I didn’t either. The company called out similar factors as it did in the last call. “The period was affected by significant inflation, slowing markets and LVT impacting sales of other products.”
Unfortunately, I don’t these headwinds are abating any time soon. As I noted in my last post, MHK has gotten a massive margin uplift from a decline in raw materials. That’s starting to normalize.
Here’s the trend on LTM EBITDA margins over time.
Contrarian investors might say, “well, what if it snaps back? Then the stock is cheap”. That may be true, but I doubt it. The street is currently expecting 17% EBITDA margins for next year and 18.5% the following year. So essentially they are expecting a snap back. As such, I think the company is trading more at around 8.0x+ 2020 EBITDA, instead of 7.3x it would suggest.
Are the forgetting before the commodity collapse, Mohawk had ~13-14% EBITDA margins??
I think Mohawk stock is still too expensive considering these expected headwinds. More importantly, I think sentiment has room to fall, which we all know can be a larger driver of stock performance.
This morning, Univar announced earnings and that it was divesting Nexeo plastics. Let’s break down what the divestiture means for Univar stock and the nexeo warrants (Note: the company has not held its call yet, and plans to do in late Tuesday, so items here are subject to change).
First, how good of a price is the sale? Univar is acquiring Nexeo for ~$2BN and had plans to divest plastics. Plastics distribution is a low margin business, based on what management has said.
I am going to assume it generates between 3.5% and 4.0% margins. That implies 6.5% margins for the chemical segment, which is lower than Univar, but makes sense given Nexeo’s smaller scale.
That means the $640MM divestiture implies ~8.6x EBITDA (9.2x if I assume 3.5% margins, 8.1x if I assume 4.0%).
Second, what are the implications on Univar stock? If I subtract my estimate of Nexeo’s plastics EBITDA, I get PF EBITDA of $135MM. Univar is now (unfortunately, this is a big miss from $680MM of expectations from the street) guiding to flat EBITDA for 2019. Then I add in half the total expected synergies ($50MM). The good news is I get $32 Univar stock price.
And the warrants? Well, if you think Univar stock is worth $32 over the next 12 months, that implies $13.05 of “merger consideration” for Nexeo and a warrant value of at lest $0.78, not including any time value. That’s double where they trade as of 2/8/2019…
Margin of safety is the theme today. Made famous by Seth Klarman, the famous value investor harps on this notion given that predicting the future is an imprecise science.
The stock is CorePoint Lodging (ticker CPLG) and represents the owned assets of La Quinta that were spun out on their own in early 2018. When I think of La Quinta hotel, I first ask myself “when was the last time I stayed in a La Quinta??” and I think the answer is once, maybe never. But just because I also don’t shop at a discount grocer like Dollar General, doesn’t mean that the market isn’t huge for low-to-mid economy businesses.
CorePoint currently consists of 315 hotels in 41 states, with high concentrations in Texas, Florida, and California with most of the hotels being in the midscale range.
Importantly, and discussed a bit more below, the company is ended a capex program to renovate its hotels. This should help the dated-looking portfolio compete with other chains. As shown below, this appears to be a positive step:
There are also a few benefits of being folded into Wyndham. For example, La Quinta hotels will now be included in the Wyndham network and endorsed by Wyndham, which includes their rewards program. Additionally, there are cost efficiency opportunities to be had from Wyndham’s scale and procurement strategies.
All this sounds good. So what has happened with the stock?
CorePoint’s stock is down 50-55% from the initial spin at the time of writing. What happened?
