Intentionally or not, Fortune Brands has created a Good Co, Bad Co with their spin-out of Masterbrand Cabinets stock. It is very easy to be cautious on 2023 and say, cabinets are F’d. Instead, cling to your Fortune Brands shares which sell into plumbing, security products, and decking.
Cabinets are a super cyclical business. I tend to think a cabinet sale occurs during new construction… or when they fall off the wall. But really they are also replaced when there is heavy remodeling work done. All require some discretionary income.
The cabinet business proved its cyclicality back in the financial crisis. Featured below is Masco’s (since divested) cabinets business operating income. It took until 2016 to get back to Op income profitability! Woof.
Now, of course we were in a housing bubble back then… Masco also added in a ton of capacity right before the market turned. This number includes some impairments and restructuring charges. In addition, China started to nip at the heels of the industry by competing in the really commoditized, “stock”, low-end product (ready-to-assemble cabinets).
American Woodmark’s EBITDA perhaps is a better example:
Typically, competition is pretty localized in cabinets as shipping costs can be really expensive. That’s still true, but the industry had to flush out losing some of that lower-end business.
In 2021, they were hit by labor costs (building cabinets is labor intensive), freight, as well as hardwood costs. It’s a high fixed cost business too, so when operational issues occurred (omnicron absenteeism for example), it really hit them on the chin as throughput suffered.
As such, the industry has been trying to get price to recover this. Backlogs have been huge, but that wasn’t necessarily a good thing as the price on the backlog didn’t match the new input-cost reality.
The industry is doing better to recover margin. As you can see from American Woodmark’s EBITDA margin, they are slowly but surely getting back to a reasonable margin level.
We’re talking big price increases rolling through now.
Volumes for the industry are pretty flat lately, but price increases are 15-20%. That will help margins going forward. KCMA publishes data and in October, volumes fell 2.6%, but price was up 17%
AMWD’s FQ2’23 (ended Oct’23), showed EBITDA margins expanding from 6.8% to 12.0% Y/Y. And therefore EBITDA $ more than doubled.
Taking a step back, I think this tends to surprise people – demand was so strong for cabinets that it hurt profitability. And as demand has cooled a bit now, that’s helping? WEIRD.
Back to Masterbrand – Fortune Brands decided to spin the company out. My guess is for a re-rating. Get rid of the more cyclical, lower margin business. Heck, that’s what Masco did (though it didn’t really re-rate).
But my guess is everyone is thinking the same thing on MBC. “Get away”
Masterbrand, I will say, has outperformed its peers on maintaining margin. They have a long history of that. I believe they are THE best run cabinet player in the space. Even so, they think they can get to 16% EBITDA margins over time.
I like low hurdles to jump over. So I did some rough math. I used their estimate for “high-single digit” sales decline next year, 25% decremental. But then I basically say no growth from there. I give no credit for W/C being a benefit either, after a couple years of a large build. Maybe that’s too aggressive? I don’t know, I think expectations for Masterbrand Cabinets stock are probably pretty low…
That looks like a lot of cash…. And when I compare it to the current market cap, we’re talking nearly a 20% FCF yield for Masterbrand Cabinets stock.
Historically, cabinets businesses have traded for 6-8x, in some cases higher for private M&A. It intuitively makes sense given what we’ve discussed. But I think this valuation, IF YOU HAVE A LONG TIME HORIZON, makes a lot of sense.
Obviously there are risks. The cycle could be a nasty one. The spin could have some stutter-steps (though MBC was a separate segment for a long time). But I like the risk-reward here and the forced selling.
The other major risk is I am writing this the day of the spin! That’s a no no. Wait for it to bleed out, Dilly D! This is a $1BN market cap and hated industry right now!
Ehhhhhhh whatever. AMWD is trading at 7.3x ’23 and in my view, has performed worse. Capital intensity is also higher there. I like the risk reward.
Vimeo stock collapsed following the spin from IAC. That caught my attention, I read some of their calls, but I never really dug in. Then, in early January, I tweeted there was an interesting cash-covered put trade you could do at $12.50 strike. As Vimeo stock has fallen more, I decided to do some “napkin” math on the stock.
Say Vimeo grows half the rate of management’s target, FCF margins end at 20%, and priced at 20x FCF. Discount that back at 10% and you get a market cap that isn’t too far off from today. These are all “finger in the air” numbers, but it showed me I should do more work.
