Tag: cheap stock

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

B&G 2018 Wrap Up: Not even the Green Giant is immune to food sector challenges. Been wrong on the name so far, but reaction creates solid entry point + high dividend. $BGS

Reading Time: 3 minutes

B&G reported Q4’18 EBITDA of $59MM compared to $69MM in the prior year. While this was partially impacted by the sale of Pirate Brands to Hershey, it was still a tough comp due to input cost inflation (freight, procurement, as well as mix). As a result, EBITDA was 200bps lower as a % of sales than the prior year.

I expect B&G’s stock will react negatively to this (already down 10% after hours to $22) and I am disappointed with the stock’s performance since I wrote on it first in Aug 2017 (down ~25-30% depending on where it opens).

That said, I think there are a few positive take-aways from this quarter that will keep me grounded. Bottom line, I still think B&G is a long-term compounder. Food sector sentiment is particularly negative right now (especially with the KHC news) and 2019 should be an easier comp from a freight and inflation perspective.

  • Green Giant Continues to Grow at Attractive Levels, Despite Challenges in Shelf Stable:
    • Green Giant’s sales increased 4.9% this Q and grew 6.1% for the entire year. This has been mainly driven by new innovations in the frozen food aisle that have countered challenging trends in the canned, shelf stable category (down 8.2% for the year).
    • Part of the thesis in buying B&G is that these managers are good at buying mature assets, harvesting the cash, and restarting the process (rinse & repeat). They sold Pirates Booty to Hershey for $420MM after they bought it for $195MM in 2013. I continue to think Green Giant was a solid acquisition.
    • Given there are many other consumer staple brands struggling to date, I think this is an opportunity for B&G. They repaid $500MM of their TL with help of the Pirates’ sale so that also adds some capacity.
  • Company is managing other mature brands well. Would you have believed me if I said Cream of Wheat increased sales 4.3% this Q? Or Ortega was up 7.2%? Excluding Victoria, which saw a $2.5MM decrease in sales from a shift in promotional activity, I think the company is doing a good job with this portfolio.
  • Continues to generate significant FCF to support dividend. B&G pays $1.90 dividend which based on the after-hours quoted price currently amounts to a 8.6% yield. Typically, dividend yields that high imply the market thinks there is risk of being cut. Setting aside the fact that the company generated $165MM of FCF this year (reduced a lot of inventory), I still think the dividend is covered.
    • Using ~66MM shares outstanding, this implies a $125MM cash use.
    • Based on the company’s guidance range, this implies you are ~1.3-1.4x covered.
    • Said another way, based on my FCF walk, we would need to see EBITDA decline 17% from the mid-point of guidance for it to be 1.0x covered.
BGS Dividend RIsk

Personally, I’d prefer if the company bought back a significant amount of stock at these levels. Unfortunately, the stigma of keeping a dividend out there forever (which is dumb) prevents that from happening (as the stock would get crushed).

Guide from the company:

BGS Guidance

Realogy Q2’18 Recap: Some puts and takes, but solid beat sends shares up. Still think the stock looks too cheap despite industry pressures

Reading Time: 2 minutesWhen I told some peers that I thought RLGY might be worth over $40/share, I was told I was nuts. The secular pressure on commission splits was too much to overcome… Realtors are going to be replaced with the internet…. RLGY is losing share… blah blah blah…

OK it is too early to celebrate and all those arguments haven’t been proven wrong yet, unfortunately. But the important thing is that RLGY had a good Q2’18. The company posted $276MM of EBITDA compared to estimates of $268MM. The main reason for the beat unfortunately was some of the more non-core segments like Cartus, the relocation business. NRT, the owned brokerages underperformed again and EBITDA was down 22%, from $78MM to $61MM. The company expects split pressure to moderate in the 2H, but this seems to be a clear issue.

RLGY Q2'18

On the flip side, when looking at Realogy from a behavioral standpoint… every one is trying to avoid the company. It is unloved and the split pressure is known. To me, if they perform moderately better than expected (and continue to buy back stock with their tremendous FCF) then we as investors will do OK, though there may be some significant volatility.

RLGY still trades at 8.7x 2019 EBITDA, which seems too low to me given the cash flow here. Taking a look at another franchisor, Dine Equity (franchises IHOP, or IHOB, and Applebees) is undergoing significant pressure and trades at 10x 2019 EBITDA.

