Tuesday, December 20, 2016

December 2016 update – Single Names

It’s been a while since I last wrote. Here I will just give a quick update then sketch out a couple stock ideas I’m still in. I will leave the forward looking macro view for the next post.

It’s been a good month for all investors and I’m no exception. Post the Trump win I loaded up on financials (SLM and WFC), and tripled my holdings in Sterling Constructions (STRL). These are concentrated 7%-12% positions. I also went long the US dollar against yen and euro, riding USD/JPY from 105 to 115. A week ago I cut back on STRL, exited WFC completely, then went long Russian rubles.

This series of frantic trading and macro maneuvers paid off. In the last month I did better than the S&P index even with all my large cash holdings/shorts/hedges. I started taking chips off the table as the market looks extended again.

Single Names I'm still Bullish On

I’m still very bullish on Salle Mae and Sterling Constructions over the next 3 years. FNF is another that can double. Below are a just some bullet points.

Sallie Mae (SLM)

So the stock trades at $10.8 at the time of writing. Downside is $10-$10.5. Upside could be $15+ and a highly probable one.

This is a company that was doing well even before the election – strong growth, strong ROE, and solid capital levels. Management is also trying to improving cost efficiency. The only thing that held back the stock was Democrats’ various attempts to undermine the private student loan market (free college, student loan forgiveness, and general hostility toward lenders…etc).

After November, all the sudden we have 1) decline in regulatory risk, 2) potential market size expansion as Republicans might scale back government funded student loans, 3) higher rates and steeper yield curve driving higher net interest margins, 4) a big tax cut (SLM pays a high 35-40% and their preferred dividend further leverages EPS to tax cuts). The last point alone could juice their earnings by 30%+.

Here’s how I roughly think about floor value and upside. The stock was trading in the $7-$7.5 range before election. Republican president and congress removes an existential threat to the business and should make this worth $8-$8.5. Tax cut improves earnings by 30%+, so add another $2/share and we’re already at $10-$10.5 as floor value – not far from where the stock trades now.

And that’s before factoring in better net interest margin and market size expansion! All together, there’s a high probability that SLM earns $1.5/share within 3 years. At a fair 10x multiple SLM could easily be worth $15/share.

We have a nice bet here. SLM represents 7-8% of my portfolio and I will look to add on weakness.

Sterling Construction (STRL)

Although a construction/infrastructure stock, this is not really a “Trump Trade”, as I wrote about Sterling Construction back in July here. The thesis has not changed much, but the emphasis has shifted from company specific factors to the industry and macro pictures, which has gotten much better.

The company is highly leveraged to gross margins, which was already improving back in July, but now will likely go higher due to 3 factors. First, management has stated their intention to go after higher margin, non-highway projects (commercial, airports…etc), and have in fact started to win them. Second, the local projects passed during November 9th will be supportive for industry competitive landscape and margins.

Finally, Trump’s $1 trillion infrastructure plan threatens to take margins, and by extension STRL’s stock, to a whole new level.

So both the probability and magnitude of a win are much higher now. Right before the November election, I would say STRL’s floor value is about $6.5 and ceiling about $8.5. Now I would say the floor is ~$7.5 and the upside is uncapped until the teens’ or even $20’s.

The key is to not get ahead of ourselves too much though. I’m looking for improved quarterly results, new contract wins, or legislative progress on Trump’s plan to add to my positions.

Fidelity National Financial (FNF)

This is the largest title company and the most profitable one. The company operates in an oligopoly with captive customers - title insurance is mandatory purchase. At $34 per share, the stock is acting incredibly bearish right now. But a catalyst has surfaced.

Currently there are 2 negatives holding back the stock in my opinion. First is structural complexity. FNF consist of the core FNF title insurance company, a publicly traded subsidiary Black Knight Financial (BKFS) and the FNFV tracking stock (which represent a portfolio of side bets like restaurants). The second problem is commercial title revenues are slowing down.

There's a catalyst coming next Fall. Management announced they will address the structural complexity issue by cleanly splitting out core FNF title division, BKFS, and FNFV. This would allow the core FNF business be included in indices.

The core FNF title business then has a path to double once commercial revenue stabilizes. Here's what could happen with some back of the envelope math:
  • Home sales picks up. Perhaps because millenials are reaching the 30-40 age zone for peak home buying, or because Trumponomics puts more money in peoples pocket. Say home sales up 5% and housing price up 5%, that's a 10% revenue gain. With operating leverage you get to 15% gain pretax.
    • 3 years from now pretax grew by 1.15^3-1 or 50%.
  • Tax rate cut from 35% to 20-25%. That means EPS could be 70%+ higher in 3 years
    • Just making up some numbers - right now $1 pretax get you 0.65. In 3 years you have $1.5 pretax at 25% tax rates. That results in an 70% higher EPS.
  • P/E multiple of core title business re-rates from 12-15x because revenue outlook reverted to growth. Removal of structural complexity in the FNF complex also helps. That's another 25% gain.
Compounding these effects get you a double. I already have a solid position on this. But I could really go big (thinking like 20% position) if I see commercial title revenue to stabilize.