If I had one takeaway from reviewing the company is that each Vimeo subscriber is not created equally! And when you break down the math, the targets become much more believable. If you want to cut to the chase, I’d suggest reading the “All Customers are Not Created Equal” section below as well as the model cut outs I have.
Is there risk? Of course. But I think many are likely saying, “eh, I’ll just wait” right now and that’s big time group think.
But first, I’ll go through a quick background, why the stock has gotten pummeled, and what you need to believe to make money from here. I’ve included a few screen shots of two of my models to emphasize this point.
Vimeo was spun out of IAC in May 2021. The spin followed strong 2020 results as Vimeo enabled many businesses to operate during the pandemic. No doubt, Barry Diller & Joey Levin at IAC recognized tech / SaaS multiples were high and a partial sale + spin would be best for shareholders.
Indeed, IAC sold a partial stake in Vimeo for $150MM which valued the company at $2.75BN in November 2020. Then in January 2021, another $300MM of equity was sold valuing Vimeo between $5.2BN – $5.7BN. In the first case, the valuation was a touch under 10x ’20 sales and then quickly moved to about 20x sales.
Today, we’re looking at Vimeo with a market cap of $2.3BN, or 6x ’21 sales (5x if you exclude cash, as Vimeo is FCF+, albeit from SBC & deferred revenue). Spun out at $57, the stock can now be purchased for under $14.
Ok with that background of “why Vimeo is even public” out of the way, we can explore why the stock is getting hammered, and then we can address why it’s a reasonable buy.
Why did Vimeo stock get pummeled?
Vimeo’s stock has gotten smoked for a variety of reasons.
Pandemic-enabled companies are coming home to roost (Peloton, Zoom, Docusign, Moderna are all down >50%)
Joey Levin straight up said it was expensive!
Growth is decelerating
Lost credibility: Vimeo will likely miss targets in its first year following an investor day that promised 30% growth for next 5 years
They are changing price strategy starting in ’22. A foundational change can lead to volatility
Spin dynamics, possibly
Investors are less enamored with tech / SaaS
I won’t go into all of these, but I think the first few are worth going through.
Pandemic-enabled and “a bit rich” at the spin:
In IAC’s Q3’20 letter, Levin stated that Vimeo was “a business that benefited meaningfully from the pandemic.” They also said, “we can’t be certain that the magnitude of the positive lift to Vimeo will persist when the virus’ effect on our lives becomes less pronounced…“
They went on to say, “Vimeo’s access to capital inside of IAC will be much more expensive than access to capital outside of IAC.” They decided to test the market by selling some shares (Nov ’20) and then some more (Jan ’21). They noted how the investors were willing to pay on a P/S multiple, almost besmirching the reputation of the buyers!
Read between the lines. They were saying others are willing to pay much more for Vimeo than we are.
Growth deceleration + Lost credibility
In that same IAC letter, they called out acceleration during the pandemic which was obvious.
Prior to the pandemic, we were steadily proving Vimeo’s fit in the market. Organic bookings growth consistently accelerated last year from 11% in Q1’19 to 27% in Q4’19 as we began to expand from our filmmaker roots to a broader audience of small businesses and large enterprises. Then the pandemic hit, and that acceleration exploded to 41% in Q1, 79% in Q2, and 56% in the most recent quarter.
If we look at the latest monthly metrics, we can see Vimeo is growing strongly, but at a slower pace. They actually face the worst comps in Q1’22 so it is likely this decelerates even more.
Total revenue is coming down from high-50s to 60% to 40s, high-twenties and now around 23% in December. Look at Q1’21 figures and we can probably conclude comps will be tough. Perhaps the company grows “just” high-teens / low twenties.
This is problematic as management set out much more lofty 5 year goals at their investor day in March 2021. A few quarters in and it looks like we will be under the goal.
Vimeo hasn’t reported Q4 yet, but investors can look at the reported monthly metrics as a guide. Even before they reported December metrics, they were guiding investors down at conferences:
[Regarding Q4]. What we have said is that revenue growth to be about 25% year-over-year. And if you think about that, we are lapping a very strong growth rate in the fourth quarter of last year, which was about 54%. So on a 2-year stack basis, we are significantly higher even compared to Q3 of this year. We haven’t talked specifically about 2022 and what the growth rates would be there. We are still in the planning process and for all the reasons that you talked about, the visibility being harder. We’ll provide more guidance as we get through this year and into early next year.
