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

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

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

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

This led me to ask myself:

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

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

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

Is AWS a good business?

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

-Jeff Bezos, 2014 Letter to Shareholders

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

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

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


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

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


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

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

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

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

Jeff Bezos, 2016 Letter to Shareholders

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

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


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

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

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

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

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

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


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

What do you think AWS is worth?

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

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

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

Assessing the Age Old Question: Invest in Home Depot or Lowe’s? $HD $LOW

I’ve been studying Bill Ackman’s portfolio and strong performance so far in 2019 and it seems the hedge fund manager is getting back to his roots. Gone are the shorts in Herbalife and aggressive long in Valeant, and instead he has waved in a new era of “high-quality, simple, predictable, free-cash-flow-generative businesses with formidable barriers to entry.” As shown in the slide below, it seems as if Ackman is positioning himself towards high-quality blue chip names. And not pictured, he added Berkshire Hathaway to the mix and existed UTX and ADP.

As a quick aside, this strategy is puzzling to me. For a hedge fund manager to be buying huge, blue chip stocks… it just seems odd. Perhaps it is due to his view on the business cycle and these investments, with good balance sheets, will perform fine in good or bad economic times. However, they also are now mostly consumer discretionary businesses.  Maybe he is bullish on the consumer 10 years into an expansion? Odd indeed.


In this post, I am going to examine Lowe’s which Ackman’s fund, Pershing Square, now has a ~$1bn investment. This is an age old question. We have two companies in a big industry. Everyone knows their names… why and how do you pick one over the other?

Ackman’s thesis seems to rest on Lowe’s “closing the gap” with Home Depot. Ackman even says Marvin Ellison, the Lowe’s CEO announced in May 2018 who is an ex-Home Depot executive, was his top pick for the CEO job.

As such, I will be examining Lowe’s in comparison with Home Depot and also determining if there are any structural differences between the two companies. In essence, I will see if Ackman’s thesis has merit. I hope to finally tie that into valuation. Because so much of this report will be comparing the two building product juggernauts, this might as well be viewed as a report on both Home Depot and Lowe’s.

Company Overview:

Brief History

Lowe’s history dates back to the early 1920’s when it opened its first hardware store in North Wilkesboro, North Carolina. In anticipation of dramatic increase in construction following WWII, Jim Lowe (the son of the original founder) and his partner Carl Buchan began focusing on hardware and building materials. Following some years’ operating together, the two disagreed on focus and Jim Lowe split with his partner to focus on grocery (and started Lows Foods grocery chain) while Buchan operated Lowe’s.

The company expanded in the Southeast. After Buchan died in the early 60’s, his executive team took the company public with 21 stores.

In the 1980s, the company suffered against Home Depot and the big-box retail concept. Home Depot was formed in just the late 1970s and early 80s with the home-improvement superstore concept. Their first stores were built in spaces leased from JC Penney in Atlanta and began branching out in the southeast US. By 1989, Home Depot surpassed Lowe’s in annual sales.

Lowe’s resisted this big-box format, mainly arguing that Lowe’s served smaller, rural communities where a big box chain doesn’t make much sense. However, it eventually did succumb to pressures. Today, Lowe’s has ~2,000 stores and ~209 million square feet of store space and does ~$72BN in sales. Home Depot, in contrast, has 2,289 stores, ~240 million square feet, and ~$110BN in sales. More on these comparisons later.

Market Overview

Lowe’s and Home Depot operate in what is estimated to be a $900BN market. With $72BN in sales, this means Lowe’s has less than 8% market share while Home Depot has ~12%.

However, I will say it is unclear to me what this market size estimate includes. Obviously, the housing market is huge and the market that Home Depot and Lowe’s serve must be big given the size of their respective sales ($180BN combined). But if they’re including everything within home improvement, the addressable market is likely much smaller for the duo. They will never truly displace the lumber yard. Nor should they. That is a low margin, commodity business. Home Depot in the past as alluded the market is more like $600BN, which makes more sense to me.

