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.

KAR Auction Services is Not in Secular Decline $KAR

Reading Time: 7 minutes


KAR auction services, the company that runs used car auctions, looks on sale right now.

KAR has been under pressure from COVID impacts to the business, but unlike other COVID-impacted names (where investors are seeing through the clouds), the stock is still down meaningfully.

KAR reported earnings Q4’20 earnings and guidance last week (on Feb-16) and the stock is down about 24% in the past week.

KAR Auction Services Stock

It seems to me investors do not realize KAR Auction Services current pressures are cyclical, not secular. Today, we’re able to buy a really good business at ~10% FCF yield on depressed earnings.

KAR Auction Services FCF Yield


Why is the stock getting hammered?

For one, disappointing guidance. The company expects EBITDA of at least $475MM in 2021 as they continue to recover from COVID.

Consensus was expecting $566MM – ouch.

Kicking the Can? The other issue with guidance is it is 2H’21 weighted.

In my experience, this can be a “kick-the-can” move for management. In other words, they know 2021 EBITDA has the chance of being lower, but they’ll wait for Q2 earnings to break that news or maybe things will turn around.

Fingers crossed. This isn’t always true, but just my experience.

Management left wiggle room – they did say at least $475MM. They also explicitly said the guide is conservative. That’s not something I’m banking on. I also don’t really care about 2021 earnings in isolation. That’s way too short-term focused in a year that will continue to be impacted by COVID, as noted further below.


Why the weak guide?

Car values are high right now. During the height of COVID, the manufacturers pulled back in the face of a new, deep recession. Plus, they had to reset manufacturing processes during a global pandemic. Lo and behold – demand for cars held in. This is known as the bull whip effect.

Supply < Demand = really high used car prices.

Manheim Used Car Price Index

Normally, this would benefit KAR Auction Services, because their auctions would be earnings higher auction fees on cars. But there is clearly lower volume going through the lanes.

Not just from the shortage of cars, but also when residual values are high, you will see less lease returns as the customer decides it’s a good deal to buy out the lease at the value that is better than current market. There has also been less repossessions, another volume headwind.


What is the Street Missing?

Number one, the stock looks cheap when you bridge using the current FCF guide.

Yes, there is risk the guidance, but I don’t actually think KAR’s go forward earnings potential is limited by this year’s factors. The things I mentioned all seem cyclical.

Second, they are caught up on secular changes versus cyclical.

KAR’s earnings are being hit by cyclical issues that I think will abate.

Every investor is trying to see how COVID will change the world and how technology will reshape it. A lot of investors are saying KAR’s barriers to entry have been lowered now that auctions are online. I do not think that is true.


I read one note expressing concern that a survey revealed a lot of dealers are looking to buy and sell cars via online auctions this year. Given KAR Auction Services has a strong physical presence, this caused some concern. Pardon my French, but my response to that is – No Sh*t, Sherlock.

We’re in a pandemic. Of course dealers are looking to buy and sell online. They have to. And this was definitely the case during 2020.

If you read my About Me page, I used to have a dealer’s license. I know a thing or two about buying used cars and I used to go to Adesa all the time. It truly is a great business, which I’ll go into some brief detail later.

But anecdotally, I can tell you buying cars online is not easy. You’re buying a car with limited info, no ability to drive the car to see how it feels, how it sounds, check the oil, etc. The cars I bought online (as opposed to the seeing it in person online) were some of the worst purchases I ever made and I pretty much vowed to never do it again because it was a waste of time.

“But Dilly D”, you’re asking, “can’t this be improved?”

Of course, this could be improved with technology and better disclosure. You need to realize, though, that these online platforms are turning over thousands of cars. And as much as cars may seem like a commodity, used cars really aren’t.

Think about all the options a car has and then fold in a good versus bad service record. The band of prices could easily be +/- 10%, which is thousands of dollars we’re talking about.