But what we have said is that the 30% growth rate is unlikely next year. And we also believe the first half of next year and the growth rates will be muted for the same comp reasons that we talked about earlier, and we expect the growth rate to be accelerated in the second half of the year. So if you think about our growth rates coming down in the second half of this year, that would continue through the first half and then we expect it to reaccelerate sometime in the second half of the year.
My emphasis added.
But let me say one heuristic I have learned over time.Anytime a company says that “we’ll make it up in the second half”, it is a SHORT for me.
“But Dilly D – if that is the case, how can you possibly buy the stock now?”
I think a lot is priced in at this point (also dangerous words as making it up in the second half). But after studying the business model, strategy, and thinking about the TAM, I do think this business can continue to grow at high rates.
Ok enough depressing talk, let’s talk about why Vimeo now looks cheap!
Why Does Vimeo Stock Look Cheap?
Vimeo is a more focused company, post-spin. They are free to operate the way they want & invest where they want. Focus on a singular goal is important.
End of the day, Vimeo is a good business
Classic “freemium” model converts users to paid in highly efficient manner. That said, enterprise customers (where decent amount of S&M is dedicated) are worth way more than typical “Pro” subscriber.
Enterprise 1% of subscribers, but 25% of revenue.
50% of paid customers started off with the free plan (i.e. freemium model)
Vimeo is an alternative to YouTube for business
Pandemic likely pulled forward sales, but also accelerated market growth and adoption.
Decent amount of growth is “locked in”
I’d gamble some things from the pandemic will stay (e.g. virtual “town halls” for companies, more video options for live events, etc.)
Brand value is worth something (I won’t dive in here, but something to think about)
The “What do I need to believe?” case seems reasonable
First, I think a focused, small company can really do wonders. Investors worry big tech will squash the “little guy.” See online dating, industrial distribution, media content, marketplaces, among many others. But Vimeo lives and dies by this “niche.” They come into the office everyday thinking about this one thing.
Steve Jobs said with “focus and simplicity you can move mountains.” To me: stand alone company = more focus, though maybe Vimeo requires more investment short-term.
I think we started the year with about 75 quota-carrying sales headcount, and we would end the year at about 150, so almost doubling. We have opened offices, at least in 4 or 5 new geographies that we didn’t have at the beginning of this year, so significant expansion
Seems like they are investing for growth.
End of Day, Vimeo is a good business
On the Self-Serve segment of our revenue (meaning, a customer begins to pay Vimeo without having spoken to a salesperson), we’re seeing about $5 in profit for every $1 we spend in marketing. That ratio has continued to steadily improve and we haven’t yet found the limit on our ability to spend on marketing with those returns
IAC also mentioned during the pandemic that Vimeo “accidentally” went EBITDA positive as the growth resulted in a lot of operating leverage.
Go back to the 2020 summary results with long-term goals below. Look at that operating leverage on the gross margin line and EBITDA. Pretty impeccable. This has been true over time when you spread the financials as well and look back to 2018 and 2019. I do think a SaaS company like Vimeo should be able to reach 20%+ EBITDA margins, which we can get into in the model later.
All Customers are Not Created Equal
As mentioned, Enterprise is just 1% of subscribers, but 25% of revenue. This checks out with their other disclosures:
As of December 31, 2020, we had over 3,800 enterprise customers, who, as of the quarter ended December 31, 2020, pay us over $22,000 per year, on average. We define “enterprise customers” as those who purchase plans through contact with our sales force. Our enterprise customers grew 87% year-over-year for the quarter ended December 31, 2020, and these customers now represent nearly 25% of our total revenue for the same period.
The goal is to increase Enterprise exposure. In fact, as of Q3’21, it was 30% of revenue.
I created a hypothetical scenario where Vimeo had 100 paid customers, 99 on a “Plus, Pro, or Premium” contract and 1 enterprise customer. Let’s assume nothing changes other than their ability to gain one more enterprise customers. Note, I somewhat made up numbers to back into an ARPU roughly around today’s levels.
The other subs can be flat, ARPU can be flat, but the mix effectcan drive significant results.
And assuming ARPU is flat is pretty conservative. They stated in their S-1 that Net Revenue Retention was 110% and in Q3’21 they stated:
“Our enterprise net revenue retention remains healthy with our sixth consecutive quarter of NRR above 100%.”
