What is AWS worth? Thoughts on the business and whether it should remain part of Amazon $AMZN

As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2”, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures.

I came to the conclusion that Amazon was preparing for a split up of the company. The traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources.

For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources. This allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.

This led me to ask myself:

  • What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
  • Is AWS actually a good business?
  • Would splitting the company make sense?

I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:

  • Allow focus in areas of strength.
    • Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
    • Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
    • Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
  • Optimize capital allocation
    • AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
    • Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
    • You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
  • Better align incentives
    • Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
    • Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
    • Wouldn’t it be better if your performance and the company’s performance were linked?

Is AWS a good business?

“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”

-Jeff Bezos, 2014 Letter to Shareholders

Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.

The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models.

As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.


AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.

Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.


The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers.

However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.

How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:

We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.

Jeff Bezos, 2016 Letter to Shareholders

In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns. In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…

Lastly, its no secret that building data centers to support growth is capital intensive (see AWS financial table above). They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.


Unfortunately, I DO think returns are going to come down materially over time. The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.

Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage. Think about commodity businesses that report utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.

As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.

Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.

I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?

How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far.


So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.

What do you think AWS is worth?

Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases. I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.

For the reasons stated above, I think this results in returns coming down over time. I still model good returns to be clear, but that the return on assets comes down meaningfully.

This may be hard to read, but I end up with a valuation of $164BN for AWS. Given the value of AMZN today is around $830BN even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately. However, I maintain that the business would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.

Hudson Enters New Deal with Lenders & Extends Runway – Thesis is Intact $HDSN

Hudson Technologies (HDSN) just filed an 8-k stating it entered a new revolver with Wells Fargo ($60MM of borrowing capacity) and terminated its one with PNC. It also received a waiver for its covenant default through December 2021. This is big news. This will surely buy the company time and allow for the refrigerant market to turn around.

 

“The Fourth Amendment waived financial covenant defaults at June 30, 2019 and September 30, 2019 and amended the Term Loan Credit and Security Agreement to reset the maximum total leverage ratio financial covenant through December 31, 2021; reset the minimum liquidity requirement; and added a minimum LTM adjusted EBITDA covenant”

If the market does turnaround, then I think Hudson’s stock will move much higher than where it stands today as (i) the market realizes the company is not going bankrupt and (ii) it earns much higher earnings from increased pricing of R-22. As stated before, I don’t think the lenders want to bankrupt the company as long as it can stay current on interest.

Stay tuned.

The Case for Credit Acceptance $CACC

I think despite Credit Acceptance Corp’s incredible stock performance, it still looks interesting.

Credit Acceptance Corp (“CACC”) is “non-bank lender”, essentially meaning they make loans to borrowers who are deemed to be low credit quality. How low? As of the end of 2018, 96% of borrowers had FICO’s below 650.

The majority of CACC’s loans go to purchase automobiles. Without credit, these customers would not be able to buy a vehicle. Their incomes are typically strained and most likely they have damaged credit. Vehicles are necessary in most parts of the US to get to your job so there is a reason why there needs to be some sort of credit provider for these borrowers. In exchange, CACC charges high rates of interest (more on this later).

I think CACC will continue to compound earnings at a high rate – perhaps even better than recent history. Trading at 12.5x 2020 EPS and 2.6x book value is way too low. My thesis is not predicated on any catalyst, but more so on long-term capital appreciation.

  • CACC has averaged ~35% ROE over the past 10 years. In 2008 & 2009, it earned 22% and 35% respectively.
  • Median and average ROE since 2000 is 26% and 30% respectively
  • Credit performance has been stronger than you think = buying a strong management team
  • Performance has been hindered by strong credit and competition, but this is typical of a cycle. Credit is overextended and then pulls back – historically an opportunity for CACC

But you may be asking yourself, “Hey – doesn’t that mean CACC is making extremely risky loans?”

