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

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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

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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.

The Fed Started Cutting Rates in November 2022, You Just Missed It

Reading Time: 3 minutesThe Fed cutting cycle began in November 2022. You just missed it. While you’ll hear a bunch of debate about whether the Fed will raise rates “25bps at the next meeting”, or “they’ll pause!”, or “25bps now and 25bps again at the next one!”…. It all misses the point.

And look, I just did a post on hating all the “Fed speak” predictions. I’m so done with all of it. But I’ll add one more thought to the cocktail party as I recognize it drives markets.

Yes, the Fed isn’t actually cutting rates (yet). But if you are confused by market reaction right now (equities are well off the bottom and credit markets are thawing each day), it is because the market is forward looking and already started to price cuts in. In fact, no matter how hawkish Fed officials have been, rates even at the short-end refuse to budge.

It all started when this happened:

October CPI came in weak. Weak enough to piece together inflation had clearly peaked.

In turn, we had a massive move in the market. The S&P closed up 5.5% that day, but more importantly, look at the yield curve:

The 10 year tightened nearly 30bps, as did the 3, 5 and 7 yr. Since then it has continued to be a dramatic difference, with the 10yr now 70bps inside.

But how else can we see this view changed exactly on that day?

The US Dollar also peaked: 

Homebuilders have ripped:

Here are 3 month SOFR Spreads, which is a way to look at market expectations of future Fed policy. Big change around November, huh?

It is no different when the Fed says it will, “likely raise rates 50-75bps at a meeting” like it did in 2022. The market priced that in largely at announcement. The Fed didn’t actually have to start raising rates yet for financial conditions to tighten to that level.

Likewise, the market understands inflation is now much more in control. In fact, as I have written due to the bullwhip effect, it could overshoot to the downside with inventory glut and lower demand.

We all like to believe the market is inefficient, and I have seen inefficiencies first hand. In some cases though, it is pretty good at sniffing out the truth. It’s pieced out inflation has peaked and now is time to focus on the second mandate, employment.

Quick Recap on $WDFC Q4: GMs +400bps sequentially. Europe main disappointment. No change to thesis.

Reading Time: 2 minutesQuick update of WDFC, doubt I do this often, but they reported so soon after I wrote on it I thought I’d give some thoughts. We’re seeing the green shoots of recovery on margins, but EMEA was weak, much more than expected. All in all, nothing changed in my thesis, but I’ll expand.

Maintenance sales (their core product) declined about 30% in EMEA. That’s stark for a business that was resilient in 2008. It would have been just 15% FX-neutral and they did exit some Russian and Belarus business, but still. It was only down 1% in the Q ended Aug. They sell through distributors in the EU, so no surprise in the face of uncertainty, distributors are destocking.

As such, EBITDA missed my estimate by about $5MM ($23MM vs. $28MM) solely due to this. GMs even beat my estimate by about 50bps. And mgmt basically said they have no change to their expectations, which is a second-half story. Normally I take the under on any second-half story, but this one makes complete sense.

I reviewed the “cost of a can” to see what is really driving the margin erosion. Basically 65% of a WD-40 can is either related to oil or tin. While packaging doubled in $s, the real needle movers are the chemical inputs, can, and manufacturing fees. These manufacturing fees are essentially warehousing and freight costs.

I think all of these will be tailwinds in second half.

Plus, China sales grew 22% on the maintenance side and 32.5% in APAC-ex China. So that is a good sign and probably more room to run as China re-opens.

Outside of that, last thing I’ll highlight is they have way too much inventory. They should destock themselves. But anyway, I expect that’ll be a 2H cash source. Could be up to $85MM, honestly. That may seem small, but it ain’t nothing for a company I expect to recover to $120MM+ EBITDA plus have a cash release like that.


Never a “good” time to own $WDFC, but now might be “OK”

Reading Time: 5 minutesI wrote up WDFC stock in 2021. The inspiration was wanting to know why TF WDFC stock always traded at such a rich multiple. Persistantly. It would not have been a good short leading up to that time. Is everyone who hates it missing something in the numbers? At the time WDFC stock was trading around $300/share at 35x LTM EBITDA and 52x LTM EPS. Now it is more like $165, so if you could’ve top ticked it, good for you.

It was a good exercise. It’s easy to discard a stock simply by looking at the multiple and saying “nope too high”, when I think we can all agree we’ve bought companies with low P/E multiples and really regretted it, too.