I’m sticking with it… Heck, given all the LBOs that have occurred recently and the enormous war chest PE firms have gathered,  I wouldn’t be surprised to see someone try to re-LBO RLGY. I know, I know, that is a weak argument, but you never know.

-DD

Cheap building products stock trading with at near 12% FCF yield

Reading Time: 3 minutesI’ve written previously about competitive advantages, moats, and investing in high quality businesses. That’s the ideal scenario. But sometimes, the valuation can be so attractive that the investment case is still strong.

I posit that Atkore International (ticker: ATKR) is now too cheap to ignore. Management seems focused on this as well, having repurchased a large portion of stock (26.5% of shares outstanding) from the former Sponsor owner, CD&R.

Atkore is a leading manufacturer of electrical raceway products and tubes that are used in a variety of construction applications.  The Electrical Raceway segment (65% of sales) is a leader in products that isolate, deploy, and protect electric circuitry as it moves through a building. The products include armored cable & fittings, steel and PVC conduit, and flexible conduit and cable trays. The Mechanical Products & Solutions segment (the balance of sales) manufactures in-line galvanized tube, metal framing and fittings, and other mechanical products used in non-residential construction.

I think it helps to see what these products include, as shown below.

ATKR Products

Atkore generates roughly 85% of its sales from markets where it is the No. 1 or No. 2 player. Products are distributed through national electrical distributors such as WESCO, Rexel, and Graybar, independent electrical distributors, industrial distributors including Grainger and Fastenal, and big box retail including Home Depot, Lowe’s, and Menards.

When you look at these products, its really hard for me to see how “secret sauce” is involved with manufacturing these products. However, you would probably be surprised to learn the company has 15% EBITDA margins and capex has averaged <1.5% of sales for the past 5 years. That brings me to one of the metrics I tend to follow and that is unlevered FCF conversion. And by that I mean, (EBITDA-Capex)/EBITDA as a percent. The reason why I like to look at this is to move beyond some business that might have lower EBITDA margins (like distributors with 3-7% margins), but convert a lot of that EBITDA into FCF. Typically FCF conversion greater than 80-85%+ is a really solid business. ATKR averages 90%.

ATKR unlevered FCF

Now you can see that 2015 was not as high as the past 2 years. That is because ATKR undertook a significant portfolio restructuring, as summarized in the company’s slide below. The company divested low margin product and focused on higher margin product where it had strong market share and areas where it could raise price. Raising price is important part of the story here, as that extra price drops straight to the bottom line. EBITDA margins were less than 6% in 2011, moved to 15% by 2017 and their long-term goal is to reach 20% EBITDA margins.

ATKR Transformation

Now to valuation. ATKR trades at a significant discount to peers. Most building products companies right now are trading at 10-12x and a FCF yield of about 5%. As can be seen below, ATKR is trading well below that and will generate a significant amount of its market cap in FCF. This provides flexibility for the company to pay a dividend, acquire additional companies, buy back stock, or even down debt (which builds equity value).

ATKR FCF Walk

One quick comment about the projections – the top line growth expected in 2018 is mainly due to an acquisition and the moderation in 2019 is due to a divestiture. I do not expect much growth in 2020 just as we get to a more mature place in the cycle. Either way, the stock is too cheap to ignore.

Even using a 7% FCF yield, which foots to less than 9x EV/EBITDA, the stock has significant upside.

ATKR Price Target

Now, the risk here is really the non-residential cycle. It could quite possibly be near peak or slowing down, but I don’t think my assumptions are too aggressive.

Let me know what you think.

-DD

Business facing headwinds, but cheap + Strong FCF generator = Buy. RLGY Stock Pitch

Reading Time: 8 minutesReal estate brokerage is a competitive business. The business doesn’t have that much barriers to entry, so the reason why someone chooses to work for a company like Realogy is the brand. The brand attracts the first call from a buyer looking for guidance and the brand helps drive leads. But currently, agent retention is under pressure given how competitive the market place is which in turn is pressuring commission splits, that is, the % of commissions that are split with Realogy.

However, I hope to explain over this write-up why despite these pressures that RLGY is a strong buy at current levels.

