Tag: Compounder

WD-40 Stock: Breaking Down the Bull Case and Valuation $WDFC

Reading Time: 10 minutes

Something different today – I’m going to make a counter argument on a battleground stock. WD-40 stock is one of those names that easily is discarded by analysts for trading at too high of a multiple (myself included, typically). But comparing multiples is not valuation.

For context, WD-40 multiple can be defined as high – currently trades at 35x EV / LTM EBITDA and ~52x price to LTM EPS – and it has expanded significantly over time, too.

Again, this is not valuation. In fact, as I try to lay out in this next chart, you could argue that WD-40 stock has been consistently undervalued by the market. Obviously hindsight 20/20 with a share price going up.

But the red line shows the price where you could buy the stock versus the orange dashed line which is where you would need to buy to realize a 10% IRR (ex-dividends).

Therefore, I’m going to try to look at WD-40 stock with fresh eyes.

I do have biases, so I am going to lay those out upfront. However, I will not cling to any of those biases in my model.

Here is my assumptions about WD-40 stock and why it trades so rich:

  • Interest rates are very low. WD-40 is a high quality company, has little debt, and probably grows at GDP+.
  • If I’m a large diversified asset manager, such as a pension fund, and I need to invest in something for 30 years, I can either pick a ~1-2% bond or a high ROIC company that has staying power and will grow earnings above GDP.
    • The choice obviously isn’t that simple, but bear with me.
  • WD-40 stock also has a 0.85% dividend yield at the time of writing, which will probably grow vs. be fixed with a bond
  • As such, as rates have continued to decline over time, the multiple paid for WD-40’s earnings have gone up
  • In essence, this is a classic “bond proxy” stock. And investors will get punished severely if rates rise.

Again, that’s just my bias as I look at WD-40 stock and I think previously, that would have caused me to do zero work.

Here is a waterfall chart outlining the source of WD-40 stock returns. As you can see, most of the shareholder returns come from multiple expansion (used to trade at 20.5x LTM EPS in 2006 and now trades at ~60.0x:

So I’m going to ignore this narrative for now and ignore the valuation and just plug into (i) the business, first and (ii) what management is saying that could drive the stock higher.

First and foremost, here are some of my initial takeaways (some obvious):

  • WD-40’s name comes from “Water Displacement, 40th attempt”. Basically a secretive lubricant.
    • There are some other facts, myths, and legends on their website, including a bus driver used WD-40 to remove a python from their undercarriage.
  • WD-40 is an excellent company.
    • Highly recognizable brand is worth something that is hard to quantify
    • Earn extremely high returns on invested capital (ROIC) – I estimate ~65% pre-tax in TTM
    • High ROIC is also demonstrated by high margins, low capex: they have 24% EBITDA margins and spend 1.5%-2.0% of sales in capex.
  • LT target is to operate under the 55/30/25, which is 55% gross margins, 30% cost of business, and that implies 25% EBITDA margins. They are already pretty close to these metrics.
  • Management is pretty conservative and leverage is consistently low (0.5x net debt to EBITDA)
    • Management lays out their multi-year initiatives and harps on those initiatives. Every… single… call…
    • Management has also been consistent… like, the people themselves. Garry Ridge has been CEO since 1997.

Some other things I learned after further work:

  • I expected WD-40 to be a big emerging markets play. It kinda is, but not the way I thought.
    • Yes, 65% of revenues come from outside the US, but a lot of that is developed or developing Europe, LATAM, or Australia.
    • China is $15MM of sales in the TTM, which is just ~3.5% of total sales. India is also small.
    • If you think they can win emerging Asia – that growth is still on the come. If WD-40 can be as successful there as it is here in the US, then there is a long runway for growth.
    • Over the long run, they expect to grow APAC 10-13% annually.
  • WD-40 sells through distributors in new regions and slowly moves into direct sales model
    • If I were an investor, I’d actually be frustrated with how slow China growth for WD-40 seems to be.
    • One benefit of WD-40 though, as mentioned, is that they’ve had the same CEO for 2 decades and he’s remarkably consistent.
    • Here are his thoughts from a 2006 earnings call when they first entered China:

    • You can actually see this play out in the employee count. However, I wouldn’t really call it a “success” so far. They aren’t really getting better and better leverage on employee costs.
    • Sales per employee (blue line) is consistently going down, which is counter to what I would have thought.