But Adesa is also one of the biggest players. And they’ve had an online presence for at least 15 years (just speaking from my memory). They, along with Manheim (a private competitor), do a decent job at it. Adesa also has invested heavily in inspection services to make it better and faster process, as well as other services.

So I’m not too concerned about any upstarts or anything like that. Upstarts don’t have access to the same supply the big players have. And the dealers, like I was, like Adesa and Manheim because they get the supply plus the best prices because they are essentially getting a bulk discount. And you know competition is somewhat limited as a dealer because you have to have a license to access the auction.


This leads me to why Adesa is a great business.

As I was just leading into, Adesa is a great business because it connects sellers with buyers and just takes a fee off the top. The fee goes up or down based on the sale price, but has large enough bands that if used car prices fall, let’s say, 10%, it doesn’t hurt their earnings that much.

Sellers want access to a large supply of buyers who are committed to buy their product (i.e. they are selling to dealers who need the supply). This way, they can offload slow inventory or lease vehicles quickly and achieve good prices for them. This frees up working capital to re-deploy in their business.

Buyers want access to a large swath of cars at good prices that they can sell at a profit. For me, having a wide array of cars to pick from helped me find “hidden gems” that I could quickly turn.


The same note I mentioned above (which was absurd) highlighted online competition from Copart, which has been a “competitor” for forever and is really more a competitor of IAA, the insurance-loss auction spin from KAR. Copart is no doubt a great business, but I think it’s comparing two different markets.

If you compare IAA to Copart, their results during 2020 were much closer to each other than comparing it to KAR Auction Services – just different markets. Copart outperformed KAR and IAA sales were actually up, though they were able to benefit from improved pricing despite volumes being down. Although Copart discusses their “platform” a decent amount, but personally, I’d say it’s a different market.


Here’s another anecdote to explain why they are different markets: I remember being at an auction and a totally smashed Cadillac Escalade came through. The front was actually fine, but the back looked like it was caved in by an 18-wheeler.

I laughed to myself thinking, “I guess someone will try to part this thing” and lo and behold, the bids started to come in at really high levels. I want to say the car sold for over $20,000, despite being crumpled. I was in person, but the bidder was online and you could see the location. The bidder was in Saudi Arabia. That’s when I learned many of these salvaged cars are worth a lot internationally. Buyers can part them out, but some countries also have less strict rules on piecing cars together.

Anyway, as the dollar becomes weaker, this helps a Copart who sells a lot of inventory to these buyers:

Roughly 35% of Copart’s inventory is purchased by foreign buyers:


Back to that absurd sell-side note one more time: They also highlighted online competition from Carvana. Carvana uses KAR to buy and sell wholesale inventory. They do not provide nearly enough volume as a separate wholesale auction to be attractive. It really doesn’t make sense at all.

CarMax and Carvana really want to sell retail… yes, they get trade-ins they want to sell, but they want good prices on those and want to turn them quickly. Carmax has its own auction because its huge, but it still uses KAR  to fill inventory. Carmax can use their auction to sell inventory they don’t want anymore quickly.

Adesa provides that for everyone. It’s not really different than the marketplaces investors love today, they just have primarily relied on a physical presence. As stated, I think this will continue to be an industry that needs the physical presence.

KAR Auction Services ROIC

Masco: No Credit for Portfolio Transformation & Improved ROIC $MAS

Reading Time: 5 minutesMasco is a leading building products company. If you own a home, there is a decent chance you’ve bought their products at some point. Products range from Behr and Kilz paint to plumbing products such as the Delta brand, among many others. Masco has undergone a significant portfolio shift overtime, and meaningfully improved the ROIC,  but I don’t think the market is giving them enough credit.


Masco set out on a divestiture plan a few years ago, divesting their cabinets and windows business lines. These were highly cyclical businesses with low-to-average ROICs. Now that they’ve sold those segments, they have meaningfully improved the ROIC (to top-quartile), they have a much more resilient business, and they have more cash on the balance sheet than ever.

