Competitive Strategy – Business Decisions that Strengthened Companies, No Matter the Industry

Reading Time: 2 minutes

I’m launching a new, recurring series called: Competitive Strategy – Spotlight on Decisions that Strengthened Companies, No Matter the Industry. Why am I doing this? Frankly, I am tired of hearing “this is a good business” or “this is a bad business” with some blanket statements behind why. How many times have you heard why a certain company is a “good business”?

  • Consolidated industry
  • Leading national market share
  • Asset light
  • High margins
  • Stable demand
  • Of course, saying a business has a “moat” doesn’t hurt

A company that has some of these features isn’t necessarily great. If you want to learn why (or disagree and would like to hear differing thoughts) stay tuned. I am actually launching the first in the series today – and what better way than to start with a company like Amazon.


A company’s competitive strategy outlines what decisions it will follow every day.

Where it will compete, what segments of the market it will target, where it will choose to scale, how it will use its balance sheet, and what will customers value?

These decisions can result the metrics I mentioned above, but the metrics themselves do not make the business good, or differentiated.

I will go through the competitive strategy of a wide array of companies.  Decisions companies have made / are making to show how those decisions upgraded them from good to great.

I hope to surprise some folks by discussing names that are in “bad” or cyclical industries. Sometimes you can have a bad industry, but a great company within that industry – and sometimes the stars align for a great investment opportunity.

After writing a few of these, knowledge will build and I probably will refer back to previous posts for examples on different company tactics (e.g. hard to not say Amazon Prime is similar to the Costco Membership strategy)


Here is a preliminary timeline of companies and industries I will examine (subject to change). If there are any companies you’d like for me to add, reach out to me in the comments or on twitter and I’ll add it to the queue. Some names may jump to the top if there is enough demand.

Here’s the one’s published so far:

AWS Valuation: Thoughts on the business and whether it should remain part of Amazon

Reading Time: 9 minutes

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 and I would need to think of AWS valuation.

The split would be simple: take 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. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.

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.

AWS 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?
  • Is the AWS valuation not factored in to the stock price today?

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?

Note, AWS valuation being underappreciated is not really a core tenant here.


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 an aside, what a beautiful competitive decision that was.

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. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.

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). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.

But Microsoft 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, and that will impact the AWS valuation (see 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. And that will hurt the AWS valuation.

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 reports 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. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.


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.

AWS Valution: Final Thoughts

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 an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.

However, AWS 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.

Earnings Check-in: $STRT Some things you think are priced-in…. are not

Reading Time: 2 minutesStrattec just reported FQ1’22 with sales of $100MM vs. $126MM PY and basically break-even on the net income line vs. $8MM PY. The stock is down ~7% on the news.

I am a bit surprised this wouldn’t be priced in more pre-earnings, but I get it: it is a microcap and actually seeing the poor results may be stark realization of what is going on.

As I mentioned in my first post,  as well as American Axle, investors are stepping out of the way of any of these names due to the semiconductor shortage that is causing auto OEMs to shutdown plants temporarily.

Here’s the company’s reasoning for the results and it is obvious:

Sales to Stellantis / Fiat Chrysler Automobiles (FCA) and General Motors Company in the current year quarter decreased over the same period in the prior year quarter due primarily to lower vehicle production volumes for which we supply components due to the continuing impact of the global semiconductor chip shortage.  Sales to the Ford Motor Company in the current quarter increased primarily due to the increased content on the F-150 pick-up truck for which we supply components. Tier 1 Customers and Commercial and Other OEM Customers were down in the current year quarter compared to the prior year quarter due to lower production vehicle volumes relating to the semiconductor chip shortage referenced above

Short-term, results will be ugly! Long-term, this bodes well for an elongated up cycle.

The reason why used car prices continue to make new highs is simply because people can’t get new cars. As new cars are continuously delayed, the existing fleet will continue to age, resulting in a large restocking cycle down the road of new cars. It isn’t that people don’t want cars – it is that they can’t get them. I’d much rather have that alternative than the latter.

Case in point, check out Lithia Motors inventory numbers lately and look how limited new vehicle inventory is (and used for that matter). They typically have 77 days supply of new cars, but instead now just have 24 days! 

Long-run, I still think Strattec stock is going for <3.5x normalized EBITDA, which is not too bad!

Candle in the Tailwinds: Bath & Body is “Secret SaaS” in Plain Sight $BBWI

Reading Time: 7 minutesL Brands officially spun off Victoria Secret and now Bath & Body Works (BBWI) is an independent company. This is great news to me as I think BBWI is a “Secret SaaS” business, a topic which I discussed before and will get into here.