    • Ridge, the CEO, knows China is key as he said in an interview in 2015 and the commentary makes total sense to me.
    • For context, he brings up factories because an average household consumer maybe uses $0.40 of WD-40 per year. Someone in a workshop may use $40-$70 per year.

  • This is a small company. They do just $435MM in revenue and $106MM in EBITDA.
    • Seems like a conscious decision. Whereas Rust-Oleum owner, RPM, uses cash to buy other brands, WD-40 basically said it doesn’t want to do that – it doesn’t want to di-“worse”-ify.
    • Instead, they are focused more on “specialist” brands, such as a silicone lubricant, bike chain lube, or marine grade products, among many others.
    • It is unclear whether that’s really the best approach, but I can’t argue with their shareholder returns so far.
  • Growth has been… just OK. Sales have grown at a 3% CAGR for 14.25 years and EBITDA has grown at 5%. Excluding the run-off products discussed below, sales have grown at a 5% CAGR, too.
    • I will say this is basically all organic. And if we go back to “bond-proxy” status, earnings held up pretty well in the GFC (were down 15% from peak, but snapped back fast) so the reliability of those slow earnings is rock solid.
    • If all companies earned the same ROIC, then growth would be the only differentiating factor between investments. And WD-40 clearly is top quartile for ROIC.
    • But back to China / EM, I feel like management hasn’t pushed growth their enough. They do discuss it a lot on calls, but would expect sales to be much, much higher than current or even projected. They would drive so much more value given their ROIC if they pushed growth here.
  • WD-40 owns some home cleaning brands, but they are essentially in run-off and management expressly says they just harvest the businesses for cash (see how orange bars have shrunk)

  • The company (maybe not too unsurprisingly) spends little in advertising. It spends about the same each year in advertising as it did in 2006, yet gross profit is +60% higher
  • Capital allocation: investor in 2006 would have gotten all his cash back from FCF
    • In 2006, WDFC traded at 11.6x EBITDA, 20.5x EPS and ~23x FCF.
    • Not “cheap” by any means… The market cap was ~$576MM
    • As shown below, an investor then would have received more than the market cap through dividends and share buybacks since then.
    • Obviously left with a much more valuable piece as well

What type of Moat Business is WD-40?

Connor Leonard did a guest post on Saber Capital’s blog back in 2016, (Saber is run by John Huber and I highly recommend you check out his posts or twitter). In that, Connor outlined four different types of businesses: No moat, Legacy Moat, Legacy Moat with “Outsider” Management and Reinvestment Moat.

It seems to me that WD-40 could fall into one of the last three buckets. The brand value of WD-40 is clearly a legacy moat, but the question is whether or not there are really reinvestment opportunities.

I don’t really consider management here to be “outsiders” but it is hard to argue that earnings have been allocated poorly. The CEO also hasn’t succumbed to debt or M&A pressures by the market. So they haven’t been allocating dumb-ly.

As Connor says,

“[It is] the rare company that has all of the benefits of a Legacy Moat along with ample opportunities to deploy incremental capital at high rates within the current business. In my opinion this business is superior to the “Legacy Moat – Outsider Management” because it removes the variable of capital allocation: at the end of each year the profits are simply plowed right back into growing the existing business.”

WD-40 has plenty of opportunity to reinvest in China and India, but I also still think the capital required to grow there will be pretty limited.

And there lies the point of his post – introducing a fifth model of “capital light compounders.” Those that can grow earnings with very little capital. Instead of reinvesting into the business with long-runway, they systematically repurchase shares.

In my view, you are essentially creating a scarce asset. The powerful business is acquiring itself each year, and crowding out other purchasers of the shares each year.

Expectations Investing

I did a deep dive on WDFC and built projections on that. Frankly, I did them a bit more aggressively than I normally do, but I was using mgmt’s LT targets as a guide (they are shooting for $700MM of sales by 2025).

Frankly, that may be pretty hard target and I actually don’t have them hitting their sales target. Just look at their performance pre-COVID. It wasn’t on-track. However, I do have WDFC expanding margins as they leverage their costs better and beating the 25% EBITDA margin target. It seems to me they already have the infrastructure in place to grow Asia significantly.

I have them using their FCF to repurchase shares and pay their dividend.

While capex might look low, they’ve actually been overspending recently (the big bump in 2017 was building a new office building; in 2020 it was building capacity for their Smart Straw product). At the end of the day, that’s essentially what high ROIC means – they can grow FCF with limited incremental capital invested.