The customer base is split in DIY (do it yourself) and DIFM (do it for me) customers as well as professional contractor customers. I think we can all understand the DIY / DIFM customers well. These people are doing repairs on their home and come into Home Depot or Lowe’s for a certain tool, toilet, door, window, flooring, etc. Lowe’s and Home Depot serve as a one-stop shop for them.

Contractors on the other hand are a bit different. This is the segment Lowe’s is now aggressively targeting. As noted at Lowe’s investor day in 2018,

“[Our] final focus area will be intensifying customer engagement. At the core of this objective is winning the Pro. We have a tremendous opportunity to grow this portion of our business. This is a customer that is very important because the typical Pro spends 5x as much as the average DIY customer.”

We will discuss this in more detail later on, but I can see the challenge of this sector of the market. Time is money for a Pro and when they need something, they need to go to one place. That is why specific building supply stores and distributors exist. Not necessarily for one stop shop of everything (cabinets and windows in the same purchase), but more like, “You need plumbing products for that job? Head to Ferguson. Need HVAC products? Head to Watsco.”  There are also showrooms around the country to sell tile, flooring and cabinets specifically for the pro channel. For example, Fastenal, Grainger, Ferguson, HD Supply, Watsco each have a niche they are targeting in the Pro segment. 

It makes sense why Home Depot and Lowe’s would target this customer. If a pro stops in to buy one product and then decides to throw a hammer, some fasteners, adhesives, and paper towels in the cart as well, that is all upside to Lowe’s.

Comparison – How do Lowe’s and Home Depot Stack up?

Now that we’re starting to get into their differences, I’d like to provide a simple breakdown first of Lowe’s and Home Depot’s stats. I think this is where it becomes clear that their performance differential is stark, despite seemingly similar store count.

Clearly, Home Depot has similar store count, but is much more productive. Home Depot has 14% more stores, but 50% higher sales, 140% higher EBITDA, and incredible return metrics on invested capital, despite spending about 2x as much per store.

What about like-for-like sales comparisons?

As shown below, Lowe’s was performing well against Home Depot up until the financial crisis. Since that time, Home Depot has been eating Lowe’s lunch.

This is more clearly seen by looking at the two-year stack (that is, comparing the last two years sales growth rate together). Coming out of the crisis, Home Depot took a strong lead and has since maintained it.

If we look at the drivers of Lowe’s sales since 2010, we can see in the chart below that in the past few years, most of the growth has come from larger average ticket sizes, while transaction growth (or volume) stalled.

At the same time, Home Depot has had a good mix of volume and pricing gains. To me, it looks as if share shift is clearly demonstrated in the last two years, where Home Depot is reporting stronger transaction growth to Lowe’s negative comps.


Rationale for the Underperformance?

Lowe’s called out some of the reasons for under performance here: 

“We took a hard look at the current state of our stores. We saw that customers were very excited to come to Lowe’s. And therefore, our traffic growth was quite strong. However, frequent out of stocks led to poor conversion, lower transaction growth and a frustrated, disappointed customer. We have terrific associates who know this business well and give their all each and every day to find solutions for our customers. But we also saw that we made it difficult for those associates to do their job. Lack of process, procedures and clear direction made their work inefficient. Complex, outdated point-of-sale systems require too much time and training to navigate, leaving our dedicated associates scrambling and long lines of customers waiting. In effect, the staffing models placed too many hours in associate and tasking activities and not enough in selling activities.

In addition, the company called out the lack of focus on the Pro.

“We had also fallen out of step with the Pro. They had been a lack of focus on the depth of inventory, the right pricing and the products that they expect. In fact, we lost some critical brands years ago because there was a focus on margin rate rather than the understanding and responding to the comprehensive needs of that important customer. We also found that our online assortment was lacking with a significant SKU deficit versus the competition.”

Home Depot has had much more success with Pros recently vs. Lowe’s. On Home Depot’s Q2’18 call, they stated that Pro penetration is ~45%, while Lowe’s stated it is ~20-25%.