Anyway, my conclusion was it was a really good brand, great business with super high ROIC, long-growth runway that required little capital. Pristine balance sheet… too pristine if you ask me….

Plus, its been highlighted before, that WDFC stock has some particular things going for it.

Setting all that aside, I couldn’t make the numbers work to meet my return threshold. In other words, a business can have a high return on its capital, but if I pay too much for that invested capital, my return will suck. the company has some long-term targets I thought they had really low chance of hitting based on their trajectory. I still think that’s the case, but the company has started to talk those down.

So it wasn’t a good time to buy. But I also pointed out WDFC stock never looked great to buy, but somehow you could’ve earned a >10% return buying at many points in the past when it looked expensive.

I’ll re-post that chart here – red line is where you could buy it 3 years before the current date, dotted orange is where it needed to be for 10% CAGR. Blue line is where it was. In other words, you could buy it below that price much of the time and it ended up being much higher in the end. 

Now with the stock at ~$165, I think it is actually an OK time to buy. I won’t rehash everything I did in the first post. This time it comes down to a 3 basic ideas:

  • Earnings are depressed from a price / raw material mismatch (this is true for many specialty chemical companies, such as Sherwin-Williams, PPG, etc). Price is flowing through now at the same time raw materials are collapsing. Earnings estimates look too low, in my opinion.
  • China is a growth story LT. It is still a small segment. Re-opening will help drive higher growth perhaps faster than people expect.
  • Last but not least, it is a great business and you have to pay up for quality. I’ve quibbled with execution in the past, but it does have a long growth trajectory (how is China only $20MM of revenue??).

I’m not sure what is exactly in WD-40, but I know it is a lot of oil derivatives.

Here is how true specialty chemicals typically work (and footnote- this is kinda what caused Sherwin Williams to re-rate, among other things).

  1. They are typically resilient businesses with pricing power and their customer doesn’t keep track of their raw materials and keep an index of inputs to change price (i.e. not a commodity)
  2.  In an benign environment, should grow volumes GDP+ and get price too
  3. However, if oil spikes, there can be a mismatch in raws and price, compressing margins
  4. BUT what specialty chem players do is they get MORE price to cover raws and when they fall again, they never lower price.

So what happens? True specialty chemical players may realize some compressed margins short-term in an oil spike, but long-term they reset higher. 

You can kind of see that play out for WDFC gross margins over time. It tends to move inverse with oil, but then reset higher:

In their fiscal year 2022 (ended August) they realized nearly 500bps of gross margin compression. Their long-term target is >55% gross margins, and they did 49% in ’22 when they had just done 54% in ’21. They break down more of the headwinds here, but keep in mind each of these have turned to tailwinds now and the company likely won’t be lowering price.

They go on to say they have implemented significant price increases that will recover margins over time. And yet, when you look at street expectations, they don’t have them getting back to slightly-below 54% gross margins until 2024. To be fair, 2023 guidance from management is wide – anywhere from 51%-53%.

The low end doesn’t seem right to me and is meaningfully different outcome. The low end doesn’t seem right based on their comment that a ~25% price increased went into effect late-2022. They also already had some margin benefits from price coming through, though they were masked.

They also say they will be implementing these across geographies.

So you’ve got all this price coming through, right when raw materials are falling. Sure, we may be in a recession in 2023, but that’s a big maybe too. I’m at ~$6.85 of EPS and the company guided to $5.15 for 2023… I only model 5% volume growth (big price increases result in some elasticity plus weaker market).

Again, history shows they regain this margin and then some…

Moving on to keep this short.

The other thing about this company is China. APAC in total for WDFC is <$75MM. I don’t see why this geography couldn’t be well above $200MM (Europe and North America are $200MM and $240MM).

There’s a lot of squeaky, rusty stuff in Asia too.

So I can’t say when, but that seems inevitable if they can get the branding and distribution right. Which they clearly haven’t so far.

But the CEO who had been there for forever just retired. They brought up an insider so not totally optimistic, but at least you know things won’t be shooken up too much.

In sum, I think at we’re at a much more reasonable point optically on valuation (24x my 2023 EPS), but again EPS doesn’t matter. What does matter is FCF per share is likely going to go grow double-digits for essentially a consumer staple where estimates are too low and the required capital to grow is very limited.