Pricing Strategy Change
Let me also say they are changing their pricing strategy. As I said, foundational changes can cause a lot of turmoil. Currently, this is in “beta” but they are moving from a storage-based model to a “per seat” model. In other words, they are going to try to base payment tiers off of customer success. You host a webinar, Vimeo will charge off of registrants. If you have an internal library of content, it will be based off of admin seats.
This may turn off some people. But Vimeo is doing it now because they feel they’ve expanded the product platform enough to make it enticing. Plus, aligned payoffs makes a lot of sense. Think about Facebook ads where the company buying the ad only pays when someone clicks – that is high ROI and easy to tie which increases lock in.
This is no doubt a big project and scary, but they have been talking about it for at least a year. If it works, they’ll move customers up in pricing tiers (e.g. from the self-serve model to a higher tier). For what it is worth, most SaaS companies are on a per seat model.
Here is Vimeo talking about converting customers and retaining them, as well as bringing up per-seat pricing. This is from March-21, but they also spoke about this in 2020.
In terms of the conversion and upgrade mechanisms, so I think of it in two ways. One of the biggest features that we see help unlock our free users to convert in the first place is being able to create content. The creation of content is a big barrier. So things like our Create app or Vimeo Create app, being able to record your screen and send a video message, those actions are really the things that we found activate a free user to get them to be paid.
From there, the way we tend to move our users and subscribers up tiers is unlocking more advanced functionality. Some examples would be livestreaming, advanced marketing tools, the ability to capture e-mails within a player, put your customization and branding, add calls to action, privately and securely share content or create a video portal, those are all the mechanisms today. Tomorrow, we see even more mechanisms. You’ll see us do things as we expand our product suite. You’ll see us look at per-seat pricing, for example, so that we can actually use the number of seats or the size of your team as a way to move people up tiers. But even what we have today, we see, I think, about 25% of our self-serve subscribers move up tiers from those other features I just mentioned.
Vimeo has >200 million free users today and they have a good history of converting them to paid. I think about Dropbox: it is much easier said than done converting free users, but when you are actually able to bring them up the chain, it is a beautiful thing.
If you go back to the S-1, it seems like this isn’t a “new” change, but something thought about for awhile now:
Over 65% of our new enterprise contracts came from customers who were existing free users or self-serve subscribers first
We seek to employ a “land and expand” strategy where we inspire our existing subscribers to increase video adoption and usage and upgrade to higher-priced plans over time. For enterprise customers, we seek to expand the number of employees, teams and departments using our platform and increase contract value organization-wide.
What about YouTube?
All of this can be a disconnect for people who quickly think of YouTube as a competitor. I’d say a lot of YouTube is B2C, ad-driven revenue.
Most people today probably still think of us as the sort of indie smaller version of YouTube. And for most of our history, that’s what we were. We were a viewing destination and a place to watch a video, like YouTube.
And 3 years ago, we pivoted away from that strategy to really being a B2B video SaaS company…today, we enable any business of any size to connect with their customers and their employees with video…we do this by providing a very simple, high-quality, end-to-end solution for those businesses and professionals. So SMBs and marketers will use us to make social media videos, post them all over the web and drive traffic back to their business or store. Fitness studios and churches will use us to live stream their classes and their sermons. And yes, we have Fortune 500 companies using us to host virtual town halls and conferences and events
Video is a big market and there are a lot of different use cases (read: niches). To head off the “YouTube vs. Vimeo” argument, let me pause and offer a few reasons why someone would choose Vimeo.
YouTube is quantity over quality: Vimeo can offer higher quality videos with more customization
No ads: there is a component of control here, such as no control over what ad plays in front of your video. Plus, an ad is inherently trying to drive traffic away from the site. That is NOT what a Vimeo customer wants.
Make money with pay per view: Back to that fitness class example, a small business can set up a “pay per view” using Vimeo
Password / privacy protection: Can create company specific vids or those for customers without sharing with the world
It’s reasons like these that the NYSE does live stream of opening and closing bell on Vimeo, or why Starbucks does workforce training on the platform. From a quality perspective, a lot of music videos are now on Vimeo as well as short-films where the filmmakers care about their videos not being compressed.
Anyway, it is a difficult question for many of the 800lbs gorilla squashing Vimeo’s niche, but I go back to how big the video market is. To me, the analogy is similar to an Etsy vs. Amazon – both can exist.
