Tag: Equity Analysis

Service Properties Trust – A Special Situation with a Catalyst $SVC

Reading Time: 6 minutes

Quick idea today: I am looking at Service Properties Trust (SVC). I think the idea is interesting and there is a catalyst. Here’s the situation:

  • Company Overview: SVC is an externally managed REIT (managed by RMR – more on this later), owning 304 hotels and nearly 800 “service-oriented properties” which are net lease
  • Glance at the Opportunity:
    • $1.4BN market cap, $913MM in cash*, $7.14BN in Debt = $7.7BN EV
    • Tangible book $10.62 vs. stock at $8.61 = 19% discount to book value
      • Book value likely underestimates the net lease portfolio value
      • Book value is also depreciated – i.e. the assets bought many years ago likely didn’t go down in price from the price paid, but accounting is accounting. Depreciation is $3.5BN of value – think about that in the context of the market cap.
      • See Value Build table below. You could arrive at $40 implied stock price depending on what you want to believe. I used 7% cap rate for the net lease portfolio which is a decent discount to a recent comp.
    • You can also get to ~$12 stock using 12x EBITDA, which is 37% upside, and ignores a lot of other things I’ll mention. True value likely is somewhere in between these data points.
    • The cap structure is overlevered, they have a $500MM of bonds due Aug 2022 and the $1BN revolver is technically due as well.
      • *They have $1BN drawn on revolver. The rest of the debt is unsecured bonds.
      • The revolver draw isn’t all bad – they transitioned ~200 hotels to Sonesta in 2020/2021 and thought it had a chance of being disruptive, so they did it out of abundance of caution. It *was* disruptive when you add in COVID lock-downs, but both are looking like they are in the rear view mirror.
      • In some ways, this reminds me of CPLG, but sketchier – CPLG owned hotels and leverage got a bit too high. But CPLG sold poor-quality hotels at amazing levels, delevered and create value. Eventually they sold the whole business.
    • Bottom line: Given this is a levered equity, if you think the enterprise value is too low, that likely means the equity stub could have A LOT of upside. But also means A LOT of risk!
  • The Assets – Hotels and Service Properties:
    • The hotels are managed or operated by franchisees of Sonesta (261 hotels), Hyatt (17 hotels) or Marriott (16 hotels), etc.
      • About half of these are extended stay hotels, with the other being a mix of mid-level to some luxury. But luxury is in the eye of the hotel-er.
      • The hotels are recovering from COVID nicely, but no where near peak. The company did provide monthly operating stats in their deck which is nice.

    • The Service Properties / net lease portfolio came from the SMTA acquisition, which was a special situation if anyone followed it
      • The largest tenant in the net lease portfolio is TravelCenter of America (45% of minimum rent owed, but larger on a $ value basis – likely 60%)
      • TravelCenter is public (ticker: TA) and is a full-service truck stop.
      • TA is doing quite well fundamentally. Looks like EBITDA has doubled LTM 9/30/21 vs. 2018. Haven’t fully dug in, but seems like if trucking in America is doing well, TA is doing well.
      • Other tenants in the net lease portfolio include Shopping Centers (20%) AMC (2%), The Great Escape (2%), Life Time Fitness (~2%), and a tail of others. You can imagine many of these were battered by COVID, but mattered less compared to TA and Shopping Centers.
      • Either way, the company is collecting 100% of rents now and the portfolio is 98% occupied with well staggered maturities. I encourage you to check out the investor deck for more.
  • What else makes this interesting?
    • The situation is hairy: RMR involvement (I’ll get to it) and a levered equity. The latter tends to produce high returns if you get the entry point right and you think the B/S is fixable
    • Abandoned REIT: SVC had to cut its dividend during COVID. Went from 54 cents to a penny.
    • Catalyst: Currently marketing 68 hotels for sale ($579MM of carrying value). Mgmt stated they expect to get at least carrying value in Q1’22.
      • Mgmt said they have term sheets on all properties, though one is a bit more complicated. I suspect we will see staggered announcements to multiple buyers
      • Sales proceeds will first go to refi the bonds and likely downsize and extend the revolver
      • These assets for sale lag the rest of the portfolio in earnings or had deferred capex (read: bottom tier). It also reduces hotels vs. net lease portfolio. Net / net RemainCo should be valued higher.
      • Selling these assets and taking out the impending maturity can act as a cleansing event for investors to come back to the stock
    • REIT M&A remains hot, provides comps:
  • Other Value:
    • SVC owns 8% of TA equity and 34% of Sonesta Holdco. The former is worth about $51MM, the latter I am not sure as they are not public.
      • RMR earns fee on managing Sonesta. We can infer Sonesta makes about $750MM in revenue (0.6% fee on all revenue per RMR 10k)
      • We just saw CPLG get acquired for 2.8x revenue, which would imply $2.1BN EV here.
      • Assume 60% debt / cap (total guess) = $1.26BN of debt and $840MM of equity, implies about $285MM of value for SVC. This is all a wet finger in the air and the carrying value of the investment is $62MM. I use carrying value.
  • Value Build
    • Here is the value build of what I have so far

    • There’s only one thing I haven’t talked about so far and that is the remaining 236 hotels.
    • The table below is how I got that number and it goes back to that depreciated book value discussion.
    • SVC’s lodging-REIT roots trace back to 1995. It isn’t out of the realm of possibility that many of those assets are depreciated considerably.