Why does the Pro matter? Home Depot stated in 2019 that they were going to dispell a myth: the Pro is not higher margin than DIY. The margin mix of products is similar.  However, they spend much more when in the store. Home Depot also stated that “the Pro represents nearly 40% of sales but only 4% of customers.” Therefore, you have more inventory turns in the big box store and you are much more productive. 


I think another reason why Lowe’s stores lag Home Depot’s and lag in serving Pros is geography. Lowe’s stores lag in the high density population areas, which are Pro heavy. Instead, I think they have more locations in more “rural” areas which is heavy DIY. Household incomes of these denser population areas are also higher on average, which means they have more to reinvest in their homes and renovate.

Why did Lowe’s outperform pre-crisis? I think Lowe’s stores where in areas which were likely impacted by the real estate bubble. As the bubble grew, the city sprawl grew as well and the values of homes on the outskirts of town also witnessed strong growth (at the time). This translated into higher sales for Lowe’s at the time. When the bubble popped, these areas were more heavily impacted. 

This is speculation on my part, but let’s compare some stores in areas. Note: this is completely anecdotal, but what I am trying to gauge is Home Depot’s density in city centers (where population is theoretically higher) compared to Lowe’s. I also pulled up some smaller cities to compare store count. It’s one thing if you have the same store count, but it is another if one competitor has 10 locations in Houston and another has none there, but does 10 in Des Moines. With a big box store you want to be serving as many people as possible in a day. 

Below is Boston. You can see some Lowe’s stores are peppered outside of the city, but no real ones serving the actual city. Contrast that with Home Depot on the right – more stores dead inside the population zone.

The next is Houston. This time, Home Depot has many more stores serving the 4th largest city in the US, both inside and outside.

Next is Oklahoma City. Home Depot and Lowe’s looked roughly well matched. However, Lowe’s has 11 locations there, including one outside of town. Home Depot has 9. Does it make sense for Lowe’s to have the same number of locations in Oklahoma City as it does in Houston, when Houston has 4x the population?

Next is Indianapolis. To me, it is the same story as Oklahoma City. You can argue now that Lowe’s will be better positioned as these other, smaller regions grow, but it is questionable how they’ve allocated capital in the past at least (we can open a store in Houston, or one in Indianapolis – which do you pick?).

Ok last one to test the bubble thesis. South Florida was blasted by the housing bubble due to very high speculation activity in these areas. Let’s check out the store count:

     

Are the differences structural?

I think the differences in margin are not structural. However, I do think that turning a ship with nearly $80BN in sales is not easy and will not happen quickly. There may be taste changes that Lowe’s will have to overcome (didn’t have the product before, why should the Pro trust you now) and the investments may take some years to play out.

So what is Lowe’s doing to close the gap?

Clearly, it seems Lowe’s knows it needs to target the Pro. After an internal review, they discovered that there was inadequate coverage of Pro by their staff. The staff was busy with documentation work during peak hours and missed serving Pro staff. Time is money.

It does seem simple on paper: if they can be price competitive, have the right brands and quantities, and be consistent with service, I think that will help close the gap.

Again, however, I think this can only improve so much due to geographic differences.

On the profitability side, the company said that its payroll systems are antiquated and not prepped for changes in demand by department. Outside of COGS, store payroll is the company’s largest expense and they definitely spend more than Home Depot does on a per store basis (see EBITDA margin difference in table at beginning of this post). At the same time, they will be adding sales staff to support the Pro segment. The company’s goal is for the savings from one to fund the other.

They also noted they will focus more on “high velocity” SKUs in stock. Historically, they focused more on inventory dollar position versus inventory turns. If you are turning your inventory quickly – you are making more money. This seems like retailing 101 so hopefully is a quick fix.

As shown below, Lowe’s thinks it can improve sales per sq ft by ~10% over 2018 levels (and 8% over LTM Q1’19). By having better SG&A leverage, they think this will translate into 12% operating margins, or ~300bps higher than today and ROIC will improve dramatically.