That seems like the set-up for a winner. I fully accept being “early” on this one.

Re-examining Big Lots Stock – Case for Optimism? $BIG

Reading Time: 4 minutesIt’s a start of the new year, and the end of a year where the S&P500 was down nearly 20%. Some may focus on what worked, I’ll look at an idea that did not go well. Big Lots stock, down 68% in 2022, it’s market cap is just ~$425MM.

I think there’s still room for optimism (even if its just a “dogs of the Dow” type of viewpoint). This bagholder just won’t quit. Mainly because I think the stock is trading at ~3x FY’24 EBITDA, 8% dividend yield, with some upside if they continue to sell some assets.

Don’t get me wrong. Don’t take this as “Big Lots stock is my largest position.” Far, far from it. Could we go into a recession? Sure. Am I happy that FCF may be mediocre despite the low EBITDA multiple? Of course not. That’s why position sizing is important.

That said, from here the stock looks interesting (even if that means when I first wrote it up was much too high). This could be one to add to the radar at the very least. I’m also looking out to 2024. So if you’re someone who is looking for something that will definitely do well this year, not sure this is the place. Especially because if under this new lens it just looks “interesting”, then it probably has a bit more downside before the upside arrives (just my experience).

I think my biggest mistakes in 2022 were buying low-quality business that seemed like they had tailwinds. Things can quickly change, tailwinds can evaporate, and you’re left with a low-quality business! It worked for awhile and then it really did not work…

Retail is a tough business. That’s apparent right now where many are caught with too much inventory (in the face of destocking), mark downs are evaporating profits and working capital has eaten liquidity. Freight and labor have also been challenging.

What makes this a particularly bad pick for me is I’ve been calling for the bull whip to play out for some time now and this is a clear example (here and here).

But I really liked what Big Lots was doing – pivoting store formats, bought brands with staying power (Broyhill), improving cost structure and growing stores to help absorb fixed cost leverage. I still think all of those are true. But as I’ll show below, they really got hit with freight, promotional activity, and labor costs.

Theoretically, the challenges mentioned above should be “one time” in nature, or at least cyclical problems, not secular. And they are all known now, at least I think they are…

I built a waterfall chart from 2019 to show the pressures Big Lots has seen. But just to rehash in FY2022 (which will end Jan’23, so Q4 is still an estimate).

  • Sales will have declined ~11%
  • GMs down >400bps
  • Opex up as a % of sales >350bps

Big Lots ended 2019 with ~6.5% EBITDA margins, so no surprise it is now negative.

But when you break down the reasons, Big Lots has called out freight being 400-500bps of operating margin pressure via GM and Opex. And they said that has peaked at this point. Promotional activity has peaked, too.

Looking forward, Big Lots has already faced destocking as mentioned. If we assume modest sales growth to 2024 and some of these headwinds abating, I could see Big Lots easily getting back to $255MM of EBITDA in FY’24 with some reasonable assumptions.

Bridging Big Lot’s EBITDA from 2019 to the current year to my expectation a couple years from now

With a ~$425MM market cap and ~$825MM Enterprise Value, that means Big Lots stock is trading at 3.2x EBITDA!

Is it the cheapest retailer I have ever seen? No. But I think that multiple could look even lower given more asset sales are on the come:

I have no idea what these assets could sell for. Back in 2020, they did a sale leaseback of 4 distribution centers for a gross amount of $725MM (net proceeds was more like $575mm after taxes and such). That’s not really a comp, but was interesting how low book value was compared to the actual proceeds (recorded a $463MM gain on sale).

I did find several listings of Big Lots stores that ranged anywhere from $2.5-$4.5MM (honestly averages in the middle). If it could sell 25 stores for $2MM a piece, that is $50MM gross. There’d probably be $3.5MM of incremental rent expense as a result, but that’d still be a win in my book given where the market cap is.

Big Lots has nearly $720MM of PP&E on its balance sheet. Selling assets at better than a 10% cap rate is accretive given Big Lots stock is trading at such a low multiple. It helps liquidity and can help pay down debt. I’ll take it.

While dangerous to anchor on, let’s not forget book value is $27/share.

As I mentioned at the top, a big concern here is $255MM of EBITDA may not generate much FCF. They’ll probably spend $170MM on capex per year (albeit to grow stores). I think with interest the stock is probably trading at a 10% FCF yield at best.