  • RMR / Intercompany Relationships:
    • RMR manages SVC. SVC owns a lot of Sonesta hotels and owns 34% of Sonesta. SVC owns a lot of TA properties and owns 8% of TA. RMR provides management services for Sonesta and TA!
    • Let me be clearer: RMR manages both sides.
    • I should also mention people have a lot of misgivings about RMR and the Portnoy’s who manage it.
    • Let me copy the statement straight from RMR’s 10-k:

    • Perhaps you can see the risk here. RMR might try to rob Peter to pay Paul. RMR makes more money from managing SVC than it does from Sonesta (like… a lot more. 10x more. $45MM vs. $4-5MM).
    • That said, the web of inter-ownership perversely provides some comfort (admittedly not a ton). Screwing part of the chain should ripple back through and solve nothing. And again, RMR makes more from SVC. If there is a transaction, it is to preserve value at SVC.
    • On the other hand, I will admit an outright sale of SVC isn’t likely. I doubt RMR does that.
  • Are there any signal of what RMR could do?
    • RMR also manages Diversified Healthcare Trust (DHC) which had some liquidity and covenant issues
    • RMR went out and found institutional investors for some assets, from my understanding not all core, which DHC contributed to a JV.
    • They did this recently in Jan-22 at a 5% cap rate but also at the end of 2021. Net / net, it looks to be about a $1BN of value realized.
    • It allowed DHC to get some liquidity, get a real bid on the assets, but not lose all economics
    • Why does this matter?
      • I think if your one hang-up is leverage, I think there are many solutions in addition to selling these non-core hotels in Q1.
      • If your one hang-up is RMR, then I think they’ve shown they are acting in the best interest of the company. RMR is aligned as they earn management fees on the enterprise values of the companies. They also manage the JVs in DHC’s case (lol)
    • Did RMR tip there hand to this??

That’s all for now – stay tuned for the asset sale announcements!

Expectations Reset for Vimeo, Risk/Reward Attractive $VMEO

Reading Time: 13 minutes

Vimeo stock collapsed following the spin from IAC. That caught my attention, I read some of their calls, but I never really dug in. Then, in early January, I tweeted there was an interesting cash-covered put trade you could do at $12.50 strike. As Vimeo stock has fallen more, I decided to do some “napkin” math on the stock.

Say Vimeo grows half the rate of management’s target, FCF margins end at 20%, and priced at 20x FCF. Discount that back at 10% and you get a market cap that isn’t too far off from today. These are all “finger in the air” numbers, but it showed me I should do more work.

If I had one takeaway from reviewing the company is that each Vimeo subscriber is not created equally! And when you break down the math, the targets become much more believable. If you want to cut to the chase, I’d suggest reading the “All Customers are Not Created Equal” section below as well as the model cut outs I have.

Is there risk? Of course. But I think many are likely saying, “eh, I’ll just wait” right now and that’s big time group think.

But first, I’ll go through a quick background, why the stock has gotten pummeled, and what you need to believe to make money from here. I’ve included a few screen shots of two of my models to emphasize this point.

Background:

Vimeo was spun out of IAC in May 2021. The spin followed strong 2020 results as Vimeo enabled many businesses to operate during the pandemic. No doubt, Barry Diller & Joey Levin at IAC recognized tech / SaaS multiples were high and a partial sale + spin would be best for shareholders.

Indeed, IAC sold a partial stake in Vimeo for $150MM which valued the company at $2.75BN in November 2020. Then in January 2021, another $300MM of equity was sold valuing Vimeo between $5.2BN – $5.7BN. In the first case, the valuation was a touch under 10x ’20 sales and then quickly moved to about 20x sales.

Today, we’re looking at Vimeo with a market cap of $2.3BN, or 6x ’21 sales (5x if you exclude cash, as Vimeo is FCF+, albeit from SBC & deferred revenue). Spun out at $57, the stock can now be purchased for under $14.

Ok with that background of “why Vimeo is even public” out of the way, we can explore why the stock is getting hammered, and then we can address why it’s a reasonable buy.

Why did Vimeo stock get pummeled?

Vimeo’s stock has gotten smoked for a variety of reasons.

