Quan's Notes on PetSmart (PETM)

by Geoff Gannon

Here are Quan’s notes on PetSmart (PETM).

Quan finished these notes on June 6th, 2014. At that time, one share of PetSmart was going for about $58 a share. PetSmart recently agreed to be bought out for $83 a share in cash. So these notes are entirely unactionable. But I thought some blog readers might enjoy seeing the kinds of notes Quan prepares as part of the newsletter process. And lots of you may have read articles about the PetSmart leveraged buyout and wondered about the industry, the company, its future, the price being paid here, etc. These notes – the PDF is 105 pages – give more detail on the company than press reports do.

We always have some notes that Quan has prepared but have never been used in a Singular Diligence issue. This happens for a couple reasons. One, when Quan and I discuss the notes we may come to the conclusion we were wrong about the company and the stock in our initial assessment – it’s not actually appropriate for the newsletter because of risks to the company or because the price is higher than we first thought. Two, the price of the stock can go up between the time Quan writes the notes and the time we would publish an issue.

That’s what happened in the case of PetSmart. PetSmart was going to be featured in an issue of The Avid Hog – the predecessor to Singular Diligence – during the summer. But, activist investors pushed for the company to put itself up for sale. PetSmart’s board announced they were reviewing strategic alternatives – and so the stock price rose.

The stock price went on to rise a lot more from that point, because the price ultimately paid in the LBO was higher than what traders originally speculated after the announcement.

Whether or not PetSmart was a good speculative bet at that point – it turns out it was – it was no longer a good investment to present to subscribers. The same can be said now about the leveraged buyout. The calculus for an LBO is different than it is for Quan and I deciding on a passive stake in a publicly traded buy and hold investment. PetSmart was a good buy and hold investment at $58 a share. It was not a good one at the $70 and up prices that the stock traded at after the market knew the company was for sale. The LBO might be a good deal at $83 a share for the buyers. But we wouldn’t recommend buying PetSmart at $83 a share.

As you can see in the “Value” section of the notes, we valued PetSmart at 13 times normal EBIT. That works out to something like 9.7 times EBITDA.  I want to be clear – we were not suggesting anyone should pay 9 to 10 times EBITDA for the stock – we were saying that at a price of 9 to 10 times EBITDA the future returns in PetSmart for investors would be similar to the returns they could get in the market as a whole. In fact, the quote from the notes would be “At 13 times EBIT, investors can get an adequate return in PetSmart”.

We generally want a stock to be trading at about two-thirds of our appraisal price to recommend it. So, even if we thought PetSmart was worth $90 a share – we’d want to recommend it when it traded at something like $60 a share.

As a result, both of these statements are true:

  1. After PetSmart announced it was reviewing strategic alternatives, the stock was too expensive to present in our newsletter

  2. The buyers of PetSmart who are now paying $83 a share in cash may not be overpaying

Read Quan’s Notes on PetSmart (PDF)

Talk to Geoff about PetSmart (PETM)

Check Out Singular Diligence



Archived Issues: Progressive, Ark, Town Sports, John Wiley, HomeServe, and Village

by Geoff Gannon

Now that the Avid Hog newsletter that Quan and I write has relaunched as Singular Diligence, we’ve changed how issues are made available. With Singular Diligence, as soon as you subscribe – you get access to the archived issues Toby puts up at Marketfy.

Also, unlike how we handled things with The Avid Hog, we are going to actually tell everyone what companies we’ve covered in past issues. So here are the archived issues that you get immediate access to when you subscribe.


Singular Diligence – Archived Issues

Progressive (PGR): A U.S. auto insurer that competes with GEICO online. Also the largest auto insurer in the independent agent channel.

Ark Restaurants (ARKR): Runs a small number of huge restaurants in landmark locations like: Union Station, Bryant Park, Faneuil Hall, casinos, and hotels. Also has an interest in the Meadowlands racetrack in Northern New Jersey as well as the food and beverage concession there.