Not quite. As stated in this article from the FT,

“When economists created models of consumer behaviour late in the 20th century, they tended to assume that if a household was going to default on its debt, it would do so in a particular order: first credit cards, then car loans and, last, mortgages. That was the historical pattern, and it seemed to make sense given the cultural importance of housing. In the early years of the noughties, though, it seems that this sequence began to change. Consumers started to default on mortgages before auto loans and credit cards (seemingly because it became more acceptable to walk away from a house, but Americans still needed credit cards to live).”

So first and foremost, American’s have shown they are more likely to walk away from their home than they are to walk away from their car. It makes some sense if your car is the only way to work. If you don’t go to work, you don’t have any realy income.

Second, unlike unsecured consumer credit loans, CACC’s loans are actually backed by the automobile. This means if a borrower defaults, the car’s value helps the recovery value of the loan. CACC is listed as the lien holder on the vehicle’s title in ~70% of the loans outstanding.

Typically the way it works is that a dealer will receive a down payment on the car as well as a cash advance from CACC to finance the purchase. In exchange, CACC receives the right to service the loan. Servicing the loan means that CACC will be responsible for collections and the collections coming in will first go to pay down collection costs, pay servicing fee (~20% of collections), reduce the balance advanced, and lastly pay back the dealer once the advance has been recovered (which they call the Dealer Holdback). The “waterfall” of this is shown below:

This puts CACC near the top of the stack. After underwriting each loan, the company forecasts what its collection will be. Roughly 22% of the recovery comes from the spread (interest) and balance comes from paying down the advance. There will be defaults, but what this table essentially shows you is that (i) the company bakes in significant defaults and (ii) they’ve typically been right on target.

What is notable about this table is that the spread was at the high end of the rand in 2009 and 2010 when competition was unusually favorable to CACC (when the tide goes out, you can see who has been swimming naked).

Somewhat counter-intuitively, some of the best years CACC has are when the credit markets were very tight. Since credit has been loose, more entrants have emerged and made the field more competitive. Like I said above though, quoting Warren Buffet, the way new entrant lenders typically gain share is by offering credit at more aggressive terms than its peers. CACC has been operating since the 1980s, so I trust their track record and management team.

In my view, I think CACC’s earnings then are actually being depressed by competition and the company will be somewhat countercyclical – they should outperform in a recession. This also makes some sense given the labor market is extremely tight and we’ve started to see some wage growth and overall credit quality of borrowers has improved dramatically. These are all headwinds to CACC’s available pool of customers.

How have CACC’s returns been?

As shown, the company generates really solid returns on equity.

Let’s take a look at growth in book value assuming the average ROE since 2005 or the median ROE for the past 20 years (30%). Compounding is a beautiful thing.

However, this is a bit too simple to analyze the stock given the company trades for 3.4x the latest book value and 2.6x FY+1 book value.

Let’s say the company trades for 10x earnings by year 10. That foots to a $4,000 stock price or a 25% IRR for investors. Does 10x earnings makes sense? That foots to a 10% discount rate and assumes no growth in net income after year 10, which seems conservative. Another way to think about it is if the company decided to distribute 100% of net income to shareholders and stop growing. $400 a year foots to a 10% yield on a $4,000 stock price.

As shown above, ROEs for the company could compress by ~10 percentage points (20%) and the multiple could compress to 10x and we’d still have a pretty good return. At this point in the cycle, there is no question that competition has increased. CACC historically hasn’t always been the cheapest option, but it’ll be there through the cycle – something its competitors can’t say.

New Accounting Standards May Create Opportunity

Under a new impairment model called CECL (current expected credit loss), new standards will now require CACC to change its accounting. Essentially, it is based on expected losses, rather than incurred losses.Since CACC effectively takes the loan over from the dealer, an allowance must be recorded for the difference between the initial balance and the NPV of the future cash flows.

When CACC underwrites new loans in 2020, the timing that it recognizes income will change significantly – essentially recording provision for a loan loss up front at around 12-15% of the loan amount. So that will be a large, upfront expense that usually did not occur. The amount of loan income over the life of the loan and the actual economic value of the loans will not change, but 2020 may create confusion for investors and may cause CACC’s results to look worse than they have been in the past.

I would view this as an opportunity.