  • Pandemic-enabled companies are coming home to roost (Peloton, Zoom, Docusign, Moderna are all down >50%)
  • Joey Levin straight up said it was expensive!
  • Growth is decelerating
  • Lost credibility: Vimeo will likely miss targets in its first year following an investor day that promised 30% growth for next 5 years
  • They are changing price strategy starting in ’22. A foundational change can lead to volatility
  • Spin dynamics, possibly
  • Investors are less enamored with tech / SaaS

I won’t go into all of these, but I think the first few are worth going through.

Pandemic-enabled and “a bit rich” at the spin:

In IAC’s Q3’20 letter, Levin stated that Vimeo was “a business that benefited meaningfully from the pandemic.” They also said, “we can’t be certain that the magnitude of the positive lift to Vimeo will persist when the virus’ effect on our lives becomes less pronounced…

They went on to say, “Vimeo’s access to capital inside of IAC will be much more expensive than access to capital outside of IAC.” They decided to test the market by selling some shares (Nov ’20) and then some more (Jan ’21). They noted how the investors were willing to pay on a P/S multiple, almost besmirching the reputation of the buyers!

Read between the lines. They were saying others are willing to pay much more for Vimeo than we are.

Growth deceleration + Lost credibility

In that same IAC letter, they called out acceleration during the pandemic which was obvious.

Prior to the pandemic, we were steadily proving Vimeo’s fit in the market. Organic bookings growth consistently accelerated last year from 11% in Q1’19 to 27% in Q4’19 as we began to expand from our filmmaker roots to a broader audience of small businesses and large enterprises. Then the pandemic hit, and that acceleration exploded to 41% in Q1, 79% in Q2, and 56% in the most recent quarter.

If we look at the latest monthly metrics, we can see Vimeo is growing strongly, but at a slower pace. They actually face the worst comps in Q1’22 so it is likely this decelerates even more.

Vimeo Monthly Metrics are decelerating

Total revenue is coming down from high-50s to 60% to 40s, high-twenties and now around 23% in December. Look at Q1’21 figures and we can probably conclude comps will be tough. Perhaps the company grows “just” high-teens / low twenties.

This is problematic as management set out much more lofty 5 year goals at their investor day in March 2021. A few quarters in and it looks like we will be under the goal.

Vimeo hasn’t reported Q4 yet, but investors can look at the reported monthly metrics as a guide. Even before they reported December metrics, they were guiding investors down at conferences:

[Regarding Q4]. What we have said is that revenue growth to be about 25% year-over-year. And if you think about that, we are lapping a very strong growth rate in the fourth quarter of last year, which was about 54%. So on a 2-year stack basis, we are significantly higher even compared to Q3 of this year. We haven’t talked specifically about 2022 and what the growth rates would be there. We are still in the planning process and for all the reasons that you talked about, the visibility being harder. We’ll provide more guidance as we get through this year and into early next year.

But what we have said is that the 30% growth rate is unlikely next year. And we also believe the first half of next year and the growth rates will be muted for the same comp reasons that we talked about earlier, and we expect the growth rate to be accelerated in the second half of the year. So if you think about our growth rates coming down in the second half of this year, that would continue through the first half and then we expect it to reaccelerate sometime in the second half of the year.

My emphasis added.

But let me say one heuristic I have learned over time. Anytime a company says that “we’ll make it up in the second half”, it is a SHORT for me.

But Dilly D – if that is the case, how can you possibly buy the stock now?

I think a lot is priced in at this point (also dangerous words as making it up in the second half). But after studying the business model, strategy, and thinking about the TAM, I do think this business can continue to grow at high rates.

Ok enough depressing talk, let’s talk about why Vimeo now looks cheap!

Why Does Vimeo Stock Look Cheap?

  • Vimeo is a more focused company, post-spin. They are free to operate the way they want & invest where they want. Focus on a singular goal is important.
  • End of the day, Vimeo is a good business
    • Classic “freemium” model converts users to paid in highly efficient manner. That said, enterprise customers (where decent amount of S&M is dedicated) are worth way more than typical “Pro” subscriber.
      • Enterprise 1% of subscribers, but 25% of revenue.
      • 50% of paid customers started off with the free plan (i.e. freemium model)
    • Vimeo is an alternative to YouTube for business
  • Pandemic likely pulled forward sales, but also accelerated market growth and adoption.
    • Decent amount of growth is “locked in”
    • I’d gamble some things from the pandemic will stay (e.g. virtual “town halls” for companies, more video options for live events, etc.)
  • Brand value is worth something (I won’t dive in here, but something to think about)
  • The “What do I need to believe?” case seems reasonable

More Focused

First, I think a focused, small company can really do wonders. Investors worry big tech will squash the “little guy.” See online dating, industrial distribution, media content, marketplaces, among many others. But Vimeo lives and dies by this “niche.” They come into the office everyday thinking about this one thing.

Steve Jobs said with “focus and simplicity you can move mountains.” To me: stand alone company = more focus, though maybe Vimeo requires more investment short-term.