Town Sports (CLUB): Runs urban gyms in New York City, Washington D.C., Boston, and Philadelphia under the “Sports Club” name.

HomeServe (London – HSV): A U.K. company that provides home emergency repair services using an insurer’s premium based model. Now also in countries like France and the United States.

John Wiley (JW.A): A publisher of books, textbooks, and academic journals. The vast majority of the company’s value is in its academic journals. The Wiley family has controlled the company for 207 years.

Village Supermarket (VLGEA): The second largest operator of “Shop-Rite” supermarkets. Stores are mostly in densely populated Northern New Jersey. Each store does about $1 million a week in sales.


If you have any questions about Progressive, Ark, Town Sports, HomeServe, Wiley, or Village – feel free to email me.

Talk to Geoff about Progressive, Ark, Town Sports, HomeServe, Wiley, or Village

Check Out Singular Diligence

The Avid Hog is Now Singular Diligence

by Geoff Gannon

The Avid Hog has been reformatted and renamed SINGULAR DILIGENCE, reflecting a singular focus on business diligence. The defining idea behind The Avid Hog of finding and profiling "a wonderful business at an attractive price" for buy-and-hold investors has been continued in SINGULAR DILIGENCE. Geoff Gannon and Quan Hoang have teamed up with Tobias Carlisle as the publisher and the newsletter is being hosted at Marketfy

The attached special report on America's Car Mart, profiled in the The Avid Hog back in June, explains why we selected that stock. It also give you a look at the depth of analysis and extent of the data that appears in every newsletter.

The current issue of SINGULAR DILIGENCE is Progressive Insurance. If you sign up now, you can read our December issue, Progressive Insurance, right away, and also be assured of getting the next issue when it comes out on January 1st. 

Read the America's Car-Mart (CRMT) Sample Issue (PDF)

Visit the New Singular Diligence Website

Adidas Announces Share Buyback

by Geoff Gannon

Adidas announced plans to spend up to 1.5 billion Euros over 3 years buying back its own stock. The company will take on debt (it has no net debt) and continue to pay a dividend. Dealbook quotes the company's CFO as saying:

"We believe that our shares are currently significantly undervalued and this provides an excellent opportunity to optimize the company’s cost of capital, deploy cash and create further value for our shareholders"


At the current share price, the company could buy up to 10% of its own shares over 3 years. Bloomberg also has an article on the buyback and it focuses more on the possibility of activist investors targeting the company. The article speculates activists would want the company to replace its CEO and spin-off Reebok and TaylorMade.

Adidas is very cheap compared to its two best known - and expensive - peers: Nike (NKE) and UnderArmour (UA).

Adidas is valued more in line with the company with which it shares a founding family: Puma.

When looking at the history of those 4 companies and their cultures - it is difficult to argue that Adidas is truly comparable to either Nike or Under Armour.

Regardless, Adidas is cheap given the level of stock prices generally and the multiples at which athletic apparel companies normally trade.

Talk to Geoff about Adidas

Babcock & Wilcox (BWC): Considering Separation into Two Companies

by Geoff Gannon

Babcock & Wilcox (BWC) just announced it is considering separating into two companies:

"...Board of Directors is evaluating the separation of the Company’s Power Generation Business and Government & Nuclear Operations Business into two publicly traded companies. The Board’s goal is to determine whether a separation creates the opportunity for enhanced shareholder value and business focus. B&W has retained JPMorgan as its financial advisor and Wachtell, Lipton, Rosen & Katz and Jones Day as legal advisors to assist in this process."

The company reports its results in 4 segments (one of which is the experimental money losing mPower - tiny nuclear generator - business). So it is easy to analyze what the company will look like post any possible break-up. The stock is up 7% as I write this.

It still looks cheap.

