Hammond Power

May 6, 2013

Dean at Petty Cash tweeted me a question: “curious to hear your thoughts on HPS.A after most recent qtr? Haven’t sold any, but wondering if we see a downtrend in ebit”

I have been thinking about Hammond Power. The stock had risen more than 20% this year, but lost a big chunk of that gain after reporting its Q1 numbers on April 25th. To be honest, I don’t know what caused the heavy selling and the drop. But I have been too complacent in the past when bad news pushes a stock down, deciding later—at lower prices—that the changes are material.

My guess is that the concern is about the Canadian economy, especially resource extraction, which accounts for a fair portion of Hammond’s earnings. If it really is collapsing then Hammond’s earnings will probably fall, reducing the value of the business. I have no special information about any of this, and I do not think that I can take any action where I’m just guessing about what might happen and what impact that may have on Hammond Power.

We might see a downtrend in EBIT - Hammond is in cyclical businesses, so we will certainly see a downtrend sometime in the future. I think that is ok. Overall I think that Hammond Power is a good business with decent (ie. >10%) returns on invested capital over the cycle. I also think that the management team is good at operating the business - they seem to do better than the competition, gaining share in new markets and successfully pushing through price increases. The earnings will be lumpy, but I like the business and how it is managed, and I think that normalized earnings are closer to $1 per share than $0.50 (especially after removing European and Indian losses).

Again, maybe I am too complacent, but I am not terribly worried that the stock is overvalued at $9 even if we do have falling EBIT (which is not guaranteed).

What I worry about with Hammond Power is how management allocates capital. In the past 2 1/2 years, the company bought Euroelettro, PETE, and Marnate. The total cost is about C$42.6m, or $3.66 per share, and the acquisitions have added nothing positive to earnings and cash flow. So $3.66 per share spent with $0 (or negative!) in returns to date. I understand the strategic rationale for intercontinental expansion, but I do not like the ROI to date. I want to own good businesses with management that is great at operating the business and great at allocating capital - all in a cheap stock. The stock seems cheap, the business good, and management good at running it - but I worry about the money spent acquiring Indian and Italian businesses.

The short answer is that I do not know whether Hammond Power’s EBIT will decline over the next few quarters, and I do not feel confident making any changes based on my fear that the economy will slow (I already sold Engility and Strattec at lower prices, no need to keep going!). What I do want to get a better sense for is Hammond’s capital allocation plans. The pros are that Bill Hammond is a large shareholder and is spending his own money when he makes acquisitions. The company has bought back shares at good prices over the past few years, and the Delta Transformers acquisition in 2008 does not seem terrible. In a few years, the European transformer business may be much improved, and these acquisitions might look great. The cons are that $3.66 per share of money that could have gone to shareholders was instead directed to the former owners of Euroelettro, PETE, and Marnate.

Avuncular

May 4, 2013

Definition: (Adjective) Kind and friendly toward a younger or less experienced person.

Charlie Munger described Teledyne’s Singleton as a genius, who promoted his stock in the 60s and used its high price as currency for building the conglomerate. He then bought back massive quantities of stock (90+%) in the years that it was cheap. He treated shareholders as a group that should be exploited. Berkshire is more avuncular.

Sold Engility and Strattec

April 10, 2013

Yesterday I sold my 450 shares of Engility ($EGL) for $22.40, after commission. I also sold my 500 shares of Strattec ($STRT) for $34.02, after commission.

I like both companies and both are still cheap, but I looked at my portfolio, with 5% in cash, and decided that I needed to sell something to raise cash. I was sorely tempted to sell Punch Taverns, but I decided to give the company the next three months to effect a debt restructuring (or stop supporting the Securitizations). This was a tough decision, and may be wrong. I want to own excellent businesses that grow over time, with excellent management teams that allocate capital well on behalf of shareholders - at a good price. Punch does not fit the bill, Matthew Clark is a good business, but leasing pubs is a low ROIC business, requiring lots of leverage to get ROE to a good level. We have a near term catalyst, so I am going to grit my teeth and wait a little longer.

