Tag: Equity Analysis

Different Way to Play Housing: Manufactured $CVCO $SKY

Reading Time: 7 minutes

I did a recent post on Sun Communities, a manufactured housing and RV park manager. I liked the core business and outlook, but returns on capital seemed too low and the the REIT structure made them over reliant on capital markets for growth. I could be wrong on that name, but I think I found where I’d prefer to play: manufactured housing stocks. And there are two stocks in the space: Cavco (CVCO) and Skyline Champion (SKY). The Oracle of Omaha owns the other, biggest player in the space, Clayton Homes.

Why Manufactured Housing?

Bottom line: Manufactured housing has improved considerably over the past 30 years (both from a product perspective and an industry perspective). With home prices moving higher with tight supply vs. demand, I think we will see considerable demand for something more affordable for years to come. I also think these stocks are “off the radar” for most people. COVID also masked a very large build in backlog.


Why is Housing in a Shortage? Following the last downturn, where we clearly overbuilt housing supply, we went too far in the other direction. We’ve been underbuilding arguably since 2010 when the housing market started to bottom.

If you look at the long-term average of construction starts (pictured below), its around 1.5-1.6MM average starts per year. We just got back to that level 11 years after the bottom. So we just got to long term averages. In 2012-2013, we were still building in line with the lows of 1980’s and 1990’s recessions (I’ll add that the average mortgage rate in the 80s was in the teens percent range… not below 4%).

Another simple way I think about it is, if there are 120MM households in the US and that grows 1% per year, we need at least 1.2MM new housing developments each year, and that is before any teardowns or second homes.

In reality, household formations over the past 10 years have been held back. We all remember the stories of millennials moving back in with mom and dad. Well, that is a deferred housing formation. And that is finally starting to unwind as millennials age, get married, and have higher savings.


Another way to look at it is from “months supply of inventory.” Months supply of single-family homes hit a new all time low recently at 1.9 months. This means at the current sales pace, all of the housing inventory available for sale would be sold in less than 2 months – a new record low.

Tight supply + strong demand = increased prices. Econ 101. And that is bearing out. CoreLogic reported home prices increased 10% Y/Y in January 2021. Low interest rates also haven’t hurt to spur demand…

Could housing cycle down again? Yes. Absolutely. In 2018, when rates were rising, people paused their purchases. You can kind of see the surge in months supply of inventory on that last chart in 2018. However, that just deferred demand.


I encourage you to scan your local market for “entry level” homes. There just aren’t any available. Part of that is also because of investors scooping up rental homes, too. We also now have 3 publicly traded REITs that play in the single-family home market that didn’t exist prior to the financial crisis.

All of this tells me that housing will remain unaffordable to a large swath of the population.

Enter: Manufactured Housing

In areas I look at real estate, the $150k entry-level home doesn’t exist anymore. At least, not within an hour’s drive. Heck, even $250k is becoming more scarce.

SKY had an interesting stat from 2018 that noted, 80% of homes sold below $150k are now manufactured homes. The average price SKY sold homes at was ~$63k, so there is a huge disparity between entry-level single family home and buying manufactured housing.

We also can’t forget that ~37% of American’s earn less than $50k per year. One out of four Americans make less than $35k per year. And that’s the market for manufactured housing.

Statistic: Percentage distribution of household income in the U.S. in 2019 | Statista
Find more statistics at Statista

Some Quick History

This might be a good time to explain some history on manufactured housing. In short, MH saw a mini-preview of the Great Financial Crisis in the 1990s. Both consumers AND retailers were able to get ultra-easy financing. When you think about that in relation to supply / demand, it basically meant demand from consumers was artificially propped up AND retailers were able to stockpile inventory cheaply.  This eventually caused the industry to implode and it still hasn’t recovered from a shipments perspective.

Recovery to these levels isn’t my thesis though. It is pretty hard to argue shipments will go back to bubble levels.

The share of manufactured housing as % of housing starts has been pretty constant though over the past 15 years, which I think could improve some in an affordability crisis. I think it could also exceed recent levels because of this. I also think starts will continue to be above long-term averages.