Despite this, Masco trades at 14.8x 2022 EPS, or ~13.5x when you exclude cash. Compare this to Sherwin Williams trading at 24x or even the more industrial-exposed PPG trading at 17x. Home Depot also trades at ~20x.

Personally, I think Masco should trade at 20x EPS given how resilient / how high a ROIC business it is, which would put it at ~$74/share – nearly 40% higher than where it trades today.

Re-rating is tough to bank on, but I think a business that earns a 40-50% ROIC that is growing well should trade at least at the market level (the S&P trades at 22x forward EPS).


Background

I won’t go into the full background of Masco, but if we rewind to pre-financial crisis, Masco was made up of 5 segments:

  • Plumbing Products: Faucets, plumbing products, valves, tubs, showers, etc.
  • Cabinets: Kitchen & bath cabinets
  • Installation & Other Services: installed building products like gutters, fireplaces, garage doors and insulation products
  • Decorative Architectural Products: Mainly paint, under the Behr name
  • Windows & Other Specialty Products: Windows and window frame components

Several of these business are not what I would view as “high quality” and some were very cyclical.

For example, in a recession, how inclined are you to change your cabinets? If income is tight and you might not feel good about the equity in your home, then you might not replace them until they fall off the wall.

Cabinets are highly exposed to new build construction or remodel projects. Same goes for windows, some plumbing products and the installation products mentioned. With the benefit of hindsight, we know how many of these segments performed: Cabinets, windows, and installation each went operating profit negative at some point during the great financial crisis:

Here is a chart of the earnings of the main segments. As you can see, the more cyclical businesses got crushed and never really recovered. Plumbing and pant just kept on chugging.

Masco's segment performance varied wildly in the last recession

Plumbing and paint really kept profitability and they are great businesses.


Paint is a great business, as many people have figured out by investing in Sherwin Williams. People love to paint their home for a general refresh, or they may paint it before they sell their home. When a new buyer comes in, they often paint right over it again. It’s a relatively cheap remodel project that can really make your home feel upgraded.

It’s also a really consolidated industry, the housing crisis really showed how resilient the business was, and also showed the industry had pricing power.

Masco essentially competes with Sherwin Williams and PPG (note, Sherwin Williams beat out PPG for Lowe’s exclusive retail business, whereas Masco’s Behr paint has Home Depot’s business. I’d prefer to have Home Depot, for what it is worth.) Sherwin Williams also has its own stores where it mainly sells to the pro paint contractors.

The housing crisis really caused the industry to re-rate. Mainly because the competitors demonstrated such resilient performance, but also when oil spiked in 2008, they were able to raise praise and maintain margin. The industry realized that they could bank on pretty consistent price increases and not crimp demand.

You can see SHW and PPG traded around 8x EBITDA pre-crisis and clearly re-rated since then.

Note, I exclude Masco here because the chart gets messy since some of their segments (now divested) went EBITDA negative. Even though these segments are gone, Masco trades at a 2x discount to PPG and 7x discount to SHW today.


Masco’s paint segment is ~20% EBITDA margin and essentially takes no capital to grow (e.g. the company spent $25MM in capex for $620MM of EBITDA).

Plumbing is similar, albeit it will be more cyclical and more competitive (though its hard to even tell compared to the other segments in the chart above). It too earns really high margins — around 20% and 2% of sales for capex.

Lo and behold, that is the portfolio that Masco has today and those metrics point to really high ROIC. They are clearly solid businesses, as demonstrated by prior performance.

And here is a chart of Masco’s Return on Invested Capital (ROIC) over time and what I expect going forward:

Masco ROIC has improved meaningfully


I personally believe this housing cycle has legs, driven by the limited supply additions post-crisis and tight inventory, which I’ve discussed in the past. However, it’s hard to predict cycles.

Management gets 5 stars from me for divesting these lower margin, more cyclical business lines at arguably the best time possible (maybe not absolute peak earnings, but closer to peak than trough and selling for near peak valuations).


