WDC – Speed Reading the Financial Statements

Practice makes perfect. And boy, am I far from perfect.

In past efforts to research companies I have started with the soft stuff – descriptions of the business and industry. For this exercise I’ve armed myself only with the numbers – four years of financial statements. These are some notes/calculations I jotted down while reading. Western Digital is the company but who knows what they do ;).

Balance Sheet

Cash is a hefty portion of the balance sheet, roughly 33% of total assets as of 2015. The majority of that cash can be considered “excess” whether you use the 2% of sales rule of thumb or look at average working capital needs. My take is that this makes the balance sheet less risky, allows the company to use that cash (reinvest, acquire, dividend, repurchase, etc.), and ultimately makes any valuation ratios appear cheaper ex-cash.

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On the liability side, things look pretty in-check too. The debt ratio has improved over the last four years and long-term debt is less than half of total liabilities.

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Inventory appears well managed. I think the cash conversion cycle is probably more illustrative compared against industry averages but 20 days doesn’t seem too high. Additionally, I don’t notice any alarming trends comparing accounts receivable balances to sales.

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Income Statement

After normalizing operating margins I would expect about 12% for this business. While margins have held up pretty well over recent years revenue has unfortunately declined at a -2.5% CAGR since 2013. Since I’m only in the numbers here, it’s hard for me to understand the why.

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Interest expense is well covered by operating income. An income statement view affirms my thoughts from a balance sheet perspective.

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I took a quick peek at Other Comprehensive Income just to make sure there weren’t any unusual charges I was overlooking. The majority falls under unrealized gain/loss on FX contracts and isn’t surprising.

Cash Flow

WDC still throws off a lot of free cash flow though the trend is less than positive over the last few years. Maintenance capital expenditures were estimated by averaging the past couple years of depreciation and amortization expense.

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I also took a quick look at the financing section with an eye out for possible dilution and capital uses and sources. The company pays a decent dividend to shareholders and has been purchasing back some stock. Shares have only been issued in conjunction with employee stock plans and represent less than total repurchases.

Valuation/Closing Thoughts

To get a sense for the quality of this company I broke out ROIC. An average of 21% is quite healthy.

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I took two approaches to valuation. My normalized operating margin of 12% suggests a Price-to-Sales ratio of 1x (see #8 on my valuation post for more information). A quick check on Bloomberg shows estimated revenue of about $12.5 billion in 2016/2017 and shares outstanding of nearly 233 million. This implies a value of $53.60 per share, roughly 20% higher than current prices.

Alternatively, I considered what normalized FCF might look like. An average of the last four years suggests more than $1.5 billion. 2015 FCF suggests slightly less than $1 billion. Finally, taking the estimated sales from Bloomberg along with a 12% operating margin, 8% average tax rate, and working capital/capex/depreciation needs in line with the cash flow table above, we get somewhere around $1.3 billion. If I capitalize this final in between number at 10% (estimated cost of capital), subtract debt of $2.5 billion and give no credit for “excess cash” due to the favorable tax jurisdiction I get a value of $45 per share or pretty much current prices.

 

 

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Idea Generation

Something I always took for granted when thinking about investing or reading about great investors was how they came up with their ideas. As I started on my investing journey, I realized that not only did I not know what I was doing but I was lacking something at which to direct my ineptitude! So, other than jamming a few letters on my keyboard and looking up the resulting ticker, I took some cues from others before me.

To the extent I can link to other sources that discuss the method more clearly, I do, otherwise I leave brief notes picked up from general reading.

Best of Breed– Pick a group of competitors in the same industry and figure out which one is the leader and why.

Reading the Paper– Read it like Michael Price. Skip to around the 40:15 mark from this lecture at Columbia.

Vertical Stripping– Map out the value chain of an entire industry and find out where the profits are going. This a good post from Wall Street Oasis in general but also specifically for this method.

Here and There– Find a great idea in your home country and look for similar companies abroad.

Screening– Lots of ways to slice this one. Low price ratios, high profitability ratios, etc. I’d really like to pick up a copy of Quantitative Value on this subject.

