Tag: Equity Analysis

Why has AutoZone stock been one of the best compounders of all time? $AZO

I’ve been tardy in my Competitive Strategy posts – living in a global pandemic really disrupts a routine. The focus of this article is on AutoZone stock which would have been a tremendous winner to buy and hold over time.

AutoZone fits the exact mold for my Competitive Strategy Series: auto parts retailing isn’t a sexy business and it’s competitive, but I wanted to dive into any strategic choices the company has made and why that translated into such strong equity returns.

If I could sum up AutoZone stock in one phrase I would say it is: “perennially underestimated.”

Quick Background

AutoZone started as “Auto Shack” in 1979 and quickly expanded from 1 store in Arkansas, to 23 stores by 1980, to greater than 250 by 1985. The company also sold a majority stake to KKR around this time (which may be part of the firm’s culture of understanding of capital allocation priorities and its capital structure). By 1989 they exceeded $500 million in sales and opened the 500th store. The company went public in 1991.

Focus on the Customer

AutoZone’s core strategy was to offer low price automotive parts with high quality customer service. Similar to Amazon, it seems as though AutoZone figured out early on if the customer is happy, they’ll keep buying from you, and that will translate into good outcomes for shareholders. In other words, customer interests and shareholder interests are aligned.

AutoZone likely also took cues from Wal-Mart, which focuses on low everyday prices, given the company’s founder sat on the Wal-Mart board several years before starting “Auto Shack”. The Chairman & CEO of AutoZone, William Rhodes III is also a board member at Dollar General. Both tremendous retail equity stories… is it any wonder that AutoZone stock was destined for greatness?


As a quick aside, seeing these company associations made me think about my own experience of seeing AutoZones. When I drive through a small town I don’t know, there are two stores I typically see front and center… a Dollar General store (or something similar) and an AutoZone. Dollar General specifically targets these towns because a “dollar” store becomes the one-stop shop for many of its consumers. I went back to AutoZone’s original prospectus to see what they said about store strategy. It seems to me that they must also target areas where (i) there are plenty of older vehicles on the road that need maintenance and (ii) a high population of DIY-ers.


Back in the 1980s, the company began using an electronic catalog to help employees determine which parts were needed for specific vehicles quickly. This system helped pave the way for AutoZone to launch an e-retailing site relatively early on – in 1996.

Second, it trained employees to have general knowledge of cars so that they could answer customers’ questions in an educated way. Then, it would even install some parts for the customer. Think of windshield wipers, or running a diagnostic on the car for free to see what’s wrong without visiting a dealer, or replacing a battery for the customer.

Resilient business driven by aging vehicles on the road

AutoZone is a surprisingly resilient business. If you think about it, this makes sense. There will always be a base group of customers that repair their own cars (either to save money or because of interest in cars).

In a recession, AutoZone probably gains a few more customers that would’ve taken it to a repair shop. People may not buy that new car either in a recession and instead opt for fixing the old one they own. This plays exactly to AutoZone’s benefit:

Here is a graph of the vehicle age over time:

I don’t know of many companies that kept same-store sales growth up during the financial crisis, but you can clearly see they started to quickly grow low-to-mid single digits after that as well (likely because it was a long, slog of a recovery).

Recall, 2009-2011 was a period of high unemployment. People weren’t buying new cars and were repairing existing ones. That could play out again.

Thinking about post-COVID for AutoZone: One thing I am thinking about is that new car sales, pre-COVID, were at record levels for the past few years. AutoZone will likely see a recession benefit post-COVID as well, but then those new cars sold the past few years will start needed repairs. In other words, cars sold in 2015 will start to be 7 years old in 2022, which could buoy results for some period of time.

How has AutoZone warded off competition – isn’t it ripe for Amazon to steal share?

Yes and no. First, AutoZone has been in the online retail business for a while now. As of writing, it doesn’t offer two day, free shipping like Amazon does, but that may not matter right now.

Why? Because when something isn’t functioning on your car (and you are part of AutoZone’s core customer base as a DIY-er) then you probably are going to go fix it soon.

