Now with the S&P back up to near highs, many are calling out Buffett and saying he’s lost his touch. “Maybe he’s too old now” and “maybe he doesn’t care anymore now that he’s approaching 90 and loaded” or “maybe the oracle has lost his touch”.
I don’t really think that’s the case and think the negative sentiment creates an opportunity in Berkshire Hathaway stock. People who argue that Buffett is too old and “lost it” could have easily argued the same thing when he was 65 going on 70, 75 going to 80… Buffett has that itch that can’t be scratched.
I do think some of his methods are too old fashioned. I can’t actually confirm this is true, but he has said he won’t participate in auctions. What board would actually be able to justify selling to him without a second bid? Especially when times are good and they are a good business.
I’m taking Berkshire Hathaway’s current market cap and subtracting the market values of his equity holdings (note, I pulled this from Bloomberg, so it may not be 100% accurate). I then subtracted the cash to arrive at the value the market is ascribing to the “core Berkshire Hathaway” business.
I say core, but in reality there are so many subsidiaries within Berkshire Hathaway. You have GEICO, Berkshire Hathaway Energy, BNSF, Precision Castparts, just to name a few well known ones. If interested, I highly recommend perusing the list of subsidiaries on Wikipedia. I bet there are quite a few you didn’t realize he owned.
At the end of the day, you’re being asked to pay <8x earnings for the collection of businesses that Warren has acquired AND you have free upside from the cash if it is ever deployed.
Frankly, the real upside in the stock may be 5-10 years away when Berkshire Hathaway is broken up and people realize the sum of the parts is worth more than the whole.
Either way, look at the impact of Berkshire going out and deploying cash. Earnings could likely go up 30% from where they currently are and even deploying the cash at a worse multiple than where Berkshire trades today (i.e. dilutive), you’re still paying <9x earnings.
B&G reported Q4’18 EBITDA of $59MM compared to $69MM in the prior year. While this was partially impacted by the sale of Pirate Brands to Hershey, it was still a tough comp due to input cost inflation (freight, procurement, as well as mix). As a result, EBITDA was 200bps lower as a % of sales than the prior year.
That said, I think there are a few positive take-aways from this quarter that will keep me grounded. Bottom line, I still think B&G is a long-term compounder. Food sector sentiment is particularly negative right now (especially with the KHC news) and 2019 should be an easier comp from a freight and inflation perspective.
Green Giant Continues to Grow at Attractive Levels, Despite Challenges in Shelf Stable:
Green Giant’s sales increased 4.9% this Q and grew 6.1% for the entire year. This has been mainly driven by new innovations in the frozen food aisle that have countered challenging trends in the canned, shelf stable category (down 8.2% for the year).
Part of the thesis in buying B&G is that these managers are good at buying mature assets, harvesting the cash, and restarting the process (rinse & repeat). They sold Pirates Booty to Hershey for $420MM after they bought it for $195MM in 2013. I continue to think Green Giant was a solid acquisition.
Given there are many other consumer staple brands struggling to date, I think this is an opportunity for B&G. They repaid $500MM of their TL with help of the Pirates’ sale so that also adds some capacity.
Company is managing other mature brands well. Would you have believed me if I said Cream of Wheat increased sales 4.3% this Q? Or Ortega was up 7.2%? Excluding Victoria, which saw a $2.5MM decrease in sales from a shift in promotional activity, I think the company is doing a good job with this portfolio.
Continues to generate significant FCF to support dividend. B&G pays $1.90 dividend which based on the after-hours quoted price currently amounts to a 8.6% yield. Typically, dividend yields that high imply the market thinks there is risk of being cut. Setting aside the fact that the company generated $165MM of FCF this year (reduced a lot of inventory), I still think the dividend is covered.
Using ~66MM shares outstanding, this implies a $125MM cash use.
Based on the company’s guidance range, this implies you are ~1.3-1.4x covered.
Said another way, based on my FCF walk, we would need to see EBITDA decline 17% from the mid-point of guidance for it to be 1.0x covered.
Personally, I’d prefer if the company bought back a significant amount of stock at these levels. Unfortunately, the stigma of keeping a dividend out there forever (which is dumb) prevents that from happening (as the stock would get crushed).
As I covered in my case study post, when companies face transition periods, investors often shoot first and ask questions later. This happens even when the company is growing well (i.e. its a “growth stock“). This often results in leaving significant money on the table. I think this is the case with Facebook stock.
Investors talk themselves out of investing in great businesses for a variety of reasons, but I usually boil short-term blips down to this internal statement:
“This [current trend] may get worse in the near term, perhaps also longer term, so I’m not comfortable investing yet”
Investing will always have uncertainty and that’s the risk. But that is also precisely why the returns are higher for those investors that can see through the fog of negative headlines or short-term roadblocks and make superior results.
I think Facebook today is in such a situation. The company is facing negative headlines on a variety of fronts, but mainly related to how we will deal with privacy in this new age.
