Tag: Equity Analysis

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Why $BRK Should Buy $ALSN
Reading Time: 5 minutes

I 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.

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American Axle: Play the Auto Restocking Cycle $AXL
Reading Time: 3 minutes

American 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.

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Container Shipping is on Fire: Opportunity in Leasing Stock Triton $TRTN
Reading Time: 6 minutes

As 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.

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LGI is a Buy $LGIH
Reading Time: 6 minutes

I think LGIH stock is potential multi-bagger. Well, it already has been one, but I think it can do it again. When you add in solid growth, good demand fundamentals and a high ROIC business model, it spells opportunity for long-term investors.

Take a look at some of its growth metrics over time. It does around $480MM of EBITDA now, which is about 2.2x from 2 years ago, and 4.0x from 4 years ago. Also… it was the only homebuilder among the 200 largest U.S. homebuilders to report closings & revenue growth from 2006 to 2008 when the housing market experienced a significant decline. So management clearly is focused on growth.

LGIH did $12.8 in EPS for 2020, but I see the path to $23.3 in EPS by the end of 2023 (discussed more below). Therefore, shares are trading at just ~7.25x my 2023 estimates.

LGIH is interesting too because they provide monthly home closing cadence. The May 2021 was up 42% Y/Y and YTD is up 44%. On one hand, easy comps with April/May, but on the other hand, I think they will keep this strong cadence going for a decent period of time.

Let me break it down.

Perhaps by now you know of NVR, a homebuilder with a “unique” business model which I break down here and how the stock has actually outperformed Microsoft (at the time of writing). It is asset light, relying more on options than buying and developing lots, which in turn means less capital tied up, they have high inventory turns, and high ROIC.

LGIH also generates a really strong ROIC, but it doesn’t rely solely on options, as you can see below (controlled = options). It’s split ~55% owned / 45% optioned.

As you can see, LGIH’s ROIC not only is solid for any company, it is improving with scale.

LGIH ROIC

So how has LGIH stock done versus NVR’s? LGIH stock is now officially crushing NVR

LIGH stock vs. NVR stock

However, LGIH still has a unique model. Let’s break it down:

  • Very sales focused:
    • Whereas NVR focuses on the land strategy (a big thing for builders, no doubt), LGIH’s core competency comes from focus on sales and marketing
    • A sales office typically has 2-5 people in it with one loan officer.
    • LGIH trains its sales staff for 100 days
    • The main goal is to convert renters to buyers. They even send direct mailers to apartment complexes pitching renters on buying a home.
    • Now, in talking to some folks about LGIH’s process, it’s clear some people think LGIH is akin to a used-car salesperson (i.e. pushy). However, as we’ll discuss more, the model appears to work really well. Consumer reviews are also pretty solid.
  • Spec homes – big contrast from other builders
    • LGIH is 100% spec homes. Almost the opposite of NVR
      • “Spec” means they build the home without the buyer already secured. NVR only builds on the optioned land once it has the buyer.
      • Everything is typically included, so there are not specific options that each buyer needs to select. They have 4 to 5 home plans in each community that allows LGIH to build and sell faster and drive on.
      • Now, clearly LGIH seems more risky, though in a tight inventory market, the market needs spec homes. Its model is also still low cost.
      • Also, LGIH was the only top 200 builder to grow from 2006-2008
  • Focused on entry-level:
    • Average price point is around $250k, which is square in the entry level price point (meaning first time home buyers).
    • Given lots are expensive these days, LGIH is typically acquiring lots outside of city centers, but also targets areas where there is some retail anchors to attract consumers.
    • This segment of the market should have demand for years to come, given millennials deferred purchasing homes post-GFC and have been renting for longer.
  • Still earns strong returns
    • The average & median builder earns around a 12% EBIT margin, with DR Horton and Lennar near the top given their massive scale (16.1% and 15.5% respectively) and the smaller builders near the bottom, such as Beazer and Taylor Morrison around 10%
    • LGIH earned a 18.3% EBIT margin
    • Another interesting thing to note, going back to strategy, is LGIH’s absorptions blow competitors out of the water. Again, 4 is the average absorption rate per month in 2020. LGIH is around 7. The gap was even wider pre-COVID (i.e. before the buying boom).
    • This means LGIH is selling almost double the amount of homes in a period of time as competitors.

So what drives LGIH’s high returns on capital?

Dupont formula: profit margins (high for LGIH), asset turns (high for LGIH), and leverage (actually low for LGIH).

As LGIH gains size, I think ROIC will continue to grind higher. Now, they’ve gotten pricing, which helps ROIC and margins, but look at ROIC as size has scaled.

LGIH ROIC

As a quick aside, it’s funny to contrast everything we’ve talked about so far with New Home, a luxury builder I wrote about a few months ago that still trades below book value. New Home is small, so its EBIT margins are low. It’s also a luxury builder which just given the nature of the product is slower moving. However, I still think it’s cheap and it’s likely a take-out candidate in a market thirsty for inventory.

Ok – back to LGIH. To my knowledge, only a couple firms cover LGIH. I only could find JP Morgan and BTIG.

Here lies the opportunity. I think LGIH will be a long-term compounder and it’s relatively undercovered. Based on my estimates, I think LGIH will do about $23 in EPS in 3 years (from ~$15 LTM). So with the stock trading at 7.4x that forward EPS today, that seems too cheap to me.