Imagine driving in the rain and one windshield wiper stops working. You pass an AutoZone store and understand from their commercials that they’ll even put on the new one for you. Why wait 2 days and risk getting caught in the rain again, being unable to safely drive? Sure, Amazon is moving closer and closer to same day delivery, but so far that has been AutoZone’s capture. AutoZone has nearly 6,500 stores, so it’s hard to miss one!

Like I said though, AutoZone clearly tries to focus on the customer and this is called out almost upfront in its 10-k.

Another reason: comfort knowing the part will actually work with your car. I’m somewhat of a DIY-er myself and, while AutoZone isn’t perfect either, sometimes you buy a part for a car that ends up not working on your specific model. That’s frustrating. Imagine a similar example to the above but now you need to return the item and buy a new one.

Supply Chain is the key

You can already start to piece together that the thing that drives Autozone’s business, the reason why people shop there and the reason why they win your sale, actually comes down to having the part and having it for a fair price.

AutoZone has a very efficient supply chain and this is really what keeps other competitors out of the business. In reality, I would venture to say that the do-it-yourself (DIY) market has developed into an oligopoly now – AutoZone, O’Reilly, Advance Auto, NAPA dominating the market, with Amazon also in the works.

AutoZone has an interesting store concept that reminds me of what Fastenal did, which I described in a prior post. They have satellite stores, which carry around ~24k SKUs, as well as “hub stores” which carry 40-60k SKUs and deliver to the satellite stores 3x a day. This ensures if someone orders a “tail-end” SKU, AutoZone can have it available either that day or the next. Lastly, they’ve deloveped “MegaHub” stores, which have ~100k SKUs. These stores deliver to both satellite stores and hub stores.

At this point, AutoZone notes that all of its hubs and satellite stores get touched at least 1x a day so adding more hubs or MegaHubs doesn’t increase coverage…. However, adding more of these stores reduces the amount of time it takes for deliveries to make it to the end customer.

New Growth Focus – Commercial

AutoZone has historically sold mainly to folks like you and me, not garages and professional networks. Now, its new growth strategy is focused on supply garages and local shops with parts using its sophisticated supply chain. The shift is Do it Yourself to Do it for Me.

Think about this from a garage’s perspective: AutoZone will now house the inventory I need to get more jobs done quickly. This solves 2 issues for me: 1) lowers my need to hold inventory and 2) helps me turn customers which should increase my sales.

So far, the company has seen some success. In its earnings call in early March (pre-COVID impacts), it noted:

We also grew our commercial sales per store at mid-single-digit rate versus last year’s second quarter [which was up 12.9% so a tough comp]… We averaged $9,400 in weekly commercial sales per program this past quarter, up 5% over last year. We have grown our sales with mature customers and mature programs at substantially improved growth rate the last 2 years versus previous years, indicating our offerings. Products, coverage, customer service and ability to enhance the customers’ overall shopping experience are improved and have been recognized and rewarded by our customers.

I can’t prove this trend, per se, but it seems to me that the older generations felt more comfortable working on their cars whereas the younger generation would like to “outsource” that work. “Do It For Me” must be what AutoZone is seeing too and I think that is why they are targeting this market.

AutoZone generates a surprisingly high ROIC

We’ve talked through some of the pieces of the business so far, but it is astonishing to me how high of a ROIC AutoZone generates.

Yet despite this high ROIC, resilient business model, I think one reason the stock has performed so well is that it is perennially undervalued and underappreciated.

This will be hard to read (maybe click to expand), but it’s a trailing FCF yield over a long period of time. Consistently in the high single digit range as a % of market cap. The interesting thing is they plowed in excess of 100% of that FCF back into repurchasing stock.

So clearly, that increased debt of the company slightly over time if they’re spending more than 100% of FCF.

But the way I think about it is: high-single return from FCF yield (which was all plowed back into AutoZone stock) + using capex for high-return projects (new stores). That’s the formula for solid returns. Here is a chart of share count over time – they were early in the share buyback game, in my view, buying massive amounts in the 2000s.