So we may not get to 222k shipments as highlighted in the chart above, but we could come somewhere in between.


As with any downturn, this led to consolidation. Berkshire is the behemoth, followed by Skyline (which merged with Champion) and Cavco. The latter two still roll up any players that come for sale, but its pretty well consolidated at this point.

As pictured at the beginning of this post, the inventory available has really improved. And they come in all shapes and sizes…..


I Like the Business Model

The business is vertically integrated. A SKY or CAVCO typically manufacture the home, but also operate the retail side as well (though there are individual retailers, too).

Need financing? Cavco and Clayton have retail financing arms, too (and they are GSE approved). Both Fannie and Freddie offer financing support, which is relatively new and I personally view as a game-changer. There was a recent WSJ article on this as well. Now consumers can get access to cheap financing with as little as 3-5% down – very helpful to a consumer who may not have a high degree of net worth. I’ll circle back to the limits of this, though (permitting).

How do they transport the homes? They operate trucking businesses, too.

Anyway, I think the manufacturing side of these homes is interesting. Homebuilding is actually moving more and more to these sorts of “off-site construction” given labor constraints and a desire to speed up build times.


Why Permitting is an Issue

A benefit to Sun Communities is a detriment to Cavco and Skyline. Manufactured housing suffers from “NIMBY” or not in my back yard. So permitting for new communities that allow these types of housing is tough and this has clearly been a governor on growth. That is essentially why Sun has to acquire for growth versus anything organic.

However, with improved aesthetics and a broader realization that housing is unaffordable, we could see some changes here on the margin.


Cavco and Skyline are very similar, so I’ll just show CAVCO highlight below. While EBITDA margins are relatively low, capex is too. So for each dollar of EBITDA earned, they actually convert a decent amount of that into unlevered FCF (excl-taxes, excl-interest). It seems pretty clear to me that the company can scale up earnings without needing to invest too much.

For example, Cavco acquired some commercial real estate in 2020. Otherwise capex would have been $8-$10MM. Said another way, they increased EBITDA from 2016 by $42MM, but recurring capex only went up by $4MM…


Backlogs are Big

In March 2020, Cavco had a backlog of ~$124 million. Today… its $472 million. But if you looked at 2020’s results, it doesn’t look like Cavco really benefitted too much. LTM sales are up 1%. But the reason has been manufacturing disruption. So the results are really more on the come.

Skyline is in a similar place: Their backlog before the pandemic hit was $128MM… now its nearly 4x that. 


Valuation

Admittedly, Cavco and Skyline don’t screen as cheap stocks. Each trade around 15.5x March ’22 EBITDA and 25x FCF based on consensus estimates. Number one, I think the higher multiples are warranted as these businesses can generate good FCF and they also are essentially debt-free (kind of like WD40). I also think growth will be above average for years to come.

I also think consensus is way too low.

Again, these are manufacturing businesses with backlogs that are up 4x from pre-COVID and we really haven’t seen that roll through yet. Therefore, consensus estimating sales up 12-15% for CY2021 seems way too low to me. While labor and raw material increases could squeeze margins, if capacity utilization on the plants are running flat out, that fixed cost leverage will improve EBITDA considerably.

Time will tell. I like both Cavco and Skyline and am just playing it via a basket.

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

Reading Time: 10 minutes

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

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

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

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

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

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

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

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

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

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

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

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

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

Some other things I learned after further work:

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

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

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

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

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

What type of Moat Business is WD-40?

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

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

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

As Connor says,

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

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

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

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

Expectations Investing

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

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

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

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

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

DCF

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

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

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

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

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

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

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

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

Bottom line:

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

Will I be adding it to my portfolio? No.

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

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

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

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

 

KAR Auction Services is Not in Secular Decline $KAR

Reading Time: 7 minutes


KAR auction services, the company that runs used car auctions, looks on sale right now.

KAR has been under pressure from COVID impacts to the business, but unlike other COVID-impacted names (where investors are seeing through the clouds), the stock is still down meaningfully.