A to Z– Buffet talks about going through a list of companies from start to finish. Walter Schloss used to flip through copies of Value Line cover to cover. Value Uncovered has an impressive post going through pink sheets.

52 Week Lows– Find stocks that have been beaten up beyond merit.

Follow the Leader– Look for new purchases from managers your respect. The Aleph Blog has a great post on analyzing 13-F’s.

Special Situations– Mergers, spinoffs, etc. Definitely worth reading Joel Greenblatt’s book.

Blogs– One day I’d like to be able to count my own but there are fantastic blogs out there that share their investments and theses. Just remember to do your own work!

With any/all of these sometimes you’ll find a great company that Mr. Market hasn’t put on sale. In that case save your work, put it on your wishlist and wait until the price is right.

Winning by Not Losing

Many investors have articulated the concept but I have a new favorite quote from Michael Burry (emphasis my own).

While I cannot proclaim that my stock-picking ability is responsible for the gain – the size and most probably the direction of that gain is almost surely a random short-term fluctuation in our favor – I can with some confidence assert that my strategy is entirely designed to avoid and otherwise minimize the price risk in individual securities. As a result, I would argue that it is the lack of a loss in a month like November that represents the most reproducible and the most potent characteristic of the Fund. It is a tenet of my investment style that, on the subject of common stock investment, maximizing the upside means first and foremost minimizing the downside. The deleterious effect of permanent capital loss on portfolio returns cannot be overstated.

From a collection of letters from Scion Capital.

SAFM – The Chicken or the Egg?

Nothing in particular drew me to Sanderson Farms but I’m trying to learn different industries/business models and cracked open the annual report. SAFM is a vertically integrated poultry producer (i.e., production, processing, marketing, and distribution), the third largest in the US, and has been in business for nearly 70 years.

My main takeaway thus far is that this is a highly commoditized business. Most poultry sells at various spot market prices like the Georgia Dock Price or the Urner Barry Price. Sanderson claims that their efforts to avoid the “small bird” market segment and offer value-add services like cutting, deboning, chilling and packaging translates to lower price volatility and higher margins. That may be true to some extent but clearly chicken isn’t a terribly differentiated product and competes alongside other protein substitutes. SAFM is not just subject to commodity prices on the revenue side of the equation but also the cost side as corn and soybean are the major inputs in chicken feed and represent over 50% of production costs.

If Sanderson Farms is a commodity business and doesn’t have major competitive advantages this affects how one should think about the investment. My mental framework currently is this:

  1. You can’t knock a cyclical business for the things they can’t control. In the case of SAFM this means feed and chicken prices. However, good operators in cyclical industries should be as efficient as possible. To be honest, I need to spend more time thinking about what efficiency means and how it can be assessed. Maybe a good business would scale up/down production opportunistically in response to the supply-demand landscape. Or, maybe a good business would have low non-inventory related costs in relation to revenues.
  2. As an investor, you better not forget it’s a cyclical business. The time to buy SAFM would be when chicken prices were low, corn and soybean prices were high, and the stock was cheap. A perfect storm of a trough multiple on trough earnings. Then again, what is a low price for chicken?

At the moment my only other thoughts are on the business model and what I’ve termed the poultry production process.

The Poultry Production Process

  • A specialized breeding company breeds chicks (pullets and cockerels) to specifications.
  • Sanderson buys breeder chicks as 1 day olds.
  • Independent contractors grow out chicks to egg producing age.
  • Other independent contractors maintain these breeder flocks.
  • When the flocks lay eggs, Sanderson takes them to their own hatcheries.
  • Sanderson hatches and inoculates the eggs.
  • Still other independent contractors raise the chickens to 7-9 weeks.
  • Meanwhile, Sanderson purchases feed and provides other technical and veterinary services.
  • After the 7-9 weeks, Sanderson takes the grown chickens back and processes them.

This process is laid out within one paragraph in the 10-K which took me longer than I’d like to admit to decipher. I find the amount of hand-offs and specialization fascinating. Something like 700 independent contractors  are involved (I guess less if one serves multiple purposes). And more interesting…special chickens are bred to lay special eggs for the specific purpose of laying more eggs which are only then turned into poultry products…so which did come first, the chicken or the egg!!??