What about the competitors in the space? What have their returns been like?

So Pep Boys is no longer public (no owned by Icahn Enterprises), NAPA is owned by Genuine Parts, so we can really only compare O’Reilly, Advance Auto and AutoZone stock now.

What’s interesting is O’Reilly underperformed AutoZone stock up until about the early 2010s (depending on your starting point). Why did they start closing the gap? They started doing massive share-buybacks. Unlike IBM, where buybacks failed, the automotive parts retailing industry clearly has benefitted from doing this.

Advance Auto actually paused share buybacks and you can see the divergence in equity performance there as well.

Now the real question: who has the best jingle? AutoZone or O’Reilly?


But seriously, I like AutoZone’s business model. It’s a segment of retail that I think will continue to perform well over the next 5 years. I also like AutoZone stock because, compared to peers, management’s decisions have been very consistent over long periods of time. As of writing, its actually a lower multiple as well.

The question from there is obviously electric vehicles. What happens when these auto retailers lose sales related to the internal combustion engine? It’s a million dollar question. I will say, however, that penetration could be overestimated.

Overall, there are 263.6 million registered vehicles in the US. The number of battery electric vehicles sold in the US was 245,000 in 2019 and the total number of cars sold was 16.9 million, which was around cyclical peak.

Let’s say tomorrow, every new car is electric vehicle and each new car replaces an existing vehicle. So 16.9 million is 6.4% of the existing base… that would take ~15.5 years to replace the entire existing fleet.

Sure, we’d have to factor in autonomous cars next, which would drive down car ownership, but I also think that is far off.

If that gets overly priced in to AutoZone stock, I would view it as a buying opportunity.

Breaking Down Fastenal’s Moat in 3 Points

Fastenal is a company that sells nuts, bolts, and other industrial and construction supplies. Pretty simple business – and definitely not sexy. How then has Fastenal stock created so much value? In keeping with comparisons to other high-flying stocks on sexier businesses (like my post on NVR) Fastenal stock has beaten both Microsoft and Apple since the 1990s!

FAST Total Return Price Chart

FAST Total Return Price data by YCharts

 It all came down to a certain way they decided to operate – its Competitive Strategy. There probably have been hundreds of fastener businesses that have come and gone over the past 30 years, and many probably never created much value. So what gave Fastenal their competitive advantage? What drove their staying power? And how did they compound earnings so effectively? Clearly, something must be going right to translate into Fastenal stock being such a long-term winner.

One thing I’d like the reader to do is think actually how similar Fastenal’s strategy is to Amazon’s (I think the latter borrowed some things from the former’s playbook).

First, some history to shed a light on the business.


Fastenal was actually dreamt up by its founder, Bob Kierlin when he was just 11 years old.  His father ran an auto supply shop in Wisconsin and Kierlin noticed customers typically drove from store to store looking for fasteners they needed for particular jobs. If a hardware store didn’t have the right nut or bolt, the store would send the customer to Kierlin’s store, and vice-versa. Bob noticed a lot of customers had to resort to buying the part, one-off, via a special order and wait.

Kierlin and four other friends started Fastenal in with $30,000 and rented a store in Winona, Minnesota. They opened a store as a one-stop shop with thousands of fasteners for retail customer needs.

But the idea was a flop and the company almost went bust.

Instead of focusing on the retail customer, Fastenal decided to pivot and focus on the commercial customer. It turned out that price was much less of a factor than timeliness for that market segment — contractors and companies often lost money searching or waiting for a particular part. Kierlin and his partners discovered that there was a great need for a service that could quickly provide the fastener or part that a buyer needed.

In short, Fastenal segmented out its buyer base and identified what their key purchasing criteria was. They focused on industrial and commercial buyers and they realized they didn’t need to be the lowest price, they just needed to have the item in stock.

At the end of the day, you can see why this makes sense.

