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Saturday, June 24, 2017

Musings: Cash on the Sidelines and the Illusion of Market Cap Calculations

Cash on the Sidelines


I read Zero Hedge regularly. It is not the most reputable publication, but once in a while it bring up interesting topics. Like this article: Destroying The Myth Of 'Cash On The Sidelines'.

Permabulls love to argue there are all these “cash on the sidelines” ready to buy stocks and jack up prices. The article disagrees with the very idea of it. It quotes Cliff Asness:

There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Asness is saying there are no sidelines because buy/sell transactions do not increase overall cash in the system, since for every buyer there’s a seller.

I used to think that, and it’s something clever to say. But it’s wrong.

We all know friends, relatives, or neighbors who, at one point or another, try to put their growing cash piles to work. These people clearly have cash and its growing. Where does that come from?

First, it’s called money creation. As people earn wages and deposit that in their bank account, their “cash on the sideline” grows. So you say, “but the employer who paid them now has less cash, so total cash level don’t change right??” Well, at least some of the employers borrowed money, the act of which is how our financial system expands money supply.

Second, there’s asset class rotation. Asness would be right in a world where it’s just cash and equities, (and no liquidity creation). But you know, there’s such a thing as fixed income and bonds and they get used as cash alternatives. You see all these balance sheets where companies list “cash and marketable securities”? That’s your T-bill/CP’s/notes/bonds…etc.

So to the extent bond prices start going down and people rotate into equities, that’s “cash (and marketable securities) on the sidelines” which can boost equity prices.



The Illusion of Market Caps


The big news last week was Amazon buying Wholefood. As CNBC reported here, Amazon is paying $13.7bn for Wholefood, yet AMZN’s market appreciated by $15.6bn when the news hit.

CNBC wrote: “So, you could argue, they are getting Whole Foods for free, and pocketing $1.9 billion as well.

How could this be? Are investors stupid? One explanation (which is the CNBC editor’s view) is that the market thinks Amazon will get so much synergy that it exceeds the entire cost of acquisition.

Maybe. But there’s another explanation - that the way we calculate market cap renders it a flawed concept.

The CNBC article wrote: “Amazon's stock was up $32 and change mid-morning. There are 478 million shares outstanding, so Amazon's market cap has appreciated by about $15.6 billion today.

The flaw is one of extrapolation. The deal was announced on June 16th, 2017. That day 11.47mm shares of AMZN traded.

That tells us the market was willing to pay $32 more for 11.47mm shares. That’s it. It does not mean the market was willing to pay $32 more for all 478mm shares outstanding. In fact, if all 478mm shares were for sale, I’m sure AMZN stock price would crash!

But that’s what our market cap calculation does. We take the increased price for 11.47mm shares, and then extrapolate that to say every single share, to the tune of 478mm shares, gets the increased valuation. We take one single point in the stock’s demand curve, which tells us there’s demand for x # of shares at y price, and extrapolate that to total shares outstanding.

And we do this all the time. We do this whenever we calculate market cap, which goes into enterprise value, EV/EBIT, EV/sales, and so on. 

It get's dangerous when we apply this false logic to value investing. How many times have you heard this type of argument: "This company had one little bad news, and its market capitalization declined by $7bn! How can the worth of the company change that much!?  It's irrational! Misunderstood! Buy buy buy!"

Again, it's extrapolation. We take one single point on the demand curve and assume all shares will clear at that price. Then we make claims about what the whole company is worth.  

This should make you think twice about using these metrics to make buy/sell decisions! Our “fundamental” valuation isn’t just subjective based on our view of the future - it is fundamentally and precisely wrong!

Sunday, June 11, 2017

Notes on Wachenheim’s “Common Stocks and Common Sense”

Ed Wachenheim runs Greenhaven Associates, a $6 billion value fund. He piled up an enviable track record over the past 20+ years, regularly making 20%+ a year. And he does this by investing in large caps like IBM and Lowe’s. I’ve been resorting to nanocaps to in my quest for returns, so I wanted to read his book and see how he did it.

The book, "Common Stocks & Common Sense" has an excellent format. It is a series of case studies, each about a particular company Wachenheim invested in.