I think we started the year with about 75 quota-carrying sales headcount, and we would end the year at about 150, so almost doubling. We have opened offices, at least in 4 or 5 new geographies that we didn’t have at the beginning of this year, so significant expansion

Seems like they are investing for growth.

End of Day, Vimeo is a good business

On the Self-Serve segment of our revenue (meaning, a customer begins to pay Vimeo without having spoken to a salesperson), we’re seeing about $5 in profit for every $1 we spend in marketing. That ratio has continued to steadily improve and we haven’t yet found the limit on our ability to spend on marketing with those returns

IAC Letter

IAC also mentioned during the pandemic that Vimeo “accidentally” went EBITDA positive as the growth resulted in a lot of operating leverage.

Go back to the 2020 summary results with long-term goals below. Look at that operating leverage on the gross margin line and EBITDA. Pretty impeccable. This has been true over time when you spread the financials as well and look back to 2018 and 2019. I do think a SaaS company like Vimeo should be able to reach 20%+ EBITDA margins, which we can get into in the model later.

All Customers are Not Created Equal

As mentioned, Enterprise is just 1% of subscribers, but 25% of revenue. This checks out with their other disclosures:

As of December 31, 2020, we had over 3,800 enterprise customers, who, as of the quarter ended December 31, 2020, pay us over $22,000 per year, on average. We define “enterprise customers” as those who purchase plans through contact with our sales force. Our enterprise customers grew 87% year-over-year for the quarter ended December 31, 2020, and these customers now represent nearly 25% of our total revenue for the same period.

The goal is to increase Enterprise exposure. In fact, as of Q3’21, it was 30% of revenue.

I created a hypothetical scenario where Vimeo had 100 paid customers, 99 on a “Plus, Pro, or Premium” contract and 1 enterprise customer. Let’s assume nothing changes other than their ability to gain one more enterprise customers. Note, I somewhat made up numbers to back into an ARPU roughly around today’s levels.

The other subs can be flat, ARPU can be flat, but the mix effect can drive significant results.

And assuming ARPU is flat is pretty conservative. They stated in their S-1 that Net Revenue Retention was 110% and in Q3’21 they stated:

Our enterprise net revenue retention remains healthy with our sixth consecutive quarter of NRR above 100%.”

Pricing Strategy Change

Let me also say they are changing their pricing strategy. As I said, foundational changes can cause a lot of turmoil. Currently, this is in “beta” but they are moving from a storage-based model to a “per seat” model. In other words, they are going to try to base payment tiers off of customer success. You host a webinar, Vimeo will charge off of registrants. If you have an internal library of content, it will be based off of admin seats.

This may turn off some people. But Vimeo is doing it now because they feel they’ve expanded the product platform enough to make it enticing. Plus, aligned payoffs makes a lot of sense. Think about Facebook ads where the company buying the ad only pays when someone clicks – that is high ROI and easy to tie which increases lock in.

This is no doubt a big project and scary, but they have been talking about it for at least a year. If it works, they’ll move customers up in pricing tiers (e.g. from the self-serve model to a higher tier). For what it is worth, most SaaS companies are on a per seat model.

Here is Vimeo talking about converting customers and retaining them, as well as bringing up per-seat pricing. This is from March-21, but they also spoke about this in 2020.

In terms of the conversion and upgrade mechanisms, so I think of it in two ways. One of the biggest features that we see help unlock our free users to convert in the first place is being able to create content. The creation of content is a big barrier. So things like our Create app or Vimeo Create app, being able to record your screen and send a video message, those actions are really the things that we found activate a free user to get them to be paid.

From there, the way we tend to move our users and subscribers up tiers is unlocking more advanced functionality. Some examples would be livestreaming, advanced marketing tools, the ability to capture e-mails within a player, put your customization and branding, add calls to action, privately and securely share content or create a video portal, those are all the mechanisms today. Tomorrow, we see even more mechanisms. You’ll see us do things as we expand our product suite. You’ll see us look at per-seat pricing, for example, so that we can actually use the number of seats or the size of your team as a way to move people up tiers. But even what we have today, we see, I think, about 25% of our self-serve subscribers move up tiers from those other features I just mentioned.

Vimeo has >200 million free users today and they have a good history of converting them to paid. I think about Dropbox: it is much easier said than done converting free users, but when you are actually able to bring them up the chain, it is a beautiful thing.

If you go back to the S-1, it seems like this isn’t a “new” change, but something thought about for awhile now:

Over 65% of our new enterprise contracts came from customers who were existing free users or self-serve subscribers first

We seek to employ a “land and expand” strategy where we inspire our existing subscribers to increase video adoption and usage and upgrade to higher-priced plans over time. For enterprise customers, we seek to expand the number of employees, teams and departments using our platform and increase contract value organization-wide.


What about YouTube?

All of this can be a disconnect for people who quickly think of YouTube as a competitor. I’d say a lot of YouTube is B2C, ad-driven revenue.