Talk to Geoff about Babcock & Wilcox (BWC)

Barnes & Noble (BKS) Will Separate Retail from Nook

by Geoff Gannon

Barnes & Noble (BKS) announced it plans to break up the company:

 With the objective of optimizing shareholder value, the Company’s Board of Directors has authorized management of the Company to take steps to separate the Barnes & Noble Retail and NOOK Media businesses into two separate public companies.  The Company’s objective is to take the steps necessary to complete the separation by the end of the first quarter of next calendar year. 

The company provided a PDF giving segment performance.

Over the last year, Retail had positive EBITDA of $354 million. College had positive EBITDA of $115 million. Nook had negative EBITDA of $217 million.

The company ex-Nook would have $6.04 billion in sales, $1.78 billion in gross profit (29% gross margin), and $469 million in EBITDA (8% EBITDA margin).

(I do not own any shares of Barnes & Noble. I bought shares in August 2010 and sold them in December 2010).



What is the Fair Value of America’s Car-Mart (CRMT)?

by Quan Hoang

The following stock may appear in a future issue of The Avid Hog.

In the last post, Geoff mentioned the use of common sense to estimate the fair value of a stock. In this post, I’ll write about a specific example of using common sense. The stock I’m talking about is America’s Car-Mart (CRMT).

Car-Mart sells used cars in small towns in South-Central states like Arkansas, Oklahoma, and Missouri. But Car-Mart isn’t exactly a car dealer. Car-Mart lends used cars to poor people with limited credit history.

The average car price Car-Mart sells is about $9,721. Customers pay a 7% down payment on average. The remaining balance is financed at a 15% interest rate. Customers go to Car-Mark’s stores to make weekly or bi-weekly payment for the next 29 months. The average bi-weekly payment is about $175.

The focus of Car-Mart is not selling cars. The focus is collecting payments.

When Car-Mart sells a car, the car price is recognized in revenue. The principal balance also increases by the same amount, and allowance for credit loss increases by an estimated amount.

Whenever customers make payments, the part of payment composed of interest is recognized in revenue. The rest of the payment is subtracted from the principal balance.

When a customer defaults, Car-Mart repossesses the vehicle. The fair value of the vehicle is added to inventories. Car-Mart also subtracts the fair value of the vehicle from the remaining principal of the loan. That would be the amount that Car-Mart writes off.

According to these accounting policies, reported earnings are not a good measure of Car-Mart true earnings. Car sales are not cash revenue. Car-Mart can overstate the price of the car they sell to overstate revenue. Or for the same payment stream, Car-Mart can reduce the interest rate to get a higher car price that is recognized in revenue.

Loan originations are not cash spent either. Car-Mart doesn’t lend money to customers to buy cars. Car-Mart lends cars to customers.

This is where we need common sense to calculate owner earnings. The true cash flow in the business is:

CFFO = Receivable Collections - Cost of Goods Sold - G&A - Tax - Increase in Working Capital.


Excluding sales of repossessed cars at costs, Cost of Goods Sold + G&A is about 74% of Car Sales. I'll consider repossessed inventory a type of receivable collections rather than inventory. Working capital is about zero. So, we only need to calculate Receivable Collections.


As we're interested in normal earnings, we'll calculate Receivable Collections in a no growth situation. We're in Year 3 with revenue R. Year 1 and Year 2 both have revenue of R.


Receivable Collections = Collections of Year 1 loans + Collections of Year 2 loans + Collections of Year 3 loans


Collections of loans in each year = collections of successful loans + collections of payments before default + proceeds from repossession.


Car-Mart is lending at 15% and the term length is about 29 months. A $10,000 loan like that with $0 down payment would require 62 bi-weekly payments of $192 for a total of $11,923. So, a successful loan of $P can result in a total collection of 1.19 * P.


CRMT says they normally repossess about 40% of units sold (and over 40% in 2013). The average age of an account at charge-off is 10.6 months. Accounts are on average 71 days past due at the time of charge-off. So, we can say that CRMT can collect 17 bi-weekly payments before default. For the 40% of loans that end up with charge-offs, CRMT can collect 0.4 * 1.19 * R * 17/62 = 0.1305 * R before default.