He would typically start with some historical backgrounds for the industry and the company in question. Then he shows how he develops a thesis, problems the company was having (to the extent there were any), and how the idea played out the next couple years. Throughout these passages Wachenheim would sprinkle in bite sized philosophy about how to use sell-side research, his view toward interviewing management…etc.

We need more books like this. This is a little like “Alchemy of Finance” where Soros documented his real time decision making. If anything, this book provides interesting snapshots of some industries from 1990's to now.

This book was helpful in confirming some of the ideas I have on how to approach research, on top of some great insights. I will first share my observations about Wachenheim’s style, then list out some general takeaways.


Observations of Wachenheim’s style


  • Buy large cap liquid securities. 15-25 stocks in the portfolio, try to be fully invested all the time. 
  • Targets 20% return. This means individual ideas need much higher upside (say 60%+), because there will be losers also.
  • Ignore broad market moves, focus on fundamentals.
  • Not a buy and hold forever type of guy. Willing to hold for 2-3 years and sell when the thesis is played out.
  • In general stay away from growth stocks with high multiples. But also try to stay away from severely distressed companies. 
  • Typical type of plays:
    • Turnarounds/ leadership changes: e.g. IBM, Interstate Bakeries
    • Cyclicals: e.g. U.S. Home Corp, Centex, Southwest, Lowes, Whirlpool
    • Good companies with temporary issues: Union Pacific, Lowes, Boeing, Goldman Sachs 

Miscellaneous Notes and Takeaways


1) Focus on the upside first. Creativity is key in target identification.

Before doing a big deep dive, do a simple model and project 2-5 years out to see if there's enough upside to justify further work. Try to be creative in generating thesis - what can make revenue and margins go up? Can management cut cost here and there? What happens if input cost goes down…etc.

A lot of people say “focus on the downside and the upside will take care of itself”. But at least in the idea generation/filtering stage, you have to demand the upside - else you’re just wasting your time. The focus on downside can come after an idea passes the initial filtering and you’re doing deep dives and running scenarios.


2) Know the long term history of the business and industry. This helps you appreciate the structural difficulties and what it takes to fix them. 

IBM was an example in the book. In the 1990’s the company’s business model of selling, leasing, and servicing mainframes became outdated due to emergence of the PC. That left IBM with a bloated cost structure which old management was not willing to address. The buying opportunity came when Lou Gerstner became the new CEO and showed “the courage to take tough steps”.

Knowing the long term history also helped Wachenheim invest in cyclical companies. He bought Southwest Airlines in 2012, understanding that the decade of 2000's were miserable for airlines and forced them to cut capacity.


3) True insight comes from understand the unit economics of the business well.

Knowing the economics of Union Pacific helped Wachenheim differentiate between a temporary problem and a structural one. In UNP's case, congestions led to train delays, which hurt margins because revenue is a function of volume, while much of the expenses like labor are a function of time. When congestions were fixed, UNP’s margins improved and stock went along with it.

Another example is when he talked about Southwest Airline's capacity utilization. 83.1% utilization might seem like there's some excess capacity. But that is the average. Since unpopular flights (bad hours, remote locations...etc) are going to have many empty seats, the more popular flights are probably operating at full capacity and having wait lists.


4) Historical average P/E of the market is a little less than 16x. When valuing companies Wachenheim would use the 16x as a benchmark and adjust up and down based on business quality.

This is a better approach than using comparable multiples, which may be the most over-rated valuation methodology of all. “Peer comps” is an easy way for unscrupulous bankers and analysts to justify over-valuation in bubbly markets (“hey Alibaba trades at 56x PE so let me value this other shitty e-commerce stock with 45x PE! Look I’m really conservative here!”)


5) Use sell side analysts mostly as a gauge of market consensus, and think “do I see an upside here that consensus is not pricing in?” 

That makes sense because sell side guys get their feedback from buy side community, so these analyst reports in some way reflects prevailing opinions.


6) In my humble opinion, Wachenheim can screen stocks more effectively. He seems to run a lot of screens based on low valuation ratios, which he himself admitted is rarely productive, since these “cheap” stocks are usually cheap for a reason. 