Most people today probably still think of us as the sort of indie smaller version of YouTube. And for most of our history, that’s what we were. We were a viewing destination and a place to watch a video, like YouTube.

And 3 years ago, we pivoted away from that strategy to really being a B2B video SaaS company…today, we enable any business of any size to connect with their customers and their employees with video…we do this by providing a very simple, high-quality, end-to-end solution for those businesses and professionals. So SMBs and marketers will use us to make social media videos, post them all over the web and drive traffic back to their business or store. Fitness studios and churches will use us to live stream their classes and their sermons. And yes, we have Fortune 500 companies using us to host virtual town halls and conferences and events

Anjali Sud at a GS conference in 2020

Video is a big market and there are a lot of different use cases (read: niches). To head off the “YouTube vs. Vimeo” argument, let me pause and offer a few reasons why someone would choose Vimeo.

  • YouTube is quantity over quality: Vimeo can offer higher quality videos with more customization
  • No ads: there is a component of control here, such as no control over what ad plays in front of your video. Plus, an ad is inherently trying to drive traffic away from the site. That is NOT what a Vimeo customer wants.
  • Make money with pay per view: Back to that fitness class example, a small business can set up a “pay per view” using Vimeo
  • Password / privacy protection: Can create company specific vids or those for customers without sharing with the world

It’s reasons like these that the NYSE does live stream of opening and closing bell on Vimeo, or why Starbucks does workforce training on the platform. From a quality perspective, a lot of music videos are now on Vimeo as well as short-films where the filmmakers care about their videos not being compressed.

Anyway, it is a difficult question for many of the 800lbs gorilla squashing Vimeo’s niche, but I go back to how big the video market is. To me, the analogy is similar to an Etsy vs. Amazon – both can exist.

I think this conversation on Vimeo will not die down. It will likely continue to “dog” the company for some time, especially when reports of other video players adding new features (like Zoom) emerge. Unfortunately, I can’t “prove” Vimeo will win in every case. That’s the bet.

Summary Model Scenarios

For the first model summary, I wanted to show a “management case” and have ’22 at subs and ARPU growing 9-10%, for 20% revenue growth, followed by re-acceleration. I assume some modest leverage on COGS, but they are already at their goal, and some fixed cost leverage (mostly coming from G&A – where I assume ~70% of G&A is fixed).

Yes, I do assume SBC is added back to EBITDA for Adj. EBITDA.

I assume, because they’ll be generating so much cash and already have a lot of cash on hand, that they start buybacks in 2023 = FCF. They likely do acquisitions instead, such as the two at the end of 2021, but those assumptions are too hard. Buybacks start at $20/share and stock price increases 15% p.a.

Bottom line: If you think this is reasonable and want to buy the mgmt case, then we are buying the business for 3.7x 2026 EBITDA and the company will be generating a lot of the current market cap in FCF.

In this case, the company will be doing $4.35/share in FCF in 2026 (remember, stock today is <$14). 20x that figure gets you an $87 stock price.

What about the scenario where they were *just* a COVID winner?

I think that’s interesting. The truth might be somewhere in between.

Let’s say subs slow to just 3% a year but ARPU decelerates meaningfully. NOTE: This is in full contrast to the Enterprise customer math we did above! In reality “what I think will happen” is subs could slow, but ARPU accelerates.

But anyway, you can see the results here:

Given I still assume buybacks (at the same prices in the first case) I have Vimeo doing $1.20 in FCF/share by 2026. If you put 20x on that, that’s a $24 stock. That may not seem like much, but that’s 60% over 5 years and foots to a 10% CAGR.

If the truth is somewhere in between, the risk / reward looks pretty attractive now.

I tweeted this in the beginning of the year, because I saw it as an interesting way to play Vimeo and wait for a better price:

Full disclosure, I did do that trade. At the time of writing you can get $2.25 for this contract! That’s an 18% unannualized “yield!” And I also have done that. Worst case, I am buying Vimeo stock at $10.25, or $1.7BN. I am comfortable owning there, too!

Selling cash-covered puts is more conservative than buying the stock. BUT it has less long-term upside. Sentiment seems pretty low, and definitely can get worse, but there is risk you miss out owning a great, little business with a long runway ahead.

Why $BRK Should Buy $ALSN

Reading Time: 5 minutesI wrote previously about companies Berkshire Hathaway could potentially buy. One of those options actually was acquired, just not by BRK. But I think Allison Transmission ($ALSN) is another strong candidate. Why do I say that?