Why do I like BBWI?

  • High margin category with growth tailwinds (beauty, fragrance)
  • Fragrance has difficulty translating to online without trust – Brands matter
  • BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance
  • Like many other brick-and-mortar retail (B&M) businesses, discovered the power of omni-channel during COVID – I believe it will structurally benefit the business
    • Many focus on LTV / CAC as well as gross profit return on sales and marketing for SaaS and DTC businesses – the thinking being because it is a more variable cost business and you can tie the two
    • But strong B&M brands have high initial upfront investment (e.g. the stores), and then serves the customer and drives loyalty with more limited incremental spend. We shouldn’t forget this.
  • Business has been “trapped” inside L Brands
    • Not sure analysts gave BBWI its full consideration when it attached to VS – a brand that is facing significant competitive pressure and heavily dependent on malls.
  • Not as impacted by supply chain issues, but the “baby could get thrown out with the bathwater”
    • BBWI sources most products from their facility in Ohio, not China. 80% sourced from US. Broader sell-off in retail could create an opportunity

As an aside, the Victoria Secret spin may end up being like Joel Greenblatt spin-off: the market hates VS so much that it gets to an extremely attractive price as people sell the spin. Time will tell. Don’t get me wrong, I would probably be one of those dumping VS if I received it.


Business has been “trapped” inside L Brands

I’m going to start with the last point first because it is quick. If you listen to the latest BBWI call, it is clear to hear analysts are still a bit confused how to model BBWI – it hasn’t been standalone before. Things like normalized capex, SG&A, and others were frequently brought up. I had to do some digging to find long-term gross margins for BBWI. All this is to say – you have to do some work to learn the most you can about BBWI standalone.

Second, BBWI and VS fortunes have been the complete opposite. As such, if you just looked at L Brands as a whole, you might miss the success story within occurring at BBWI shown below:


High margin category with growth tailwinds (beauty, fragrance); Fragrance has difficulty translating to online without trust – Brands matter

BBWI has 28% operating income margins, which both shocked and didn’t shock me.

Granted, this is LTM, where they benefitted from more of a “DTC” model during COVID and less promotions, though their physical stores were closed for 90 days in 2020.

On one hand, the margins are top quartile. On the other, fragrance and beauty are notoriously high margin categories.

Why is fragrance a high margin category? The packaging and everything involved with fragrance related products are usually a small cost. What drives the sale is the actual smell – and that takes technical know-how that is hard to replicate.

It’s analogous to beauty – beauty products are high margin because it tends to be a tough category to replicate, it is tough to get good distribution, and there is a degree of customer trust and loyalty (“hey this worked for me, you should try it”) which is hard to break into. Oh – and obviously consumers will pay up for these products if they “work”.

BBWI is at the center of some of these trends. Clearly, you can see their growth in the numbers I posted previously as well.


BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance

I like the simple “razor, razor-blade” model from BBWI. They have “wallflowers” which consumers plug into the wall and dispenses the fragrance. These plugins can be simple or decorative, like seasonal ones shown below.

They  aren’t too cheap, as a razor is for the blade, but the scents offered are consistently refreshed and tend to be “optically” cheap. For example, 5 refills for $24 tends to be a consistent sale.

Compare that to one Yankee candle which is more than that for just one candle (which will burn longer, but the optics to a customer aren’t the same. I could dwell on this point, but to me, I don’t think consumers do that math).

I hate anec-data, but my wife and mother are consistent buyers here (thank you Peter Lynch for recognizing this investment thesis!).

Management has several slides that show they are thinking about this the right way. Find ways to increase retention rates and drive value.


If this is Secret SaaS, can we look at BBWI metrics with the lens of SaaS?

This isn’t perfectly accurate, but I think it is instructive. If you assume 15% of SG&A is for attracting incremental customers, then the company has a ~3 year payback. Again, that is just a fixed assumption and hard to get a direct feedback response for a legacy B&M player.

However, this is extremely difficult to determine for B&M retail. Especially one where we have limited stand-alone detail… But as noted before, the investment in SG&A comes upfront and to some degree, it is a “build it so they come” model.

But Warby Parker put it well in their S-1:

“While we have the ability to track where our customers transact, we’re channel agnostic to where the transaction takes place and find that many of our customers engage with us across both digital and physical channels; for example, many customers who check out online visit a store throughout their customer journey, while others choose to browse online before visiting one of our stores.”