I think you’re better off screening with charts and basic technical analysis. For example if you're looking for out of favor stocks, don't screen for low P/Es, low EV/EBIT...etc. Rather, find some price charts that dropped like a rock more than a year ago, underwent heavy capitulation selling, and have since showed price stabilization along with low volume (a sign of investor disinterest). What I typically do is screen for some minimum quality (low debt, high ROIC...etc) then run them through charts.

Monday, May 29, 2017

Recent Exits: NBIX, VIPS, SLM

Thoughts on three recent exits/position reductions. I would consider buying back at lower prices.

Neurocrine Bioscience (NBIX)

Ingrezza failed its phase 2 trial for Tourette’s syndrome; and the stock dropped from $53.5 to now $46.2.

I came away with a small profit and actually bigger confidence. The results were not good, but the decision procedure was sound – it gave me a shot at high upside while preserving capital. Had the trial results came out good this could have easily been up 30% with long term upside of 100%.

Going into the phase 2 results, NBIX was 8-9% of my total net worth with average cost of ~$47.4. I was sitting on a 13% gain. That gave me the cushion to sit through the event, knowing that a failure would probably result in a small hit to principal. The idea was to be aggressive with profits but conservative with capital. After the bad news came out I quickly cut NBIX down to a immaterial position with average exit price of more than $48, retaining a small profit for the entire trade.

Buying well is truly half the battle. That requires knowing a situation well, anticipating the scenarios, and going big when opportunities present themselves.

The episode also illustrated one of the advantages of individual investors. I highly doubt an institution could have went from 0% position to a 9% position and then down to < 1% position as quickly as I did - and come out unscathed.

The stock is now undervalued, but with no clear catalyst. If NBIX gets to low 40’s I’d strongly consider loading up again.

Vipshop (VIPS)
I exited the position before the company’s latest earnings. I had been accumulating JD and Alibaba and prefer their competitive positions.

Originally I saw Vipshop as a niche strategy (discount retailer), but the more I look at JD and Alibaba, the more I wonder if that’s even a valid category. For example, Vipshop sells excess inventory for brands – a lot of which are typically available after China’s November 11th “singles day”. Now, obviously Alibaba is the king of Single’s Day – so why can’t Alibaba just run some discount/flash sales to get rid of those exact same items, which is already listed on Tmall/Taobao?

The other thing I wonder about is the integration of warehouse and inventory systems. Let's say some apparels were listed on JD.com and was already in JD’s warehouse. Why not just let JD run its own flash sales? Why bother with moving inventory from JD’s warehouse to Vipshop’s warehouses?

As e-commerce matures and inventories get more integrated into JD or Alibaba affiliates warehouses, whoever list the items originally will also be the best candidate to get rid of that same (now excess) inventory. So is the “online discount retailer” even valid as a separate model?

Another thing that bothers me about Vipshop is its build out in last mile delivery. It seems to me they are aping JD, but with less resources. Logistics in China is becoming a crowded space, and a capital intensive one. Alibaba’s Cainiao allies are mostly publicly listed now, so they will be able to access capital and pour money into logistics. It’s not clear to me how Vipshop has a competitive advantage there.

This is another one where I bought so cheaply that I booked a nice gain. The stock actually looks like it has bottomed, but I'm in no hurry to get back in.


Sallie Mae (SLM)

I cut this down after the stock started dropping. As much as I like the growth prospects, I never felt comfortable with the political risk. SLM would have been a huge beneficiary of Trump's tax cut but it doesn't look like it will happen anytime soon.

Everyday, major news outlets report on America’s "student loan crisis". Read through the comment sections and I get the sense that people think if they can sue the hell out of Sallie Mae, cause it to go bankrupt, then they don’t have to pay back their loans.

Borrowers (a big and growing portion of society nowadays) have incentives to hurt Sallie Mae. That means politicians have great incentives to hurt Sallie Mae. That’s a dangerous place to be for shareholders.