They can’t really buyback too much of the market cap each year at these levels.

DCF

I did a DCF which I don’t normally do, because they can be overly precise and subject to wide swings based on small assumption changes, but I wanted to back into a “what do you need to believe” case.

Firms create value when they’re returns on capital are higher than their cost of capital. The cost of capital, or WACC, is the return offered for the risk that the projected cash flows don’t occur as planned. If future cash flows are more uncertain, investors require higher rates of return for the risk.

For example, here’s the value of a firm under different ROIC vs. growth assumptions with a 10% WACC. If the firm earns < 10%, they are destroying value even if they grow. The important thing is that an already high ROIC business gains more value by growing faster, not by increasing ROIC a bit more (though a low ROIC business will do better by increasing ROIC). This furthers my frustration that China growth has been so slow.

WD-40 cash flows are highly certain (implying a low WACC) and given their ROIC is around 65%, there is a huge spread between this cost of capital and ROIC.

As you can see below, we get in the ballpark of the current stock price using a 5.5% discount rate and assuming the stock grows 3% into perpetuity. Cross checking that with the implied terminal EBITDA multiple, pretty interesting to see it is very high (~29x).

If WACC moved higher (to a not-even-high number), the stock could get crushed.

If you are saying this discount rate is too low… theoretically… it isn’t. Just theory and I’ll touch on this at the very end. Again going back to the stability of WD-40 cash flows, it results in a really low cost of equity. Debt is super cheap right now too, but they barely have any.

The other factor where this DCF is weak is the terminal value: the terminal value math implies a company’s ROIC will equal its WACC in the terminal period (because of competition) and growth steps down. It’s interesting that if I just stretch my DCF out 2 more years, I get a $350 share price (assumes 5.5% WACC and 3% LT growth rate) as WD-40 still earns more than their cost of capital.

Bottom line:

I think WD-40 is a great company and they will continue to compound earnings. I think I have a lot more appreciation for why it is valued like it is valued and hope readers do as well.

Will I be adding it to my portfolio? No.

The company is clearly earning high returns on capital… but I care about returns on my capital. And my opportunity cost is higher.

If a business could invest $1,000 in a factory and earn $400 in dividends, that’s a 40% return on capital for the initial investor. But if someone buys those shares for $4,000, they’ll only receive a 10% return on capital. Price matters.

But I will be looking for other names that are viewed as “too expensive” with perhaps faster growth and similar reinvestment runways.

March 28, 2021 Update: It has come to my attention that Greenwald dedicated part of his book to WD-40. Definitely worth a read:

 

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

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


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

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

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

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


Background

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

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

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

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

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

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

Masco's segment performance varied wildly in the last recession

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


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

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

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

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

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

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


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

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

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

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

Masco ROIC has improved meaningfully


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

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


Why Do I Think Masco Is Discounted?

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

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

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

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


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

How is Dollar General Only in the “Fourth Inning”? $DG

Reading Time: 6 minutes

“We have turned the clock back. We’re actually now only in the fourth inning. We see a tremendous runway ahead of us there”

CEO Todd Vasos didn’t mince his words. I’ve never invested in Dollar General stock before (to my detriment) because I thought the growth and reinvestment story had come to a close. That was wrong.

Despite being brick-and-mortar focused, they continue to excel in basically any operating environment. Their unique real estate strategy, where they set up low-cost buildings in rural towns as the one-stop-shop at affordable prices, is key.

I’m filing this post under my competitive strategy series because clearly Dollar General is a stellar retailer with unique strategy – and the stock has delivered excess returns.

Since the beginning of 2015, I’ve watched store count grow from 11.8k to ending 2020 with over 17.1k stores. That is a 46% increase!

Dollar General stock benefitted from this growth despite being an “old school” business — no FANG here, but with FANG-like returns. Coming from brick-and-mortar retail, no less.

They don’t appear to be overloading the system either. Going back to 1993 – Dollar General hasn’t had a year when SSS comps have declined.

So if you invested in Dollar General, you’d have benefitted from

  1. Growing stores
  2. SSS Comp increases
  3. Margin enhancement from this operating leverage
  4. A high ROIC / highly cash generative model (even now, Dollar General mgmt estimates the stores are a 2-year payback)

Ok, again. I missed all of that growth. How could one possible invest in Dollar General stock now? Especially with the dawn of e-commerce, is it rational to expect the company can continue to perform?