I think this conversation on Vimeo will not die down. It will likely continue to “dog” the company for some time, especially when reports of other video players adding new features (like Zoom) emerge. Unfortunately, I can’t “prove” Vimeo will win in every case. That’s the bet.
Summary Model Scenarios
For the first model summary, I wanted to show a “management case” and have ’22 at subs and ARPU growing 9-10%, for 20% revenue growth, followed by re-acceleration. I assume some modest leverage on COGS, but they are already at their goal, and some fixed cost leverage (mostly coming from G&A – where I assume ~70% of G&A is fixed).
Yes, I do assume SBC is added back to EBITDA for Adj. EBITDA.
I assume, because they’ll be generating so much cash and already have a lot of cash on hand, that they start buybacks in 2023 = FCF. They likely do acquisitions instead, such as the two at the end of 2021, but those assumptions are too hard. Buybacks start at $20/share and stock price increases 15% p.a.
Bottom line: If you think this is reasonable and want to buy the mgmt case, then we are buying the business for 3.7x 2026 EBITDA and the company will be generating a lot of the current market cap in FCF.
In this case, the company will be doing $4.35/share in FCF in 2026 (remember, stock today is <$14). 20x that figure gets you an $87 stock price.
What about the scenario where they were *just* a COVID winner?
I think that’s interesting. The truth might be somewhere in between.
Let’s say subs slow to just 3% a year but ARPU decelerates meaningfully. NOTE: This is in full contrast to the Enterprise customer math we did above! In reality “what I think will happen” is subs could slow, but ARPU accelerates.
But anyway, you can see the results here:
Given I still assume buybacks (at the same prices in the first case) I have Vimeo doing $1.20 in FCF/share by 2026. If you put 20x on that, that’s a $24 stock. That may not seem like much, but that’s 60% over 5 years and foots to a 10% CAGR.
If the truth is somewhere in between, the risk / reward looks pretty attractive now.
I tweeted this in the beginning of the year, because I saw it as an interesting way to play Vimeo and wait for a better price:
Full disclosure, I did do that trade. At the time of writing you can get $2.25 for this contract! That’s an 18% unannualized “yield!” And I also have done that. Worst case, I am buying Vimeo stock at $10.25, or $1.7BN. I am comfortable owning there, too!
Selling cash-covered puts is more conservative than buying the stock. BUT it has less long-term upside. Sentiment seems pretty low, and definitely can get worse, but there is risk you miss out owning a great, little business with a long runway ahead.
Reading Time: 5minutesThere are certain businesses that investors have washed their hands of: Retailers, OEM auto suppliers, anything in the way of ESG… many others… And this trade probably worked well for the last 5 years. I recently wrote up at least three names that are counter to these trends, but there are many more.
I’m in the process of creating a “basket” of these names that I’m going to commit to buying and holding for at least 3 years.
I’m calling it: the Value-Trap Coffee Can portfolio.
Most of the time, a coffee can portfolio is set up of really good businesses that you should just set and forget. Let them compound.
In this case, the narrative around some stocks can be so toxic, you can convince yourself at any point to sell. But if find management teams that are very savvy, conducting effective turnarounds despite headwinds, and know how to drive shareholder value, sometimes you still want to align with them.
I fundamentally believe you can have bad industries, but great companies (driven by great management teams) and therefore great securities hidden within them.
So I’m locking these stocks up and throwing away the key to see what happens.
I am adding Strattec to the VTCC portfolio, which is an automotive supplier and I’ll get to at the bottom of this note.
Please reach out if you have any others I should be looking at!
Why the VTCC Portfolio Now?
At points in the past, this would’ve seemed nuts, but my response to that is these companies
have significant cash / FCF, especially compared to their market caps today
have a rising earnings path over next ~12+ months. Especially true now that we went through a downturn and are coming through on the other side of it, and
are completely unloved, so are still very cheap.
You can see it’s really more of a cycle + cheap call.
I cover cyclicals for my day job and cyclicals have been pretty much un-ownable since we had an industrial-recession scare back in 2015/2016. OK – they had a nice run when Trump first came in, tax cuts were implemented, and there was a brief sugar high – but after that, the stocks didn’t do well by comparison even if results were fine. I saw many companies I covered trade at super low multiples as everyone figured a cycle was inevitable.
I now think that since we may be entering a new cycle, permission to own is granted.
In other words, maybe value traps won’t be traps for too much longer. (Famous last words DillyD!) But seriously, you can mitigate this problem via position sizing.