Why Do I Think Masco Is Discounted?

My guess is people think there was a pull-forward of demand in 2020, which is possible, though it’s not as if 2020 was a “gangbusters” year. Sales were up 7% and operating profit increased 19%. Q4 sales were up 13% as the housing market had really strong turnover. I expect this will actually be a multi-year cycle for Masco, as it appears more homebuyers are entering the market.

Masco’s brands, like Behr paint, is more focused on the Do It Yourself (DIY) market, whereas Sherwin Williams is “Do It For Me” (DIFM). The trend is in favor of DIFM right now. Painting is “tough”, or at least time consuming, and it looks as though millennials would rather hire someone to do it than paint themselves (a broad generalization).

I think this DIFM trend is overplayed. Investors / sell-side seems so focused on it, it’s like they are saying Masco’s business will shrink in the long run. If DIFM continues and gets more expensive over time, I think we start to cycle back to DIY, especially has home costs have become more expensive in general. Not hiring someone to paint for you is a quick way to save some money. At the end of the day, I think there will always be a sector of the market that is DIY to save money and to have fun with their own project.

Masco’s paint segment grew 12% top line in 2020 – do I think it will continue at that rate? Probably not. But at the end of the day, Masco is a super high ROIC business that even if it grows at GDP, I think it is worth a lot more than the market is assigning right now.


With a healthy balance sheet and $1.3BN in cash, they can buy back a lot of stock to “help the market realize the right valuation.”

Secret Saas Business: Ituran $ITRN

Reading Time: 7 minutes


Last year, I laid out a handful of “secret SaaS” businesses. SaaS companies are getting massive valuations because they have highly recurring revenues (which provides earnings visibility), have low churn (highlighting how much customers like their product), and are also asset light. Many other, non-software businesses have this too, people!

I recently did a post of International Flavors & Fragrances, which seems like a secret SaaS business. IFF’s products are mainly food additives that impart taste or fragrance. Food is highly recurring and these products are mission critical. Good margins, low churn, highly recurring.

But today’s company, Ituran, won’t seem that secret. Ituran actually sells software. More importantly, I want to show that Ituran’s stock does not reflect its strong business characteristics. 

Ituran started out in the 1990s as a provider of SVR tracking services (Stolen Vehicle Recovery). The company is based in Israel, where insurance companies mandate the use of SVR services as a prerequisite for providing insurance in medium to high end vehicles. They also grew in Brazil, where car theft is high. In fact, 70% of Brazil is uninsured due to high amounts of vehicle theft. Therefore, Ituran is a cheap solution.

As you can see, Israel and Brazil are the core markets. The company has grown subscribers organically very well and got a boost from the Road Track acquisition back in 2018, which also helped expand it into other countries like Mexico, Columbia, and Ecuador. Organically though, it’s grown subscribers at a 12% CAGR.

Subscriber Base Growth
Israel and Brazil are core markets, though new geographies gained with Road Track acquisition are easy white space

In its core countries, Ituran uses RF network technology to do this tracking, which has some advantages over GPS. For example, GPS services require clear view of the sky with line-of-sight to at least three satellites within the GPS constellation. The terrestrial network technology that Ituran uses does not require line-of-sight and signals are not easily interrupted. It’s also much harder to jam the signal. Lastly, the system can be connected to the anti-theft system in the car, so you don’t have to wait for the vehicle to be reported stolen first.

According to ITRN, the average recovery time is 20 minutes.

However, there are some drawbacks, such as the need to install physical infrastructure in the region it operates. These base stations communicate with each other and help keep a precise location of the car. That said, capex for the company is still really low and ITRN has said they will be using a GPS platform to expand into new regions.

Fleet Management

With its technology, the company also expanded into fleet management. Fleet management would be something like tracking the usage of a corporate fleet, or letting truckers no about “no go” locations on their routes (perhaps a low hanging bridge).