  1. Fasteners make up a small portion of project costs (e.g. building a home, building a car), but are crucial pieces in the process that can hold up work.
  2. If Fastenal increased price of a particular fastener by 3%, their customer probably wouldn’t even notice in their project and could likely pass it on to the end customer if needed
  3. Fastenal’s customers are many in size but also small in size, so they have limited bargaining power.

Fastenal further segmented based on geographic locations.

Fastenal opened its first branch in Minnesota and continued to target very small towns. Why? By targeting small towns that had healthy construction and manufacturing industries, but were also small towns that were underserved by big distributors, Fastenal could be the only game in town.


Finding New Segments

One thing a business can do to improve its competitive advantage is find new product segments. Think about Arm & Hammer expanding baking soda into a refrigerator deodorant – that was a creative decision to target a market and improved the overall market size.

In some cases, you can find new segments by broadening and you can find new segments by narrowing focus.

Fastenal actually did both.

Narrowing Focus (and Not Being Afraid to Try Something New)

This is from Fastenal’s 1996 10-K. Satellite stores weren’t a major success, but the company did expand to 71 satellite stores opened by 2001. The key was that Fastenal was focused on improving the customer relationship. Fastenal already was getting some business from these customers in smaller areas, but they wanted to make it even easier on the customer to get their Fasteners – and it preemptively did so. Sure, it would cost resources and no one else really saw the returns from doing it, but the customer sure would be loyal. Sound familiar to Amazon?

In fact, do you know what Fastenal says its goal is? “Growth through Customer Service.”

It also reminds me of Dollar General’s strategy of serving rural America. Carve out a niche where you know your customers well and others choose not to serve and that can payoff well.

In 2014, Fastenal identified a new growth driver: Onsite locations. These are sites that are not open to the public, or a wide variety of customers, but instead serve one customer at their location.

In essence, the customer (typically a very large one) might consume enough fasteners that it could source them themselves, but they’d rather benefit from Fastenal’s scale and expertise so they hire them to serve all their needs.

Fastenal had locations like these since the 1990s, but they expanded following 2014 – growing from 214 locations to over 1,100 by 2019 and represents roughly 30% of the company now.

The company really started to build a vending solution in 2011, choosing to do so while industrial activity was still weak from the Financial Crisis.

They would give a customer a vending machine, essentially for free (estimated to be a $10,000 value), but in return it would essentially become a “mini-branch” at the customer’s site. The machines were also available to the customer 24/7 – not just when a supply room is staffed. It also helped the customer track consumption data, in some cases improving their ability to see which of their plants were consuming more or less of certain parts.

Early on, Fastenal learned that it actually cut customer consumption (2011 conference call):

As we talked about on the Amazon review, if I were to distill differentiation with a buyer into two factors it would be: cut their cost and/or improve performance.

In this case, Fastenal cut the costs for its customers buy reducing spend, but it also differentiated Fastenal as a solutions provider. It also resulted in a share shift as customers looked favorably at the vending machines (quid pro quo) and Fastenal “locked” the customer into purchasing from them.

The company now has 105,000 vending devices in the field and generate $1.1BN of revenue.

Expanding Breadth

Fastenal decided in the mid-90s to test out new products. If a customer came into the store for fasteners, they might want to pick up something else why they are in the store. Convenience outweighs price.

In 1995, threaded fasteners were ~70% of sales. By 2000, it was just 51% of sales. Now, Fastenal has 9 different product categories it sells and targeting further product diversity:

The company also decided that in some cases, it made sense to manufacture tools for a customer. This would be rare, but in some cases it would pay off royally (and gain customer loyalty).

In one instance, a Ford plant’s assembly line was shut down by a breakdown that required a few dozen special bolts. Ford’s regular supplier told the company it would have to wait until Monday—three days later. “Meanwhile, it’s costing them something like $50,000 an hour to have this line not operating,” Slaggie [one of Fastenal’s founders] said in the March 11, 1992, Successful Business. “They called us and the part is an oddball, something we don’t have in stock. We had them fax us the blueprint for the machine and we determined we could make it…. We had them finished Sunday afternoon.”