Final food for thought. If there were any publicly traded “specialized breeding companies” mentioned in the first step above, they might be interesting investments. Sanderson Farms relies exclusively on one provider but claims they could easily find another. Perhaps this business would have more opportunities for competitive advantages due to the specialization and vital role it plays in the poultry production process.

Reference Points

This will be a quick post.

In the two write ups I’ve done, and undoubtedly in any further stocks I end up researching, I have had to make a considerable amount of assumptions and projections. Each time I’ve come across across a number that requires my subjective estimation I have tried to err on the side of caution and conservatism. This is a good start but I feel I have missed opportunities to refine the process further.

I’m reminded of the quote “history doesn’t repeat itself, but it does rhyme.” My analysis needs to find more areas where I see rhyming, more reference points to guide my assumptions.

To move from generalities to specifics…when thinking about how resilient Keurig/partner branded K-cups would be in the face of the private label market I could have looked to Nestle and its Nespresso product which faces similar obstacles. Or for The Buckle, when estimating average sales $’s per square foot I could have looked to comparable company statistics alongside the stores own historical numbers.

This is a reminder to dig deeper and think creatively to find reference points that help triangulate reasonable assumptions.

BKE – Buckle Down

The impetus of this post was a lengthy document I stumbled upon of notes from a Columbia class taught by Joel Greenblatt. I’m still making my way through the material (many thanks to this keen note taker!) but have a few takeaways. Big picture, Greenblatt asks two questions of his investments: Am I buying a good business? Am I getting it for a good price? To answer these questions he uses two major metrics: ROIC which he defines as EBIT divided by some variation of invested capital and the EV/EBIT multiple. I think his preference for EV, EBIT, and ROIC is because it forces you to consider the entire company from a balance sheet and income statement perspective and also allows for comparisons between companies with different capital structures. With these thoughts in mind I ran a screener for small cap stocks and looked for high returns and low multiples and found The Buckle.

The Buckle retails “medium to better priced” clothing for fashion conscious 15-30 year olds. The company has a major presence in Texas, Florida, Ohio and Michigan and operations in Nebraska and Kansas. Overall, The Buckle has around 468 stores in 44 states across the USA. While my thesis on Keurig labored over thoughts on competitive advantages and industry dynamics, this discussion is more quantitatively focused.

ROIC

BKE leases all stores and as such does not show these as operating assets on their balance sheet. The effect of this is twofold. Capital efficiency metrics will be artificially high while operating profits will be understated due to an implicit interest portion of the rental expense. I took three approaches to capitalize the operating leases. Credit is due to Valuation which goes into much greater detail regarding off-balance sheet commitments.rental expensepv of leasecap rate

I then adjusted the reported assets and calculated ROIC.roic

Based on these results The Buckle seems like a pretty good business – I’m actually surprised by the returns just because I figured retail would be a highly competitive industry. Assets are used efficiently (or my calculations are bunk!) and operating margins are very healthy which will be explored below.

Margins and Capital Expenditures

I’m going to let the tables speak for themselves for this part.ebitda margincapex

Valuation

My approach to valuation was to think a few years out and try to project some sort of normalized EBIT using what I hope are reasonable assumptions.projections

Based on historical EV/EBIT multiples for BKE and some triangulation using publicly traded competitors a “fair” multiple looked something along the lines of this.multiplebberg

Combining the results of my projections with some considerations for an appropriate EV/EBIT multiple the valuations are shown below.valuation

My bogey/hurdle rate was a 15% annualized return. I felt like this would require equity like returns and a slight margin of safety.

Other Considerations and Risks

I think it’s also relevant to note how strong the balance sheet has been with this company – no debt and over $100M in cash. Additionally I like the fact that the company prides itself on promoting from within. Many of the company executives have not only been with BKE for a long time but also started out in the retail stores.

I would say the biggest risk is the possibility of shoddy valuation work ;). Besides that, consumer spending and merchandise margins are things to keep an eye on. FY15 has seen some discomforting trends in inventory compared to sales and growing receivable balances.