Tuesday, November 1, 2016

Revisiting the Big Picture

I try to hold in my mind several macroeconomic scenarios that are likely to play out, as facts come in and probabilities shift, I rethink my investments themes accordingly. The most bullish scenario (for equities and commodities) is as follows. The time frame I’m considering is next 2-5 years.

The outline of a macroeconomic progression:

1. Higher inflation expectations…

Crude oil has bottomed in the $40-50 range. As energy is a key ingredient in all other commodities, this is likely the end of the commodity deflation cycle. Indeed, other commodities sectors (particularly agriculture), looks to have trough too. If the world then starts eating into the currently very high inventory levels, that would leading to inflationary pressures.

2. …leading to higher yield in long bonds…

As inflation targets are hit, the central bankers will face pressure to hike rates. But hiking short rates would lead to a flat or inverted yield curve, damaging the banking system, so the central bankers have hinted they’ll let inflationary pressure push up longer term bond yields.

In recent weeks we have seen 5yr/5yr forward inflation breaking above 1.8%, and 10 year treasury yield going above 1.8%.

At this point the impact on US equity markets is unclear. Do we have real growth? Or do we just have stagflation? If the former, then inflation expectations lead to more investment and real growth, then equity markets could look up again. If the latter, then stock prices would take a hit because the market assigns higher discount rates with little growth to offset it.

3. …But underlying GDP growth is still weak, prompting fiscal stimulus.    

With rates around the world still near 0, central banker will have a harder time inventing new monetary tricks. But that’s missing the point. Pushing people to borrow don’t work because we have industrial overcapacity everywhere so businesses don’t want to invest. Thus government has to take the lead.

Fiscal stimulus can drive inflation up further. But this time both real and nominal GDP rises. 

4. We end up with (still) easy monetary policy and fiscal stimulus. 

In this world, the US dollar would be stable, commodities prices goes much higher than today, long bonds gets crushed, and US equities go through the roof into an unprecedented bubble, setting up for the next crash.

Where Are We

We seem to be at step 2 right now. But note that step 1 & 2 does not necessarily lead to 3 & 4. Alternatively, we could have just easily skipped 1-2 and go straight to fiscal stimulus in an effort to drive inflation.

My view is that inflation cannot sustain itself given the current macroeconomic regime. This is because higher inflation drives Fed rate hike expectations, which (in today's upside down world with quantitative easing) drives the US dollar up and defeats the commodity price rally.

Regardless of how the sequence plays out though, there are certain themes here for investments purposes: fiscal stimulus, commodity price recovery, steeper yield curve, companies with structural growth prospects. 

In the past month, my research have focused on the commodity front, taking a particular interest in the agriculture space. Here the key questions are 1) can price increases sustain itself or is it self-defeating? 2) what has to happen to drive a sustained increase? These will be for another post.

Sunday, September 11, 2016

Keeping Track of Ideas from This Year

After analyzing my results year to date, I see the need to be more concentrated and find more “investments” as opposed to “trades”.

Here is a table of my write-ups on this blog year to date, and how they’re doing

There’s also stuff that I did not write about that detracted from my returns. Macro trades/hedges killed me this year. Those deserve a separate post-mortem but I think the writing process forced me to think through everything more completely, yielding better results.

What’s interesting in the table above is how active management detracted from my returns. One clear pattern above is “actual return since write up” is much lower than “hypothetical return from buy & hold”. This is because I sold early: either I cut positions early, or traded in and out of the stock.

Why is that? Sometimes a sell is justified – as in when stocks simply reached my estimate of fair value, or when my thesis proved false.

But other sells are more questionable. Sometimes I would sell a position just because new facts came out and I have not had time to assess the situation. So I would sell first, sit on the sidelines until I get around to updating my assessments. This has saved me from losses in the past but can also be costly as stocks fly upward. I think it’s a sign that I have too many positions and not enough focus (I have 30-40 positions going most of the time).

Some Ideas Look Better in Models Than in Real Life

Sometimes it’s the nature of the idea itself that limited the upside. I can explain this better by grouping ideas into categories:

Pure mis-valuations

Examples: FNFV

Problem is that the initial asymmetric risk/reward goes away as soon as price moves up, so you get limited upside. Let’s say I think company A should be worth between $90 to 130. Stock is at $100 so you say “downside is 10% and upside is 30%, and the probabilities are about 50/50, this is nice risk-reward”. So you buy.

Next month the stock moves 10% to $110. But the fundamentals have not changed so your valuation range stays at $90-$130. With stock now at $110 the upside/downside is now at 18% each, and the probabilities are still 50/50. This bet is no longer tilted in your favor, so you exit the trade.

Despite the perceived 30% upside at trade inception, you exit the trade at a mere 10% gain.

Lousy businesses at attractive prices

Example: Omega Protein

These are naturally not going to be long term holds. You’re just looking for fundamentals to shift in a better direction and thus stock price along with it. But ultimately the fundamentals is capped (still a lousy business), so the upside is limited like the above “pure mis-valuation” category.


Examples: Select Harvest, Sterling Construction

The problem with these is you’re looking to catch a cyclical bottom in the industry. In practice there’s also an element of price speculation. That tends to keeps my confidence low and my positions small.