Spin off dynamics
As is typical in spin-offs, you can have a dynamic where shareholders are left holding a stub business that doesn’t meet the characteristics of what they wanted to buy in the first place (whether it be size, industry, or other business attributes)
This was a taxable spin as well, meaning not only would taxes be owed at the corporate level, shareholders would also owe taxes. This also creates selling pressure
Poor communication / expectations setting
Following the spin, it seems as though there was poor communication by management on what “real” earnings for CorePoint would be. This was no easy task, as the businesses had historically operated together with the franchise business. Estimating stand-alone cost structure is tough, but I’m of the mindset that you always underpromise and over delever (or just promise and deliver…)
The Form 10 (essentially the S-1 for a spin-off) highlighted that PF adj. EBITDA was ~$207MM. When the company had its first investor call post-spin for Q2’18, they guided to $182MM of EBITDA, a significant drop. Part of this was due to Hurricane comp, but even worse, they had to guide down 2018 again to $177MM following a weaker than expected Q3’18
Part of the decline to 2017 was due to ~$20MM of Hurricane disruption, which management called out and was expected
But a second component that I think the street missed / management did not communicate well is higher royalty & management fees as well as stand alone costs than I think many on the street were expecting
The brand is clearly concentrated here on La Quinta hotels, which can give investors a but of heart burn
The assets are also mostly in Texas, Florida, and California. Florida and Texas were each heavily impacted by Hurricanes, Florida is known for its cyclicality (tourism driven state) and Texas is impacted by the oil markets.
That being said, taking a step back, it does make sense that there assets are in these regions, as they are some of the fastest growing states and have high populations, so I think this risk is often overblown
The company also includes this slide below, detailing RevPAR is more stable than other markets
But here lies the investment opportunity. The stock, down some 50-55% since its spin has been left for dead. There’s also only one sell-side analyst covering it (who is negative) and the calls are brisk given the lack of following.
I really like situations like this, as it presents an opportunity to buy something that people are missing (I should note, its hard to find CorePoint on a stock screen unless you are looking for it specifically) or have actively thrown out (from the spin)
My thesis comes down to the following points:
Comps should improve due to:
(i) hurricane assets back online
(ii) reinvested assets garnering higher revPAR
The company re-positioned ~50 hotels so that it could upgrade the facilities. The capex ran at about $200MM of refurbishment, fortunately mostly funded by the legacy business.
The company has noted that the RevPAR for these hotels is growing faster than the balance of the portfolio, though 2019 will have some higher expenses as they ramp. For longer-term investors even looking out to 2020, these renovated hotels should be online and the company will benefit from their full contribution
(iii) no longer lapping Q’s with increased stand-alone expense (note the bridge below assumes no cost benefit from Wyndham’s purchase)
I think it is underappreciated that La Quinta had 15MM loyalty members, but Wyndham had 55MM in 2017. Those Wyndham loyalty members will now be able to book La Quinta’s in 2019.
Downside protected by solid asset coverage
The company issued CMBS debt to fund the business post-spin. As part of that, CMBS lenders wanted to know what the asset-value was backing their collateral.
This is shown in the SEC filing here. I think the interesting quote is that the properties are valued at ~$2.4BN. Subtracting out net debt of $960MM gets you to $1.4BN of equity value. This compares to current equity value ascribed by the stock market of ~$775MM
This is also supported by book value reported on the balance sheet, which is $24.7 per share compared to ~$13.0 stock price.
Upside from take-out or further acquisitions
CorePoint currently trades at 8.75x 2019e EBITDA of $200MM, a discount to where comps trade (ranges from 9.0x-11.0x for Extended Stay, Summit Hotel Properties, Apple Hospitality, Chatham Lodgin, and RLJ Lodging)
The discount is actually wider when you factor in $200MM of EBITDA includes no upside from Wyndham’s scale and operating efficiencies
Given that CorePoint is also the only mid-economy REIT on the market, an acquirer could look to take-out the portfolio at a significant discount to appraised value, and fold it into its operations for diversity
Alternatively, the company notes in its filings that it has a clean balance sheet and that it will “be well-positioned to be a consolidator given our scale….We expect to develop a disciplined acquisition strategy which will allow us to expand our presence in target markets and further diversify over time, including through the acquisition of hotels that are affiliated with other respected hotel brands and operators.” An acquisition of another portfolio may mean diversification as well from just La Quinta
This thesis isn’t without risk and, given the learning pains so far coming out of the spin, there may be additional costs the company finds or faces as a stand alone entity. However, the dividend yield is now ~6%, so I’d argue we are getting paid to wait here.