In addition, Lowe’s is expanding its leverage target from 2.25x to 2.75x EBITDAR in order to free up cash flow for the equity.

This all seems to be a tough and a bit of a stretch. While $370 / sq ft is still behind HD, I try to detail my view on earnings if this were all to happen. I can see how you would get 110bps of margin expansion all being equal, but the company is also talking about investing in additional supplies, new technology, additional sales staff… all to support the Pro and help close the gap. That will cost something and doesn’t appear reflected in their goals.

However, as I look at consensus estimates, this isn’t totally priced in either. Street estimates show EBITDA margins expanding to 12.2% from 10.6% by 2021, so still high but not giving full credit. There is some doubt in the numbers which is good. It still seems rather optimistic to me, however.

Is it reflected in the valuation?

If I pull a list of comps for Lowe’s, I of course need to look at Home Depot, but I also need to show other defensible retail. I view the Home Depot and Lowe’s duopoly as similar to the auto repair stores. The customer service and experience drives customers back to their stores and there is some moat that Amazon will have trouble crossing. That said, if you don’t have the part in auto retailing, you lose the sale. Seems rather analogous to our discussion here.

Dollar Tree and Dollar General also remind me of HD and Lowe’s. Two formidable competitors that serve a niche part of the market. Finally, I also think Walmart, TJX, Ross Stores and Target need to be included as they are retailers known for their powerhouse supply chains and ability to survive in a tough retail environment.

In each case, Lowe’s screens as pretty cheap. But given what we know, would you buy Home Depot vs. Lowe’s?

Unfortunately, it is too simplistic to just compare multiple of earnings or EBITDA. We have to also take into account ROIC. Lowe’s is currently around a 12% ROIC while Home Depot is ~25%. If we were to run a DCF on these two companies and assumed they grew at the same rate and had similar WACCs, the one with the higher ROIC would clearly receive the higher multiple. Here is a brief summary with made up numbers:

Now compare to company 2…

If you then factor in that Home Depot has been crushing Lowe’s in growth, you have the formula for a much higher multiple that is warranted. Lowe’s is just trying to close the gap, but during this time, Home Depot won’t be standing still. It could reinvest more in new projects that extend its runway.

In sum, I think that Lowe’s has a formidable competitor. While I like that they realize they were asleep at the wheel and have a former HD exec running the ship now, I am a bit afraid that HD will still be pulling away while Lowe’s is trying to catch up. I want to root for the underdog, but I’d probably put my money on HD outperforming Lowe’s.

Hudson Q2’19 Recap: Earnings in-line with pre-release, negotiations with PNC continue. No change to thesis $HDSN

Hudson’s earnings were in-line with the pre-announcement. Unfortunately, there is no real update with the covenant relief. As stated in my last post, HDSN is in violation with its covenant with PNC. PNC can either bankrupt the company, likely taking a haircut on their debt or owning the re-org equity in a tiny company, or provide relief and continue to collect interest and possibly full payment. These discussion are ongoing, but I have a feeling PNC And the other lenders will choose option 2 over option 1.

As larger refrigerant manufacturer Chemours noted, refrigerant prices were impacted in Q2 by illegal imports into Europe. This pressured prices which eventually bled into US prices. As such, HDSN reported a 19% sales decline to to price, but a 12% increase in volumes. The volume growth is pretty good in the context of unseasonably cool Q2.

Moving to the forward look, the company noted this on its earnings call (my emphasis added):

As we move through the back half of 2019, we draw closer to the end of R-22 production. In June of this year, 3 largest allocation holders notified that customers that they have discontinued the sale of R-22. This information reinforces our belief that stockpiles are dwindling and that possibly, by the end of this cooling season, the industry may have worked through its stockpiles. Upon the elimination of R-22 to stockpiles, we expect that the R-22 market will operate within a traditional supply demand model and that the negative price influence we’ve seen during the past 2 seasons will be alleviated. It’s important to note that the pricing pressures of the last 2 seasons were created by the 3 largest allocation holders, which we believe related to market dynamics, that had nothing to do with R-22 demand in the U.S. rather we believe these pricing pressures were associated with shortfalls in other areas of our businesses.