Doing some simple math, $50,000 a day is $1.2MM in cost… for 3 days that would cost the company $3.6MM. Fastenal could make a part and charge $50,000 for it, and I’m sure Ford would pay for that all day…  I have no idea what Fastenal charged in this case, but you can see why Fastenal created differentiation here as a service provider.


Decentralized. By the time Fastenal stock became public, they put out some interesting color on how they decided to manage new branch openings:

By reading the company’s filings, you can tell they first want to train their employees to understand the business and industry and then give them the power to make decisions on their own.

I’m a relatively cynical person, so I wonder to myself how the employees could possibly know more about what to stock than people who have been operating the business for 20+ years. Two words: Smile & Dial.


Putting it together

I could go on about Fastenal — there is a lot I didn’t touch on about how frugal the company chooses to be — but its performance as “just a fastener distributor” has been truly amazing.

I opened this series saying that I was tired of the terms “asset light” or “high margins” being used to say why a business is “good”… instead, you need to understand what the company has done to make its business sustainable and why they will create above average shareholder value in the long run.

Here are some summary financial metrics for Fastenal compared to other distributor peers.

What jumps off the page to me is (i) its gross margins for a distributor, (ii) its EBITDA margins and (iii) EBITA / Assets (a proxy for ROIC).

High Gross Margins: Its high gross margins relay to me that they truly have targeted their customer in a way that isn’t just based on price – otherwise I think the margins would be much lower.

EBITDA margins: Its EBITDA margins are high, which makes sense given the gross margins. But the delta between gross margins and EBITDA margins is nearly 23% of sales — meaning they spend 23% of sales on selling costs and general and administrative expenses. That’s definitely in the upper half of the group and tells me that they are spending a lot on service for the customer.

EBITA / Assets: One might look at this comp set and say, “hmmm, Fastenal’s metrics are good, but its FCF conversion (rough proxy using EBITDA – Capex over EBITDA) isn’t great because capex is so high.” That’s ok for me – when I look at EBITA / Assets, what Fastenal earns on every dollar of capex it spends is much higher than what I could go out and earn! It also will likely lead to above-average sales growth.


I hope you’ve seen from what I’ve outlined above that Fastenal is very similar to Amazon – relentless focus on the customer. But Kierlen also appreciated hiring the right people and giving autonomy, as shown in this interview I found with some hard-hitting reporters.

“I admit things I never knew how to do well – I admit I was never a good sales person, so I hired a good salesperson.” In some ways it reminds me of Steve Jobs (though it was later learned he had a tendency to micromanage), he did have a great quote:

“It doesn’t make sense to hire smart people and tell them what to do; we hire smart people so they can tell us what to do.”

The Timeshare Stocks Look Attractive… as Does Their Debt

Timeshare stocks look attractive… as does their debt. I know what you are thinking – time shares are the last place I want to be investing right now. Just look at hotels – demand has evaporated. Just look at the google search history:

But there may be some things you don’t know about the timeshare business model that may show they are more resilient than you think.

Out of the timeshare stocks, I’ll use Wyndham Destinations (WYND) as the example.  WYND generates revenue through two ways:

I’ll briefly explain “ownership” as I think most people are familiar with it. The company sells VOIs and in exchange the purchaser can use a specific unit in a property for a week or so. Or they can use allotted points to go to another property.

Typically, WYND and the other players either sell the VOI and get paid upfront or have financing options for the customer. (Note: yours truly recently attended a timeshare pitch – it was around $15k to buy the unit showed to me and they offered financing around ~14-15%).

After the purchase though, the purchaser must continue to pay an annual maintenance fee, which is the share of costs and expenses of operating and maintaining the property. So here we have a major difference between hotels. Hotels have to cover opex and maintenance of the property through its sales revenue (i.e. selling nights). Timeshares already have a book of business that they collect maintenance fees to cover costs. Timeshare costs cover:

“housekeeping, landscaping, taxes, insurance, resort labor, a management fee payable to the management company, and an assessment to fund a reserve account used to renovate, refurbish and replace furnishings, appliances, common areas and other assets, such as structural elements and equipment, as needed over time”

A lot of these costs a hotel must cover even if revenues are zero. Sure they can cut costs, but some of these (taxes and insurance) don’t go to zero just because sales are. Plus, the timeshare is clearly receiving a management fee here as well.