There are still a bunch of reinvestment opportunities at very high rates of return. I will outline six different ones the company is targeting:

  • DG Fresh – Increasing stock of perishable & frozen items. Self-distributing these products as well to control costs
    • This really started in earnest back in 2013 as DG increased the amount of cooler doors in their stores.
    • At the end of 2012, DG stated they had about 11 cooler doors per store. By the end of 2018, they had 20 doors per store. They expect to install 60k in 2020!
    • Dollar General continues to view this as the #1 sales driver going forward (again driving that one-stop shop mentality).
    • DG Fresh also entails distributing these items themselves to help lower production costs and improve in-stock position, enhancing their competitive positon.
  • The Non-Consummable Initiative (NCI) – Selling such as home decor products, seasonal items, or party items just as some examples.
    • These are higher gross margin and increase transaction amounts, which helps operating leverage on stores.
    • Seasonal items that rotate also helps the “treasure hunting” aspect in retail shopping.
  • New Store Formats (Popshelf). DG has about 17k locations… but that doesn’t mean it can’t use its infrastructure set in place for a new concept. Popshelf is a new store concept targeting suburban women, with products priced under $5 in the  seasonal, home decor and beauty products, as well as cleaning supplies and party goods.
    • This stemmed from the NCI work the company did.
    • Dollar General doesn’t take any decision lightly, so I think this could be a real opportunity and the US could easily support thousands of these stores.
      • As an aside, and call me crazy, but I could BIG as a DG acquisition target.
      • Popshelf reminds me of Big Lots, though I guess Popshelf doesn’t seem to be targeting furniture.
      • There would be immense synergies, with BIG benefitting from DG’s low cost distribution as well as scale on corporate costs.
      • Big Lots is still smallish with only 1,400 stores, but still has all the public company costs, back-office costs, HR, accounting, legal, etc. All of these could be scooped under the DG umbrella. It would give DG 1,400 more stores in a concept it wants to target.
      • BIG also trades at less than half the multiple DG does, so it would be highly accretive to DG.
  • Smaller format stores (<6,000 sq ft) for urban areas where Dollar General doesn’t currently target
  • Private label / Increased Foreign Sourcing. 
  • Other “Core” continuous improvement items like lowering “shrink” (i.e. theft), zero-based budgeting, etc

These are six items outside of tech-enabled strategies like Buy Online, Pickup in Store (BOPIS) or the ability to scan items on your phone to expedite check-out (both of which DG has been talking about for years).


Let’s put some math behind the go-forward opportunity

DG clearly has been a COVID beneficiary. I mentioned before that DG has had tremendous SSS growth over its history, but with expected SSS of +16% in 2020, I fully expect 2021 SSS may decline for the first time.

However, DG currently has more cash than ever on its balance sheet ($2.2BN). The next highest the company has had pre-COVID was $600MM back in 2011. It’s basically been around $200MM since then.

This tells DG has $1.6BN-$2.0BN of cash to invest. It means that they can pull forward many projects they have planned.

I estimate the unit economics for a new Dollar General branch based on what they’ve disclosed (the 2016 Investor Presentation was a big help) and what I know about other retailers. Clearly the returns are pretty good.

But what this really tells me is that each $1 that Dollar General invests is worth about $10 at maturity. This assumes no growth after year 10.

Said differently than above, $1.6BN to $2.0BN invested in the company’s growth will likely translate into >$16BN of value. The current market cap is $51BN.

Coincidentally, DG’s pre-tax ROIC on tangible capital averages >50% over time based on my numbers.

If they invest $1.6BN to $2.0BN at these kinds of returns (perhaps a big IF), that could mean a $800MM-$1.0BN uplift in operating income (estimated by assuming a 50% ROIC). For a company that did $2.3BN in operating income in 2019 – that is very meaningful!

Sure, they could also use that cash for share repurchases or dividends, but like my post on Big Lots, clearly the optionality for DG, and growth, has been enhanced.

While they do have 17k stores, their goal is 25,000 locations. So $1.6BN investments, when a new location just costs $250k to open, leads to 6,400 stores right there…

Remember, DG performed very well during the great recession due to a trade down effect as the consumer wanted to save costs. This led to them having more cash than competitors to expand and reinvest in the business.

As you can see in the chart below, this is when EPS really started to ratchet up.