To me, it is clearly the other way around for fragrance. Once you get comfortable that BBWI isn’t going to sell you something awful in their fragrance line up, you are likely to buy online from them (and perhaps, not from a brand you don’t trust). Or, you find several fragrances you really like and consistently re-order them.

I think they are just too interlinked to derive anything useful from this analysis. Instead, we can just focus on margins and FCF to get a sense of health.

Omni-channel

On that B&M note, the company is 35% mall (says 99% are cash flow positive), 31% are off-mall (i.e. stand-alone stores, all cash flow positive) and 31% digital – super-enabled by COVID. They also have a small, international franchise business making up the balance.

I see a similar set-up longer term as Big Lots, which I wrote about how they can pivot their footprint. You can see in the table below that off-mall stores and Class A and B malls are clearly worth keeping. Class C and D? Less… And the Class D malls have the shortest lease terms remaining.

BBWI specifically called out closing stores in non-viable declining malls and remodeling others for an sales uplift.


BBWI Driving More Loyalty

While I’ve already stated why I think BBWI has a loyal customer base, BBWI is doing more. It makes sense – to create value from their existing customers, they need either more trips or for them to spend more in stores per trip.

Loyalty programs typically achieve this. For example, offering a 25% off coupon to loyal members typically gets them to either start an order they might not have done previously, or add one more thing… this incremental sale drives a lot of value for the retailer.

BBWI is testing that now: customers in the loyalty program spend 30% more than non-loyalty members.


A Quick Word on Value

BBWI is expected to generate $5.2BN in FCF between 2022-2025, or 30% of market cap. I even think that could be conservative. The company is returning significant amounts of cash to shareholders (continued the L Brands dividend, doing a $1.5BN share buyback) and I think the valuation is very reasonable at around 10x EBITDA.

However, they are earning high margins lapping a COVID bump. Essentially, the company saw a significant increase in sales, especially online, despite their stores being closed for 90 days during the pandemic. In the 2H of 2020, they were able to pull back on promotions which boosted margins.

I am not too concerned. This is a wide gap, but management targets $10BN in revenue (from $6.4BN in 2020) over the next 3-5 years. They assume some of this margin will be given back and EBIT margins will be in the low to mid-twenties. The stock is currently trading at 10x EV/EBIT on this forward number. Not too cheap, but not overly expensive given the business model either.

If I take the $6.4BN of revenue they did in 2020, apply a 22.5% margin to it I get $1.4BN of EBIT instead of $1.8BN. Based on their PF balance sheet for the spin, I calculate ~$910MM of tangible invested capital. This is true for most successful retailers thanks to leases (which can be a double edged sword), but that ROIC is fantastic.

Bottom line, I think BBWI deserves a premium multiple.

 

Entegris: Picks & Shovels on Secular Semiconductor Growth $ENTG

Reading Time: 5 minutesI have a picks-and-shovels play on semiconductors. While it may not look “optically” cheap, I think Entegris can compound earnings at a very fast rate thanks to the secular growth in semiconductors as well as changes in semiconductor technology that will require more products from Entegris.

While I say Entegris stock is a “play” on semiconductors, I would underline that this isn’t a short-term trade for me. I am going to lock this name up in my coffee can portfolio and throw away the key. There actually is a second player as well I am reviewing, but haven’t gotten fully comfortable yet.


Why Entegris?

  • Picks-and-shovel plays on semi growth (internet of things “IoT”) which should grow well in excess of GDP
  • Semiconductors are notoriously cyclical; there is a capex-exposed portion of the business (30%), but large chunk benefits from recurring revenue (70% of products are consumed in wafer production)
  • Best-in-class technology which sets them up well in changing landscape
  • Underfollowed name, but center of several long-term trends
  • Dry powder: <1x levered, $400MM of cash on hand to make M&A or investments

While semiconductor manufacturing is complex, I want this write-up to be simple. I think once you just understand the basics, it is easy to see how Entegris can be a winner for the long-run.

So I’m going to put the main drivers of why Entegris is a winner right here:

  • The number of production steps in semiconductors is increasing…increasing demand for Entegris’ materials
  • As the steps increase, yields tend to decline…also increasing the need for materials to improve yield (which Entegris provides)
  • Lastly, Entegris’ materials improve device performance. Performance demands are also increasing in smaller structures

Overview:

Entegris is a chemical / materials company that helps with the production of semiconductors.

Semiconductor production requires hundreds of highly complex and sensitive manufacturing steps. You’ve probably seen videos of semiconductor fabs where people need to dress in full radioactive-like suits to avoid contamination in the process.