There is a risk that people stop paying these maintenance fees, but that really happened in the last recession because the timeshare managers weren’t maintaining the properties well.

How are timeshare stocks different than 2008/2009? Timeshare companies are different now in a few ways:

  • They are mostly all independent – VAC used to be a part of Marriott and Starwood, Hilton Grand Vacations is now independent from Hilton.
  • No longer sell high-end products – prior to the financial crisis, the timeshare companies got into “high end” time shares in residential units, which collapsed. They no longer focus on this.
  • No longer sell to sub-prime – as shown later, WYND’s credit book has an average FICO of ~720 compared to sub-prime, low-FICO borrowers in the prior downturn

Before I dive more thoroughly into the company, I want to explain really quickly why I am focused on WYND and keep this in mind for the remainder of the post:

Why WYND? There are other Timeshare stocks with good names like Hilton and Marriott…

  • Roughly 1/3 of WYND’s exchange business comes from membership fees, balance is from members swapping timeshares. Cash is actually received when they book, not at the time of stay. So any timeshare opportunists out there may be swapping for 2021 as we speak… and WYND will be collecting cash.
  • Another 17% from WYND come from HOA and property maintenance fees. This is very stable.
  • Solid liquidity: WYND put out a press release that it has $1.3BN of cash and $883MM of receivables it can finance. It therefore has plenty of liquidity to weather the storm.

The one benefit in favor of Hilton (HGV) and Marriott (VAC) is that they charge annual membership fees at the beginning of the year and have already collected the cash. WYND automatically deducts on a monthly basis. I’d prefer to have the cash in the door day one, but beggers cant be choosers.


Sources of Revenue:

Vacation Ownership

  • Timeshare sales (pretty intuitive)
  • Consumer Financing:
    • Finance the purchases noted above. Average customer FICO was 727, 727, 726 for 2019,2018, and 2017 respectively
    • During 2019, the company generated $1.5BN of receivables on $2.3BN of gross VOI sales – timeshare companies typically securitize this, which WYND does, so that they create capacity on the balance sheet to sell more VOIs.
  • Property Management:
    • Company has 3-5 year property management agreements, which typically renew automatically

Vacation Exchange

  • This essentially means that you can use your time share as currency for an “exchange” on another platform. RCI is a popular company for this. The tour that I did was in Florida for example, but I could exchange my points to go to a Disney vacation club or Aspen.
  • The vast majority of revenue here is driven by annual membership dues and fees for facilitating exchanges.
  • OK – if there aren’t many exchanges this year due to a slowdown in travel, that will get hit, but annual membership fees should be very stable

Now that we’ve gone through the revenues side, we should look at the major expenses. I.e. Let’s stress test WYND.

Cost breakdown

I’m doing this to see how much is variable vs. fixed and what they can cut to preserve cash. Note, I pulled these breakdowns from Hilton Grand Vacations because they do a great job breaking it out line by line whereas WYND brackets a lot of it together:

  • Cost of VOI sales – represents the costs attributable to the sales of owned VOIs recognized, as well as charges incurred related to granting credit to customers for their existing ownership when upgrading into fee-for-service projects. If you’re not selling new VOIs or acquiring new inventory and customers aren’t exchanging, this probably can flex considerably lower.
  • Sales & marketing – relatively obvious. But if you know you’ll have no sales in the next few months, you could cut this back tremendously. Perhaps 90%.
  • Rental and ancillary services expense – These expenses include personnel costs, rent, property taxes, insurance and utilities. These costs are partially covered through maintenance fees of unsold timeshare slots and by subsidizing the costs of HOAs not covered by maintenance fees collected. These are relatively fixed, however.
  • Resort & club management fees – payroll and other admin costs associated with running the clubs. I think this could be cut back drastically, but maybe will say 50%.
  • Financing – financing charges for securizations, but is offset by financing income
  • General & Administrative – back office costs in general. I assume this could be cut somewhat, but might be 75% fixed.