Saturday, May 13, 2017

Common Quotes and (Maybe Not so Common) Thoughts on Investing

1. Investment vs Speculation - the classical definition

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” - Ben Graham, from “Security Analysis”

By this definition “investments” are exceedingly rare in today’s equity market. Good companies don’t trade at <17x earnings. Great companies could be 30x-50x earnings. Justifying those prices often require extrapolating growth out for 5-10 years, then assuming 1) margins and earnings don’t get destroyed by a recession during the forecast period, and 2) multiples don’t decline due to higher risk-free rates (as if there’s such a thing).

Thus, at today’s prices, much of “investing” (certainly much of growth oriented investing) contains implicit macro bets on the direction of economy and interest rates. A high percentage of these same investors would consider questions of interest rates and macroeconomics to be rank speculation. By that logic then, one can only conclude these "investors" are really "speculators".

Given the majority of "investing" today is really speculation, Graham's distinction kind of loses its meaning and usefulness. Perhaps it's time to redefine the two. Personally, I think of investment versus speculation as follows:
  • Investment = I'm betting on real world fundamentals playing out as I figured. 
  • Speculation = I'm betting on shifting expectations. It doesn’t matter how things actually play out, as long as people think it will go well, they will buy the stock and push prices up.



2. You are NOT the owner


“You are not buying a stock, you are buying part ownership in a business” – Warren Buffett (not sure, really every value investor)

Ok, I get the point, but let’s face it - most of us are not REALLY owners in the business. Understand this is key to avoid getting ripped off by unscrupulous management and insiders. 

To me, ownership means I have access and control. If I own a coffee shop, I would be able to access the shop’s profit and loss data any given day. I would have the power to fire under-performing workers, change the marketing and advertising strategy when it’s not working…etc. 

I own GOOGL stock. But If I call up Google today, I’d be lucky if investor relations call me back in a week, let alone have access to management. I certainly don’t get to tell Sundar Pichai what to do. I’m not really an owner of Google.

When Warren Buffett buys a stock, he’s an owner. He has great access, and has at least some influence on the board. He can influence the companies’ capital allocation decisions and extract cash flows if he needs to.

I think a lot of Buffett’s ability to bet big with conviction comes from having access and control. It also explains why entrepreneurs and business owners are willing to risk their life savings on one idea – essentially take leveraged, super-concentrated bets, while most investment manager consider a 15% position a big position.



3. Bet you didn’t know Ben Graham said this!



"It would be extremely unwise - and hypocritical - for anybody to buy a list of common stocks and say that he was interested only in his dividend return and cared nothing at all about price changes…the problem is not whether price changes should be disregarded - because clearly they should not be - but rather in what way can the investor and the security analyst deal intelligently with price changes which take place." - Ben Graham, from Current Problems in Security Analysis

In recent years the so called "dividend growth investing" crowd blindly chased yield without regard to valuation. They would pull up some old Benjamin Graham quote about ignoring "Mr. Market", and babble on about "long term investing" to justify their pavlovian "buy the dip" strategy.

Yet Benjamin Graham himself would say stock prices clearly matter. After all, if you make 3% dividend and risk 10% on principal, what's so good with that?

This is all the more so if you’re not really an owner like Buffett, but rather an OPMI: outside passive minority investor.

Now, what are prices dependent on? Why, supply and demand, of course. That’s a function of 1) people’s ability to buy (liquidity on their hands), and 2) willingness to buy (based on their assessment of company’s future outlook and “intrinsic value”, versus their alternatives).

This leads me to the next point.

4. What is it worth? And to whom?


“Value investing is figuring out what something is worth and paying a lot less for it.” – Joel Greenblatt

This quote is helpful to the extent it points out “value investing” is not just low P/E, low EV/FCF, or some other valuation metric. Warren Buffet would agree: there's no "value" versus "growth" investing. You're always looking for value.

What’s not helpful though, are the discussions that typical follow. Typically, these discussions of “what something is worth” automatically jump to some sort of discounted cash flow analysis, complete with disclaimers on how estimating “intrinsic value” is more of an art than science.