KAR reported earnings Q4’20 earnings and guidance last week (on Feb-16) and the stock is down about 24% in the past week.

KAR Auction Services Stock

It seems to me investors do not realize KAR Auction Services current pressures are cyclical, not secular. Today, we’re able to buy a really good business at ~10% FCF yield on depressed earnings.

KAR Auction Services FCF Yield


Why is the stock getting hammered?

For one, disappointing guidance. The company expects EBITDA of at least $475MM in 2021 as they continue to recover from COVID.

Consensus was expecting $566MM – ouch.

Kicking the Can? The other issue with guidance is it is 2H’21 weighted.

In my experience, this can be a “kick-the-can” move for management. In other words, they know 2021 EBITDA has the chance of being lower, but they’ll wait for Q2 earnings to break that news or maybe things will turn around.

Fingers crossed. This isn’t always true, but just my experience.

Management left wiggle room – they did say at least $475MM. They also explicitly said the guide is conservative. That’s not something I’m banking on. I also don’t really care about 2021 earnings in isolation. That’s way too short-term focused in a year that will continue to be impacted by COVID, as noted further below.


Why the weak guide?

Car values are high right now. During the height of COVID, the manufacturers pulled back in the face of a new, deep recession. Plus, they had to reset manufacturing processes during a global pandemic. Lo and behold – demand for cars held in. This is known as the bull whip effect.

Supply < Demand = really high used car prices.

Manheim Used Car Price Index

Normally, this would benefit KAR Auction Services, because their auctions would be earnings higher auction fees on cars. But there is clearly lower volume going through the lanes.

Not just from the shortage of cars, but also when residual values are high, you will see less lease returns as the customer decides it’s a good deal to buy out the lease at the value that is better than current market. There has also been less repossessions, another volume headwind.


What is the Street Missing?

Number one, the stock looks cheap when you bridge using the current FCF guide.

Yes, there is risk the guidance, but I don’t actually think KAR’s go forward earnings potential is limited by this year’s factors. The things I mentioned all seem cyclical.

Second, they are caught up on secular changes versus cyclical.

KAR’s earnings are being hit by cyclical issues that I think will abate.

Every investor is trying to see how COVID will change the world and how technology will reshape it. A lot of investors are saying KAR’s barriers to entry have been lowered now that auctions are online. I do not think that is true.


I read one note expressing concern that a survey revealed a lot of dealers are looking to buy and sell cars via online auctions this year. Given KAR Auction Services has a strong physical presence, this caused some concern. Pardon my French, but my response to that is – No Sh*t, Sherlock.

We’re in a pandemic. Of course dealers are looking to buy and sell online. They have to. And this was definitely the case during 2020.

If you read my About Me page, I used to have a dealer’s license. I know a thing or two about buying used cars and I used to go to Adesa all the time. It truly is a great business, which I’ll go into some brief detail later.

But anecdotally, I can tell you buying cars online is not easy. You’re buying a car with limited info, no ability to drive the car to see how it feels, how it sounds, check the oil, etc. The cars I bought online (as opposed to the seeing it in person online) were some of the worst purchases I ever made and I pretty much vowed to never do it again because it was a waste of time.

“But Dilly D”, you’re asking, “can’t this be improved?”

Of course, this could be improved with technology and better disclosure. You need to realize, though, that these online platforms are turning over thousands of cars. And as much as cars may seem like a commodity, used cars really aren’t.

Think about all the options a car has and then fold in a good versus bad service record. The band of prices could easily be +/- 10%, which is thousands of dollars we’re talking about.

But Adesa is also one of the biggest players. And they’ve had an online presence for at least 15 years (just speaking from my memory). They, along with Manheim (a private competitor), do a decent job at it. Adesa also has invested heavily in inspection services to make it better and faster process, as well as other services.

So I’m not too concerned about any upstarts or anything like that. Upstarts don’t have access to the same supply the big players have. And the dealers, like I was, like Adesa and Manheim because they get the supply plus the best prices because they are essentially getting a bulk discount. And you know competition is somewhat limited as a dealer because you have to have a license to access the auction.