All in, I would say not super variable cost structure, but also not terrible.


Financial Summary

Here is my breakdown of what I expect could happen to WYND for the balance of 2020. Yes, it looks brutal, but at the same time, with a complete halt of travel its not really as bad as you think. They actually remain EBITDA positive throughout this year. If you look at the price of Timeshare stocks too, I can’t help but think this is priced in.

How does this translate into FCF? Believe it or not, I think the co could be FCF positive this year:

Therefore, if I think the business isn’t permanently impaired, we could be scooping it up for a great discount. This actually will build the company’s liquidity position as well.


Valuation

Looking out to 2022, WYND is trading at <3.5x EPS and ~4.5x EBITDA. That seems way too cheap to me.

Finally, why is the debt interesting?

If the company maintains over a $1bn of liquidity this year, they will have no problem addressing their next maturity, a $250MM tranche in 2021. Right now, that bond trades at around 90 for a YTW of 17.6%. I’ll take that all day. Frankly, the company may want to scoop some bonds up on the open market. Buying the bonds at even 95 cents would save the company ~$12.5MM in principal plus additional savings from interest expense.

Otis Stock Spin-out from United Technologies – Quick Thoughts $OTIS

It’s not every day that you hear “recurring business model”, “razor / razor blade”, “route density will drive margins higher” story associated with an industrial company, but here we are. Otis stock has officially spun out of United Technologies so here’s my initial read. In other words, a starting point to see if there should be more work done. I like to take quick looks at topical names (and spin-outs can get interesting) so more of these will likely follow.


Things I like:

  • Service Drives Profitability:
    • New equipment sales were 43% of sales, but just 20% of operating profit. That means service revenue, while 57% of sales, makes up 80% of operating profit
    • This is positive, as it means revenue is much more recurring. Represents a “razor / razorblade” model too in that once the new equipment is installed, the customer needs to come back to Otis for service
    • The model is pretty simple: Otis sells new equipment and operates under warranty for a couple years. After that, Otis sells long-term service agreements that typically last ~4 years.
    • According to the company, an elevator will generate 2.5x its original purchase price in aftermarket service
    • In fact, service is contractual. And I like that the company reports “Remaining Performance Obligations” because it gives a sense of what sales will be in the next 2 years.

  • Generates a lot of unlevered FCF:
    • I was somewhat surprised at the low capital intensity of the business. I would say that this level of capex spend based on my experience is top quartile and that checks a box for Otis stock
    • Further, working capital is really low relative to total assets & sales
    • This means the company likely can use a lot of cash for dividends (looking at 40% payout ratio) and buybacks plus possible M&A of other service providers as the company says the space is fragmented.

  • Consistent business model – life threatening to “skimp” on the service:
    • I like how this business really hasn’t changed in 100 years. It tells me that the next 10 years will probably look similar to the last. That’s something you can’t say about every business so perhaps this deserves a “consistency premium”
    • If I was a firm deciding which elevator to choose, I’m not sure I’d take the lowest offer. I think a firm with a solid track record actually matters here. Elevators not only get people to work
    • Failure here might be unlikely, but the cost is so huge it makes no sense to change. For me, I sense that being true on both new sales and maintenance.
    • In fact, the company says it has a 93% retention rate following end of the warranty period – not bad!

Things I don’t like

  • Operating Margins have been declining
    • At first glance, I thought this might be due to new equipment sales becoming a larger portion of the mix. However, that’s not the case. It has been relatively consistent.