Ituran’s services have been used by corporations with large fleet vehicles. Ituran uses real-time information to track driver behavior and can alert a corporation if the driver is being reckless. This is a low-cost tool for managers of fleets to set benchmarks and hold drivers accountable and in the grand scheme, likely lowers costs for the customer.

Usage-based Insurance

Finally, they also use their technology for usage-based insurance (“UBI”). Insurance companies use Ituran’s plug-in to determine how much users drive and also how they drive for custom pricing.

For insurance companies, this helps them stay competitive by saying, “hey, you could lower your insurance if you are a better-than-average driver or just drive less.” And consumers think, “hey, I’m a better than average driver and don’t drive that much, so maybe I can get a better rate than something fixed.” Truth is, everyone thinks they are a better-than-average driver.

What’s interesting about this information is that Ituran also knows when the car gets in an accident. It can see the exact location of the scene and alert emergency services. Ituran can also provide hard evidence of what actually happened in the accident (down to the G-forces, driver action-reactions, etc). Insurance companies and customers also like this because it provides clear evidence of what happened and can also save lives by cutting response times.


Significant Upside on Conservative Estimates

I think Ituran’s stock looks very cheap. As you can see from the snapshot below, Ituran has grown at a strong clip over time, has really high gross margins and EBITDA margins and generates good FCF. The other thing I should mention is that management says churn is consistently around 3%, which helps stabilize results.

On my numbers, Ituran’s stock is trading at a 10% FCF yield, which is significant when you don’t really have much debt. I also don’t assume they see 2019 revenue again until 2023, despite India launch, despite Brazil bottoming out of a recession, and despite a recovery from COVID-19.

Ituran Model Snapshot
Ituran stock looks very cheap on conservative estimates

Note: there were some accounting changes that moved expenses around + the acquisition, which is why R&D for example looks so odd over time.


Areas for Growth. SaaS businesses also get high valuations because of their growth characteristics. Ituran has a lot of white space available for growth to boost the stock awareness:

  • India.
    • India has 250M+ registered cars. If the company achieved 0.5% penetration, that would be 1.25MM incremental users.
    • The challenge with India versus some of the other locations will be what you can charge, but even at $60 a year across 1.25MM users would be $75MM of incremental revenues (or a 30% increase to where they are today)
  • Mexico, Columbia, Ecuador.
    • Ituran is already big in South America through Brazil and Argentina, but could expand the playbook into these countries which it entered via its acquisition of Road Track

  • Acquisitions
    • Ituran generates strong FCF and currently has very little debt. In my model, I assume they continue to pay down debt to zero, but they also could continue to acquire players to enter into new geographies, like they did with Road Track (albeit, that was ill-timed, as discussed below).
  • Other Optionality.
    • I like companies that have shown they can pivot. Ituran pivoted from mainly a stolen vehicle recovery business to a fleet management business to an insurance company. What else can they do?
    • With a cash rich balance sheet (net debt zero right now), this gives them a lot of optionality

Why does this opportunity exist?  Ituran stock has to be beaten down for a reason.

  • Ill-timed Road Track acquisition
    • The company acquired Road Track in 2018, which was going to provide them with several benefits. For one, it would expand their relationships with OEMs, whereas Ituran mainly played in the aftermarket space
    • Unfortunately, Brazil was ravaged by the COVID induced recession. At one point, Brazil car registrations were down 99.9% during COVID

Brazilian Car Registrations

    • The second impact was that OEMs wanted to save money. Typically OEMs provide a six-month free trial of the Ituran product, which led to pretty good conversion rate. Then the OEM cut the free trial to three months and then one month, which hurt subscriber conversion.
    • All things considered, the amount of OEM contracts lost is pretty encouraging. The losses look to be leveling out as well. This is probably boosted by the low churn rate (3% mentioned previously) in normal times.
    • Hopefully this recovers, but another good signal is that aftermarket subscribers, which is higher margin business, continues to grow
    • Road Track wasn’t all bad. They do still have better access to other Latin American countries mentioned previously and from the latest calls, it seems like the company will be leaning into those areas to grow.