In the case of Select Harvest that I missed the move completely (waiting for a pull back that never happened). In the case of Sterling Construction, I cut stakes early because I didn’t have enough conviction, only to buy back later at higher prices. Perhaps I will learn to get more conviction and bet bigger one day.

Going forward, I want to have a lower number of positions be more focused on each. And also less of these “this is a crappy to ok business but it’s cheap” ideas, and find more companies with structural growth prospects. 

"Investing" is preferable to "Trading". “Value investing” does not have to be “cigarette butt investing”. These are, of course, easier said then done and will depend on what the market gives you. For now I have been forced to look into smaller companies and foreign stocks.

Saturday, July 16, 2016

Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

Monday, July 11, 2016

Good News for Omega Protein

A quick update to my Omega Protein ("OME") write up from a few months ago.

1. On 6/28/2016, shareholders elected Wynnefield Capital's nominees for the board. The activist investor now has 2 out of 8 board seats.

2. The latest NOAA Menhaden fishing season status came out 7/5/2016 and it looks like OME is off to a strong fishing season.

These good news should lead to an upbeat 2Q'16 earning call and drive stock price upward.

Saturday, July 2, 2016

Sterling Construction Will Enjoy Higher Margins For Years to Come

Sterling Construction Company (STRL) works on transportation and water infrastructure projects (more of the former, particularly highways). It’s a microcap that few analysts cover. The stock trades at $5/share and I think it could be worth $8.

The company has all sorts of not-so-obvious positives: turnaround play with operating momentum, low margin legacy contracts fading away, big net operating losses (NOLs) to monetize, understated book value due to off-balance sheet asset. On top of all that, management incentives are aligned with shareholders.

The political/economic climate also favors Sterling. Monetary policy is running out of bullets and politicians have to start pulling fiscal levers. Highway construction is one area that enjoys bipartisan support – even Republican candidate Trump talks about using constructions to provide jobs.

The next few paragraphs will give a brief industry background before getting into company specifics.

Cyclical business, But Right Part of the Cycle

Coming out of the Great Recession, federal and state governments tightened their construction budgets. For the past few years, companies competed intensely for limited work and margins fell as a result.

That picture is reversing. At the federal level, Obama signed a $300+bn Fixing America’s Surface Transportation Act (“FAST Act”) in December 2015, which provides certainty over the next 5 years. At the state and local government level, politicians have also been working to boost construction budgets.

Texas and California are Sterling’s two biggest markets. Texas is already seeing a spike in highway construction budget. Not only that, the recently passed Proposition 7 will provide billions more in funding starting late 2017. California is also in the works - although transportation needs were not addressed in the June budget, it remains high on the agenda. Multiple stakeholders are united in their push for increased funding. Here’s a taste of what's happening from Granite Construction’s latest transcript.
"We are helping lead the charge in California where construction industry and labor leaders are working shoulder to shoulder to build legislative support for a long-term incremental commitment for transportation investment of at least an additional $40 billion over the next 10 years."
In the coming years, I expect even better legislative support for infrastructure projects as politicians turn to fiscal stimulus. With a bigger and more visible budget, competition will be more rational and that should lead to better margins.

Gross Margin Turnaround and Other Good Stuff

In fact, Sterling Construction is already seeing improving margins. Gross margin is by far the largest driver of net income and cash flows, and here’s how that’s looking:

The momentum is clear. Gross margin troughed during 2013-2014 and has been going up since. Also note that margins have plenty of upside before returning to historical norm of 10%+.

Backlog margins are improving as well. Gross margins in the backlog for the past 4 quarters (starting 1Q’15) are 6.0%, 6.5%, 7.0%, 7.7%. Management expects 8.5%-9% by year end.

Part of the margin improvement will come from better mix. Sterling has been held back by legacy low margin projects from 2013, but it is quickly working them down. Here’s what CEO Paul Varello have to say:
“…we have to complete approximately $70 million worth of legacy jobs that will finish over the next couple of quarters and will generate small to zero margins. We believe that we will start to see the higher margin projects generate stronger earnings in Q3 and beyond…In addition, by year-end we anticipate that our overall backlog margin will be in the range of 8.5% to 9%.”
Those higher margins come at a great time as Sterling had accumulated a big NOL. With the cycle turning, it will basically pay no taxes the next few years.

There are more goodies and I will quickly outline them here:
  • Sterling bought $40mm of life insurance policies. The policies are to cover Sterling’s commitment to buy out minority interests upon death of key executives. That commitment is booked as a liability on balance sheet, but the insurance policies are off balance sheet. So book value is understated by a material amount. 
  • The company just did an equity raise to deleverage the balance sheet. 
  • CEO Varello took an $1 salary and restricted stock when he took over last year. 

Put it all together

Backlogs have been increasing and will likely increase over the next five years. Margins have gone up with lots of room to go. But at $5/share the stock is trading like a normal cyclical. It certainly does not reflect the extended growth runway I described above.

2017 P/E is a modest ~9x. The real question is how does 2018+ look? I think the answer is higher revenue, higher margin, and no taxes will translate to explosive free cash flows growth and multiples expansion.