With selling Punch off the table, I sold the two stocks that I owned that I felt were furthest from my ideal. Engility can lay no claims to growth and management’s capital allocation skills are unknown. I like it a lot, but something had to get cut. Strattec faces secular decline, which demands that management is exceptional in allocating capital to new areas. They have done a great job, but the road is long and difficult. Again, it is a great company at 10x earnings, but I felt compelled to sell something.

Cash is now about 21% of the portfolio.

Downed some more Kopparberg

March 26, 2013

Last Thursday and Friday I made good on my comment that I would rather own something other than Svedbergs i Dalstorp, by buying 3,000 shares of Kopparbergs Bryggeri.

Unfortunately it took me two days to get the shares, which means two days of many-layered commissions. On Thursday I got 696 shares at my limit price of SEK 29.90. After two brokers’ commissions and the fx conversion, that worked out to $3,353, equivalent to SEK 31.26 per share. Friday I decided to stop being clever and took the remaining 2,304 shares at SEK 30.30 per share. After fees they cost $10,883, equivalent to SEK 30.67 per share.

Overall, 3,000 shares of KOBR at SEK 30.81 per share, $14,236 in USD.

My original post on Kopparbergs is here.

Sold Svedbergs

March 20, 2013

On Monday I sold my 3,000 shares of Svedbergs i Dalstorp at SEK 19.98 per share after commissions, which worked out to $9,293 after conversion to USD. This was a painful 19.4% loss from when I bought it in October.

The main reason for selling is from what I wrote a few days ago with Aeropostale - declining earnings and returns on capital with a newish manager who has not cut costs aggressively to keep up with the decline in sales. The other reasons for selling are that I bought it thinking that it would be a “bond”—which isn’t happening now that the dividend has been cut—and I would rather own something else instead of Svedbergs.

This is not to say that the company won’t turn around. It is a strong business with good returns on capital that seems to be going through a cyclical slowdown. I actually like that management isn’t cutting costs too much, as it will allow it to have good products when the market turns. I also approve of cutting the dividend to avoid taking on too much debt.

I think that these are all good actions for a turnaround - but I bought Svedbergs as a “bond”, not as a turnaround. And I paid too much (accepting almost 10%, vs the 15% that I should demand of a company that won’t grow). On my SEK 2.45 normalized earnings estimate, that implies a buy price of SEK 16-16.50, and I paid 25.50. I do not want to change the reasons for owning Svedbergs because I made a mistake when I bought it - and that would be what I am doing if I continued to hold it.

So I paid too much, broke my own rules, and have now sold the position and taken my loss.

As an update, the portfolio is now:
image

 

Engility

March 18, 2013

Overall:
Engility is a government contractor that I think best resembles a hiring firm like Robert Half; Engility provides people who then work out of government offices and locations. As a result, very little physical capital is employed in the business, and returns on capital are great:

image

As you can see, revenues have dropped dramatically, taking down margins, cash flows, and returns on capital. The reason for the decline is that the US government has reduced the amount of money that it spends on Defense activities that Engility participates in.

Business:
I made a memo for myself in July, writing:

Professional Support Services is largely SETA (Systems Engineering and Technical Assistance) work, it is a service business where the company acts as a contractor to the US government (often military), providing staff at the customer’s location to select and implement various systems. Systems can include combat, health and welfare, IT networks, and depot level maintenance (counter­IED). SETA projects involve researching, modeling, planning, and implementing solutions to the customer’s problems. The Professional Support Services segment also provides testing services for theoretical and existing equipment (including weapons, aircraft, and other potential purchases). Program Management support operations fall within this segment as well. These activities include financial and budget analysis, procurement support, and logistics support.