  • ALSN is the market leader in fully automatic transmissions for medium-to-heavy duty commercial vehicles
    • They do not play in the super cyclical Class 8 truck market
  • Because of market dominance, they have great margins: ~35% EBITDA margins and spend 6% of sales on capex
  • Generates high ROIC (>20%) and even higher returns on tangible capital
  • It’s a classic industrial, but misunderstood, which has it trading in melting ice cube territory wayyy too early
  • Mgmt has been solid capital allocators, though the stock price doesn’t reflect this yet

I recently initiated a position in ALSN. It came up as I decided to update my model (right after I did some quick work on American Axle) and noticed that the share count had reduced from ~120mm to 106mm in a pretty short period of time… but the stock was actually lower than the last time I looked at it.

I think there are many reasons to own the stock now, not least of which is a cyclical upturn in their end markets, but wanted to frame it differently for this discussion. It’s a “small” company at ~$6.5BN EV, but I don’t think that would stop Buffett.


ALSN is the Market Leader: 

This is a great slide covering ~50% of their sales, showing their dominance in “niches.” I love businesses like this.

Allison invented the automatic transmission for commercial applications and there’s been a long trend in the West away from manual transmissions.

It doesn’t matter as much in long haul, but constant starting and stopping can be annoying with a manual and Allison’s transmissions can also be more fuel efficient (lots of start and stop activity).

So who do they compete with? Well, their main customers are OEMs. Typically, their competition comes from OEMs who decide to do this in house, like Ford. Other competitors are smaller players that clearly don’t compete on the same scale.

This is mainly the North American market, so it should be noted Europe (13% of sales vs. 52% North America) has more vertically integrated players for these commercial vehicles, particularly the commercial trucks. So ALSN’s exposure in Europe is mostly garbage truck, emergency vehicles, bus and other markets.

ALSN, though, is viewed as the leader of technology and is often the most desired transmission.

I won’t dwell too much on their other markets (defense at 9% of sales, which is mostly tanks, or off-highway which is mostly construction and metals & mining exposed, but just 4% of sales).

I will say service, parts and equipment is the second largest part of sales (22%). I like this piece of business because aftermarket provides a nice, steady recurring revenue – driven by the large installed base of transmission already in existence.


ALSN has Great Margins

As mentioned, ALSN has ~35% EBITDA margins. That is actually down from peak due to (i) lower sales LTM, (ii) increase commodity costs, (iii) product mix, and (iv) a ramp in R&D expense. Given dominant share and a recovering market, I think they’ll work their way back up to high-30s EBITDA margins.

That said, the market is completely freaked out about EVs and lower margins in that category. For ALSN, it is the number one bear case. It was asked about 3 separate times on the latest earnings call, despite the existence of electric vehicles still being relatively nascent (I won’t hold my breath for the electric tank either).

This does tie into the misunderstood point, which I hash out below.


ALSN Generates a Great ROIC

Note, ROIC does get hit in cyclical downturns (2014-2016, 2020), but through cycle it is well above ALSN’s cost of capital and run-of-the-mill businesses. Enough said.


ALSN is a Classic Industrial, but Misunderstood

I think its pretty clear that ALSN is a classic industrial. An old school business. Maybe not classic given its high margins and dominant position in its market, and many, many industrials struggle to generate good returns without a lot of leverage.

ALSN does have many growth avenues, such as emerging markets which still have high manual transmission penetration. Second, there are underserved portions of the North American market it could enter, shown on the previous market share slide.

But the market is completely freaked out about EVs.

As I wrote about with Autozone, the penetration of EVs will take some time to work out in the passenger car market. The misperception with Autozone is that the market forgets how big the car parc of ICE engines is compared to new production.

It will, in my view, take even longer to happen in commercial. Add in the fact that these trucks consume so much energy from towing, it really will be tough to figure this out.

But why freak so much about EVs? Its because EVs don’t require a transmission and Tesla’s Class 8 truck doesn’t have a transmission. There. That’s the bear.

That said, ALSN is already the leader in hybrid transmissions (particularly hybrid buses), they have frequently highlighted examples where Allison transmissions have been used in electric trials over the past FIVE years, and there is a strong case that commercial EVs may benefit from a transmission (it could likely reduce the strain on electric motors, thereby reducing the need for larger, heavier batteries).

Is it a threat? Sure. I think EVs are inevitable. But will it take time? Yes. And the costs side has to be figured out so much more so on the commercial vehicle side than the passenger side (let’s not even talk about how we’re going to mine all these precious minerals for EVs…). And let’s not forget nearly a quarter of ALSN’s business is parts & services too, which will continue to benefit from a large installed base.

Maybe I’d be more concerned if ALSN had no position, had no experience, and the commercial vehicles were here and rapidly taking share. Maybe I’d be more concerned if ALSN wasn’t a FCF monster. But ALSN is priced as if this doomsday is already the case.


Mgmt has been excellent at capital allocation

It isn’t everyday that you come across a slide like this. First ALSN got their debt down after being PE owned. Then they continued to paydown debt after IPO’ing, but largely turned to share repurchases, dividends, and modest M&A. It’s pretty clear to me, that while the company is increasing spend on R&D, every dollar of FCF will be coming back to shareholders.