Note: Competitor Primoris was also bullish about Texas in its 1Q’16 call.
“We continue to expect substantial growth in the Texas heavy civil market, especially once Prop 7 money starts to flow. Which should be sometime late next year.”

Sunday, May 29, 2016

Teekay Tankers Will Be Owned By Creditors for a While

  • TNK stock has been down more ~50% year to date. It trades at less than 3x earnings and this has shareholders calling for buybacks.
  • However, management is paying down debt instead. They have to do because of lower cash flows in 2016 and 2017, as well as demanding debt maturity schedule.

Back in December 2015, Teekay Tankers (TNK) announced a $900 million refinancing, including a term loan and a revolver that are both due in 2021. I thought the deal was bullish for the stock, since it cleared out near term maturities and allows TNK to buy back stocks.

This is not the case. That deal did push out a lot of near term maturities, but a substantial amount remains. In addition, the new term loan actually has an onerous principal payment schedule.

The $525 million term loan matures in 2021 but demands principal amortization of $31.94 million per quarter for the first few quarter and $24.845 million per quarter thereafter. This amounts to $99-106 million of principal payment per year.

What’s more, a sizeable chunk from old loans remains. The annual report has a maturity schedule pro forma for the refinance. Backing out the January 2016 loans, and assuming the debt payment made during 1Q16 was toward near term maturities, the current debt schedule would look like the below.

Teekay Tankers debt

The big question is the $215 million due 2017. To put that in context, TNK only generated $167 million of cash flows from operations for the entire 2015, and that’s with peak tanker rates! So far in 2016 we are already seeing lower tanker rates and lower cash flows.

More headwinds are coming in 2017. Tanker supplies will come on line second half of 2016 and through 2017. So rates in 2017 will likely be lower. In-charters will expire so TNK will be operating with a lower number of vessels.

So forget about TNK paying off the entire $215 million out of cash flow from operations. It will struggle to even pay the ~$106 million term loan scheduled principal in a weaker market. It will certainly have to refinance the rest of 2017 maturities; failure to do so means another round of equity raise, or even bankruptcy.

To entice lenders for the 2017 refinancing, TNK will need to demonstrate credit worthiness and deleverage in the near term. This explains management’s focus on deleveraging, why the company has not repurchased any shares despite the ostensibly low P/E ratio, and why an equity offering is still on the table.

So creditors will get most of the cash flows for now. This is not to say avoid the stock, but investors should recognize the credit situation, and be willing to hang on for a couple years for their big pay day.

Advice for Investors

In this situation, demanding share buybacks is to demand a short term boost in the stock price while risking equity dilution or even bankruptcy down the line.

Instead of pushing for buybacks, big boy activist investors can provide the refinancing themselves. Just to toss some ideas around, with $250 million of 10% senior notes, weighted average cost of debt would still be under 5%.

Even after the 2017 maturity is addressed, TNK will still face a demanding term loan amortization. But by late 2017, it should have shown progress in deleveraging and tanker rates should have stabilized. Management can then refinance the January 2016 loan into another with easier principal payment schedule, and finally release free cash flows to shareholders.

There is also a lesson here. P/E ratios and free cash flow yield (free cash flow divided by market capitalization) are meaningless measures for companies loaded with debt. “Free cash flow” is not really “free” in terms of using it to reward shareholder, especially if there are near term maturities/obligations that can’t be funded from operation.

Friday, May 13, 2016

Beijing Enterprises Holdings - A Stub Trade

I first wrote about Beijing Enterprises Holdings (“BEHL”, 392.HK) last year here when the stock was trading around HKD$60. The stock is now at ~$39 HKD/share, a 36% drop. This is all despite very strong fundamentals. 2015 revenue and EPS were up 25% and 18%, respectively. 2016 results are also expected to be up double digits.

So why did the stock go down? First, it’s just a bad timing for a stock like BEHL. It’s China. It’s energy. Combine the two most hated features in this market and of course you get a lower multiple. The second reason is more concerning. There’s a risk of a tariff cut in the pipelines segment, perhaps coming in second half of 2016.

The stock is now ridiculously cheap. If you hedge out publicly traded subsidiaries Beijing Enterprises Water (371.HK) and China Gas (384.HK), that would leave you with the stub of natural gas segment, Yanjing Beer, and corporate (including waste treatment). This stub is trading at around 5x LTM earnings. Even in if you assume pipeline profits goes to 0, an extreme proposition, the stub is trading at <17x 2015 earnings.

Keep in mind natural gas usage is still set to grow in China over the next decade. LNG supplies coming online will push prices down, encourage adoption, and benefit distributors like BEHL. So I have gradually added to my positions in the past year. I suspect a tariff cut will actually be good for the stock, and that the stock will make a run after the bad news is flushed through.

Select Harvests and the Almond Boom and Bust

SHV is the second largest almond producer in Australia, behind the well diversified Olam. SHV is the only pure play almond stock I know of. The company is vertically integrated - it owns almond orchards, not just processing plants - and sells both domestically as well as export.

Almond prices have crashed over the past few months and SHV’s stock price went the same direction. Earnings will probably be way down this year.