The recovery rate is currently 30%. I looked at the industry benchmark and the recovery rate is about 32-33% of remaining principal. The remaining principal of a $10,000 loans after 17 bi-weekly payments is $7,602.70. So, the recovery amount would be 30% * $7,602.70/$10,000 = 22.8% of the face value. A 40% default rate would mean the recovery amount is 0.0912 * R. Car-Mart’s "inventory acquired in repossession and payment protection claims"/Average Principal Balance was stable at about 11-12%. So, it's conservative to say the recovery amount is 0.0912 * R.


Let's assume the amount of loan originations to be the same every two weeks. That means total loans generated in each bi-weekly payment is R/26. Excluding the 40% defaulted loans, 60% of loans originated in the first bi-weekly payment will have 10 payments in year 3 for a total of 0.6 * 1.19 * 10/62 * R/26. Similarly, loans generated in the second bi-weekly payment will have 11 payments in year 3 for a total of 0.6 * 1.19 * 11/62 * R/26, and so on.


Total collections of successful loans in year 3 would be 0.6 * 1.19 * 1567/62 * R/26 = 0.6941 * R


So, Receivable Collections is 0.6941 * R + 0.1305 * R + 0.0912 * R = 0.916 * R.


However, the down payment is 7% of principal instead of 0%. So, Receivable Collections is actually 0.07 * R + 0.93 * 0.916 * R = 0.92 * R


So, CFFO is 0.92 * R - 0.74 * R = R * 18%. As maintenance CapEx is insignificant, pre-tax FCF margin is about 18%.


This calculation has its limitations. First, there can be more than 60% of loans originated in year 2 and year 3 that are still performing in year 3. That would increase collections of successful loans and reduce pre-default collections or proceeds from repossessions. But the net effect would be positive to cash flow in year 3. The bigger limitation is that the total amount of loans originated in each bi-weekly period varies while I assume they're all equal.


If I assume the repossession rate to be 45%, pre-tax FCF margin would be 15.3%. If I assume the repossession rate to be 40% but there are 65 bi-weekly payments, pre-tax FCF margin would be 17%. So, we can see that Car-Mart would make less money with a longer loan term. And the easiest way to improve profit is to reduce the default rate.


It’s hard to estimate Car-Mart’s earnings power accurately. But these calculations show that pre-tax FCF is at least 15% of car sales.


This finding is consistent with Car-Mart’s growth record. From 1995 to 2002, Car-Mart grew sales by 20% annually. From 1998 to 2012, Car-Mart grew sales by 14% annually without using additional debt or equity. The true cash investments in this business are in Cost of Goods Sold and SG&A. A 15% pre-tax FCF margin results in about 9.75% after-tax FCF margin. As COGS + SG&A is about 74% of car sales, 9.75% after-tax FCF margin can fuel 13.18% (9.75/74) growth in COGS + SG&A. From 2003 to 2013, the annual growth rate of COGS + SG&A was 13.1%.


So, 15% is a good estimate of the pre-tax owner earnings margin.


At this point, what is the fair value of Car-Mart? My favorite yardstick is an enterprise value equal to 10 times pre-tax owner earnings. For Car-Mart, that’s equivalent to a ratio of 1.5 times car sales.


But wait! What if Car-Mart can grow 10% over the next 10 years? If that’s true, Car-Mart is worth at least 12 times pre-tax owner earnings, or 1.8 times car sales.  


The reason is simple. If today’s pre-tax owner earnings are $1, they will be 1.1^10 * 1 = $2.59 after 10 years. After 10 years, Car-Mart would be worth $25.90 based on an enterprise value of 10 times pre-tax profits. If we pay $12 for Car-Mart today, we would still get an 8% annual return. Also, at a 10% growth rate, Car-Mart would have excess cash to repurchase shares. That would add 1% or 2% to our investment return.