This leads me to why Adesa is a great business.

As I was just leading into, Adesa is a great business because it connects sellers with buyers and just takes a fee off the top. The fee goes up or down based on the sale price, but has large enough bands that if used car prices fall, let’s say, 10%, it doesn’t hurt their earnings that much.

Sellers want access to a large supply of buyers who are committed to buy their product (i.e. they are selling to dealers who need the supply). This way, they can offload slow inventory or lease vehicles quickly and achieve good prices for them. This frees up working capital to re-deploy in their business.

Buyers want access to a large swath of cars at good prices that they can sell at a profit. For me, having a wide array of cars to pick from helped me find “hidden gems” that I could quickly turn.


The same note I mentioned above (which was absurd) highlighted online competition from Copart, which has been a “competitor” for forever and is really more a competitor of IAA, the insurance-loss auction spin from KAR. Copart is no doubt a great business, but I think it’s comparing two different markets.

If you compare IAA to Copart, their results during 2020 were much closer to each other than comparing it to KAR Auction Services – just different markets. Copart outperformed KAR and IAA sales were actually up, though they were able to benefit from improved pricing despite volumes being down. Although Copart discusses their “platform” a decent amount, but personally, I’d say it’s a different market.


Here’s another anecdote to explain why they are different markets: I remember being at an auction and a totally smashed Cadillac Escalade came through. The front was actually fine, but the back looked like it was caved in by an 18-wheeler.

I laughed to myself thinking, “I guess someone will try to part this thing” and lo and behold, the bids started to come in at really high levels. I want to say the car sold for over $20,000, despite being crumpled. I was in person, but the bidder was online and you could see the location. The bidder was in Saudi Arabia. That’s when I learned many of these salvaged cars are worth a lot internationally. Buyers can part them out, but some countries also have less strict rules on piecing cars together.

Anyway, as the dollar becomes weaker, this helps a Copart who sells a lot of inventory to these buyers:

Roughly 35% of Copart’s inventory is purchased by foreign buyers:


Back to that absurd sell-side note one more time: They also highlighted online competition from Carvana. Carvana uses KAR to buy and sell wholesale inventory. They do not provide nearly enough volume as a separate wholesale auction to be attractive. It really doesn’t make sense at all.

CarMax and Carvana really want to sell retail… yes, they get trade-ins they want to sell, but they want good prices on those and want to turn them quickly. Carmax has its own auction because its huge, but it still uses KAR  to fill inventory. Carmax can use their auction to sell inventory they don’t want anymore quickly.

Adesa provides that for everyone. It’s not really different than the marketplaces investors love today, they just have primarily relied on a physical presence. As stated, I think this will continue to be an industry that needs the physical presence.

KAR Auction Services ROIC

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

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


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

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

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

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


Background

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

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

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

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

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

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

Masco's segment performance varied wildly in the last recession

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


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

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

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

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

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

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


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

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

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

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

Masco ROIC has improved meaningfully


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

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


Why Do I Think Masco Is Discounted?

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

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

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

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


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

Secret Saas Business: Ituran $ITRN

Reading Time: 7 minutes


Last year, I laid out a handful of “secret SaaS” businesses. SaaS companies are getting massive valuations because they have highly recurring revenues (which provides earnings visibility), have low churn (highlighting how much customers like their product), and are also asset light. Many other, non-software businesses have this too, people!

I recently did a post of International Flavors & Fragrances, which seems like a secret SaaS business. IFF’s products are mainly food additives that impart taste or fragrance. Food is highly recurring and these products are mission critical. Good margins, low churn, highly recurring.

But today’s company, Ituran, won’t seem that secret. Ituran actually sells software. More importantly, I want to show that Ituran’s stock does not reflect its strong business characteristics. 

Ituran started out in the 1990s as a provider of SVR tracking services (Stolen Vehicle Recovery). The company is based in Israel, where insurance companies mandate the use of SVR services as a prerequisite for providing insurance in medium to high end vehicles. They also grew in Brazil, where car theft is high. In fact, 70% of Brazil is uninsured due to high amounts of vehicle theft. Therefore, Ituran is a cheap solution.