I think there’s a lot of talk about “intrinsic value” and not enough about “intrinsic value to whom?” The latter question matters. A control investor looking to extract synergy sees a different set of cash flows versus a mutual fund investor. The Bank of Japan, which has been gobbling up local equities, sees a different set of “values” from what Warren Buffett sees.

An example of the “intrinsic value to whom?” question is Canadian real estates. Consider a very logical housing investor. He might value a house by projecting out rental income minus various expenses, capitalize that cash flow stream with some desired yield. He then arrives at an "intrinsic value" that's way lower than the market price, and declares the housing market a bubble.

A rich guy from China, however, may be willing to pay a multiple of the market price. Why? because he's not just buying a house. He’s buying fresh air, safe food, quality education for his kids…etc. Heck, even just freedom of using gmail without getting censored by the government. A few millions for a crappy Canadian house is a bargain for that guy. 

The "value to whom" question matters. Knowing who's the buyer and the seller matters.

5. Compounders? or just justification to buy high?


“Given the three ingredients of a) optimistic assumptions as to the rate of earnings growth, b) a sufficiently long projection of this growth into the future, and c) the miraculous workings of compound interest - and the security analyst is supplied with a new kind of philosopher's stone which can produce or justify any desired valuation for a really good stock” - Ben Graham, from The New Speculation in Common Stocks

Nowadays, a typical “compounder” thesis goes something like this. This company is run by management with great integrity. The company has such and such competitive advantage: low cost structure, differentiated business model, this and that. The company is awesome. This company trades at some expensive looking valuation. But hey, if you project revenue out 5 years at 30% growth rate, put some 30x terminal EV/EBIT on it (all justified by qualitative discussion of competitive advantage), then we can get to 15% IRR.

Is this really margin of safety? Or are we just stretching ourselves to justify buying a good company? 

I have no problem against paying up for compounders. In fact I have lots of these: GOOGL, BABA, JD, EW...etc. But I'm under no illusion of what will happen to these stock when investors decide they will only look 3 years ahead instead of 7 years ahead.


Wednesday, April 12, 2017

Backing Up the Truck on NBIX below $50

update 4/12/2015 - added a quick sentence about Mitsubishi Tanabe agreement and minor formatting edits.


Notes on NBIX (Neurocrine Biosciences)

INGREZZA for Tardive Dyskinesia got approved after market.  Stock jumped from low 40's to almost $50 after market.

I kept buying after market. Literally bought until Interactive Brokers wont let me by anymore.

The big surprise is the approval came with clean label. I had anticipated 50/50 chance of FDA approval, but most likely with some sort of black box warning. More upside surprises (for me): management decline to give price guidance, but pointed out that even the high end of their $20-60k estimated annual price range will be well below Teva's rival drug Austedo (which comes with black box warning).

That's a game changer. Market share and pricing assumptions that people used a week ago will likely prove conservative.

Valuation

  • INGREZZA for Tardive Dyskinesia (TD) - worth $40-60
    • US only peak sales - $1.5-$2bn, use 2-3x EV/revenue.  Get you to roughly $40-$60
    • That's just US.  
  • Elagolix for Endometriosis - 800mm-1bn peak sales, assume NBIX takes 20% royalty get you $150mm ballpark revenue. This is an NDA filing 3Q17, which has about 85% probability of success.  works out to $3-4/share.  
  • Opicapone - 150mm peak sales, NBIX takes 63%, 2x EV/revenue.  thats another $2/share

This gets to $45/share floor price already. Could be $65


What am I not counting?

1) Not counting 300mm of cash - I just assume they'll be burned near term for development and bridging to commercialization.

2) They have an agreement with Mitsubishi Tanabe Pharma to commercialize INGREZZA for TD in Japan & Asia. I'm assigned 0 value for now but it's certainly something.

3) Elagolix for Uterine Fibroids  - this is in Phase 3, which empirically have 55-65% probability of success. This is a bigger market than Elagolix for Endometriosis. Could be $2-5/share. 

4) and finally, the big one:

INGREZZA for Tourette Syndrome (TS), in Phase 2.  This is a bigger market than TD!.  If Ingrezza for TD is worth $40 conservatively, then TS indication could be worth $50/share.  That could doubles the stock price right there.