The Mission Support Services segment provides personnel, including police, instructors at the Department of Defence (DoD) Information School, military trainers, law enforcement trainers, USAID trainers, linguists, counter IED analysts, and seized asset management support.

Under the Obama administration, DoD spending has become less profitable for some military contractors. Revenues and margins have shrunk for some companies, including Engility. Since 2008, “OCI’ (organizational conflict of interest) regulations have become more strict, preventing SETA contractors from working on projects that other entities in the corporate group may provide. To avoid these OCI restrictions, some defense contractors have sold off their SETA businesses, including Northrop Grumman selling TASC and Lockheed Martin selling SI Organization (in November 2009 and October 2010, respectively). L­3 Communications has followed in their footsteps in spinning out Engility. The stated rationale at the July 2011 announcement of the spinoff (one year prior to it taking effect) was to allow Engility to bid for more projects, and to allow L­3 to dispose of a shrinking business without selling it (because L­3’s cost basis was quite low).

M&A Multiples
Two transactions for SETA businesses were the sale of TASC and the sale of SI Organization. TASC was sold at 107% of trailing revenue, and 11.1x trailing EBIT. SI Organization was sold at 130% of trailing Revenue and 11.7x trailing EBITDA. Comparable to the Mission Support Business, DynCorp (aka Delta Tucker) was sold in April 2010 for 40% of trailing Revenue and 5.7x trailing EBITDA. Clearly the more stable SETA business has been awarded a higher multiple than the Mission Support business.

Valuation
I estimate the Engility’s Professional Support Business is worth 100% of its estimated Revenue, and the Mission Support Business is worth 40% of its estimated Revenue. Professional Support accounts for 55% of the company’s sales, implying that the company’s $1.6B estimated 2012 sales are worth about $1,170 million. This is equivalent to 14x my estimate of the company’s 2012 earnings power. Engility has a 5.75% 1st lien loan of $335m, due July 2017, and $10m of borrowing on its revolver, which has the interest rate and maturity as the loan. Engility borrowed this money to pay a $335m dividend to L­3 Communications. With an EV of $1,170 million, and $345m of debt, Engility has an equity value of $823m. With 16.7m diluted shares, this is an estimated value of $49 per share. With a 40­-50% margin of safety, the buy price for Engility stock is between $13-something and $20.

In Form 10, company calculates goodwill impairment. There is no reason for the company to be optimistic in its assumptions, because of the spinoff. Assumptions include 15% annual drop in Professional Services Revenue and 20% annual drop in Mission Support Revenue - each for three years (2012-2014). Using the pro-forma 2012 NOPATA margin of 5.5%, that implies NOPATA of $64m on Revenue of $1,175m. That works out to EPS of $3.11, and a value of $23 at 10x NOPATA-Debt, and $30 at 12x NOPATA-Debt. Of course a simple P/E implies an even higher value.

In a reasonable downside scenario, Engility would have revenues of $1,175m, a 2% NOPATA margin decline to 3.5%, so NOPATA would be $41m, and EPS would be ~$1.78.

Above is what I wrote last year - what has changed?

I have gotten more comfortable with the management and the decline in business. Management has focused on cost-cutting and earnings do not seem to be declining toward the $1.70s. The company expects 2013 earnings to be $3.25-3.55 per share. Free cash flow should be even higher because as revenues decline, working capital is released. On last week’s call, management indicated that they wanted to do something more interesting with FCF than pay down debt. They seem acquisition hungry, which is a negative, but the whole defense contracting industry is under pressure, so they might not have to overpay. In any case, there are indications that this is a good operating manager and possibly good with the balance sheet too. I do not—unfortunately!—see the decline in defense spending as secular. The US will get itself into other foreign entanglements, and contractors like Engility will get new work.

At $22.615 I bought a 2013 earnings yield of 14%-16%. The free cash flow yield should be higher. On M&A multiples the company is worth around $50. If management is unable to arrest the decline in profitability,  I paid a bit under 13x earnings, a few years out, for a business that produces huge free cash flows.