Given the existing installed base of R-22 equipment and with the elimination of Persian production, we expect to see a shortfall in the supply of R-22, and we believe our ability to reclaim and resell R-22 creates a tremendous opportunity to position Hudson to address the anticipated supply shortage and become the leading producer of R-22. Currently, we’re seeing R-22 pricing of approximately $9 per pound, while this pricing dynamic has negatively impacted our 2019 selling season to date, we expect that the R-22 market will demonstrate more traditional supply-demand behavior once production has stopped, which will result in increased pricing for R-22.

In sum, management’s thesis is unchanged.

As for the debt, the company disclosed it will be getting a $9MM payment from Airgas for a working capital adjustment. That may seem small, but helps with some breathing room. PNC has been getting monthly details on HDSN’s performance so seems like it knew there would be a breach so hopefully conversations end soon.  Can’t help but like this statement:

We didn’t generate cash relative to our increased interest rates and debt services and so forth. So that really [indiscernible] get into what cash we generated, but the we had to have a little bit more borrowings during the period. We’re good at come out of that cycle though. We originally thought we would generate about $20 million of free cash flow. We’re not going to generate that level but certainly, with the cash award that we have with the Airgas, we’ll probably end up being in the mid-teens for the year. So you’ll start to see the dead coming down and the availability increase over the remainder of the year.

Mid-teens FCF on a $20MM market cap company… I’ll take it.

The company also mentioned its looking to tap new lenders in the 2H’19.

Certainly, we should and have publicly said that we will be looking to seek new lenders in this back half of ’19. That is our intention. But we also need to resolve the matter with the current lenders relative to a wavier and amendment to get that behind us

These likely will be more of the “special situation” type lenders, so may come at a price (and possibly new equity or some hybrid type of security that might include PIK interest to help cash flow, but I’m just hypothesizing here). This too is good news. No bankruptcy is good news.

Disappointing Q, but asset sales will help close value disconnect $CPLG

Clearly a challenging Q and guide down from CPLG. To recap earnings, RevPAR decreased 6.1%, but adjusted EBITDA came in ahead of expectations at $46MM and street estimates of $36MM. However, due to an issue discussed more in detail below, as well as pressure on oil markets, the company reduced EBITDA guide to $155MM (down 13% from prior) and expects RevPAR to decline from -4.5% to -2.5% (from +1%).

This guidance assumes that disruptions that occurred in 2Q continue through the balance of the year (mgmt noted RevPAR was already down 5.1% Y/Y in July).

Disruption Event

From the call, it sounds like the company had issues with its “revenue management tools, customer interfaces and the administration of corporate and group bookings” which had an adverse impact on the business. This is run by Wyndham, which is technically the property manager on CPLG’s properties. CPLG noted because of this disruption, “there are several events of default under the management agreements relating to all of our wholly owned properties.” This also seemed to be the main driver of the guide reduction.

For the second quarter, total U.S. industry RevPAR grew 1.1%, and RevPAR performance in the upper midscale, midscale and economy chain scales in the quarter was 0%, down 0.7% and up 1.7%, respectively.

As a result of our 6.1% decline in comparable RevPAR for the second quarter, our comparable RevPAR Index declined 455 basis points.

We believe this underperformance is well outside normal expectations and reflects the impact of an adverse disruption to our business.

It remains to be seen what remedies will occur under this. Wyndham likely will fight these claims, but considering the disruption at CPLG one could envision that it is owed monetary damages from the lost earnings (and not to mention stock price).

For now, it will continue to pressure earnings… but I continue to think that misses the point of the whole story behind CPLG….