They repurchased 5% of their stake in the 1H’21… they’ve repurchased 50% of their shares outstanding since 2012! All while delevering, not levering up.

ALSN IPO’d in 2012, so you can see they clearly turned cash to repurchases

Back to Berkshire – look, if this cash is better spent on other businesses, let Buffett make the call. But at this point, the market is just not giving them credit for the cash!


Why Now?

Why buy the stock now? You make your own call, but for me, we are witnessing a cyclical upswing. ALSN will be growing sales and EBITDA for at least the next 3 years just to get back to a baseline.

Using consensus FCF numbers, ALSN currently trades at 14.5% FCF yield on 2022 FCF estimates and 15.7% on 2023. This likely means they’ll be buying ~12% or so of the stock back + the dividend. With that much buying pressure, plus a cyclical upswing, I think it is very hard for a stock to NOT work.

On EV / EBITDA, ALSN trades at 6.5x ’22 EBITDA. I regularly see paper companies trade for around that. That seems too cheap to me.

Sponsors have owned the business before and they may own it again. It can support a lot of leverage…Or, Mr. Buffett might give it a look.

American Axle: Play the Auto Restocking Cycle $AXL

Reading Time: 3 minutesAmerican Axle is a crappy company. But I currently view that we are going to see a large increase in auto production to (i) meet demand which we are unable to do right now and (ii) restock to baseline inventory levels. So with the stock at a ~40% FCF yield, I’m interested.

This could be a value trap, but my thesis is simple:

  • SAAR came way down during COVID, but demand held in
  • Semiconductor shortages have limited production to catch up, which will sort itself out over time. But it will take time. And this will result in a prolonged auto upcycle
  • Credit is cheap + average age of vehicles has continued to tick up which tells me there’s room for even more restocking.
  • US personal savings averaged $3.5 trillion during first 5 months of 2021, nearly 3x the level seen in 2019. We could see a decline in the average age of vehicles in the car parc for the first time in many, many years
  • Inventory continues to decline. Days supply of autos is now around 20 days compared to long-term averages of 60 days. Auto producers need to meet current demand + restock inventories to some sort of normal level

Add this all together, I think the next 3+ years will need to see above average production to catch up.

Here is SAAR, auto inventories and the average age of cars on one chart:

What is a levered bet on this? Shitty auto suppliers. And that is where American Axle comes in to play (and I’m open / reviewing others). AXL trades for ~4x EBITDA for a reason – when auto production collapses, they get crushed. But on the other side, they can generate great FCF when the cycle is in their favor.

How often do you see sell side pointing out the FCF yield is ~40%?. That is also an appeal here – the FCF yield to equity is quite high and I don’t think expectations are high for this company. At the very least, there is a lot of doubt in this cyclical name that the cycle will be short-lived.

$AXL used to have “a balance sheet problem.” While it might’ve only been 3x levered, it was on a business worth 4x, so it mattered. That’s a 75% LTV, which is pretty high. But they generate cash flow now and will definitely in this market.

I should go ahead and point out why they are not great:

  • AXL is a Tier 1 auto supplier, which is a tough business and cycles hard
  • ~40% of sales are to GM. If GM needs to take a plant down, like in the case of no semi’s, that won’t be ideal. This also means GM has significant power of AXL. Fiat Chrysler is another ~20%
  • Pretty capital intensive, as 6-7% of sales is spent on capex in normal times.
  • Investors view anything related to powertrain parts as secularly challenged from EVs (however, AXL did note it is quoting $1.5bn of new & incremental work, with 80% related to hybrids / EVs). In an EV world, perhaps there is less AXL content needed

So there lies the main risks. The other hard part is where this company should trade. I am not calling for a re-rating. I just think earnings / FCF will likely be much higher than consensus expects for the next 3 years. Leverage is down to 2.5x and once they get to 2.0x or less, I think that FCF will really start accruing to the equity.

If this stock underperforms – I’ll know why. I bought a value trap.

Container Shipping is on Fire: Opportunity in Leasing Stock Triton $TRTN

Reading Time: 6 minutesAs everyone I am sure is aware, container shipping rates right now are astronomical. The re-opening of the economy and associated supply-chain bottlenecks has created a situation where people will pay up just to make sure their items are actually on that boat!

This has caused blow-out earnings for the shipping lines. Maersk reported a 166% increase in EBITDA for Q1’21 for example.

However, I don’t think this is sustainable and no one else does, probably. Shipping is also a fraught industry to invest in – when times are good, capacity is brought online. These ships are long-lived assets so when times aren’t good, the supply is still there.


There’s alternative however, with a much stronger industry structure, ROEs, cash flow, on and on. That is container leasing. Triton is the largest player in the space after it merged with TAL in 2016.