This is not a great business - it requires excellent management to produce high returns on capital, especially given the increasing competition that it will face as US government demand continues to drop. However, the price is low, and the management seems good.

Cyprus - Canary in the Coal Mine?

March 18, 2013

I finally read about the Cyprus bank bailout today. I am interested in financial failures, because I think that when things on the frontier fall, it might be a sign that things are rotten to the core. This was what happened in 2007 - when the failure of mortgage originators and Bear Stearns’ money market funds heralded the impending financial crisis in the US. So I was fascinated by the news about Cyprus.

For me, the relevant issues are:
* Two large Cypriot banks were in trouble - but all depositors in the country have to pay
* About 8.3% (5.8 “contribution” / 70B total deposits) of all bank deposits are disappearing from customer accounts
* EU deposit insurance will not prevent customers with less than €100,000 from suffering losses
* I have seen nothing about what was actually wrong with the two big banks - what were their problem loans??

This is amazing! There was a problem at two banks - but all depositors are hurt, even if they had small accounts that should be protected by deposit insurance. So deposit insurance does not protect you, and being at a strong bank does not protect you. The message is: if you have money in a bank in a country with a weak banking system, your money is not safe.

If I had a bank account in a country with a weak banking system (Greece, Spain, Italy, etc…), I would be thinking hard about how to take as much money as possible out of my bank accounts. That is how bank runs start.

Sold Aeropostale

March 17, 2013

As I wrote on Friday, I sold all of my Aeropostale shares. I lost money on Aeropostale, so I need to review the mistakes that I made, and try to find lessons, so I don’t repeat those mistakes in the future.

I did not understand what drove Aeropostale’s high returns on capital, and what would allow the company to maintain them in the future. As it turned out, Aeropostale was not able to maintain its highs ROICs. Earnings dropped, ROIC dropped, and the company has been unable to return to its prior glory.

So what are the lessons here?
* make sure that I understand what drives a company’s high ROICs and whether they are sustainable - if I don’t know why they have done well, I will not know when they are losing those advantages. This is especially important when I look at “magic formula” stocks
* do not buy teen retailers - customers turn over every few years, making it almost impossible to build a sustainable moat
* be very wary when a successful manager leaves a historically successful business in a highly competitive industry - the new management has its work cut out for itself simply to match prior performance
* if I want to sell part of my position, I should sell my entire position. For me, selling a loser is hard. If I manage to sell a little of a loser, then I know something is wrong; I need to stop indulging myself, accept that I am wrong, and get out completely.

How do the lessons of Aeropostale apply to the rest of my portfolio? With Teikoku Sen-I, I do not have a strong sense for how the company generates high ROICs. I am supported by a stock that is still selling for less than book, so I am not paying for the high ROICs and the earnings that they produce. With Svedbergs I Dalstorp, I have a loser with newish management and declining earnings and ROICs. The business is more sustainable than teen retail, but there are a lot of similarities with the mistakes that i made with Aeropostale.

Bought Engility, Sold Aeropostale

March 15, 2013
Two days ago I bought 450 shares of Engility, at an after commission price of $22.615 per share. I looked at the company prior to the spinoff last July, but waited until now (much higher!) to buy it in this account.

Today I sold my 300 shares of Aeropostale at an after commission price of $13.755.

Too busy now, but I plan to write up the whys of both soon.

Punch Taverns - Restructuring Update

February 18, 2013

It has almost been two weeks since Punch Taverns announced their restructuring plan. I have been slow to analyse it, but with the stock almost back to where it was before the announcement, it looks like my dallying has not hurt.

Summary
For Punch Taverns equity, we have owned an option on the two securitizations, the option’s life was determined by how long HoldCo cash could be used to avoid tripping the securitizations’ DSCR covenants. We probably had about a year left. The proposed restructuring would extend the life of this “option” by at least five years.