Breakdown of Ituran's Subscribers
While OEM has faced pressure, it hasn’t been that bad in the context of the decline of OEM registrations

  • FX Headwinds Cloud Earnings Strength:
    • Most of the company’s earnings are in currencies that have fluctuated a lot
    • This includes the Israeli shekel, Brazilian real and to a degree, the argentine peso.
    • When you look at results, particularly 2015/2016 time frame when the Latin American currencies depreciated a lot, the results can seem more lumpy than reality

Common Questions

  • Doesn’t GM’s Onstar do this?
    • They do, but also much more expensive paid subscription at $350/year (around 3.5x the cost).
    • It uses GPS, which Ituran also uses in its growth areas, but again the core for Ituran is RF network
    • Ituran is actually the provider to GM in Brazil, which they originally signed in 2012.
  • Are there any comps to help us understand the value in Ituran stock ?
    • Lojack is actually public via a subsidiary of CalAmp (ticker: CAMP). They’re also a small cap, expected to do about $340MM of revenue in FY2020 and just $30MM of EBITDA (i.e. Ituron is much more profitable). They trade at ~18x ’20 EBITDA and 11.5x FY2022 EBITDA. They also have more debt.
    • Pointer was an Israel-based company that was also small, but was public and was acquired by a company called I.D. Systems for ~10x EBITDA in 2018
    • TomTom isn’t a great comp, has been shrinking and will be just slightly EBITDA positive in 2020 (though COVID had an impact). It has about 2x Ituran’s sales, but trades at 1.8x 2020 sales and 1.6x 2021 sales. This is where Ituran trades, but Ituran is expected to grow, is profitable, and generates good FCF.
  • Is Management aligned with Shareholders?
    • I follow another Israel-based company and I will say they tend to be very conservative.
      • For example, I think Ituran should probably carry a bit more debt, but perhaps the culture there frowns upon that. And Ituran’s management seems proud to be back in a “net cash position.”
      • Fortunately, for the Road Track acquisition, they did not issue Ituran stock to fund the deal
    • Management owns ~23.5% of Ituran stock via a holding company “Moked Ituran Ltd”. Moked literally means “focus” in Hebrew, so hopefully that’s a good sign

Bottom line: I think expectations for Ituran stock are pretty low. I also think it’s a cash cow with a highly recurring business model. I’ll admit, my biggest concerns are about technology disruption, but that’s true for a lot of businesses I own as well. That also probably stems from their brand not being known well in the US, where I am located.

I think Ituran’s results will improve over the year, which may mean it gets more attention and Ituran stock can re-rate. They also have enough cash to cause a re-rating themselves (i.e. buybacks) which is always positive.

Fresh Look at AgroFresh Stock $AGFS

Reading Time: 6 minutes

AgroFresh is a company that sells 1-MCP, a chemical that helps slow down the ripening process of fruit and vegetables. You know how you can eat apples all year long? Did you ever think that’s strange given harvest season is September-October? With 1-MCP, apples can be stored for a year. That’s right – sometimes you are eating year-old apples. I’ve been following AgroFresh for years and there are certain times when the skew on the stock becomes very interesting.


Disclaimer

This is a quick idea today and I need a disclaimer upfront. This is not investment advice and I use this blog as an investment journal. The subject company today is very risky. You should expect that I may invest in this company and then quickly move on if I see a quick return. You should do your own due diligence.