I like Triton stock because:

  • Leader in the market – scale in the leasing industry matters and drives much higher margins + lower cost of capital
  • Fundamentals are in terrific shape
  • They are signing long leases at high rates – abnormally long and abnormally high (over a decade) – which will give strong visibility into cash flows for foreseeable future
  • Can flex capex spend with the market – has a history of shutting of capex and buying back stock + dividend
  •  Triton stock trades for ~6x ’21 EPS, 1.3x ’21 BV – historically generated mid-teens+ ROE in normal times. This should improve

The business historically went something like this:

  • Triton buys containers and places them on lease with shipping companies.
  • Historically, these would be 5 year leases. However, with limited technological obsolescence (just renting a steel box in most cases), the age of the asset didn’t really matter. So they can pretty quickly re-lease the box, but the lease rate may change
  • The assets (boxes) last about 15-20 years with pretty minimal maintenance. Maybe slightly more for a refrigerated box, called a reefer (yes the actually  name), but the lease rates would also be higher. So historically there’d be 3+ leases involved
  • End of life – they sell the box for some residual value, which also helps recoup part of their investment. It used to be they buy a box for $2,000-$2,500 and could sell it for ~$1,000. Right now, they can sell the used box for about $1,500, which is pretty nice.

Why do shipping companies lease instead of owning their own containers? It outsources capex in an already capex-heavy industry. It’s off balance sheet financing for them. The shipping lines do still own their own containers (about half of the market), but that’s been trending down pretty consistently over time. It just makes more sense for them to focus on shipping and flex leases up and down with the market.


Investment Thesis

I don’t think I need to dwell on why fundamentals are good right now or why buying Triton stock at 6x earnings is optically cheap. I’m going to focus on the lease rates and new longer duration contracts being signed right now.

If you are worried about the current conditions being unsustainable, long, contracted lease rates help that. As shown below, Triton is trying to tell investors that not only is it leasing more containers than basically ever….  putting assets to work… the lease durations are now approaching 12-13 years.

If you like SaaS, you’ll *love* container leasing companies.

We’ll have to think about these rolling off in 2031-2033, but meanwhile, the company will be earning above average ROEs.

Here is a chart from their Q1 basically showing lease rates are 1.6x the general average. You can see there was a dip in 2019, but the company pulled back – the size of the bubble indicates how many containers were put on lease (so very few). In a sense, Triton is an asset manager just like a Blackstone – you kind of need to trust that they will be deploying capital when times are good and pulling back when times are bad.


What could go wrong?

I should mention what could go wrong. We have seen this situation before – following the GFC, world trade snapped back and lease rates surged. Unfortunately, they all basically expired in 2015/2016. This was also when we were in a quasi-industrial recession. This was also when steel prices were in the gutter, which makes up most of the price of a box and makes it tough to sell used boxes at a fair price. Hanjin, a major shipping line, also effectively liquidated (in a BK case, most of the time a shipping line will just keep its assets rolling in a Ch. 11 because the containers are critical assets to operating – Hanjin just disappeared.)

In many ways, 2015/2016 was worse that the GFC. I mean, it actually was worse. The GFC wasn’t actually that bad because global trade remained pretty steady.

Even with a trade war, it’s hard to knock off the secular trend of the western countries importing from Asia. If it isn’t from China, it is from Malaysia, Vietnam, and so on.

Did I strike to buy Triton stock in 2015-2016?? No. I was gun shy as I’ve been following the industry for quite some time and they never seemed to generate real FCF (CFO-Capex). It was an asset gathering game.

But then in 2019-2020, when the market wasn’t particularly great, they actually proved they could shut-off capex. They starting generating a ton of FCF and showing signs to shareholders that they care about the stock (they even issued a pref as well to help fund buybacks)

Another sign they care about capital allocation is this fantastic sources and potential uses of cash in their deck:

Basically they are telling you they could buy back 12% of the stock in one year. Share count is down about 15% in 2.5 years, but now I think they’ll be deploying cash into higher ROE opportunities, which is fine by me.


Financing

One thing I should mention is typically Triton finances itself through the ABS market. They get 80-85% LTV against the asset value for very long duration. Happy to answer any questions on this, but I’m not too concerned with the ABS market financing.

Triton issued $2.3 billion of ABS notes during the third quarter at an average interest rate of 2.2%. Most of the proceeds were used to prepay $1.8 billion of higher cost notes, which is expected to reduce interest expense by more than $25 million over the next year

They are also diversifying financing – so they just issued an IG secured bond and have talked about moving up to IG ratings. If their cost of capital goes even lower, it will be great for the business in the long run.


EPS Estimates

Last thing I’ll say is basically Triton is covered by one company. You’d think modeling it would be easy enough, but we are talking about hundreds of thousands of containers, utilization can change, etc etc. However, I think EPS estimates are probably still too low in the long-run. It’s been that way in the short-run, so far, but we shall see. It’s hard for sell side to model operating leverage + high lease rates + deploying cash into such a significant amount of assets.