When buybacks fail… a quick look at IBM’s performance $IBM

I typically look for underappreciated, high FCF businesses that are shareholder friendly. As I was screening for new ideas, an old giant popped up – IBM. This is a personal opinion, but with so much focus on Google, Facebook, Amazon, Microsoft and Apple it seems as though no one even discusses IBM anymore. Could this be a Microsoft-in-2011 moment? At that time, MSFT was trading at a P/E of 9-10x and was viewed as a slow, lagging behemoth, and certainly not exciting anymore… just a dividend paying stock. They got a new CEO after many years of Balmer and reignited excitement and ingenuity at the company. The rest is history.

IBM currently trades with a 4.8% dividend yield, 9.5x 2020e EBITDA and 10.1x 2020e EPS. The business looks like it hasn’t grown much at all in the past, but does have some exciting segments like Watson (“Cognitive Solutions”) which is wildly profitable – in 2018, Cognitive Solutions had nearly 68% gross profit margins and 38% EBITDA margins…

Should we compare Microsoft then to IBM? Clearly over the same time frame as Microsoft, IBM has been floundering.

Cognitive Solutions is clearly an exciting segment, but at the end of 2014 the company did $93BN in revenue and $24.6BN in EBITDA. In the past 12 month, the company did $77BN in revenue and $16.6BN in EBITDA. Moreover, if we go back to the end of 2003, the company’s market cap was $161BN. When they reported Q3’19 results, IBM’s market cap was $120BN. Meaning after nearly 16 years, no real value had been created.

So what happened? What were the drivers of these abysmal returns?

Clearly, a significant driver is the changing technology landscape. Over this time period, IBMs standing as a leader in tech has been eroded by competition. Over this time period, net income is up only $1.2BN, from $6.5BN to $7.7BN, which is a 1% CAGR.

With its changing position, investors no longer valued the company as an exciting leader. At the end of 2003, IBM was trading at 24.5x LTM earnings. By the end of Q3’19, it is trading at 15.5x LTM earnings. That de-rating of 10x had a significant impact on its stock performance.

Secondly, I think the company made some really poor investments. What investments you ask? Buying its own stock in large amounts. Admittedly without these buybacks, the price performance of IBM would have been abysmal.

I pulled the company’s cash flow statement over these ~16 years and analyzed what it did with cash. While we have hindsight bias, the company deployed too much into its own stock instead of trying to strengthen its position in a changing climate. You could even argue that they should have done more acquisitions. Excluding the recent RedHat acquisition, which was $33BN, the company did not actually spend that much on acquisitions over this time frame.

Outside of acquisitions, you could even argue that they should have just distributed cash to shareholders with special dividends. Again in hindsight, that would have allowed investors to purchase other businesses that are allocating capital for growth.

Let me be clear, I am a huge fan of buybacks and not trying to beat the drum that politicians like to use (buybacks aren’t an efficient use of resources and stifle growth etc.). One of my favorite companies is LyondellBasel (ticker LYB). While it is a cyclical, commodity chemical company operating near peak, they’re capital allocation decisions make sense. First, invest in their equipment for safety. Second, ensure that they are well prepared in an evolving landscape. Third, return cash to shareholders while managing a prudent balance sheet. They have bought back 10% of their outstanding shares each year for the past few years.

In this case, it seems like IBM bought back shares just to buyback shares. I wouldn’t be surprised if we see an activist approach IBM. Following Elliot’s success with AT&T, it seems like an activist could approach IBM regarding a spin-off or sale of its Cognitive Solutions business. I think a split of “old business” and “new business” similar to what happened at HP could be very interesting.

 

 

CorePoint Q3’19 results weak, as expected, but once again asset sales are the real story $CPLG

CorePoint reported weak Q3’19 results, but as I said in my last post where I decided to exit my long call on the stock, this was expected.  In positive news, the company came to an agreement with Wyndham on its booking issue and will receive $17MM from them to settle their tax agreement. In total, the company will get about $37MM in awards from Wyndham and Wyndham will have to create a new system for them.