Silicon wafers are the core building block for semiconductors, and during the manufacturing process, a variety of materials are applied to silicon wafer to build integrated circuits on the wafer surface.

I snagged this picture from an ASML page. If you don’t know ASML, they also are a picks-and-shovels play on semiconductor growth, particularly high value-add. But I thought this chart showed the processes well.

EUV beginners

Entegris is one of the companies providing these materials in each step. Here are some examples:

  • Etching
  • Deposition
  • Photolithography
  • Ion Implant
  • Chemical Mechanical Planarization (CMP)

I’m not going to explain each one to keep it simple, so please go read the 10-K for that (which I link to above).

Wafers are consuming more materials as the production process becomes more complex. Nodes in semiconductors are getting smaller, which requires more processes and yields potentially go down with each step. This requires new materials of increasing purity, quality, and stability to maximize yields.

For example, in memory chips, the industry is migrating to 3D NAND which requires 128 layers from 64 layers previously. In logic devices, there is a shift to 7 nanometer (nm) from 28nm. In both of these cases, there has been a 2x increase in material spending.

Fabs must reduce defects at each individual step in order to achieve the same final yield. I got this chart from this website which breaks down why the steps are increasing, but this reduction of the situation helps me understand it clearly.

Entegris noted, “by 2022, approximately 25% of the wafer produced in logic fabs will be at 20-nanometer technology or below. And in that same time frame, we expect almost all 90% of the 3D NAND chips to have 96 layers or more” – so that is very positive for Entegris.

Additionally, these materials play a role in performance of the chip. As the Entegris explains:

New materials have played a significant role in enabling improved device performance, and we expect this trend to continue. As dimensions get smaller, new materials will be required to enable transistor connectivity. For example, leading-edge semiconductor manufacturers are moving towards atomic layer scale, where the precision of the manufacturing process and purity of the materials used is vital to maintain device integrity. These materials need to be supplied and delivered at ever-increasing levels of purity and control, from point-of-production to point-of-dispense on the wafer.

So again, the boiled down, simple thesis:

  • The number of production steps is increasing, increasing demand for Entegris’ materials.
  • However, as the steps increase, yields tend to decline – also increasing the need for materials to improve yield.
  • Lastly, these materials also help improve device performance. Performance demands are also increasing in smaller and smaller structures

All of this paints the picture of Entegris compounding at a multiple of whatever semiconductor growth is.

Historically – you can see that is the case:


Quick Word on Value

Entegris valuation isn’t for the faint of heart (neither is ASML mentioned earlier), but the I think the dynamics outlined here, as well as M&A opportunities, makes me think the company can grow FCF/Share at double digits for a long-period of time.

The stock trades at 37x 2022 FCF, or <3% yield. So to get a 15% IRR, I somewhat need to expect a double-digit growth rate.

But here’s the thing that gives me comfort: a lot of capital is being put in to build new semiconductors.

  • TSMC: Investing $100 billion over next 3 years to boost production capacity and R&D on advanced nodes and specialty technology equipment
  • Intel: Announced two new factories in Arizona at $20 billion
  • Samsung: Not disclosed, but analysts expect $37 billion in capex annually in 2021-2023, up from $32 billion in 2020

The current shortage in 2021 is going to leave a lasting impression on the industry and capital is cheap to add strategic capacity. Frankly, odds are several years down the road, we might be oversupplied (a classic cycle).

But the shortage today is here, giving companies comfort in putting new capital in the ground. And countries are looking at their production as increasingly strategic (US vs. China) which may lead to duplicative, but localized capacity. Bottom line: I think that might add even more capacity in the long run.

Again, Entegris is mostly tied to units sold. Semi fabs need to run at high utilization rates (because they are high fixed cost businesses) so maybe that pressure prices down the road, but I can comfortably bet more units will shipped than today.

I recently saw JPM estimate wafer shipments at growing double-digits in 2022, but then moderating to GDP-like growth in 2023+. That seems too conservative to me, but again, Entegris can likely outgrow this due to the factors mentioned previously.

Earnings Check-in: Don’t Miss the Forest for the Trees $LGIH

Reading Time: 2 minutesI last did a “don’t miss the forest for the trees” post on Big Lots. That company went on to rally from when I posted it (not because of me, but because the reaction was way too negative). Unfortunately, supply chain concerns have created new pressures on BIG. In a similar vein, supply concerns are now pressuring LGIH stock, but I remain unfazed and take comfort in the long-term story.

LGIH just posted September home closings were 793 vs. 811 last year, which is a miss for a company “growth” company and I believe this is below expectations. They didn’t report earnings, but investors closely watch these reports for signals of how the quarter will shape up.