Key Issues

Anyway, back to AgroFresh stock. The issues have always been:

  • They were bought by a SPAC, which raised red flags given SPAC deal dynamics. AgroFresh stock has not been a good performer since then.
  • It was a carve-out from Dow Chemical, who knows a thing or two about chemicals. So their choice to sell a high margin business was odd (Dow later re-invested in the company through the open market).
  • They have a decent amount of debt (recently refinanced, though expensive).
  • This typically was viewed as a 1 product, 1 market company (viewed as only Smartfresh 1-MCP product with apples).
  • One patent had rolled off in 2015 and more were coming in 2019 and 2020. It was unclear whether earnings would collapse or not

Each of these are valid issues  with AgroFresh stock. The last issue is the most important one in my view. As you can see below, the gross margins and EBITDA margins are super high. They do about $71MM in EBITDA, with 42.5% margins, and only have $3MM in capex (less than 2% of sales) so have extremely high FCF conversion.

Excluding the intangibles assets from their buyout and cash, they have $153MM in assets, but do $71MM in EBITDA – that’s a super high ROIC and highlights the intellectual property and high service model is creating a barrier.


So why is this worth a look?

Frankly, I think the risk / reward is getting very compelling. I’ve made a decent amount of money in stocks the rest of the market thinks is going bankrupt, but where I think the odds are more likely it does not.

First of all, they generate a lot of FCF. Despite a new onerous debt restructuring entered into last year (their prior term loan matured in July 2021, so it was about to become “current”), I still think we’re accruing cash to equity at around 20%. As mentioned a lot, I like good companies with bad balance sheets. This may just be an OK company with a bad balance sheet, but thats OK.

Debt Refinancing

The debt deal was entered into because the company had an upcoming maturity. They got a new $275MM term loan at L+625bps with a 1% floor, which foots to about $20MM of interest per year. I think they’ll be able to refinance that at a better rate, but the loan does have 101 hard call protection until July 2021.

More importantly, they have a seriously onerous convertible pref equity that was put in place by Paine Schwartz Partners (PSP). It accrues at 16% (half cash / half PIK in year one). Call protection is determined by a multiple of invested capital, which also seems aggressive:

If they can take this pref out before July 2021, Agrofresh will need to pay 1.5x the pref amount of $150MM, which is ~$225MM (it is actually less than this, because MOIC includes original issue discount + coupons, but you get the idea).

Otherwise, Agrofresh has to pay 16% interest while this thing is outstanding. For me, I’d want that out of here as fast as possible. On the other hand, if AGFS takes it out in year one, it’s basically like paying 50% interest. I guess that’s the cost of capital during a pandemic when you have a maturity coming due.

Here’s how the pref shakes out, assuming they PIK the minimum amount each year (the PIK interest is added to the balance). As you can see, the PSP pref is brutal because the high rate incentivizes a refi, but the make-whole is large too so it is actually better to wait a bit and execute on your business plan.

There are some other green shoots. Agrofresh won an IP lawsuit against UPL, one of the largest ag chemical companies, and was awarded over $30MM. They can actually use this to paydown the preferred at more favorable terms. Obviously there are two good outcomes of this that I don’t need to directly spell out for readers.


Patent Protection

Smartfresh is the flagship product for Agrofresh. Fortunately or unfortunately, the patent that still applies to a bulk in revenue still lasts until 2022. So unfortunately, it is still a wait and see story.

And what does management say about competition, otherwise? It’s not really new. Here’s a quote back from 2016 (by the way, this TruPick product they are talking about it what they won the lawsuit for):


Optionality

The last thing I’ll say is there is other optionality in this investment. Essentially, take this chemical and apply it to other fruits and vegetables that could be preserved. Man, avocados go from too hard to too ripe way before I’m even ready for it.

So far, they’ve actually done a decent job. Back in 2014, the company was 88% apple-related sales. Now it’s just 60%.

It seems like the company wants to aggressively expand here. Part of the management teams bonus is tied to it (25%).


Management Alignment

Speaking of bonuses, I like that mgmt has a decent amount of options that are way out of the money at $2/share. Mgmt was also in the open market in 2019 buying at $2.35/share.

However, I’m not super thrilled that total comp is around $2MM / year for a company doing $71MM in EBITDA with abysmal stock performance so far.


So why now?

AGFS stock has been a value trap to some extent.