Now for some bad news. Results continued to be very weak on the portfolio. Comparable RevPAR was down 6.3% with nearly 550bps of market share loss. Occupancy was down 250bps Y?Y and hotel EBITDA margins were down 520bps, from 26.3% of sales to 21.1%. This was a bad print by any measure.

The company also reduced its outlook for the rest of 2019, calling for RevPar to be down ~4.5% for the year vs. their August expectation of -3.5%. EBITDA was also lowered from $155MM to $147MM, though $2MM was from asset sales and the rest was from Hurricane Dorian (which I noted in my last post) and its outlook revision reflecting weaker macro trends. Unfortunately, on the call the company said,

“Although we’re not providing guidance for 2020 at this time, we are expecting to face several headwinds in the business next year. In addition to slowed industry expectations, we will be impacted by everything we just discussed with respect to the performance of our portfolio, the timing of the full functionality of the new tools as well as limited visibility at present into any near-term potential lift from being part of the Wyndham distribution network.”

So not overly confident in the 2020 outlook.

But here is the interesting thing: There is still a strong dichotomy between what the private and public markets are willing to pay for these assets. CPLG is literally selling its worst assets for well above where they trade in the public market. The public market also seems to completely ignore this phenomenon. The company announced with this release that they sold 7 hotels that they previously noted in Q3, but also 18 others in 12 different markets for $70MM. The multiple was 38x EBITDA of 2.4x sales… They also sold 12 hotels for $42MM so far in Q4 for 2.4x sales and 29x EBITDA… They also have 25 more hotels for sale for $115MM, though unclear what the multiples are.

Recall, these assets are operating well under the threshold for what the company considers its “core portfolio.” I continue to believe they should continue to sell the company off piece-by-piece AND including the core portfolio assets. When you are trading for ~0.5x book value and 8-10x EBITDA, there is no better way to create shareholder value than to sell assets for higher than where you trade and either buyback stock or pay dividends.

Open Letter to B&G Food’s Management: IPO Green Giant & Create Shareholder Value $BGS

With a sagging stock price and disappointing underlying performance, I wanted to share my thoughts with B&G foods management (particularly CEO Ken Romanzi) on how to create the most shareholder value from here. Here is the play by play:

  1. IPO Green Giant as a separate company
  2. Use the capital from the Green Giant IPO / Spin to delever Core B&G
  3. Cut the aggregate dividend, focus on share repurchases & M&A with more flexibility

Here is the open letter. Note I haven’t actually sent this to them, but it is my view on what should be done. Hopefully they consider some of these items.


Ken,

As you can see in the chart below, B&G’s stock price performance has been abysmal. Investors are concerned over the mature brands in your portfolio, the changing landscape within grocery stores, and that your leverage will prevent you from being flexible. I do believe your portfolio has strong characteristics and like so many other things, investors are likely overestimating how fast these changes will occur and underestimating the power of your business (both its cash value and brand value of Green Giant).

But at the end of the day, you are getting no credit. You are definitely not getting credit for the value of Green Giant and the turn-around story the team commenced.  Green Giant was acquired at the end of 2015… but your share price has suffered meaningfully since then.

I personally believe Green Giant has tremendous platform value and would be more appropriately valued as a separate company. Once separated, I think both Green Giant and the legacy business would be much better served and have more appropriate capital structures that would allow growth. I therefore recommend the following “game plan” for the team:

  1. Spin-out / IPO / float Green Giant as a separate company
  2. Distribute capital back to B&G, which will be used to delever the core business
  3. Cut the aggregate dividend, focus on share repurchases or accretive M&A when appropriate

 


Spin-out / IPO / float Green Giant as a separate company

There is no doubt in my mind that the acquisition of Green Giant has been a success, despite some pressure on the shelf-stable side of the business. With the growth of the frozen category, you have created a formidable opponent to Birds Eye. As summarized in the table below, the aggregate Green Giant business has grown despite significant pressure in shelf-stable and I think 2020 is set up well with cauliflower crust pizza, vegetable hash browns, and veggie gnocchi launches. There will also be further growth as grocery stores expand the freezer aisles at the expense of the center aisles.