But again, don’t worry too much about what’s the fair multiple. It can be 12, 13 or 14 times pre-tax owner earnings for Car-Mart. The bigger questions are about qualitative factors. Is Car-Mart durable? Does Car-Mart have a strong competitive position? If yes, is the competitive position sustainable? How likely is it for Car-Mart to lose underwriting discipline? Is Car-Mart’s capital allocation good or bad? And does Car-Mart have favorable future prospects?


If the answers to all these questions are positive, we know that we would get a good bargain paying an enterprise value of 10 times pre-tax profits.


Talk to Quan about America’s Car-Mart (CRMT)


Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Stock Price Guidelines

by Geoff Gannon

A recent blog post at The Brooklyn Investor discusses whether Warren Buffett pays 10x pre-tax earnings for both private companies and public stocks:

It's amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that. Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying. And yes, right now I'm the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it's really interesting.

(The Brooklyn Investor)

I’m often asked what’s a fair price to pay for a good business? This is a tough question, because people seem to mean different things when they say “fair price” and different things when they say “good business”.

I will suggest one awfully automatic approach to deciding what stocks are acceptable candidates for long-term investment. The simplest approach I can suggest requires 2 criteria be met. To qualify as a “good business” the stock must:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry

In other words, we are defining a good business as a stock in a “defensive” industry with at least 10 straight years of profits.

If those two business quality criteria are met, what is a fair price to pay for the stock? I suggest three yardsticks:

  1. Market Cap to Free Cash Flow: 15x
  2. Enterprise Value to Owner Earnings: 10x
  3. Enterprise Value to EBITDA: 8x

These are “fair” prices. A value investor likes to pay an unfair price. So, these are upper limits. They are prohibitions on ever paying more than 15 times free cash flow, 10 times owner earnings, or 8 times EBITDA.

At Berkshire, Buffett is willing to pay a fair price – 10 times pre-tax earnings – for 2 reasons:

  1. Berkshire amplifies its returns with leverage (“float”)
  2. Buffett has learned to find a margin of safety in places other than price

For example, Buffett talks about Coca-Cola (KO) as if the margin of safety was the profitable future growth of the company. He was paying a fair absolute price (it was a high price relative to other stocks at the time), because he knew it was a good price relative to earnings a few years out.

Let’s take a look at the 5 guidelines I laid out:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry
  3. Market Cap to Free Cash Flow: 15x
  4. Enterprise Value to Pre-Tax Owner Earnings: 10x
  5. Enterprise Value to EBITDA: 8x

Implementation of this – or any – checklist approach requires one additional thing: common sense.

Common sense often finds itself at odds with two other types of sense:

  1. Theoretical Sense
  2. Technical Sense

Technical sense is when you notice that Carnival (CCL) trades at more than 8x EBITDA and more than 10x Pre-Tax Earnings and disqualify the stock right there. Technically, you have applied the checklist correctly. However, let’s look at 3 companies and their 10 year average tax rate:

Village Supermarket (VLGEA): 41.8%

John Wiley (JW.A): 24.8%

Carnival: 1.1%

Common sense tells you that – when it comes to taxes – Carnival is a special case and needs to be examined as such. You must apply the spirit of the above laws rather than the letter. The letter of the law was not written with a company that pays no taxes in mind.

Theoretical sense is when you catch yourself thinking thoughts that while conceptually true are habitually dangerous. These are usually thoughts that are provable by mathematics but leave the human in you a little queasy for having thought them.

For example: let “a fair price” equal the price at which a buy and hold forever investor would earn the same return in this stock as he would in the S&P 500.

I want you to take two stocks I just mentioned: Village and John Wiley. Both companies have been public since the 1960s. Now go to your favorite data source and look up the oldest stock price you can find for each company. For example, choose Google Finance (which goes back to 1978) and use 1978 to today as your holding period. Then, plot each of these stocks against an index. You can also calculate the CAGR of the stock and the CAGR of the index. Now, work back from these calculations to find what multiple of the then current price you needed to pay for the stock to equalize its future return with that of the S&P 500 over the full holding period from then till today.