The thesis comes down to the following points:

  • U.S. Housing is still recovering, despite being 10 yrs after the prior cycle. Continued homes sales will drive additional volumes for RLGY
  • Largest real estate brokerage in the US, but asset-lite given franchise model. This leads to solid FCF
  • Company is turning focus to organic initiatives and returning excess cash to investors, rather than its previous M&A strategy

In sum, my PT on RLGY stock is $45, which foots to a 7% FCF yield to equity .

I will also attempt to answer some questions that people have on the business, such as the value realtors provide and their long-term place in the market.

U.S. Housing Still in Recovery Mode

No matter how you cut it, it is clear that US single family housing starts are still well below long-term averages. In fact, the ~850k starts in 2017 was the low point in some prior housing cycles. Part of this slow recovery was obviously overbuilding in the last cycle, but also the tepid recovery in the economy. In addition, permitting processes have lengthened and finding skilled labor to buy homes has been tough now that employment has tightened.

US housing Starts

However, since the financial crises, the population has not stopped growing. What did change, was household formations. As people decided to move in together to save on rent or as those darn millennials stayed with mom and dad longer, and put off getting married and starting a family, it also put off new household formations which is the #1 driver of starts.

If all 30 year olds lived with 1 other roommates, there would be 1 house per 2 people for a headship rate of 50%. Changes in these headship rates have had a negative impact on housing growth. According to Joint Center for Housing, “from 2010-2015, when population growth and change would have produced 1.39 million additional households a year, [but] declines in headship rates reduced that growth by nearly 200,000 households per year.”

JCHS Headship

If you look at recent formations data, the positive news is that home owner formations are growing now at the expense of rentals, a sign that this trend of buddying up is starting to reverse and that the american dream to own your own home was delayed, not abandoned.

What does this mean for RLGY? Well, the 2 drivers of RLGY’s business are sales of existing homes and prices. Why am I discussing new home construction? To point out the current market is under-supplied relative to the amount of pent-up demand there is in the system. And if you review homebuilders’ earnings calls, you will find that they simply can’t find labor or lots to build homes. This should keep a cap on incremental supply which will lead to increased sales of existing homes + buoy prices.

As can be seen below, housing inventory remains near all time lows. While this will limit RLGY on the volume side, the price side of its transactions should move up meaningfully.

Existing New and old homes

Asset-lite Business Equates to Strong FCF

RLGY is a service business and therefore it has a low asset base. In addition, most (~65%) of its earnings are derived from the franchise fees of its brands. It is the franchisor of some of the most recognized brands in the industry including Coldwell Banker, Sotheby’s, Century 21, and Better Homes and Garden Real Estate.

It also has its own company owned real estate brokerage service, a title insurance business, and an employee relocation service (Cartus).

But the bottom line is this is a franchise business model which generates significant FCF (as the franchise business carries 65-67% EBITDA margins).

Based on my estimates, I see RLGY generating ~$400MM of FCF in 2019, which is slightly over 13% of the company’s $3.05BN market cap. In other words, they could buy back over 10% of their company’s stock each year and still accrue cash.

First and foremost, I need to answer the question of, “what value does a real estate agent / broker actually provide?”. Buying a house is a significant commitment and lots of people I know have anecdotally not had great experiences. But hey, real estate is an inefficient market and that is part of the appeal from an investing standpoint.

Do realtors earn their fee? Let me first quote Warren Buffett at his latest annual meeting: “The purchase of a home is the largest financial transaction for a significant percentage of the population. A lot of people need a lot of attention. A realtor can show a lot of houses before they sell one.” He then noted that while real estate agents make a decent living, asset managers make “far more money with less welfare to the client.” He then said he would continue to acquire brokers in the future.

At the end of the day, however, a seller of a home doesn’t need to use an agent in order to execute a deal. However, the National Association for Realtors recently reported that in 2017, “87% of buyers purchased their home through a real estate agent or broker—a share that has steadily increased from 69 percent in 2001… 90% of sellers used a real estate agent” Why has it increased? Well for one, the service is free to buyers. The seller pays the commission. Also, a realtor can provide some value-added advice. For example, the same statistics highlight the median realtor has 10 years experience. This means they likely know the neighborhoods that are of higher quality, and that ranks higher on peoples list of desires compared to overall home size. Another study by NAR found that sellers that use an agent on average sell their home for more than if they otherwise did not use one. Since the realtor is paid based on the transaction value, they are aligned to get the best price.