As of right now, you are getting no credit for this brand.

Let’s look at a group of comps that also include mature businesses, some of which are experiencing low-to-no growth. When compared to B&G – they trade well above. The reason B&G trades so low is that the “core” or legacy business drags everything else down because it is mature and under pressure. Also, people view the dividend at risk so they might as well get out now. Lastly, leverage of B&G is well above its peers. As discussed further in this note, each of these concerns could be assuaged by spinning out Green Giant.

The names that are growing should trade at a premium. Based on this, I think Green Giant should be worth at least 12-13x, which seems reasonable given the trends in frozen vegetables, consumer demand, and the ability to add more to the business from a platform perspective. Offsetting it will be its “shelf stable” Green Giant business, but that could serve as a source of cash to help fund the growth of the freezer business. At the end of the day, if Kellogg and General Mills  (which face secular demand pressure in cereal), then so should Green Giant (again perhaps a premium given the growth story). Bob Evans was acquired by post for 15.4x or 12.5x post-synergies. The play there was a pure-play refrigerated sides, frozen food, and breakfast sausage business. I think this is an excellent comp for Green Giant and shows other avenues it could expand into.

Here is my breakdown of the current B&G enterprise value (TEV). Note, I’m using an estimate for net debt based on the company’s refinancing that occurred in October (post quarter-end):

If we assume Green Giant grows top line 3% next year and assume 19% EBITDA margins, that implies we are getting the rest of the business for ~8.0x.

Why does a spin make sense?

First, you should get better value for Green Giant. As shown in the comps, Green Giant seems cheap. Second, you should get more value for the cash flow. B&G currently trades at a 12% dividend yield. The market is clearly implying the dividend will be cut. And as I will say later, you might as well cut it and buyback stock if you’re not getting credit for it. This leads me to the second part of the recommendation:


Use the capital from the Green Giant IPO / Spin to delever Core B&G

First, we should look at a reasonable capitalization for Green Giant. I think given the growth of the business, its strong brand, and opportunity for further product tack-ons, plus where the comps trade – I think 13x is reasonable. The company could raise 4.5x of leverage (which would only be 35% of TEV) and the balance would be an equity raise.

Does this make sense? Well comparing it to what the company would do in FCF, it foots to a 6% FCF yield to equity- which seems fair.

More importantly, I’ve provided a summary of what we think the impact on the legacy B&G business and capital structure would be:

So first, this would reduce leverage at core B&G considerably. Second, if the stock still traded at 8.0x EBITDA then that foots to ~$930MM market cap.

If we generate $109MM of FCF on this new EBITDA number, that would foot to a 12% FCF yield… If your cost of equity is 9%, then a 12% FCF yield essentially implies a 3% decline in perpetuity. That could be reasonable, but if you (as management) think that is unreasonable you could deploy cash to buyback stock. At the end of the day, the point is that you will be more flexible. You could use cash the way you see fit – buybacks, dividends, pay down debt.

A 6.3x business that is struggling organically is much more risky to investors than one that is 3.5x that can be stabilized and generates gobs of cash. That is why you are getting no credit for the dividend today. Hopefully this analysis gives you some sense on how the two businesses when separated could be significantly de-risked and also provide breathing room to grow.

This leads me to the next recommendation…


Cut the aggregate dividend, focus on share repurchases & M&A with more flexibility

The problem with dividends is that they are viewed as sacrosanct. If you cut the dividend, you’re stock will get punished. However, a dividend policy established many years ago may not be right for this environment. I think Green Giant should almost pay no dividend. Instead focusing on M&A that may enhance its portfolio or opportunistically repurchase shares. Invest for growth.

The legacy B&G could pay a large dividend to entice yield-hungry buyers (e.g. 4-5% yield), but also have flexibility for share buybacks or M&A. You cannot honestly tell me you do not wish the dividend quantum was lower right now so you could repurchase shares or have more flexibility for M&A today.  Again, give yourself the capital allocation flexibility – buybacks, M&A, dividends, pay down debt. Put the power back in your hands.