Asset Sales

The company’s asset sale program continues to go very well. To highlight some data points from the call:

  • Sold 3 hotels in May for $16MM
  • Sold 1 hotel in Illinois that was non-operational for $3MM
  • Sold 7 non-core hotels in July and August for $29MM, the average hotel-level EBITDA was 1,200bps below the company average
  • “We have 27 hotels under contract with qualified buyers, expected to generate over $100 million of gross proceeds at pricing in line with our initial expectations, which we expect to close by the end of the year”

Let’s recap what they’ve sold and announced thus far then:

This is clearly accretive to the equity, whether they pay down debt or buyback stock. A dollar of debt paid down is a dollar to the equity. 

So two questions we can ask ourselves is: What will the rest of the ~36 hotels be sold for?  And two, why don’t they find more hotels to sell?

Well, to answer question number two, it seems like mgmt is open to that:

“Given the early success we’ve seen in our noncore asset sales, we will continue to evaluate the composition of our portfolio in order to drive long-term shareholder value.”

If the rest of the hotels are sold at 20x EBITDA, we know they generate ~$5MM of EBITDA based on the presentation posted. That would be another $100MM in proceeds. This foots to management’s quasi-guide: 

“These hotels typically trade on revenue, and we’ve targeted a range of generally 1.5x to 2.5x revenue. To date, we have been well within that range, which could translate to potential gross proceeds of at least $250 million, if we are successful in disposing of the noncore portfolio in its entirety. “

Valuation

Given the fact that the asset sales have gone so well, I would strongly encourage more or a sale of the whole company at this point. We know from this chart there are a lot of hotels that have less than 25% EBITDA margins and those could be added to the list. 

In the meantime, I think the valuation on CPLG is fine, not overly compelling when solely looking on EV/EBITDA. Again, the real story is selling assets well above BV and closing the gap. Book value remains above $20/share. I think mgmt should focus on more sales to realize value.

Hudson Technologies delays 10-Q filing due to covenant negotiations. Disclosure seems positive, all things considered $HDSN

After close on Friday, Hudson filed a late filing notification with the following statement:

Hudson Technologies, Inc. (the “Company”) was not in compliance with (i) the total leverage ratio covenant, calculated as of June 30, 2019, set forth in its Term Loan Credit and Security Agreement, as amended, with U.S. Bank National Association, as agent, and the term loan lenders (the “Term Loan”) and (ii) the minimum liquidity covenant under the Term Loan at July 31, 2019. The Company was also not in compliance with the minimum EBITDA covenant for the four quarters ended June 30, 2019 set forth in its Amended and Restated Revolving Credit and Security Agreement, as amended (the “Revolving Facility”), with PNC Bank, National Association, as administrative agent, collateral agent and lender, PNC Capital Markets LLC as lead arranger and sole bookrunner, and such other lenders thereunder.

 

The Company is currently seeking a waiver and/or amendment from its lenders under both the Term Loan and the Revolving Facility, which the Company is working to complete on or before August 14, 2019. As a result of the impact of foregoing discussions, the Company is not in a position to file its Quarterly Report on Form 10-Q for the quarter ended June 30, 2019 (the “10-Q”) on a timely basis. The Company is working diligently to resolve these matters and management currently believes that the Company will be in a position to file the aforementioned 10-Q not later than August 14, 2019.

This should be relatively in line with market expectations, given Hudson is trading at ~$0.50 which implies the market is expecting bankruptcy.

Although Hudson will not comply with its covenants, I think it is relatively positive language that was posted. Clearly, PNC is negotiating with the company. This makes sense. Does PNC really want to take this tiny company to bankruptcy? If it did, it probably would only recover some of its par amount of debt and would own the re-org equity of the company, which would be highly illiquid. Alternatively, PNC can give some leeway, allow the company to continue operations, and hopefully realize a full recovery.