DG doesn’t look optically cheap today. Currently it trades at roughly 16x 2021 EBITDA and 21x EPS. That’s what used to be called a “growth” multiple. However, they have several growth avenues and you’re backstopped by earnings that actually go up in recessions. So you have growth + stability in cash flow, which drives a premium valuation.

One thing I like to look for in a stock is a doubling of EPS over 5 years. It helps me gain comfort in the multiple I am buying in at (the multiple can be cut in half and I still wouldn’t lose money). This would be tough given where we are buying in at DG (coming off of a peak COVID earnings), but they will have so much capital to deploy with many avenues. I have EPS 70% higher from where it will end 2020 due to store growth, modest SSS growth, modest margin expansion over 2019 levels and share buybacks. Assuming shares trade at 20x FCF in 5 years, I think you can earn a 14.5% IRR. 


I can’t talk about a retailer without addressing e-commerce. If you think about Dollar General’s footprint, it is immense and its generally where e-commerce is still underpenetrated (i.e. rural areas).

However, that also means DG is best positioned with their distribution capabilities to attack that market. Much like they segmented rural areas for brick-and-mortar retail, they could do the same thing in e-commerce. They are the anti-Whole Foods, if you will, which many believe Amazon acquired to enhance their platform.

Why Hasn’t Autozone Stock Re-rated with Other Pandemic Winners? $AZO #COVID19

Reading Time: 3 minutesI just did a post where I evaluated my holdings of Apple following its recent surge, which looks to be a quite big move for the US’s largest public company. One thing I didn’t really discuss in that post was that Apple may have re-rated recently due to perception of it being a pandemic winner. If your sales have held in well this year, or even increased, you are viewed as either defensive or on a continued growth trek. In turn, your stock has rocketed up.

Here’s a list of stocks that I would say fall into that category. I can’t include them all, but you get the point:

FB Chart

FB data by YCharts

The S&P total return is ~5.5% at this point in the year.  Home Depot is doing well because housing is holding in well, and the pandemic is causing people to reinvest in their homes. Same store sales were up ~24%+! No wonder Home Depot has surged.

The same is true for other retailers, such as Target or Wal-mart, which despite possibly missing the back-to-school shopping season (which is big bucks) they are reporting some of the best comps in years.

So let me take off some of the true high fliers and compare Autozone stock and other auto part retailers to these names.
FB Chart

FB data by YCharts

If you’re having trouble finding the auto retailers on this busy chart – they’re all at the bottom!

This is odd to me. O’Reilly reported +16% SSS comps for Q2 and a 57% increase in net income. Advance Autoparts has a different fiscal period, but they reported 58% increase in EPS on a 7.5% SSS comp.

Why is that? There are several reasons.

  1. In recessions, people keep their car longer and do more work themselves. See my post on AutoZone for some discussion on their comps after the 2008 financial crisis.
  2. After reaching about 7 years in age, cars tend to need more work. The average age of a car in the car parc today is around 12 years
  3. Retailers focused on cleaning products and other pandemic needs consumers would need and auto parts took the back seat. It’s likely that the pure-plays auto stores picked up share

So I fully expect Autozone’s sales to benefit when they report at the end of September. And if this current crisis persists, then their increased comps will likely persist as well.

I’ve been watching street estimates for Autozone. They still sit around pre-pandemic levels. My guess is AZO handily beats these estimates, though admittedly there are some tough comps (believe there were additional selling days in the prior year).

Look, I’m a long term holder at the end of the day and I wouldn’t recommend trading around a  quarter. All I’m saying is you have (i) a high ROIC business that (ii) historically has returned every dollar of FCF to shareholders that (iii) is probably benefiting in COVID where (iv) estimates might be too low. I like the set up.

Should you hold Apple stock here? $AAPL

Reading Time: 6 minutesI’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.

One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.

Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.

Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.

If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at  the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.

In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare.  One reason why active management is so hard.

Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.


Ok, back to my view on Apple’s valuation. What do we need to believe here?

First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.

So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?

Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.

Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.

I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.

Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.


Of course, there are some other drivers for Apple recently.

The core driver for Apple here has to be the upgrade “super cycle.”

    • If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
    • To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
    • That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
    • The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
    • Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
    • ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.

Apple’s bundling could create a “services” powerhouse

    • First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
    • Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
    • Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
    • These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
    • Apple next launched “bundling” most recently and this could be a game changer.
    • Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
    • Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
    • Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
    • Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.

Bundle services… Bundle hardware

    • What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
    • Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
    • Then they push the software bundle. Rinse and repeat.

Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.

Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.