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Is a recession coming? past recessions have begun with unemployment bottoming…

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The million dollar question 10 years into an expansion like this is, “is a recession coming?”

We have heard pundit after pundit claim that 2012 was the top. No 2013. No 2015. No 2018. Each, so far, has been wrong.

It makes sense why they do it. If they are seen as the investor that “called the top”, they instantly gain success for the balance of their careers. That means more media coverage, more book deals, and better asset inflows if they manage money.

This clearly has been one of the most hated bull markets in history, but even I, a “bottoms-up” investor, must admit that I am watching for signs of the top. Is a recession coming?

That brings me to the unemployment rate. Each time it has gone below 5%, this usually signaled that things can’t possibly get better and a recession would loom.

The unemployment rate got down to 3.7% in December 2018 which is one of the lowest levels since the 1960s. Does this mean the end is near?

Not so fast. The unemployment rate represents those people who are unemployed that are still in the labor force. Those who are not in the labor force are not counted. If we look at the labor force participation rate, it is at the lowest level in decades

Let’s put some math behind it then.

Using the data from the Bureau of Labor Statistics, I can see that a 4% unemployment rate equates to 6.5MM people looking for jobs. The flip side of that is that 162.5MM are in the labor force, but we know some have dropped out since the recession.

As such, let’s try to “normalize” the numbers. In other words, what if the participation rate went back up to ~66%. That would mean the labor force would grow by about 3%. That equates to 4.9MM workers. If these workers were counted in the participation rate, that would mean that the current unemployment rate is more like 6.8%.

Of course, these workers won’t enter the workforce without prospects of jobs, but even if 1/3 don’t, the unemployment rate ticks up to 4.8% from 4.0%.

Another factor this doesn’t include is underemployed workers. Think, college educated engineer who drives for Uber for employment. This is an exaggeration, but also not factored in the results.

Bottom Line: Be careful of scary statistics. “There are three kinds of lies: lies, damned lies, and statistics” Clearly unemployment is low, but that only tells one part of the story.

“Is your refrigerator running?” Don’t get frozen out of this trade. $HDSN could heat up through 2020

Reading Time: 6 minutesAlas, 2018 was a very tough year for Hudson (ticker HDSN). Based on my analysis below, however, I think the stock could be a multi-bagger. Currently trading around $1, with the rest of the street thinking the company is in trouble of bankruptcy, I think we could reasonably see it move up to $8/share over the next 2 years. Indeed, I think in a few years, the company will be doing $60MM of EBITDA compared to a $175MM EV today…

To recap a tough 2018:

The company, which supplies refrigerants for HVAC systems, just completed the acquisition of Air Products refrigerants business, ASPEN, when 2018 had two factors that pressured results:

  • Pricing on refrigerants in 2018 declined across the board
  • Customers left little inventory on the shelf, and moved to a just-in-time purchasing model. This was a consequence of pricing behavior

To give a picture of how bad it was, 1H’18 sales were up 22%, mainly from the ASPEN acquisition, but EBITDA was down 70%. Yikes. The company also took on only debt to fund its acquisition and was ~10x levered. Double yikes. The stock plummeted to around $1 after peaking around $9 in 2017.

HDSN6

These two negative factors that pressured results can be traced back to events of 2017.

  • Prices on refrigerants in that year were increasing rapidly, so customers bought early to get ahead of further increases in pricing.
  • As pricing leveled off coming into 2018, customers had to devalue their inventory to re-align with market pricing. As a result, buyers were much more cautious with their inventory levels in 2018.
  • This caused further pressure on pricing in a catch-22, circular fashion.

Pricing has since stabilized since Q2’18 and inventory in the channel remains relatively low.

What was going on with pricing?

Before I start, I should give some historical context that will provide a better picture of the market.

Refrigerants go through phase-down cycles due to environmental regulations. Chlorofluorocarbons (CFCs) were used from the 1930s through the 1990s. But with awareness on their ozone depleting effects, the Montreal Protocol introduced the phase down of CFCs. We then moved to HCFCs and then HFCs and then HFOs and I am sure there will be many more acronyms to come. The point is, as concern over global warming and depletion of the ozone advances, new regulations (across the globe) and new refrigerants are introduced.

HDSN3

R-22 refrigerants, a type of hydrochlorofluorocarbon or HCFC, has been one of the most widely used refrigerant, but is being phased out. Pricing had been increasing in 2017 as customers wanted to get ahead of the phase out of new production, which limits new supply in the market.

HDSN1

As such, no new production of R-22 can be produced by 2020. To be clear, this does NOT mean you can’t use R-22 anymore. Many HVAC machines have 20+ year lifespans and often would require retrofitting for the new refrigerant types to work, which is more expensive than just using the same refrigerant.