There is another item that I didn’t touch on and that is a potential tax payment. You see, La Quinta and Wyndham set aside $240MM to pay for corporate taxes of the Core Point spin. If taxes were less than that, CorePoint keeps the balance. It is estimated that taxes will be less than $240MM and originally the company thought they’d be getting $56MM, but this is uncertain. I ascribe no value to this given the uncertainty, but it could be a nice surprise.
I think the stock is worth at least $24, assuming only 1x book, with upside as comps get easier. This represents ~87.5% of upside from today’s levels plus a 6% dividend.
I haven’t provided an update on the Univar/Nexeo transaction in a while and given some questions I have received on the warrant mechanics plus general volatility in the market, there couldn’t be a better time.
First of all, let me just re-iterate that I think this is a good transaction. PF Univar is trading at a very cheap multiple and I see solid upside if the company realizes synergies and trades at just 10x EBITDA.
The warrants in Nexeo should strongly benefit from this over time, if the higher price is realized. Following the acquisition, warrant holders will be entitled to receive the “Merger Consideration” through their expiration. For background on this, check the warrant agreement as well as recent proxies where it clearly outlines a PF balance sheet “adjustment to record the fair value of the Nexeo outstanding warrants (exercisable through 2021). Upon completion of the merger, the warrants will be converted into the right to receive, upon exercise, the merger consideration consisting of Univar common stock and cash, in accordance with the terms of the Warrant Agreement.” As we all know, the merger consideration swings based on the value of Univar’s stock.
As shown below, based on Univar’s stock price, the equity consideration as a % of total drops below 70%. This is important because based on Section 4.4 in the Warrant Agreement, the strike price will be lowered.
You can read the definition for yourself, but the strike price will be lowered by the difference in the strike price and (i) the per share consideration value and (ii) the Black-Scholes value.
As of right now, the “consideration” is around $8.83 (Univar is trading at around $19.50 at the time of writing) derived from the equity holder receiving $5.95 of value in Univar stock ($19.5 x .305) plus $2.88 in cash (minimum amount).
Therefore, taking the strike price of $11.50 less $8.83 less the Black-Scholes value of the warrant should get us to the new strike price.
What is the Black-Scholes value?
Well, Univar in its most recent proxy noted it uses an Option life of 2 years (the warrants don’t expire until 2021), volatility of 23.8%, and a risk free rate of 2.8%. Plugging this into a spreadsheet and using Nexeo’s price today of $8.96 gets a implied value of $0.58.
In sum, we take $11.5 less $8.83 less $0.58 and that gets us $2.09. This is the amount the warrant strike will be reduced by. In other words, $11.50 minus $2.09 = $9.41.
if less than 70% of the consideration receivable by the holders of the Common Stock in the applicable event is payable in the form of common stock in the successor entity that is listed for trading on a national securities exchange or is quoted in an established over-the-counter market, or is to be so listed for trading or quoted immediately following such event, and if the Registered Holder properly exercises the Warrant within thirty (30) days following the public disclosure of the consummation of such applicable event by the Company pursuant to a Current Report on Form 8-K filed with the SEC, the Warrant Price shall be reduced by an amount….
To me, the catch here implies that you must exercise the warrant within 30 days of close of the deal. However, the warrants may still be out of the money. That being said, if they are even slightly in the money (break even moves up to $21.5 for UNVR’s stock), it may make sense to take risk off the table.
I plan on following up with the investor relations folks to make sure I am thinking about this last component correctly.
It makes some sense. If investments are competing for my next dollar, it is true that treasuries at 3% look a lot better than <1%.
I have already argued that I am bearish on the notion that interest rates will rise much further from here.
I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.
Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company.
I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).
Here’s a summary below of where it is currently trading and model:
As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.
As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?
Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.
As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.
So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.
Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much.