A couple pushbacks to that simple thesis:
You could completely disagree with me that we are entering an upcycle – people are already saying what we went through in 2020 doesn’t count as a “normal” recession (whatever that means) and is more like a natural disaster. Semantics. Whatever. This is the theory I have and am going to bet that way.
Stocks already at all-time highs, too. So how can there be much of a recovery? Well… FANG is like 25% of the S&P500. None of these basket stocks are in tech.
Supply chains are a mess. This could derail the thesis, but I think it would be a temporary derailment vs. anything long-term.
It seems very hard to argue to me that any of the sectors I am going to buy a basket of are “overbid” territory. We can also reach new highs if FANG stocks stay flat and cyclicals have a really nice run, too, ya know?
I think retail is interesting because the consensus narrative was that they are dead, that we pulled forward a ton of e-commerce progress… and yet, if you actually looked at some of these player’s results, you’d see they either adapted very well (some did) or the buyer is coming back.
The anti-ESG trade is only interesting to me in names that can solve the problem – by buying back stock themselves at really attractive prices. Some names are in the ESG crosshairs, but either can’t or are unwilling to effect change in their share prices.
Strattec is an interesting little auto supplier that makes locks, power lift gates, latches, among other things. It was originally spun out of Briggs & Stratton in 1995. Here’s a [kinda hilarious] video of them trying to sell why people need a power lift tailgate.
They have their OEM concentration issues, like American Axle, but that is the name of the game. They actually have much better concentration than American Axle which you can go see in their 10-k.
Similar to my American Axle thesis, I think we are going to need a massive restocking of cars. Inventory days are ~22-23, compared to the normal 50. However, this cycle is going to take a long time to sort itself out.
But it’s a double-edged sword. The longer it takes to replenish inventories to “normal” the longer this auto upcycle will likely last. Yes, less sales today, but I think the tailwinds will be there for some time to come. Again, I wrote about all of this in my AXL post.
Even with these headwinds, Strattec still did $110MM in the latest FQ4 (ended June, reflecting the impact of the semi issue) and $485MM for the FY, down from $129MM in the quarter ending June 2019, but in-line for the FY $487MM. However, EBITDA increased by ~50%. Again, this was due to cost improvements and efficiencies in the business that the company says is structural.
Bottom line, I think Strettec will emerge more profitable than ever, and if permitted to run flat out (semi issue abates somewhat) then we will see awesome fixed cost leverage, too.
Strattec is only a $150MM market cap company, but an enterprise value of ~$147MM.
Over the past 12 months, they cut their dividend during the COVID panic and paid down $23MM in debt. If you fully count JV debt, they have $12MM in debt now, but $14.5MM in cash.
At the same time, let’s say you expect the top line to grow a bit, but they’ll give some margin back, the company is trading <3x EBITDA. And it isn’t like that EBITDA won’t convert into FCF: the company has guided to $12MM in capex, they’ll have no interest expense (basically) and taxes in the range of $8-10MM. That’s $35MM of FCF on a $150MM market cap company.
Not bad! Just last 4-5 more years and I’ll have my money back.
Reading Time: 6minutesAs everyone I am sure is aware, container shipping rates right now are astronomical. The re-opening of the economy and associated supply-chain bottlenecks has created a situation where people will pay up just to make sure their items are actually on that boat!
This has caused blow-out earnings for the shipping lines. Maersk reported a 166% increase in EBITDA for Q1’21 for example.
However, I don’t think this is sustainable and no one else does, probably. Shipping is also a fraught industry to invest in – when times are good, capacity is brought online. These ships are long-lived assets so when times aren’t good, the supply is still there.
There’s alternative however, with a much stronger industry structure, ROEs, cash flow, on and on. That is container leasing. Triton is the largest player in the space after it merged with TAL in 2016.
I like Triton stock because:
Leader in the market – scale in the leasing industry matters and drives much higher margins + lower cost of capital
Fundamentals are in terrific shape
They are signing long leases at high rates – abnormally long and abnormally high (over a decade) – which will give strong visibility into cash flows for foreseeable future
Can flex capex spend with the market – has a history of shutting of capex and buying back stock + dividend
Triton stock trades for ~6x ’21 EPS, 1.3x ’21 BV – historically generated mid-teens+ ROE in normal times. This should improve
The business historically went something like this:
Triton buys containers and places them on lease with shipping companies.