So one to watch. I still think this business and brand are underappreciated long-term. But alas, buying low-quality businesses even at cheap prices can be a dangerous game.

Interesting (Hated) Spin-out – Masterbrand Cabinets Stock $MBC

Reading Time: 4 minutesIntentionally or not, Fortune Brands has created a Good Co, Bad Co with their spin-out of Masterbrand Cabinets stock. It is very easy to be cautious on 2023 and say, cabinets are F’d. Instead, cling to your Fortune Brands shares which sell into plumbing, security products, and decking.

Cabinets are a super cyclical business. I tend to think a cabinet sale occurs during new construction… or when they fall off the wall. But really they are also replaced when there is heavy remodeling work done. All require some discretionary income.

The cabinet business proved its cyclicality back in the financial crisis. Featured below is Masco’s (since divested) cabinets business operating income. It took until 2016 to get back to Op income profitability! Woof.

Now, of course we were in a housing bubble back then… Masco also added in a ton of capacity right before the market turned. This number includes some impairments and restructuring charges. In addition, China started to nip at the heels of the industry by competing in the really commoditized, “stock”, low-end product (ready-to-assemble cabinets).

American Woodmark’s EBITDA perhaps is a better example:

Typically, competition is pretty localized in cabinets as shipping costs can be really expensive. That’s still true, but the industry had to flush out losing some of that lower-end business.

Fast forward a bit to today, American Woodmark (AMWD), Masterbands (MBC) and Cabinetworks (private, but bought the former Armstrong and Masco cabinet businesses along with Elkay), now dominate the industry. Definitely flip through Masterbrands investor day deck if you want more background

It is still a tough business, no question.

In 2021, they were hit by labor costs (building cabinets is labor intensive), freight, as well as hardwood costs. It’s a high fixed cost business too, so when operational issues occurred (omnicron absenteeism for example), it really hit them on the chin as throughput suffered.

As such, the industry has been trying to get price to recover this. Backlogs have been huge, but that wasn’t necessarily a good thing as the price on the backlog didn’t match the new input-cost reality.

The industry is doing better to recover margin. As you can see from American Woodmark’s EBITDA margin, they are slowly but surely getting back to a reasonable margin level.

We’re talking big price increases rolling through now.

Volumes for the industry are pretty flat lately, but price increases are 15-20%. That will help margins going forward. KCMA publishes data and in October, volumes fell 2.6%, but price was up 17%

AMWD’s FQ2’23 (ended Oct’23), showed EBITDA margins expanding from 6.8% to 12.0% Y/Y. And therefore EBITDA $ more than doubled.

Taking a step back, I think this tends to surprise people – demand was so strong for cabinets that it hurt profitability. And as demand has cooled a bit now, that’s helping? WEIRD.

Back to Masterbrand – Fortune Brands decided to spin the company out. My guess is for a re-rating. Get rid of the more cyclical, lower margin business. Heck, that’s what Masco did (though it didn’t really re-rate).

But my guess is everyone is thinking the same thing on MBC. “Get away”

Masterbrand, I will say, has outperformed its peers on maintaining margin. They have a long history of that. I believe they are THE best run cabinet player in the space. Even so, they think they can get to 16% EBITDA margins over time.

I like low hurdles to jump over. So I did some rough math. I used their estimate for “high-single digit” sales decline next year, 25% decremental. But then I basically say no growth from there. I give no credit for W/C being a benefit either, after a couple years of a large build. Maybe that’s too aggressive? I don’t know, I think expectations for Masterbrand Cabinets stock are probably pretty low…

That looks like a lot of cash…. And when I compare it to the current market cap, we’re talking nearly a 20% FCF yield for Masterbrand Cabinets stock.

Historically, cabinets businesses have traded for 6-8x, in some cases higher for private M&A. It intuitively makes sense given what we’ve discussed. But I think this valuation, IF YOU HAVE A LONG TIME HORIZON, makes a lot of sense.

Obviously there are risks. The cycle could be a nasty one. The spin could have some stutter-steps (though MBC was a separate segment for a long time). But I like the risk-reward here and the forced selling.

The other major risk is I am writing this the day of the spin! That’s a no no. Wait for it to bleed out, Dilly D! This is a $1BN market cap and hated industry right now!

Ehhhhhhh whatever. AMWD is trading at 7.3x ’23 and in my view, has performed worse. Capital intensity is also higher there. I like the risk reward.