My thesis for Facebook stock looks through to the future and comes down to the following points:
Facebook is a dominant platform with 2.5 billion unique users
Advertising via social media platforms is still in its infancy
The ROI advertisers receive from using social media platforms is much higher than traditional methods, which will grow the pie
Expect high growth from FB as it monetizes Facebook and ramps Instagram, video, Whatsapp and FB messenger
Before I get to the positives, my guess is that you are likely reading this and saying, “yeah, yeah blah blah, I’ve heard that story before. But what is Facebook going to do in a more privacy concerned market?”
One big concern, is the new legislation in the EU called GDPR (General Data Protection Regulation) which went into effect in May of 2018. The purpose of the legislation was to give consumers more control over their personal information.
You probably have noticed the pop-ups asking if you are OK with websites collecting cookies and this is why that exists. GDPR applies to all companies processing and holding personal data of consumers residing in the EU, irrespective of the company’s location.
This has created uncertainty for digital advertisers as it creates additional friction in the process (i.e. users must opt-in, which may mean less data is available). However, I think Facebook is practically embedded with users’ daily lives which is a strong benefit. In other words, users are already proactively sharing personal data on a daily basis.
I assert that Facebook’s platform then is one of the best positioned to deal with this new regulation.
I think Facebook and Google could likely update their terms of service which would permit Facebook to continue their existing path. In any case, if users do not accept, the downside is that Facebook will show non-personalized ads. Worth less to advertisers, but still worth something.
In addition, similar to my discussion on why sin stocks outperform, I think this entrenches Facebook’s leadership position going forward, meaning that it will be much harder for new social media platforms to launch.
Bottom Line: Transition periods can be painful, and more regulation likely is coming, but in assessing whether this is a lot of noise or whether the business model is impaired, I go with the former.
That is what I mean by growth paying for sins — eventually investors will have to look at Facebook’s growth in earnings and want a piece of Facebook stock.
Back to the positives
I’ll make this brief, as I tie much of the positives into the growth / valuation discussed below, but I think there is a chance that not only are investors being overly punitive on FB, they are missing the long positive road ahead of its platforms.
At this point, I think we all can see the value of Instagram as the Company’s next growth engine. It has become just as ubiquitous with millennials as Facebook was and is. The interesting turns are how the company has monetized the business. Advertisers are obviously involved now, and the ads placed represent high return on investment for them. In addition, some polls have showed that people, if they had to choose, enjoy ads that are more personalized to them, rather than random ones that do not apply.
Now I have seen shopping on the platform, which is so early in its stages, I do not think Wallstreet understands the opportunity. Facebook can now move from just an ad platform to possibly taking a modest skim off of items sold on the platform, similar to eBay’s business model.
Lastly, Facebook has just launched ads on Whatsapp, the messaging platform with 1.5 billion users. Is this priced into the stock today? I’d argue not. Most sell-side models break out the company’s revenue into Facebook Ads, Payments, Instagram, and Oculus. Turning the switch on for Whatsapp could be a large incremental opportunity that is not accounted for.
Facebook Stock Valuation
Now to get back to what I entitled this pitch: Growth can pay for a lot of sins. And that makes Facebook stock attractive.
With Facebook growing at 17% per year on the top line from 2018-2021, that growth can offset a lot. Of course, you have to bank on that occurring, but let me run through some numbers.
Even with assumed margin headwinds from additional investments in securing data and privacy initiatives (I model EBITDA margins moving from 66.5% of sales in 2017 to 60.0% of sales by 2021), the company grows EBITDA at a ~17% rate. Despite some capex spend to support growth, the company generates good FCF and as you can see, that cash builds over time (the company is already in a net cash position).
This means we are essentially buying Facebook stock for 7.2x 2021 EBITDA, which is very low. What multiple should the company trade at at that time?
I would argue for a very high multiple driven by the company’s high return on invested capital (ROIC).
If you want to learn more about the relationship between ROIC and EV/EBITDA multiples, I highly suggest you read Michael Mauboussin’s recent article here and also this baseline one here for more. In it, he explains that what matters is investing in companies that generate a positive return on newly invested capital, in excess of their weighted-average cost of capital. It makes intuitive sense to me… if I am continuously investing new capital in projects that don’t earn my cost of capital, that destroys value.
As shown, Facebook is clearly earning well in excess of its cost of capital. This makes sense given how much operating leverage the company has. It is similar to an old newspaper model which also has substantial operating leverage — a newspaper with 1 advertisement slot that widens it to 2 slots will earn very large incremental returns on that second ad slot sold. The same is true of Facebook and its various platforms.
There are limits, of course. With return metrics like these, we should hope Facebook reinvests every dollar possible into its business and see stellar return prospects, but that is not always possible.