  • Refi that expensive preferred capital  and potentially the term loan.
    • Fortunately or unfortunately, the credit market is aggressive right now and many companies will be able to survive this cycle that wouldn’t have survived past ones.
    • In reality, perhaps they should come to market with a 9% unsecured bond. It’d be juicy in this market (and HoldCo PIKs are trading at lower yields)
    • AgroFresh could do a $375MM deal to takeout the pref + TL and still come out with cheaper cost of capital all-in.
    • Doing this would free up capital for the common shareholders
    • I think they may be able to do something by July 2021. But thesis isn’t predicated on that.
  • Sentiment feels bad on it. Stock seems completely washed out. I like that. Slightly positive news would send it higher.
    • I like the skew: If I see patent weakness or too much competitive threat, can likely exit before losing the whole position. If they surprise to the upside, even modestly, the stock will re-rate very quickly (especially with the leverage).
    • Small wins are meaningful: If AGFS gets a $10MM win, that’s much more incremental to them because they are a microcap.

The Market is Now Game $GME $AMC $AMCX $NCMI $BGS

Reading Time: 3 minutesWhen history is written about GameStop, the book will start with Dave Portnoy and Davey Day Trader Global.  Here’s a degenerate sports gambler who is completely bored during a pandemic and discovers speculating on stocks is fun. Add in stimulus payments, boredom, and millennials controlling $5.4 trillion of wealth, and a lot can happen.

A lot has been written as to why GME is ripping higher, so I just want to add in a few of my own observations.

Gamestop’s price action really comes down to high short interest combined with gamma hedging.  When someone is short a stock, or betting against it, they need to borrow the shares and hopefully return them at a lower price. That’s how they make money. However, your downside is theoretically unlimited because the stock can theoretically go up and up and up. As such, when a stock rips higher, shorts typically need to cover their position so they aren’t destroyed.

The second factor is gamma hedging. Reddit users on r/WallstreetBets are buying a lot of call options. The seller of those call options needs to protect their position, so they actually buy some stock as a hedge (selling a call is a bearish position, so to be more neutral, they buy the stock). When the stock rises, they need to buy more stock to continue their hedge (this is really delta hedging).

So as you can see, even if Reddit users or Robinhood investors don’t have a lot of money, they can drive extreme price movements from what others have to do. Just recently, Melvin Capital needed a bailout because its short on GME blew up. In fact, it seems to me that Redditors are going line by line through Melvin Capital’s short book and trying to blow him up.

Even a Blockbuster remnant is surging.

AMC, the movie theater chain, has been issuing equity en masse to stay alive while theaters are shut down. It has completely diluted shareholders. Share count is now 7.5x higher than it was pre-pandemic. They also had to take on more debt. Even if theaters were packed tomorrow, I think returns would be abysmal for shareholders. And yet… the stock has surged.

But what is really  funny is that AMC Networks, the TV network that had Madmen and The Walking Dead, is also ripping in sympathy.

Buyer  beware.


I don’t plan on adding any fuel to the fire on these names. It is funny that some names I have written about previously are being taken up in the rush, like National Cinemedia, Big Lots and B&G foods.

There are some interesting transactions out there. Andrew Walker posted on Twitter about selling puts on GME. When you sell an option, you are really selling volatility. Given GME has been incredibly volatile, you can make some decent trades.

Look at the $0.50 put options. If you sold 1 contracts you could need to set aside $50 as cash to secure the position and you would collect $3. That may not sound like much, but that’s a 6% return. Over 79 days. Annualized that more like a 30% return.

The only way you lose is if GME crashes to less than $0.47 (or 99.8% from here, lol), which is way below where it even traded when its outlook was terrible (it’s worst was around ~$3.50). Look at the interest as well and the volumes. You could sell A LOT of these contracts for your PA.

My thinking is GME will clearly issue equity. And because the price is so high, the dilution will be low and then they’ll have cash. This will raise the floor that the stock used to trade at.