All in all, I feel the reasonable valuation assumptions suggest BKE is a viable investment and I plan to allocate a 5% position.

 

 

 

 

Valuation Methods

Valuation is obviously an important part of the investment process as it gives you an estimate to which you can compare Mr. Market’s price. Below is a list of methods I’ve compiled over the course of studying blogs/books/managers. I am not intimately knowledgeable about any of these and it remains to be seen which approach(es) I will find most compelling. Each method could easily be blown out to its own post if not college course but I will try to leave some brief thoughts or links to more thorough information. I would also add that some methods definitely overlap or share concepts (e.g., discounting some value/cash metric).

A final word of caution. I still think any number crunching exercise requires a qualitative understanding of the business and some mental framework to hang your numbers on. Garbage-in-garbage-out right!? Probably the best suggestion when valuing a security is to view it from multiple lenses and pay close attention to when answers diverge.


1) Discounted Cash Flow Model (DCF)

Tends to get a bad rap for being sensitive to discount rates and exit values. However, the conceptual underpinnings – that price should be the present value of all future cash flows – is sound. Professor Damodaran is a great resource to see this method in action.

2) Relative Multiples

Values the security in question based on what other competitors are selling for using a selected multiple (P/E, EV/EBITDA, etc.). Sometimes this can feel more like pricing than valuation if the competitors/multiples are unreasonable.

3) Economic Value Added (EVA)

Focuses on the value created when companies produce returns above their cost of capital (ROIC > WACC). I picked up a reference book on this method after seeing the red corner suggest and use the approach. I think I’ll do a small post on the basic premise in the future.

4) Asset Based

I would throw a few flavors under this heading but all are focused on the balance sheet. Liquidation value considers what you could extract from tangible assets after liabilities are settled. Net-Nets, are stricter in looking at only current assets. Asset value can also just be plainly hidden for example in the case of understated real estate.

5) Earnings Power Value

I must admit to know very little of this one other than its link to Bruce Greenwald, a great professor at Columbia who teaches value investing courses. At some point I’d like to pick up his book and learn this technique.

6) Absolute Multiples

Is a stock cheap compared to its own history or some general concept of what a fair multiple would be for a business of the same kind/quality.

7) Hurdle Rates

I’ve seen references to two ways of using this concept. Discounting using your risk-adjusted required rate of return or figuring out normalized FCF/OE and demanding a certain yield.

8) Private Transactions

Mario Gabelli pioneered the concept of Private Market Value, what an informed buyer would pay for the asset, and Michael Price often talks about looking for valuation clues in M&A activity. Another example would be Wexboy, who primarily thinks about valuation based on a “10-12.5% operating margin deserve[ing] a 1.0 P/S, on average.”

9) 5 Year Forward P/E Multiple

This is particular to one investor as far as I can tell. There’s a great interview with Andrew Wellington in the Winter 2015 issue of the Graham and Doddsville Newsletter where he talks about his valuation methodology: “Our approach is to value companies on their five-year forward normalized earnings. The multiple we use comes from the history of the market. While we know the market has historically been valued at about 15.5x one-year forward earnings, our analysis of historical valuations suggests the market is valued at about 9x five-year normalized forward earnings.” I have yet to substantiate this idea with my own research though I sheepishly admit to using it in my GMCR post

10) Reverse DCF

Similar to number one but instead of solving for a price the current market price is used and the DCF assumptions are reverse engineered. If overly conservative assumptions are required to spit out the current price compared to your own expectations then the security might be undervalued.

11) Security vs. Market Opportunity Cost

Perhaps more of a thought process than a valuation tool but Leon Cooperman likes to compare his picks to the opportunity cost of the larger market. He might say why own the S&P 500 which grows at 6%, yields 2% and has a P/E of 18 when I can own company XYZ which grows as 10%, yields 8% and has a P/E of 12 (hypothetical!).


I think the real question to keep in mind when using any valuation method is whether you are investing or speculating. As an investor make sure you are valuing a business. As a value investor make sure you focus on the downside first. The holy grail will be an asymmetric  risk-reward opportunity…heads I win, tails I don’t lose much!