As you can see, Israel and Brazil are the core markets. The company has grown subscribers organically very well and got a boost from the Road Track acquisition back in 2018, which also helped expand it into other countries like Mexico, Columbia, and Ecuador. Organically though, it’s grown subscribers at a 12% CAGR.

Subscriber Base Growth
Israel and Brazil are core markets, though new geographies gained with Road Track acquisition are easy white space

In its core countries, Ituran uses RF network technology to do this tracking, which has some advantages over GPS. For example, GPS services require clear view of the sky with line-of-sight to at least three satellites within the GPS constellation. The terrestrial network technology that Ituran uses does not require line-of-sight and signals are not easily interrupted. It’s also much harder to jam the signal. Lastly, the system can be connected to the anti-theft system in the car, so you don’t have to wait for the vehicle to be reported stolen first.

According to ITRN, the average recovery time is 20 minutes.

However, there are some drawbacks, such as the need to install physical infrastructure in the region it operates. These base stations communicate with each other and help keep a precise location of the car. That said, capex for the company is still really low and ITRN has said they will be using a GPS platform to expand into new regions.

Fleet Management

With its technology, the company also expanded into fleet management. Fleet management would be something like tracking the usage of a corporate fleet, or letting truckers no about “no go” locations on their routes (perhaps a low hanging bridge).

Ituran’s services have been used by corporations with large fleet vehicles. Ituran uses real-time information to track driver behavior and can alert a corporation if the driver is being reckless. This is a low-cost tool for managers of fleets to set benchmarks and hold drivers accountable and in the grand scheme, likely lowers costs for the customer.

Usage-based Insurance

Finally, they also use their technology for usage-based insurance (“UBI”). Insurance companies use Ituran’s plug-in to determine how much users drive and also how they drive for custom pricing.

For insurance companies, this helps them stay competitive by saying, “hey, you could lower your insurance if you are a better-than-average driver or just drive less.” And consumers think, “hey, I’m a better than average driver and don’t drive that much, so maybe I can get a better rate than something fixed.” Truth is, everyone thinks they are a better-than-average driver.

What’s interesting about this information is that Ituran also knows when the car gets in an accident. It can see the exact location of the scene and alert emergency services. Ituran can also provide hard evidence of what actually happened in the accident (down to the G-forces, driver action-reactions, etc). Insurance companies and customers also like this because it provides clear evidence of what happened and can also save lives by cutting response times.


Significant Upside on Conservative Estimates

I think Ituran’s stock looks very cheap. As you can see from the snapshot below, Ituran has grown at a strong clip over time, has really high gross margins and EBITDA margins and generates good FCF. The other thing I should mention is that management says churn is consistently around 3%, which helps stabilize results.

On my numbers, Ituran’s stock is trading at a 10% FCF yield, which is significant when you don’t really have much debt. I also don’t assume they see 2019 revenue again until 2023, despite India launch, despite Brazil bottoming out of a recession, and despite a recovery from COVID-19.

Ituran Model Snapshot
Ituran stock looks very cheap on conservative estimates

Note: there were some accounting changes that moved expenses around + the acquisition, which is why R&D for example looks so odd over time.


Areas for Growth. SaaS businesses also get high valuations because of their growth characteristics. Ituran has a lot of white space available for growth to boost the stock awareness:

  • India.
    • India has 250M+ registered cars. If the company achieved 0.5% penetration, that would be 1.25MM incremental users.
    • The challenge with India versus some of the other locations will be what you can charge, but even at $60 a year across 1.25MM users would be $75MM of incremental revenues (or a 30% increase to where they are today)
  • Mexico, Columbia, Ecuador.
    • Ituran is already big in South America through Brazil and Argentina, but could expand the playbook into these countries which it entered via its acquisition of Road Track

  • Acquisitions
    • Ituran generates strong FCF and currently has very little debt. In my model, I assume they continue to pay down debt to zero, but they also could continue to acquire players to enter into new geographies, like they did with Road Track (albeit, that was ill-timed, as discussed below).
  • Other Optionality.
    • I like companies that have shown they can pivot. Ituran pivoted from mainly a stolen vehicle recovery business to a fleet management business to an insurance company. What else can they do?
    • With a cash rich balance sheet (net debt zero right now), this gives them a lot of optionality

Why does this opportunity exist?  Ituran stock has to be beaten down for a reason.