A bullish story for Australian producers emerges once you look past the recent boom and bust of almond prices. Global demand for almonds continues to increase over time, driven by health trends. California supplies the majority of the world’s almonds, but it faces structural difficulties from drought and water shortage. Australia is the second largest producer and is in position to take more market share. Australian producers also have geographic advantage in terms of being closer to key growth markets of India and China.

I think almond prices are probably at or near a trough. The current price of $2.3/lb in California is already near break even. According to this presentation (see slide 43), growers need $2.15/lb to break even and $2.5/lb to insure a minimal profit. Longer term, stabilizing California supplies should put a floor on global prices.

Select Harvest will enjoy a natural production ramp in a few years (think like ~2019) as trees age and reach production sweet spots. Between higher normalized price and higher production, I can see earnings stabilizing.

The risk is California productivity. Yield per acre have consistently went up over the past decade. It is conceivable that Californian farmers can find a way to cut down water usage while keeping up production, so supply may actually not be constrained for years.

To be conservative I assume prices of USD 2.25-2.75/lb and fully ramped production of 19,000 tons. This would correspond to earnings of A$0.2 to 0.5 per share for SHV. The stock had a nice run during my research and it is now at A$5.4-5.5/share. I’m waiting for a pull back toward $5 or below to pull the trigger.

Wednesday, April 13, 2016

Virtus Health

Business and Industry Overview

Virtus Health Ltd (“Virtus”, “VRT”) is a steady dividend grower I found while scanning through Australian stocks.

Virtus operates In Vitro Fertilization (IVF) clinics. Fertility specialists contract with Virtus to use the clinics for IVF and related operations and get a split of the revenue. When a couple gets an IVF at Virtus, they pay the bill initially but gets heavy reimbursement from the federal government (Medicare and EMSN) as well as Private insurance if they have it. As a result, Virtus’ revenue is AUD 10,000-14,000 per IVF cycle but typical out-of-pocket costs for each patient is 1/3-1/2 of the total price.

The Australian assisted reproductive services (ARS) industry is concentrated. The top 3 players Virtus, Monash IVF, and Genea owns over 70% market share and are all privately owned. ARS are mostly provided by private clinics as there are virtually no public sector fertility clinics in Australia. Virtus is the biggest of the three with ~1/3 market share. At the local level VRT is even stronger since it is number one or number two in its geographies.

Why I Like It

There's lots to like about the industry and specifically Virtus. You have a product that is naturally price inelastic (we’re talking about babies here), good market structure, and very long growth runway due to demographics.

The industry structure is a big attraction for me as new entrants will have difficulty recruiting fertility specialists. This is the key to market share gains. But there are only some 300 odds fertility specialists in Australia and they are typically under contract with the big three.

Australia’s low birth rates provide Virtus a long growth runway. Those data were cited extensively in IPO prospectuses so I won’t recite them here.

Acquisitions have been sensible and generally at below 10x earnings. As a result return on incremental capital is solid low-mid teens. Management has been good about returning excess cash in the form of dividends.

My plan to make money with this stock is buy and hold, let the company accrete value over time and receive dividends in the interim. That should give 5-15% IRR over the next few years, maybe even decades.

Risks and Mitigants

What might change my mind? If the key risks turn out worse than expected: government funding risk, lower price competition, and alternative technologies.

By “funding risk” I mean risk that government will reduce reimbursement for IVF, or reduce subsidies for private insurance. Despite the chaos in Australian politics I have actually gotten comfortable here. First, unlike other benefits that add to expenses for the government, an IVF actually creates a future tax payer. 

Second, in the extreme and unlikely case where funding is removed and patients pay 100% out of pocket you're talking about AUD 10,000-14,000 per IVF cycle, a lot of couples would still pay. Keep in mind Australia is one of the wealthiest countries on Earth and typical clients are women in their late 30’s, who tend to be well educated and have sound financial positions (which is often why they delayed starting a family in the first place)

Competition is a bigger worry. Primary Health is in the market with low end $500 or even $0 out of pocket services. There has been some impact on Virtus' lower price, less service clinic but management indicates their full service IVF is still going strong. Industry IVF cycle growth have been higher than normal since Primary Health’s entry, so it would seem that they enlarged the pie by drawing in new customer segments. 

Primary only has two IVF clinics so far and I think scaling up and signing up doctors will be tough. I don’t see why doctors would leave a high priced practice for a low end one.

Longer term tail risks is that an alternative technology emerging to replace IVF. Also if IVF success rates (currently ~25-30% for women in late 30's) improve then people would need less service.

Why Virtus and Not Monash IVF; Catalysts

I prefer Virtus because Monash has business concentration risk with 1/3 of IVF cycle from 5 doctors. It also hasn't really been exposed to competition from Primary Health, which only recently opened a clinic in Melbourne. Yes, Monash IVF does have higher margins mostly due lower employee benefits, but Virtus is not a provider of low cost commodity services and in fact there's something positive to be said about paying your employees well.

“Self-help” earning opportunities are available in the next year or so. The company’s Singapore operations can swing from loss to profit (management indicated this can happen in a couple quarters). One of the Ireland Clinics had some temporary staffing issues in FY1H16 which has been addressed. VRT can also benefit from general ramp up of new facilities and younger doctors as they grow their reputation and attract new clients.