We’ve seen other builders also lower their guidance already:

  • Pulte (PHM) lowered closings 6%
  • DR Horton (DHI) lowered closings 9%, but raised GM target, so net / net EPS impact was margins
  • Lennar (LEN) lowered closings 5%
  • KB Homes missed closings by 7%
  • Hovnanian just lowered guidance for closings and lowered EBITDA expectations (see yellow line below).

So clearly the homebuilders are all aligned here.

But you need to understand why they are all guiding down: tight supply. To me, this firms the thesis.

LGIH is a largely spec builder at really attractive price points. While they are selling lots very quickly and now need to reinvest, I am comfortable that this model will continue to do very well in the long run. Absorptions are still running at 7.7 (compared to average pace of 6.5) so again, this isn’t really a demand issue, but more so a supply problem. I like it when demand outstrips supply.

Interest rates have also increased modestly, so can’t help but think that is pressuring the stock. That could have a severe impact on the price, but again, I’d likely be unfazed given the long-run story here.

At ~8x forward PE and 2x TBV, I also think valuation is undemanding (DHI trades at 1.6x TBV).

Earnings Check-in: ABM Stock Performance is Perplexing $ABM

Reading Time: 3 minutesThis update will be brief, but I wanted to highlight that ABM recently reported last week, following its M&A announcement that I covered in this note.

When I first wrote about ABM stock, I said (i) guidance was way too low, and I expect a lift in guidance across the board (ii) there’s upside optionality from doing a large acquisition and (iii) the stock is cheap.

If you had told me that ABM would go on to raise EPS guidance TWICE and announce an $830MM accretive-day-one deal, yet ABM stock would be little changed, I’d be SHOCKED. The stock is actually down about 6% since I wrote about it…

When ABM reported, they increased EPS guide now to $3.5 at mid-point. This is now at the high range of the previously stated EPS guide.

Not to brag, but this is exactly where I thought it should be, which you can see in the original table I posted:


Why the Muted Reaction?

I struggle to believe this was “priced in” to ABM stock when I first wrote about it, I just think sustainability of earnings is being questioned.  However, management actually noted the current high margin environment will likely persist for even longer than I thought:

Overall, demand for ABM’s higher-margin virus protection services remained elevated in the quarter, underscoring ongoing client concerns regarding cleaning and disinfection of their facilities. As anticipated, demand for virus protection eased slightly in the third quarter compared to the second quarter of fiscal 2021, but remained well above pre-pandemic levels. The emergence of the Delta variant and rising COVID-19 cases nationally have gained heightened interest in the need for disinfection prevention measures, particularly in high-traffic areas. As we look forward to 2022 and beyond, we believe that virus protection services will remain a contributor to our overall revenue as disinfection becomes a standard service protocol in facility maintenance programs

….So I think it’s still hard for us to pin down a formal long-term margin. We’re looking forward to giving you full year guidance in the next 3 months, and then that will give you the insight for the next year. But look, we’re going to say what we’ve continued to say throughout, which is the 2 areas for elevated margins are in disinfecting and labor arbitrage. And we believe we will permanently keep portions of that. As we restaff these buildings, we believe we’re going to be able to do it more efficiently, and we’ll capture some savings. Again, it’s still too early to figure out how much.

And then the disinfecting, we see like maybe 2 quarters ago, there was — or maybe even a quarter ago, there was no Delta variant, right? So like I think this is going to continue to evolve. And we’ve all just said it even anecdotally. It’s just… I don’t think facility managers or landlords or principals of schools, I don’t think anyone thinks it’s responsible to discontinue disinfection services, especially in high-touch areas. So that’s going to continue, too. So we believe we will continue to be elevated, but give us until next quarter when we do full year guidance to kind of give you that year outlook.


So again, I go back to the original pitch. I’m not necessarily expecting this work to last forever, but here’s what ABM will do (and basically already did):

  • they’ll generate a ton of FCF (about 11% of market cap by my math)
  • they will use cash first to pay down debt from the Able acquisition
  • Once they are in a comfortable range, they’ll buy something else
  • Rinse & Repeat

This is what compounders do, it’s just a bit frustrating when this compounder gets no love.


I think the pushback is that margins likely will go down in the future – but what does it matter if earnings DOLLARS are higher? (They buy something else, there are some structural changes in the business, aviation and education segments are roaring back at higher margins which is happening, etc.)

The point of this slide to me is not that ABM is some dividend stock, but that it does a pretty good job compounding earnings.