Looking forward, though one could see a re-stocking event occuring in 2019. Pricing should also increase for the refrigerants they sell, which I will touch on below.

Why is pricing going up?

Demand for the old types of refrigerants remains relatively steady, but supply goes down dramatically (i.e. to zero). Given the offset, pricing moves up as well. Only 4MM pounds can be produced in 2019 and then moves to 0 in 2020+. The EPA projects that aftermarket demand will be ~50MM pounds by 2020. As a result, the company expects that R-22 will move like other previous refrigerants. It thinks that pricing will move from $10-11/lbs to $30/lbs.

HDSN4

To state the obvious, pricing on Hudson’s products should improve. First from the lack of new supply and second if demand increases as customers re-stock inventory. This should also drastically improve margins, as price increases drop to the bottom line.

Reclamation

Hudson is also the largest provider of reclamation services, summarized in the graphic below. These reclaimed refrigerants can and will replace/displace virgin production. Reclaimers will provide 100% of R-22 following 2020. There are over 50 million residential and light commercial systems using R-22 in 2018. This should bode well for Hudson, who has 35% market share.

HDSN2

What happens when R-22 is phased out?

A question you have to ask yourself is whether or not Hudson has a business following the eventual phase-out of R-22. Obviously, the terminal value of the company has a lot to do with its valuation.

In 2016, the Montreal Protocol reached an agreement to phasedown HFC compounds by 85% between bow and 2047. HFCs are the next generation compounds, meant to phase-out HCFCs (like R-22) and CFCs. While these HFCs were designed to have zero impact on the ozone layer, they have determined that HFCs still have a high global warming effect. Lo and behold, we have a new product (and acronym) coming out, called HFOs that will reduce both global warming impact and ozone depletion.

But for the next few decades, HDSN will not only work to reclaim R-22, but then will switch to reclaiming the HFCs providing a long-lead time to the business. In addition, emerging market countries tend to ratify global warming protocols at later dates and use older refrigerant types for longer. As such, these markets will likely continue using older technology for longer.

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Reclamation is not all the HDSN does. I should also take a step back here to also note that you can think of Hudson like a distributor of virgin product. It also sells refrigerants to customers from its suppliers. For example, in 2016, Hudson was awarded a $400MM contract to the Department of Defense to supply refrigerants, gases, and other related items to the military. This is a 5 year contract with a 5 year renewal option. As an aside, the value of this contract does not appear to be factored into the stock price today.

What do we think the company is worth?

On a PF basis, Hudson and ASPEN generated $255MM of sales in 2017. Given changes in pricing plus volume improvement from JIT ordering patterns unwinding, I think it’s not unreasonable to see sales move past $300MM in 2020. Remember, R-22 will move from $11/lbs to $30/lbs over time, which is a huge uplift.

The company has stated this will result in 20% margins (though I think that’s conservative given pricing). Assuming the business is worth 8x, I think the stock is worth $8/share, which is significant upside from today’s levels.

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Why am I not concerned with the leverage?

As of today, HDSN remains highly levered (~9x) and it was required to get a waiver from its banks on its covenants. Banks typically are willing to do this if they view the challenges the business is facing as 1x in nature. At the end of the day, they don’t want to take the keys and run the business themselves. Most of the time in bankruptcy, the company haircuts its debts in Ch.11 and continues operating.

Hudson is still able to manage its debts and paid down $37MM of debt in Q3’18. The term loans also does not come due until 2022, a point at which HDSN (hopefully) is rocking and rolling again.

As I’ve said in the past, I like these situations. Every dollar of debt paid down will accrue to the equity!

Lodging play trading at a substantial discount to asset value. High margin of safety + solid dividend means we are paid to wait for value to be realized $CPLG

Reading Time: 6 minutesMargin 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.

In mid-2017, La Quinta decided to spin its owned real estate into a new company and the remain-co would be an asset-lite franchise and management company, which tends to garner high multiples. Then, in 2018, Wyndham announced it would acquire the La Quinta business (i.e. the high margin franchise business) for $1BN. Therefore, the La Quinta brand and management of the hotels would be folded into Wyndham’s portfolio and plans for CorePoint remained for it to be spun out to shareholders before the Wyndham acquisition was consummated.

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.

geography

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:

Hotel refurb.PNG

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

EBITDA Bridge.PNG

  • Concentration:
    • 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

REVPAR.PNG

 

Investment Thesis

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.

2019 EBITDA Bridge.PNG

  • 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.

CMBS Valuation.PNG

  • 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.