Do I think Zillow and other services like Redfin will pressure the industry? I think these services will probably make the market more efficient from the perspective of what home values are, but again, that’s just one factor. Realtors also have a network in the industry that may help expedite a transaction that zillow will not.

MLS is another barrier to entry. MLS is essentially a listing of every home for sale or rent that is represented by an agent. In order to get into MLS, you have to have an agent. Zillow and Trulia, to my knowledge, do not. Only agents can search this database of homes that is right for their clients. While this may not last forever, it is something that provides some competitive moat.

Realtors do provide value

I need to answer the question of, “what value does a real estate agent / broker actually provide?” to continue this pitch. Buying a house is a significant commitment and lots of people I know have anecdotally not had great experiences. But hey, real estate is an inefficient market and that is part of the appeal from an investing standpoint.

Do realtors earn their fee? Let me first quote Warren Buffett at his latest annual meeting: “The purchase of a home is the largest financial transaction for a significant percentage of the population. A lot of people need a lot of attention. A realtor can show a lot of houses before they sell one.” He then noted that while real estate agents make a decent living, asset managers make “far more money with less welfare to the client.” He then said he would continue to acquire brokers in the future.

At the end of the day, however, a seller of a home doesn’t need to use an agent in order to execute a deal. However, the National Association for Realtors recently reported that in 2017, “87% of buyers purchased their home through a real estate agent or broker—a share that has steadily increased from 69 percent in 2001… 90% of sellers used a real estate agent” Why has it increased? Well for one, the service is free to buyers. The seller pays the commission. Also, a realtor can provide some value-added advice. For example, the same statistics highlight the median realtor has 10 years experience. This means they likely know the neighborhoods that are of higher quality, and that ranks higher on peoples list of desires compared to overall home size. Another study by NAR found that sellers that use an agent on average sell their home for more than if they otherwise did not use one. Since the realtor is paid based on the transaction value, they are aligned to get the best price.

Do I think Zillow and other services like Redfin will pressure the industry? I think these services will probably make the market more efficient from the perspective of what home values are, but again, that’s just one factor. Realtors also have a network in the industry that may help expedite a transaction that zillow will not.

MLS is another barrier to entry. MLS is essentially a listing of every home for sale or rent that is represented by an agent. In order to get into MLS, you have to have an agent. Zillow and Trulia, to my knowledge, do not. Only agents can search this database of homes that is right for their clients. While this may not last forever, it is something that provides some competitive moat.

Self-help Story

The company wouldn’t trade where it does if it was a straightforward story. That’s partly what makes investing challenging, yet fun. Realogy is sensitive to what is “split” with the agents. While commission rates have been relatively stable over the past 10 years, splits have moved from 65% of sales to nearly 71%.

To put it in context of RLGY, lets say they represebted 350k home sales (volume) at an average price of $515k. Collecting a commission of 2.4% would bring in $4.3BN of gross revenue (note, this is very similar to what RLGY’s NRT segment did in 2017). If splits were at 65%, then earnings before other costs (such as marketing or corporate costs) would be $1.52BN. However, at 71%, it is $1.36BN, or 17% lower.

This has been less-than-ideal for RLGY and although mgmt has said they expect commission split pressure to moderate, I still model it increasing over time moving from 69.6% at the end of 2017 to 70.8% by YE2019 (as a % of company-owned brokerages). However, there is a new CEO in place that is focused less on M&A and more on reinvesting in the core business. This includes investing in technology and hopefully curbing the split pressure the business has faced. This is a risk to the thesis, but with a stock this cheap, there seems to be plenty of room for error given little success is actually priced in.

Bottom Line: I model ~$400MM of FCF on $870MM of EBITDA for RLGY in 2019, which foots to a 13% FCF yield. This is well in excess of the 5% FCF or less that the average S&P 500 company trades for. Targeting a 7% FCF yield, acknowledging there are some pressures on the business, my PT on RLGY is $45, which represents ~85% upside from the closing price of $24. Again, I think positive fundamentals plus strong FCF will at least provide a floor in the near term and give upside to the stock as the company uses the cash to repurchase shares.