  • Ill-timed Road Track acquisition
    • The company acquired Road Track in 2018, which was going to provide them with several benefits. For one, it would expand their relationships with OEMs, whereas Ituran mainly played in the aftermarket space
    • Unfortunately, Brazil was ravaged by the COVID induced recession. At one point, Brazil car registrations were down 99.9% during COVID

Brazilian Car Registrations

    • The second impact was that OEMs wanted to save money. Typically OEMs provide a six-month free trial of the Ituran product, which led to pretty good conversion rate. Then the OEM cut the free trial to three months and then one month, which hurt subscriber conversion.
    • All things considered, the amount of OEM contracts lost is pretty encouraging. The losses look to be leveling out as well. This is probably boosted by the low churn rate (3% mentioned previously) in normal times.
    • Hopefully this recovers, but another good signal is that aftermarket subscribers, which is higher margin business, continues to grow
    • Road Track wasn’t all bad. They do still have better access to other Latin American countries mentioned previously and from the latest calls, it seems like the company will be leaning into those areas to grow.

Breakdown of Ituran's Subscribers
While OEM has faced pressure, it hasn’t been that bad in the context of the decline of OEM registrations

  • FX Headwinds Cloud Earnings Strength:
    • Most of the company’s earnings are in currencies that have fluctuated a lot
    • This includes the Israeli shekel, Brazilian real and to a degree, the argentine peso.
    • When you look at results, particularly 2015/2016 time frame when the Latin American currencies depreciated a lot, the results can seem more lumpy than reality

Common Questions

  • Doesn’t GM’s Onstar do this?
    • They do, but also much more expensive paid subscription at $350/year (around 3.5x the cost).
    • It uses GPS, which Ituran also uses in its growth areas, but again the core for Ituran is RF network
    • Ituran is actually the provider to GM in Brazil, which they originally signed in 2012.
  • Are there any comps to help us understand the value in Ituran stock ?
    • Lojack is actually public via a subsidiary of CalAmp (ticker: CAMP). They’re also a small cap, expected to do about $340MM of revenue in FY2020 and just $30MM of EBITDA (i.e. Ituron is much more profitable). They trade at ~18x ’20 EBITDA and 11.5x FY2022 EBITDA. They also have more debt.
    • Pointer was an Israel-based company that was also small, but was public and was acquired by a company called I.D. Systems for ~10x EBITDA in 2018
    • TomTom isn’t a great comp, has been shrinking and will be just slightly EBITDA positive in 2020 (though COVID had an impact). It has about 2x Ituran’s sales, but trades at 1.8x 2020 sales and 1.6x 2021 sales. This is where Ituran trades, but Ituran is expected to grow, is profitable, and generates good FCF.
  • Is Management aligned with Shareholders?
    • I follow another Israel-based company and I will say they tend to be very conservative.
      • For example, I think Ituran should probably carry a bit more debt, but perhaps the culture there frowns upon that. And Ituran’s management seems proud to be back in a “net cash position.”
      • Fortunately, for the Road Track acquisition, they did not issue Ituran stock to fund the deal
    • Management owns ~23.5% of Ituran stock via a holding company “Moked Ituran Ltd”. Moked literally means “focus” in Hebrew, so hopefully that’s a good sign

Bottom line: I think expectations for Ituran stock are pretty low. I also think it’s a cash cow with a highly recurring business model. I’ll admit, my biggest concerns are about technology disruption, but that’s true for a lot of businesses I own as well. That also probably stems from their brand not being known well in the US, where I am located.

I think Ituran’s results will improve over the year, which may mean it gets more attention and Ituran stock can re-rate. They also have enough cash to cause a re-rating themselves (i.e. buybacks) which is always positive.