    • It seems to be China sales are the issue. The company has called out this “mix” effect, but also Otis doesn’t not have leading share there. In this business, density matters. So it will take time for the company to build density and improve margins.
    • Quote from prior call on Otis on the importance of route density:

“So today, if you look at us versus our peer competitors, we have a 200- to 300 point — basis point premium margin. We believe with our scale and density that will continue through the future. Add that to, again, this drop-through of productivity enhancements. But scale and density matters in this industry. You go to any city, whether it’s this building, anywhere else, if you’ve already got mechanics, if they’re already out on a route and you can add new customers, you get, obviously, a little additional incremental cost, but you get to add to the portfolio significantly.”

  • Mitigant: Company is targeting supply chain savings (3% of gross spend per year) and thinks it can reduce SG&A from 13.6% of sales to ~12.25% over the medium term, but somewhat of a “show-me story”
  • China is the growth story
    • China’s construction growth worries me. The talk of “ghost cities” being built to support GDP makes me concerned that a reckoning is eventually coming. And the problem is that many of these buildings may be unoccupied and therefore you don’t need to service them.
    • China is the largest elevator market – 60% of global volume. It’s also more competitive it seems.
    • Mitigant: China is getting more focused on building maintenance code, which should support global players like Otis. It should allow more sales to the big players as well as larger service contracts. Real estate developers in China are also consolidating, so it likely means they will want to work with one supplier.

Otis Stock Valuation:

I would say the valuation here is reasonable. Not super compelling in the COVID world, but at least it should be a long-term compounder.

Thysennkrupp’s elevator business was acquired by private equity for $18.7BN, or roughly 17x forward EBITDA. That would point to Otis stock being very cheap on that basis… Given it’s stability and strong cash flow, I can see why P/E would buy out a player. Otis stock is actually a mid-cap, but not too big for someone in Omaha…

CorePoint Q1’19 Recap: Asset sales are the real story $CPLG

CorePoint reported Q1’19 EBITDA of $43MM compared to $40MM estimates and $37MM last year.

Net/net this was an OK result. Obviously, EBITDA beat expectations. RevPar was up 3% according to the company, which is ahead of their 0-2% growth guidance. Unfortunately,  though, excluding the hurricane-impacted hotels of last year RevPar would’ve been down ~1%. EBITDA improved due to these hotels coming back online, but that was to be expected.

April was also looking slightly weak due to oil related market which the company noted was softer than Q1’19 as well as an outage at their call center.

Fortunately, the outlook was also left largely unchanged. The company filed an 8-K that shows they are taking steps to lower G&A (reducing headcount which should save 7% of G&A or $1.5MM).

As I noted in my prior post, the real developing story, Core Point is looking to divest “non-core” hotel assets. They had conducted 2 sales at very attractive multiples when they initially announced this.

They also announced 3 more hotel sales. The hotels carried an average hotel RevPar that was 25% lower than the portfolio average and the average hotel EBITDA margin was 700bps below the portfolio average.

Therefore the implied valuation for these 15x at EBITDAre or 2.5x revenue multiple, per the company disclosure. This is a great result. Let’s take a look at what that means so far for the five hotels sold:

We know from this chart below that there is still a lot of wood left to chop.

Since the 76 non-core hotels were already excluding the 2 asset sales sold for $4.5MM, there are still 73 hotels left worth $132MM of sales and $11MM of EBITDA.

This is important because the sales proceeds / multiples thus far have come well in excess of where CPLG is trading. CPLG currently trades at 9.9x 2019 EBITDA… If it can continue to divest non-core assets at multiples above where it trades, this could be very incremental to the stock, as shown below:

More than likely, the company will probably sell these assets for 2.0x Sales as they move forward, meaning CPLG would be trading at 8.4x on a PF basis. If the stock were to trade at 10x, this would mean it is worth $18.7/share, or 35% upside.

That said, I think that would still be too cheap given multiple ways to look at it, whether it be cap rate, book value, EV/EBITDA, etc. CPLG is too cheap.  Imagine if CPLG just traded at book value… the stock would be worth $21/share.

It seems to me that the reported book value as well as the JP Morgan valuation is looking more and more accurate.

The company has also started to buy back some stock. Per the earnings call, “Our priority has been on paying down debt and opportunistically repurchasing our shares accretively at a discount to NAV.”