At anything < $50/share there's zero or very limited downside.  You're getting a free option on INGREZZA for TS - 100% upside. The Phase 2 results come out for that next month. 



Other Notes


CEO is loaded with stocks. This is an R&D focused company. Management team is full of PhD and MD's with decades of industry experience.

Obvious acquisition target with attractive pipeline/assets/catalysts. Great R&D capability, But I'm not sure they're willing to sell. NBIX is building out its sales force/commercialization capabilities. We could see them transform from a small biotech to the next great pharma.

There's almost 4mm shares short interest and those will get squeezed.

Sunday, April 9, 2017

R1 RCM (RCM) Has a Long Way to Go Up

R1 RCM (formerly Accretive Health) is a high probability trade with >2:1 upside/downside. The stock is trading at ~$3.3/share and I can easily see this going to $5 if not more. This is an idea that’s been on the radar for years. Here are just a few write-ups that helped along the way.

2014: From Buyside Notes

Also late 2014: write up by Sententia Capital

2016: mentions by Reminiscences of a Stockblogger


So why another write-up? This is now a material position for me and I owe myself a write-up for documentation. Also, given the recent run up, it would be helpful to explain why the stock can go a lot further, as well as provide some valuation ranges.

R1 RCM (formerly Accretive Health) does revenue cycle management for hospitals. I won’t bore you with what that means - that’s covered by the various write-ups I cited above. In any case I’m not enamored by the business. Basically I’m investing in the stock, not the business.

A few years back company had accounting/customer issues which caused delisting. They fixed those problems and just re-listed. The ugly history, customer concentration, combined with (still) ugly accounting and capital structure all combined to discourage investors and create this opportunity. I know that because for the last 3 years every time I looked at the company I thought “yuck” and skipped, until recently the opportunity simply became too good to resist.


Cheap Valuation Relative to High Probability of Delivery Next 3-4 years.


Management has a 2020 plan for free cash flows of $75-105mm by 2020. They expect to be free cash flow positive by 2H17.

Notably, management stated that currently contracted business alone would deliver 90%+ of the low end of that 2020 projection.

Capital structure is messy but not crazy once you work it out. Here are the basics.
  • $181mm of cash, but ~16mm of that is “customer float”. So excess cash is about $165mm
  • $0 debt. 
  • $214mm of Convertible Preferred’s that Pay-In-Kind (PIK) at 8%, convertible at $2.5/share. 
  • 60mm shares of warrants convertible at $3.5. 

The best way to value RCM is to roll the capital structure forward to 2020 and factoring in all the dilutions.
  • Cash and debt. The company will be cash flow positive by 2H17, so I give them credit for the full $165m cash at 2020, and still no debt.
  • Convertible Prefs. $214mm at 8% quarterly compounding get you to ~$295mm by 2020, which at $2.5 conversion price get you about 118mm dilutive shares at 2020.
  • Warrants: I used treasury stock method, assuming warrant holders exercise at $3.5/share, and then company buy it back at higher average price of $4/share (just to have some conservatism built in). This gets us 7.5mm dilutive shares.

All in, there should be ~125mm of total dilutive shares from convertible preferreds + warrants, getting to total share count of 239mm by 2020.

So here’s what valuation looks like. Using conservative EV/FCF multiples of 10-12x, RCM should be worth $3.8-$6.0 per share by 2020.

R1 RCM valuation


Given today’s stock price of about $3.3, there is no downside, while the mid-point of that valuation range provide almost 60% upside and ~20% IRR

This is almost too good to be true. At what point would I say “I may be wrong, let’s cut out and re-evaluate”? There appears to be some support around $2.4. Using that as a stop loss, downside is about 30%. Compare that to 60% upside that’s a 2:1 reward to risk ratio.

Again, this is a high probability given that currently contracted business delivers 90% of the low end projection. God forbid they actually win new contracts, the shares could go through the roof.

Catalysts


1) The recent listing has brought increased volume and the stock is already trending higher.

2) Company will go through an accounting change 1Q17 to simplify the story.  