Australian budget comes out in May and we will have more color on the government funding risk then. The technicals are not great - the stock is coming upon a resistance zone at $7.0-7.25. But I’m inclined to ignore that and hold even if it gets there.

I have a 2-3% position right now with average cost basis of $6.56. Virtus trades at 15-16x forward earnings. Accounting earnings tracks cash flows well and leverage is moderate at 2-2.5x EBITDA.

Friday, March 18, 2016

NexPoint Residential Trust Passes My Stress Test, Has Room to Improve

NexPoint Residential Trust (NXRT) is a dividend growth play. They own and operate apartment buildings in the south. I view NXRT as having both defensiveness and optionality.

Defensiveness comes from the fact that NexPoint invest in Class B apartments, which are actually more defensive than high end Class A’s because tenants live there not out luxury, but of necessity. Growth optionality comes from their strategy of buying apartments that they can rehabilitate, which then allow them to raise the rent.

The company's geographic exposure is below. In this article I want think through a stress case on NXRT, then some of the more qualitative factors.

Defining the Stress Case

Rental vacancies for the South Region, where NXRT operates, peaked around 13.5% during the great recession of 2007-2009. There are large local variations though. Spot checking MSA level data on some of NXRT’s cities I get the following rental vacancies (using 1Q to 4Q 2009 as proxy):
  • Atlanta: 14.6% - 18.4%
  • Charlotte: 10.9% -14.6%
  • Dallas: 9.9%-14.2%
  • Nashville: 5.7%-10.9%
  • Orlando: 18.2%-28.1%

US rental vacancy by region

How about rental prices? According to Axiometrics, class B rent growth went negative for about 7 quarters from 4Q2008 to 1Q2010. Importantly, rent never declined more than 10% before it rebounded.

apartment rent growth

So I think a reasonable stress case for NXRT would be 85% occupancy and 10% rent cut from current levels. Since we’re modeling stressful times, I assume they cut down a little on G&A expenses and shut off all capital expenditures, which is not good but understandable.

In this stress scenario NXRT can still get to ~$16mm of funds from operations (FFO) which, along with cash on hand, should let them maintain current dividend of $17.5mm per year. Realistically, if they get to that point I would expect a dividend cut, but the point is even in stress scenarios NXRT will generate enough cash to have options.

The credit and liquidity picture looks fine. They are highly leveraged but no big maturities until 2020+.

Quality of Apartments - Need to Get Better

I googled around Nexpoint's properties for ratings, and ended up settling on since this is the one site I know of that has all NXRT’s properties. Since people tend to write reviews only when they have negative things to say, the key is to see how NXRT's properties stack up relative to their peers. For example, if an NXRT apartment in Dallas has 20% of reviewers recommending it, while the average apartment in Dallas gets has 60% its reviewers recommending it, then the NXRT property probably have some room to improve.

In the table below I listed out NXRT’s properties. The four columns on the right (highlighted in green) shows 1) number of reviews, 2) percentage of reviewers that recommend that particular apartment, 3) average percentage of “recommends” for apartments in that city, 4) difference between NXRT’s property versus city average.

Nextpoint property ratings

This is not pretty. Nexpoint’s properties in Texas generally get much worse reviews than city averages. Some of their Florida properties get excellent reviews. In general though, this is a picture of lower quality versus peers.

I understand NXRT’s strategy is buy apartments and rehab them, so arguably it’s the migration of ratings that matters, not ratings at a snapshot in time. Unfortunately, NXRT do not have any rating improvement data. The only related data are improving occupancies and higher rents – which are functions of not just quality, but also overall industry demand.

On the positive side, clearly they have lots of room and options for improvement.


For valuation I have always struggled to determining an appropriate amount of “maintenance capital expenditure” to deduct from FFO. This gets a bit hazy as some of the natural decays of the building might be offset by regular maintenance and repair expenses, which are already charged through the income statement. (The IR person I spoke to argues that it’s all accounted for in the income statement, so there’s no need for a separate maintenance capex deduction. But I think that’s a bit aggressive since repairs are expensed, but you still get one-off replacements like roofing/tiles which are not).

I ended up using an extremely rough proxy. Maintenance capex from fellow apartment REITS UDR and Post Properties are stated at $1150-1250 per unit. For NXRT that works out to ~16mm of maintenance capex. The company currently has about $34mm of FFO (which mirrors cash flow from operations excluding working capital); deducting $16mm maintenance capex would leave $18mm of free cash flow, which is almost 100% used toward paying dividends.

Since free cash flow mirrors dividend payments, this also means FCF yield = dividend yield = ~6.2% at the current price of $13.2 per share.

I would give this idea a B. It has enough defensiveness and growth optionality, but the apartment reviews are something to monitor. That NXRT is externally managed is another ding. I have a small amount of NXRT in my IRA account.

Monday, March 14, 2016

Omega Protein: Low Expectations and Activist Presence

Omega Protein ("OME") catches fish then processes them into fish meal and fish oils. It has two segments, Animal Nutrition and Human Nutrition, corresponding to the use of its products. Profit mostly came from the former while the latter is currently losing money.