I take it as a positive that they’ll have an answer by Wednesday, August 14th. My base case is PNC will require some debt paydown or higher rate in exchange for relief, but we shall see. Net, net – I “PNC” the light…

Hudson also noted:

For the quarter ended June 30, 2019, the Company’s revenues were $56.0 million, a decrease of 3% compared to $57.8 million in the comparable 2018 period. The Company recorded lower of cost or net realizable value adjustments to its inventory of $9.2 million and $34.7 million during the second quarter of 2019 and 2018, respectively. Due in part to the impact of the inventory adjustments referenced above, the Company’s preliminary net loss for the second quarter of 2019 was $13.7 million, or ($0.32) per basic and diluted share, compared to a net loss of $30.6 million or ($0.72) per basic and diluted share in the second quarter of 2018.

The sales line is relatively in-line with my expectations. I was expecting ~flat sales, driven by 5% lower sales pricing, offset by higher volumes, but my guess is temperate weather reduced demand.

We know net loss is $13.7MM.  From this, we can bridge to what EBITDA likely was:

This seems less than ideal, but remember that PY was negative $2mm so all things considered, I guess we’ll call that improvement. It’s lower than my $5mm estimate, though. Hopefully the company drew down on inventory, which it still has $100mm in value of, to generate some cash and pay down debt. Recall the company repaid $30MM of debt in Q4 of last year, mainly driven by a release in W/C.

What will really matter is Q3 outlook. I presume pricing has not improved for refrigerants, but I also think Q2 was impacted negatively by weather (which was called out by Watsco and Lennox, among other building products names). If Hudson’s Q3 looks more favorable, perhaps PNC will be more lenient.

Deja Vu Part Deux: This Market Seems Eerily Similar to Recent Past $SPY $TLT $GLD $USO

“It’s like deja vu all over again” – Yogi Berra

With China letting the yuan slide and the U.S. labeling the country as a currency manipulator, it reminded me of something I’ve seen before. And not that long ago.

In my last post on this, I noted how similar this market felt to the 2015/2016 market. To briefly recap what I noted in that post:

  • Oil has tanked: Oil was $75 / bbl in last October and now is ~$54 / bbl today. That is nearly a 30% decline. It is also down ~8.5% in just the last five days.
  •  Earnings have been lackluster: While 76% of companies have beaten consensus estimates, they have been a number of earnings revisions lower and pre-released numbers that have guided down expected numbers. The blended earnings decline for the S&P so far has been -1%. If the rest of the market ends up being down, this will be the first time we’ve had 2 consecutive earnings declines since Q1’16 and Q2’16
  • People are concerned about China: This time it is a little different, but what hasn’t changed is that China is a black box and people are concerned this time that the tariffs are negatively impacting the economy there.
  • Interest rates plunged: Due to market concern and fear, the 10 year treasury hit 1.6% in early 2016. It is now at 1.7% after being at ~2.5% for the rest of the year. Notably, the S&P dividend yield also exceeds the treasury yield like it did back then.

Now, a new deja vu candidate has emerged. On Monday, China allowed its currency to dip to levels not seen in over a decade. But wait… Can anyone name when this headline came out?

The S&P declined 4% this day… So when did it come out? This news came out almost exactly 4 years ago in August 2015. Please read each of these articles and note how similar they sound to today:

The interesting thing about the devaluation concern now is that it is much less than the devaluation that occurred back then. It also continued to devalue against the US dollar throughout 2016, but people seemed less concerned:

Note: I nabbed this picture from the WSJ here

Should we prepare for a further sell-off? Or does last time teach us that this news was overblown? Did we narrowly skate by last time and this time is the real signal?

I tend to think that the market is most concerned about uncertainty, which causes this perpetual fear with China. It is a persistent unknown. Does it surprise me that a dominate export country is devaluing its currency (that was long pegged against the dollar) to entice more exports? No. Especially in light of the tariffs.

I think China clearly must be facing some pain, but the fact of the matter is that the US earns very little revenue from Chinese sales. We import from them, we don’t sell that much to them (in the context of earnings in the S&P, that is). I think further concern on China can and will eventually cause a real market correction, but I’ll likely be buying that dip based on US earnings likely being relatively resilient in that situation (outside of commodities, which could get crushed from lower infrastructure building in China).