Right now the accounting is a mess: GAAP revenue is completely meaningless, so investors have to rely on management’s non-GAAP measures. I remember spending lots of time reconciling GAAP revenue and EBITDA to management's corresponding gross and net "cash generated from customers", and then from that to GAAP cash flow from operations and management's free cash flow measure. It was a super pain in the ass. A simpler GAAP accounting profile would go a long way to remove the “yick” factor and bring in investors.

3) If they win a contract outside of Ascension and Intermountain, that could "prove" their capability and help the story. 

I think they can do it. The company offers a fully outsourced model where they effectively take the risk of cost overrun and reap the rewards of cost savings. I think that makes a lot of sense in today's hospital landscape where margin is tight, and where payers pushing "value based care" are pushing risk into hospitals.


Other notes

Dr. Rizk served as the Chief Executive Officer of Accretive Health, Inc. from July 21, 2014 to May 26, 2016.  It’s likely he left voluntarily because 1) he became CEO of Verisk Health (now Verscend) in Aug 2016, like 3 months later 2) they groomed Flanagan as COO for a while.

Wednesday, March 22, 2017

Transcat Can Double in 3-5 Years

Transcat (TRNS) distributes, services, and calibrates equipment for a variety of industries, particularly highly regulated industries such as life sciences. Transcat serves as a one stop shop to make sure the equipment are working properly, without customers having to schedule with each and every OEM. The link here shows the instrument types they can calibrate.

I will try to provide the outline of a long thesis as succinctly as I can. Someone has a more thorough write-up here (paywall).


Thesis Sketch


Transcat can double its EBITDA in 3-5 years, and the stock can double as well. The reasons are below:

  • The company has 2 segments, one growing and one declining/stabilizing. Revenue growth is set to accelerate because the growing segment is now outpacing the declining one.
  • Growth is further enhanced by a roll-up strategy in its services segment (in addition to organic growth) 
  • Margins will benefit from mix (Services segment has higher margin), as well as operating leverage.

As a bonus - I'm not counting on this - the company pays 30-40% tax. A corporate tax cut to 20% would immediately boost earnings by 14-33%

Mix Shift Toward Higher Growth and Higher Margin Segment


The company has 2 segments: Services and Distribution. Right now they contribute about 50/50 in terms of revenue. The Services segment has been a steady grower (both organic and via acquisition). Distribution segment revenue declined the past few years due to the oil and gas industry downturn, but seems to have stabilized in the past few quarters.

Going forward, the growth in Services will outpace the decline in Distribution. Since Services enjoys a higher EBITDA margin (low double digits vs mid-single digits), EBITDA will grow faster than revenue.

The slide below shows the revenue and profitability crossover.

Transcat revenue and operating income


Roll-Up Strategy


The Services segment is also a rollup story, supported by reasonable debt levels (~2x Debt/EBITDA). The company is a disciplined acquirer, typically paying 4-6x EBITDA with IRR hurdle of 15%.

Calibration services is an $1bn market, split 40%/35%/25% between 3rd party services providers, in-house labs, and OEMs. Within ~the $400mm market for the 3rd party services provider, Transcat is the 2nd largest with behind Tektronix (18% share versus 22% share).

Notably, almost 40% of 3rd party providers market is serviced by smaller regional and local players. That’s a ~$160mm space that Transcat has been, and will continue to be consolidating.

I believe the company can improve its share of that 3rd party market from 18% to low 20%’s, providing a tailwind for revenue and margins.


Valuation


With TRNS stock trading at $12.4/share, the company has $89mm of market cap and ~$115mm of enterprise value.

Management is targeting $175-200mm of revenue and double digit EBITDA margin in 4-5 years. Using the midpoint of $187.5mm revenue and a 12% margin gets you to $22.5mm EBITDA. With a 10x EV/EBITDA and you have $225mm of enterprise value – almost a double from the current $115mm EV.

That is in 4-5 years. But as markets are forward looking, I expect the stock to double sooner.

Here’s my rough model on 1) how revenue and EBITDA might progress over the next few years to FY2021, and 2) what they look like if management’s goals are met.

The 2 are fairly close so I think management’s goals are reasonable. Recent financial results suggest they are well on their way.

Transcat model