Historically, these would be 5 year leases. However, with limited technological obsolescence (just renting a steel box in most cases), the age of the asset didn’t really matter. So they can pretty quickly re-lease the box, but the lease rate may change
The assets (boxes) last about 15-20 years with pretty minimal maintenance. Maybe slightly more for a refrigerated box, called a reefer (yes the actually name), but the lease rates would also be higher. So historically there’d be 3+ leases involved
End of life – they sell the box for some residual value, which also helps recoup part of their investment. It used to be they buy a box for $2,000-$2,500 and could sell it for ~$1,000. Right now, they can sell the used box for about $1,500, which is pretty nice.
Why do shipping companies lease instead of owning their own containers? It outsources capex in an already capex-heavy industry. It’s off balance sheet financing for them. The shipping lines do still own their own containers (about half of the market), but that’s been trending down pretty consistently over time. It just makes more sense for them to focus on shipping and flex leases up and down with the market.
I don’t think I need to dwell on why fundamentals are good right now or why buying Triton stock at 6x earnings is optically cheap. I’m going to focus on the lease rates and new longer duration contracts being signed right now.
If you are worried about the current conditions being unsustainable, long, contracted lease rates help that. As shown below, Triton is trying to tell investors that not only is it leasing more containers than basically ever…. putting assets to work… the lease durations are now approaching 12-13 years.
If you like SaaS, you’ll *love* container leasing companies.
We’ll have to think about these rolling off in 2031-2033, but meanwhile, the company will be earning above average ROEs.
Here is a chart from their Q1 basically showing lease rates are 1.6x the general average. You can see there was a dip in 2019, but the company pulled back – the size of the bubble indicates how many containers were put on lease (so very few). In a sense, Triton is an asset manager just like a Blackstone – you kind of need to trust that they will be deploying capital when times are good and pulling back when times are bad.
What could go wrong?
I should mention what could go wrong. We have seen this situation before – following the GFC, world trade snapped back and lease rates surged. Unfortunately, they all basically expired in 2015/2016. This was also when we were in a quasi-industrial recession. This was also when steel prices were in the gutter, which makes up most of the price of a box and makes it tough to sell used boxes at a fair price. Hanjin, a major shipping line, also effectively liquidated (in a BK case, most of the time a shipping line will just keep its assets rolling in a Ch. 11 because the containers are critical assets to operating – Hanjin just disappeared.)
In many ways, 2015/2016 was worse that the GFC. I mean, it actually was worse. The GFC wasn’t actually that bad because global trade remained pretty steady.
Even with a trade war, it’s hard to knock off the secular trend of the western countries importing from Asia. If it isn’t from China, it is from Malaysia, Vietnam, and so on.
Did I strike to buy Triton stock in 2015-2016?? No. I was gun shy as I’ve been following the industry for quite some time and they never seemed to generate real FCF (CFO-Capex). It was an asset gathering game.
But then in 2019-2020, when the market wasn’t particularly great, they actually proved they could shut-off capex. They starting generating a ton of FCF and showing signs to shareholders that they care about the stock (they even issued a pref as well to help fund buybacks)
Another sign they care about capital allocation is this fantastic sources and potential uses of cash in their deck:
Basically they are telling you they could buy back 12% of the stock in one year. Share count is down about 15% in 2.5 years, but now I think they’ll be deploying cash into higher ROE opportunities, which is fine by me.
One thing I should mention is typically Triton finances itself through the ABS market. They get 80-85% LTV against the asset value for very long duration. Happy to answer any questions on this, but I’m not too concerned with the ABS market financing.
Triton issued $2.3 billion of ABS notes during the third quarter at an average interest rate of 2.2%. Most of the proceeds were used to prepay $1.8 billion of higher cost notes, which is expected to reduce interest expense by more than $25 million over the next year
They are also diversifying financing – so they just issued an IG secured bond and have talked about moving up to IG ratings. If their cost of capital goes even lower, it will be great for the business in the long run.
Last thing I’ll say is basically Triton is covered by one company. You’d think modeling it would be easy enough, but we are talking about hundreds of thousands of containers, utilization can change, etc etc. However, I think EPS estimates are probably still too low in the long-run. It’s been that way in the short-run, so far, but we shall see. It’s hard for sell side to model operating leverage + high lease rates + deploying cash into such a significant amount of assets.
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.
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.
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.
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.