(note, NOPAT = Net Operating Profit After Tax)
Either way, I think Facebook stock is grossly undervalued at current levels. Currently, the median S&P 500 company trades at 13.7x EBITDA. Do I think a company that earns nearly all the capital it invests back in one year as better than average? You bet I do. If Facebook trades at just 10x EBITDA in 2021 (which is closer than you think), that foots to $215 stock under my estimates. That is ~33% upside, or ~10% CAGR.
Although I do not think the company is worth 10.0x, I think using a 10.0x multiple accounts for a couple things . It helps handicap for whether or not I am wrong on my thoughts on the stock performing amidst all of this political uncertainty. However, on the high end, you can see the result looks very, very attractive.
The bottom line is, it is very hard to see over the medium-to-long term how you lose money in a company growing earnings as fast as Facebook is and at the quality it is. This ties back to my thoughts on growth vs. value stocks (i.e. Facebook is a growth company, but still is a value).
“I can understand [Coca cola]… Anyone can understand [it]… It’s a simple business.”
Today’s stock pitch is a simple business. It’s easy to understand and in many ways, it is very similar to Warren Buffet’s Coke investment. And that is… Hostess Brands! That’s right – the maker of Twinkies, Ho-Hos and Ding-dongs, is making a pitch appearance.
Food staple stocks have been under pressure recently, relatively speaking. Call it sector rotation or moving out of bond proxy stocks (i.e. those equities viewed as safe enough to move into when interest rates are too low), but the indiscriminate selling as opened up buying opportunities.
So what’s the pitch for Hostess Brands?
Strong brand name
Great return metrics (high EBITDA margins, little capex)
Very stable business (people don’t stop eating Twinkies in a recession)
The stock may be looked over due to misguided perception of healthy vs. indulgent snacking
Plenty of white space to drive growth
But DD – aren’t Twinkies bad for you and isn’t that segment shrinking?
Good question Reader, but the answer is yes and no. I will just note that a Twinkie is only 135 calories – that’s less than half the calories of a Twix bar. But, yes the health-conscious segment is growing, but the indulgent snack trend is still strong. In fact, indulgent snacks have posted low single digit growth rates over the past several years, roughly in-line with healthy snacks (3.1% and 3.4% in 2014 & 2015 respectively vs. 2.5% and 3.8% for healthy snacks).
Ok, even if that’s true, didn’t Hostess declare bankruptcy? Yes! But it has emerged as a much stronger company. Hostess’ previous distribution strategy drove it into bankruptcy. Hostess declared Ch. 7 bankruptcy, which means it went into liquidation. After selling some brands (Wonderbread) and shedding liabilities (pension etc.), Apollo bought the Hostess brand name and reinvested in the business, utilizing automation and a direct distribution strategy to drive efficiency. The table below summarizes it well.
It should be noted that since Hostess entered Ch. 7, its products were pulled from the shelves and competitors took market share. Now that Hostess is back, one reason why it is growing well is simply that it is regaining that market share.
Another reason why I like Hostess is simply the amount of white space available to the company. With the acquisition of Superior Cake the company entered a new space of in-bakery items. Hostess has since then launched a series of peanut butter products, deep fried Twinkies, and chocolate covered items. New product introductions like these should drive better than GDP growth over the long-run.
Another way Hostess can drive growth is geographic white space. Its mostly a U.S. company today and I could easily see a launch of Hostess products moving into Mexico and South America, where Grupo Bimbo dominates.
“Coke’s moat is wider than it was thirty years ago. You can’t see the moat day by day, but every time the infrastructure gets built in some country that isn’t yet profitable for Coke, but will be twenty years from now, the moat is widening a little bit… That’s the business that I’m looking for. Now what kind of businesses am I going to find like that… I’m going to find them in simple products. Because I’m not going to be able to figure out what the moat is going to look like for Oracle, or Lotus, or Microsoft ten years from now…”
Financials & Valuation
Aside from good growth, I really like the free cash flow characteristics of Hostess’ business. With 30% EBITDA margins and capex (including growth capex) at around 5% of sales, that means a lot of earnings translate into free cash.
And given these goods cash flow characteristics, strong brand value of Hostess I would put Hostess’ valuation in the top tier of peers. But when we look at where the comps trade, there is clearly a dislocation and opportunity for investors.
I think Hostess should trade at 13x EBITDA, and perhaps higher. As seen at the bottom of my model snapshot, this is pretty close to a 5% FCF yield, which I think is fair. For this point, I’d also like to highight how much cash builds on Hostess’ balance sheet. It is unlikely that they just sit on this cash – this will likely go to acquisitions, share buybacks, or even eventually, a dividend.
This is the time to bring up the fact that the CEO is leaving. He is well respected in the industry and I can’t say this isn’t a loss for the company. I do still like that Dean Metropoulous will remain executive chairman, a leader who has more than 30 years of experience in the food & beverage space.
What do you guys think? Let me know if you guys have any thoughts or questions.