In the Animal Nutrition segment, fish meal and fish oils are used as feed in aquaculture, swine, and pet food industries. Aquaculture customers have become more important in recent years. I expect this tailwind to remain the next few years as the Atlantic salmon producers increase capital expenditure and production.


Earning expectations through 2017E are now reasonable and beatable. Valuation is undemanding at 11x forward PE.

Wynnefield Capital is trying to get OME to dump the money losing Human Nutrition segment. The company has been conducting a strategic review and is scheduled to announce a decision in a couple quarters. The activist wants to nominate their own directors, further putting pressure on the company.

For now I see the activist stuff as bonus. Given the valuation, the key is to make sure earnings are not going to fall off a cliff.

The Core Animal Nutrition Segment

After the latest earnings OME stock took a hit and earnings estimates have been cut, so there’s already some de-risking here.

Currently sell-side expects 10% and ~6.7% EPS gains for 2016 and 2017, respectively. Much of the growth can be fulfilled by just 2015 revenue getting pulled into 2016. 4Q15 was weak on revenue but productions sold forward were up some 20% yoy. Given the big jump in inventory, Omega should be able to fill these orders. Here are details on the forward contract from the 10K.
“As of December 31, 2015, Omega Protein has sold forward on a contract basis approximately 72,000 short tons (1 short ton = 2,000 pounds) of fish meal and 10,000 metric tons (1 metric ton = 2,204.6 pounds) of fish oil for 2016, contingent on 2016 production and product availability… As a basis of comparison, as of December 31, 2014, Omega Protein had sold forward on a contract basis approximately 54,000 short tons of fish meal and 14,000 metric tons of fish oil for 2015.”
Pricing has marched steadily upward the past few years. Management says the 1H2016 forward sales are generally at or slightly below 2015 levels. Global productions of fish meal and fish oil have been depressed the past few years, providing some support for pricing.

Cost per unit is driven by production volume (93% R-squared the past 5 years), which itself is catch volume multiplied by yield percentage. As the company explains it, yield is basically luck.
o The “total yield,” or the percentage of fish meal, fish oil and fish solubles products derived from the menhaden fish has fluctuated over the years and from month to month due to natural conditions relating to fish biology over which Omega Protein has no control “
o The Company believes that fish oil yields are influenced by multiple factors, including but not limited to, fish diet, weather, water temperature and nutrient content, fish population and age of fish, but such possible relationships and inter-relationships are not generally well understood.”
It sounds awful that a key driver should be left to chance, but that’s actually positive in this case because yield has been well below average (see chart below), so mean reversion would lead to higher yields.

Fish catch volumes are in line with historical norm. Combining a stable fish catch volume with better yield percentage should mean improved production, so cost per unit could improve over the next few years. The company is also investing $18mm on equipment to increase productivity.

Margins should hold up given these unit price and cost outlooks. Add in 15-20% increase in volumes, I can certainly see big revenue and earnings bump from Animal Nutrition segment in 2016.

If they ditch or fix that money losing Human Nutrition segment then earnings have further upside.

Omega Protein production yield

Omega Protein fish catch, production, and sold volumes

Omega Protein Unit costs depend on production volume

Downside and Conclusion

This is simply a crappy business. There’s little competitive advantage or moat. The fish processing business is growth constrained – harvest volumes are capped by quotas and fish in the sea which is gradually deteriorating. The company can make it up with higher prices but price is constrained by substitutes (fish farms can use vegetable based protein instead of fish based, even though the latter is considered higher quality). The company has little control over key drivers of production, as yield is basically luck of the ocean.

Management has not done well. The company takes impairment and “non-recurring loss” almost every year. In recent years the company has ramped up capital expenditure. Acquisitions have been questionable.

The unattractiveness of the business are mitigated by the fact that stock trades at ~11x PE – hey you get what you pay for. Throw in low expectations through 2017E and some activist presence, I’m inclined to roll the dice on this one.

Thursday, March 3, 2016

When Does it Make Sense to Adjust for Amortization of Intangible Assets?

Buffet’s 2015 annual report contained his usual warning about amortization charges.
“… serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality
Buffet goes on to say about 20% of Berkshire’s amortization charges are “real”, therefore adding back about 80% of amortization charges in his non-GAAP presentations.

For a lot of companies, non-GAAP earnings routinely doubles that of the GAAP version after adjusting for amortization of intangibles and stock-based compensation. Clearly these are no trivial matter. Since Buffett already criticized the latter, here I want to focus on the former.

Most Intangible Amortizations are Real Expenses

If the key question is, as Buffett suggested, whether the intangible asset depletes over time, then I would say most of them do. They are called “finite-lived intangibles” for a reason. Software and patents are fairly obvious - they deplete due to technological obsolescence and legal expirations, respectively. But even customer relationships and brands depletes overtime. 

Buffett cited customer relationship as an intangible asset that does not deplete. But I would argue even that decays overtime as your customers change (they move out of your geography, retire, move to another company…etc.) and competitors try to steal your customers. Brand value decays as well. If you literally buy out the Coca-Cola brand for a gazillion dollars and then subsequently spend zero on marketing, advertising, or promotional budgets while Pepsi continues their efforts, I believe even Coke would gradually lose “mind share” and its revenue will slowly decay overtime.

