes were solid allowing them to spend more on fertilizer and other inputs. When corn supply caught up with demand (driven by higher ethanol demands), the price collapsed and potash has fallen with it, as shown in the chart below.

IPCMPSP_IUSCFPR_chart

All the potash and other fertilizer producers stocks fell as well. This obviously makes sense because the earnings of these companies looked to be significantly impacted, at least in the near term. To make things worse, in the “good times” several major potash producers announced they would be adding capacity. Well, it takes about 5 years for that capacity to come online and guess what… it came on right at the worst time.

In my opinion, this is a classic example of a cyclical (not secular) downturn in a commodity. Demand for food should move up +/- 2% each year with a rise in population, which will in turn increase demand for corn. Increased demand for corn, in turn, will increase demand for inputs, like potash. In the short term though, the price of commodities can be highly volatile due to mismatches between supply and demand and could be low for awhile before the new supply is absorbed by slowly increasing demand.

Being higher up on the cost curve was a problem for Intrepid. IPI’s realized potash prices went from a peak of $541 / ton to $200 / ton. While the company was able to take some costs out, its COGS / ton moved from ~$225 / ton to  $175 / ton. Obviously, that means margins earned on each ton sold were squeezed significantly and that’s before S,G&A and capex are taken into account as well.

That’s when the negative headlines came out. You see, fundamentals were bad and there was no sign of a turn around. Worse still, the company was about 6.5x levered and the company was in breach of its covenants. Headlines at that point came out about the company filing for bankruptcy. However, all you had to do is go to the filings and see that the lenders to IPI were a group of Agricultural focused banks. These banks understand that Ag has cycles, though it may not cycle with the general economy, and they likely wouldn’t want to force bankruptcy on IPI and take the keys. IPI after all was still in an OK liquidity position at the depths of a pretty bad cycle (and it was clear the banks were issuing extensions to help the company). I also liked that the CEO of the company was buying stock en masse during these times. Lastly, the company was public, so it could issue stock if it needed.

And that’s actually what the company did. I found it surprising, but instead of pressuring the stock further, it put liquidity / bankruptcy concerns at rest and stock went from $1 to over $3 on the news. The company issued $58MM of equity and moved on and instead of the stock falling from dilution, it shot up 300%.

IPI_chart

The stock still has well to go before it recovers to the levels seen before, but keep in mind we’re still what I would call trough fundamentals, given where potash and corn prices are.


Case Study 4: Lululemon

The last case study is Lululemon, the athletic wear retailer, ran into a few PR snafus during 2014. First, the company’s leggings were found to be shear and even at some points see through. Instead of the CEO saying, “mea culpa… we’re working to fix these quality issues and will provide refunds to those who purchased products not up to our standards,” he blamed it on customers being too “big” to fit in the products.

LULU_chart

The CEO and founder then stepped down. Lululemon at the time seemed to be in peril. Retail is littered with companies who have been left behind as consumer tastes changed.

But that is the thing. Customer perception of the product remained favorable. In addition, it was a brand focused mainly on women at the time and has now started to gain entry into men’s fashion as well. That would mean an untapped market for the company to provide extra growth. Lastly, at the end of 2013, the company had 254 locations in the US and Canada. Compare that to a more mature company, like the Gap, which had 3,700 locations at the time and you can see there was a long roadway ahead before the brand matured. Lululemon now has 415 locations and is still growing.

Holding on, or buying in, to the stock would’ve been the right call as the company has continued to have positive momentum and the stock chart below shows that.

LULU_chart (1)


My goal of this post was for you to read these case studies and see if they apply to any other companies you can think of now. Hopefully you take note of these situations as well, so you can apply these scenarios to future ones. The goal is to profit from lessons learned, especially regarding mismatches in negative sentiment and actual fundamentals. Some of these sentiment changes occur over and over with the same companies (Apple and Facebook), but I’ve recently seen these examples in other companies as well.

Any companies you follow now that seem to be on this trend?

-DD

 

The question NOT being asked about Tax reform’s impact on stocks

A lot has been written about the Tax Plan passed at the tail end of 2017. I recently wrote a post on, while I think the plan is very beneficial to US equities, some considerations we should have on the rest of our portfolio.

And not to be a debbie downer, but I am here again to discuss some questions that are not being asked here. If you’re buying individual stocks today, I think the main underlying question for investing in that company comes down to one thing: Does this company have a strong competitive advantage?

In highly competitive industries, typically those that compete solely on price or sell commodities and have little differentiation, these tax benefits may soon be competed away.

Consider a distributor, which typically sells many goods and the only value it adds is perhaps customer service. Grainger has been an example of a distributor that has faced headwinds from price competition as customers look to Amazon for cheaper products. Take a look at GWW’s stock chart over 2017 to gain an understanding of this impact (stock was down 3-4% when the S&P was up 20%).

GWW’s stock really started to recover at the end of the year, one from earnings being better than feared on low expectations, but also due to its tax rate which should decline from 38%.

Given GWW’s heightened competition, due you think those savings will be used for buybacks or high return projects, or do you think they’ll be used to compete and maintain market share? Let’s say you think that’s fine if they use it to maintain share, as they’ll be in a better position. Well, do you think Amazon and other competitors won’t also respond?

Also consider the recent hikes in minimum wage from companies and $1,000 bonuses. They are doing that to attract and retain talent, which is simply another form of competition.

Hopefully you can see what I am getting at. Low competitive moat industries likely will compete the savings away. While the tax rate will be low, returns on capital may end up being the same.

-DD