Some Details
The proposed restructuring would have the Punch A Securitizations relax their covenants, forgoing the mandatory amortization of debt over the next five years. Because the DSCR covenant is based on the ratio of EBITDA to mandatory payments to debtholders, this would allow the HoldCo to avoid providing support to Punch A for the next five years. This is a “kick the can” approach - but kicking the can may well work, as a lot of good things can happen in five years (at least for the equity).

For Punch B, £93m of cash (presumably £38m from Punch B and £55m from the HoldCo) and £56m of new 7.3% B3 notes would be used to pay off the £285m of B1, B2 and C1 notes. Those notes would be paid off with aggregate consideration worth 52.3% of par value. The more senior A notes would receive the same treatment as the Punch A notes - removal of mandatory debt amortization, which will prevent the DSCR covenant from forcing the HoldCo to provide support.

In a nutshell, the proposed restructuring is for the “senior” noteholders (all at Punch A, and the A series of Punch B) to waive their covenants and for the junior noteholders to get paid out now at a discount (but probably not to what they paid), and for the equityholders to put up HoldCo cash now, thereby avoiding future support payments and dramatically improving the odds getting value out of the two securitizations.

The investors running this show own both stock and junior Punch B notes, and it shows in the restructuring proposal. But as an equity holder I will hold my nose, because I am very grateful that the big investors made it clear that issuing more equity would not work. That had been proposed, and I believed that it was the number one way for an equity holder to lose money. This proposal fits my view - restructure the debt, or let the Punch A and Punch B securitizations default. Wiping out equity holders with a massive share issuance would be stupid in light of the assets (cash and the Matthew Clark JV) at the HoldCo.

There are some “sticks” (and not very many carrots) to encourage the Punch A and senior Punch B noteholders to accept the proposed restructuring. For Punch A, the stick is that if Punch B defaults, it has some claims on group assets, which could cause Punch A to default too. For Punch B, the situation is worse. Punch B pubs are managed by Punch A, so if Punch B defaults—it would trip its DSCR covenant as soon as the HoldCo stopped providing support—there would be no one to manage the company’s assets. Noteholders would have to handle the restructuring and build up a new HQ, all at the same time.

Outcomes
I do not know what the probabilities are, but I see two potential outcomes:
1) The proposed restructuring is not approved by all parties, and the two securitizations default. Punch (HoldCo) equity holders keep Matthew Clark and what is left of the HoldCo cash.
2) The proposed restructuring is approved by all parties. Equity holders give up HoldCo cash in exchange for a much better chance of keeping the equity value of the two securitizations.

Under outcome 1), I estimate that the Matthew Clark JV is worth 6-8p per share, that HoldCo cash—with no tax upstreaming and one year of support—would decline to £10m, and that pubs held at the HoldCo are worth about £8m. If the restructuring proposal fails, then equity is worth 8-11p per share.

In outcome 2), Punch equity is probably worth between 7-40p per share. The wide variability is due to the uncertainty over the value of the heavily indebted pub estate. Operating improvement (or a high earnings multiple, such as 18x) is required for the asset value to actually exceed the outstanding debt. But much is possible over the long period of time that the company would have to repay the debt. Also, it’s hard to see the pubs being worthless to HoldCo shareholders, because Punch B will be able to distribute 25% of its FCF to the HoldCo, which should come to about 0.8p per share annually, and that could be paid out as a dividend. At 12x, plus the Matthew Clark JV, it’s probably worth at least 16p per share. Add in the option value on Punch A and things get interesting.

What to Do?
At 11p per share, I estimate that the stock is pricing in a bit less than a 50% chance of the restructuring being effected. I do not have a sense for what the true probabilities are. At almost a fifth of the portfolio, I already own a fair amount of Punch Taverns. I see no reason to buy or sell here. I will wait and watch for more information on the restructuring.