Criteria for Adding Back Amortization Charges

So when is it ok to add back amortization of intangibles? I think the real question is not whether something depletes – they pretty much all do. What really matters are 1) whether the company is spending to replace or maintain that earning power and 2) whether that cost is already accounted for.

Due to the quirks of accounting, intangible assets are capitalized when they are acquired. But the costs to internally replace that earning power (think R&D, advertising expense, marketing expense, and so on) are usually expensed. This means they already flow through the income statement, as opposed to getting capitalized on the balance sheet then amortized later.

Go back to the Coke example. Let’s say you buy out the Coke brand, and now you got a massive intangible asset and lots of amortization expenses. But instead of letting it rust, you actively incur expenses on sales/marketing/advertising to maintain or increase that brand value. Since these costs are already reflected in the income statement, not adding back amortization expense would be double counting.

Compare this to depreciation of hard assets. Since ongoing cost of maintenance would be capitalized and not expensed in the income statement, an accurate earning measure would either treat depreciation as a real expense, or add it back but subtract an estimate of maintenance capex.

The Verdict

To conclude, adding back amortization of intangibles makes sense. Not because they are not “real expenses”, but because the cost of replacing that intangible asset is likely already reflected in the income statement and you don’t want to double count. It is “likely”, but not always, because the appropriate treatment would differ company by company, and asset by asset. There’s no one size fits all answer.

Berkshire Hathaway is unlikely to skimp on spending to maintain its earning power, so Buffett’s adding back 80% of their intangible amortization seems sensible.

On the other hand, if a company’s core business model is acquisition of intangibles (say patents for drugs), yet does nothing to maintain or replace its decay (no R&D capability in house), then adding back amortization would be voodoo math.


1) Whether a number is “correct” will depend on how it’s used. So if you add back amortization to earning or free cash flows per share, then apply a low multiple to account for the gradual depletion of earning power, then I have no problem with that. But more often than not people add back amortization of intangibles to come up with EPS or FCF/share, then apply 15-20x or even higher valuation multiple – therefore implying the earning stream is perpetual.

2) Intangibles have to be judged on a case by case basis because the same thing could be expensed or capitalized depend on situation (as this article explains, it depends on whether the intangible is acquired versus internally generated, and “identifiable” vs “unidentifiable”)

Sunday, January 10, 2016

Fidelity National Financial Ventures (FNFV) - at $10 This is a Buy

Fidelity National Financial Ventures (FNFV) is a tracking stock that mirrors the investment arm of Fidelity National Financial, Inc (FNF). FNF’s management team, led by chairman Bill Foley, has a strong track record of making good investments, including Fidelity National Information Services (FIS), and Sedgwick CMS (now a KKR owned money machine). Management are have strong operating experience, as evident by FNF’s core title insurance business being the best run, highest margin compared to its peers.

An introduction to FNFV’s structure, portfolio investments, and track record can be found here.

The thesis is a simple one – sum of the parts asset play. FNFV's main portfolio investments are American Blue Ribbon (“ABRH”, owns restaurants and bakeries), Digital Insurance (employee benefits platform), and Ceridian (human capital management software). My analysis is shown below. At ~$10/share FNFV has limited downside.

The main uncertainty comes from Ceridian and that’s the variable in my scenario analysis. Other than that, both ABRH and Digital Insurance are fairly stable; while Fleetcor and Del Frisco’s are simply marked at current market prices.


Ceridian “provides human resources, payroll, workforce management, talent management, tax compliance, benefits, employee assistance and wellness programs to more than 100,000 clients in over 50 countries”. Basically it competes with guys like Oracle, SAP, and Workday. Ceridian has traditionally been a strong player in the payroll business but was late to the cloud/software-as-a-service game. It has been playing catch-up on SAAS with its main Dayforce product. Checking around the web, DayForce does have fairly good reviews (an example here).

Note that Ceridian is extremely leveraged at 9-10x Debt/EBITDA. So this is either home run or bust. That’s why I assign value of $0 for Ceridian in my downside case. I do think more likely than not Ceridian will work out though. In the latest earning call, management provided the following comments (emphasis mine):

“I think you’re seeing finally kind of an inflection point and we highlighted this earlier this year…will the growth in the cloud business outpace the decline in the harvest business? The harvest business means that we have a lot of customer – payroll customers are sitting on our service bureau platforms and we’ve been converting those to Dayforce as well as getting net new customers…. But we’re starting to see – as we speak, the growth of the cloud is outpacing the decline in the harvest business.
Basically growth in cloud business is starting to outpace decline in legacy business. This is good news. I also think the entire HCM industry have some growth runway as U.S. now only have ~5% unemployment. 

There are certain factors that made the stock cheap. As a spin-off this is kind of under the radar. Being a tracking stock in a complex FNF corporate structure does warrant some discount. FNFV is not very liquid. All these factors cause me to discount the stock by some ~15% in my base and downside cases.

In the hands of savvy management, however, these can also be upside levers. When the time is right they can provide more color around Ceridian (currently very little). Cleaning up the corporate structure would surely help. Low liquidity also means buybacks can have greater positive effect on its stock price.