LGIH projections

Sure, I’m looking 3 years out on a cyclical business, but I’d rather have LGIH stock than buy a questionable SAAS name for 20x sales.

The risk to the thesis is, can they keep up the growth? Well, 2020 will definitely be a tough comp. Right now, we are still lapping the easier part of 2020.

However, the risk to LGIH’s growth is not the same as NVR for example.

Recall, NVR uses solely options on lots and those don’t exist in every market. LGIH’s risk is acquiring lots at attractive prices and selling them in high demand areas – lot prices are going up, but so is entry level demand. I think LGIH will just pass that through.

There are other obvious risks to homebuilders. Interest rates, the economy, etc. etc. But I think this cycle is going to last awhile. Sure, we could have a buyers’ strike like the end of 2018 as rates were rising, but I think we actually need several years of housing starts >2MM (vs. new cycle high of 1.5MM right now) to sustain demand.

I watch the builder stocks from time to time. In some ways, they’re HODL’ers. They are so volatile. But a few are worth grabbing on to and just taking along for the ride.

So bottom line: LGIH stock may not be a straight path up, but I think it will compound earnings for a long period of time.

Columns, Security Analysis

Forced Seller + 25% FCF Yield = Interesting Civeo Stock $CVEO
Reading Time: 4 minutes

Today will be a quick idea on Civeo. The bottom line is that CVEO stock trades at ~25% FCF yield, is only ~2.5x levered, and there is a “forced” seller I think is driving down the stock.

Ok – “forced” seller is kinda click bait. The company completed an acquisition a few years ago, giving the seller some stock as consideration. That seller is now blasting out nearly every day, which I get into below.

Background

Civeo provides hospitality services to commodity industries. So think about remote locations where companies are mining precious metals and pumping oil and gas, Civeo provides lodging, food service, and housekeeping for those companies.

Commodity prices generally have been completely bombed for several years now, particularly where the company participates. This includes oil, liquified natural gas, met coal (the coal used to make steel), and iron ore, though demand has still been OK (as I noted in this oil post). The nature of the business also means they typically are in highly commodity driven areas – Australia (given their met coal and other metals help serve the China / Asia demand), Canada (oil sands) and the US E&Ps.

As you can see, the stock has not performed too well in this environment.

The company currently operates around 28 lodges covering 30,000 rooms. They also own a fleet of modular assets that are typically used for short-term stays in the US and Canada.

“Forced Seller”

ANYWAY –  if you were to look at the company’s insider transactions, it would look UGLY. The Torgerson’s have sold 3% of CVEO stock (almost $7MM) in near-daily blocks since August 2020.

That is until you realize the Torgerson family were the sellers of a company Civeo bought, Noralta Lodge, for $165MM. Of the total purchase price, $69MM was issued in equity to the holders of Noralta.

This was a little over 3 years ago at this point, so no surprise following a COVID scare + some time since you’ve sold your business that’d you would just want to move on.

The Torgersons still own 11% of the company, so there is a long way to go, but I can’t call the end of this technical factor.

Nearly 25% FCF Yield

The seller is obviously not selling because the value of the CVEO stock looks too rich.

On the latest call, Civeo management guided to $55MM of FCF. This compares to a market cap of ~$230MM. Previously, the company used FCF to delever (after levering up for Noralta), but now that it is at 2.5x, there is a bit more flexibility. As I’ve talked about, I like these busted balance sheet names as they start to improve, but are still in the penalty box of equity holders.

When a stock trades at 25% FCF yield, the market is saying there is high bankruptcy risk. I don’t think that’s the case here. The term loan and revolver mature in 2023 and they generate plenty of FCF to keep lenders happy.

Fortunately, the COVID snapback has caused commodities to rip. If they stay elevated, who knows, but I think it will at least help the company extend contracts on existing lodging facilities and maybe sign some new ones (that will also help any concerns with credit facilities, but again – I’m not concerned there).

There is a bit of a spat going on between China and Australia over trade, but I think it’ll be sorted out eventually. Either way – this was included in mgmt’s FCF guidance. Secondly, the company announced it renewed several key Australian contracts on its latest call.

Back to the FCF yield guidance – there should be pretty good visibility. You have a set number of rooms available on site, you talk to your customers about need and what they are planning for the year, and you have a general gauge of commodities (are they up or down, is demand up or down) so you can try to win more business. This makes me believe FCF guide is a decent one to bank on.

Last thing I’ll say, the past 3 years the company actually generated $63MM of FCF on average. There was some working capital movements there, but it doesn’t seem unreasonable at all to me.

M&A Target (Seriously)

Using “M&A target” as an investment thesis is weak… yet here we are.

Typically its weak because its like, yeah sure… in SOME scenarios, this COULD get acquired (especially in a deal hungry private equity market), but any time I hear that, it doesn’t come to fruition.

In this case, Target Hospitality received a buyout offer from TDR Capital. Now, it was apparently a really cheap price of $1.50 and now Target Hospitality is trading at $3.40. Target Hospitality currently trades at 7.25x ’21 EBITDA vs. 6.0x for CVEO. HOWEVER, Target is also pretty levered still at 5x EBITDA vs. 2.5x for CVEO. Their cash flow has also been much less consistent. 

I also think the capital markets are supportive and perhaps this company would be better suited as a private company, rather than a $230MM public company. Just saying.