I think it will surprise you. It won’t be 1.5 times the then market price. It’ll be more like 3 or 4 times the price. In other words, if the stock had a P/E of 12 back then, it turns out it really should have had a P/E of 36 or 48 or some other absurd multiple.

Buffett’s Coca-Cola investment is well known. Go back to 1988 and try to figure out what a “fair” price for Coca-Cola stock would’ve been if we define fair to mean the price that equalizes long-term future returns between the stock and the S&P 500. Imagine this number in terms of what the P/E, EV/EBITDA, etc. would need to be to make holding Coca-Cola merely a “fair” investment from 1988 through today.

Based on these calculations, you can then go back in time and say that there were times when John Wiley or Village or Coca-Cola (or a great many other public companies) had a margin of safety of 75% or 80%.

I’ll admit this makes theoretical sense. But I won’t admit it makes common sense.

It is a dangerous habit to pay those kinds of multiples. Not because they aren’t justified. And not because the future is unknowable. Per capita consumption of Coke was going to grow. Buffett knew that.

It is dangerous to pay high multiples, because it complicates rather than simplifies you process. It requires more quantification rather than less.

The whole point of having a rule of thumb like “we pay 10 times pre-tax earnings” is to make taking the correct action easier. Warren Buffett is a focused investor – especially in the sense that he makes relatively few new purchases (of private companies or public stocks) each year. He spends a lot of time looking for things to buy and presumably passes on most. So, for Buffett, the approach that makes taking a correct action easier is one that eliminates most errors. It doesn’t matter as much to Buffett if he eliminates a lot of potentially good investments as long as he limits the number of false positives.

I think the same is true for most buy and hold investors. Try using common sense and these 5 guideposts:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry
  3. Market Cap to Free Cash Flow: 15x
  4. Enterprise Value to Pre-Tax Owner Earnings: 10x
  5. Enterprise Value to EBITDA: 8x

I think it will allow you to focus more quickly on those businesses that may be above average in quality and below average in price.

Is this what I do?

Not exactly. I was recently talking to someone who noticed that in a past issue of The Avid Hog I gave a much higher “normal” EBITDA number than the company had actually generated from 2008 through 2012. Wouldn’t it be more conservative to use an average of the recent past?

I answered: “Yes. It would be more conservative. But it would also be intellectually dishonest.”

Simply put, I did not believe that the period from 2008 through 2012 was normal. I could mention the recent past. But, I couldn’t suggest it would have anything to do with the future.

This brings me to the place where I split off from the guidelines I suggested above. When selecting a stock – and when attempting to appraise a stock – I do not think about the price in terms of today’s EBITDA, owner earnings, or free cash flow.

I don’t care what the earnings of a stock are when I buy it. I care what the earnings are when I sell it. In the example I just mentioned, I was thinking in 2013 what the EBITDA of that company was likely to be in 2016 to 2018 (3 to 5 years from my purchase date). I did not believe that the period from 2016 to 2018 would be at all like the period from 2008 through 2012. So, I did not consider the recent past to be a terribly helpful guide.

In most years, this will not be such a big problem. The more normal the economic climate is when you are selecting a stock and the more stable the industry you are looking at is – the more you can trust the most recent EBITDA and pre-tax earnings.

Of course, what I care about is free cash flow. Let’s take another look at the same 3 companies. This time I want to talk about the 10-year average ratio of free cash flow to net income as calculated by Morningstar:

Carnival: 0.31x

Village: 1.10x

John Wiley: 1.84x

In an average year, Carnival turned $1 of earnings into 31 cents of free cash flow. Village turned $1 of earnings into $1.10 of free cash flow. And John Wiley turned $1 of earnings into $1.84 of free cash flow.

I don’t agree with these exact numbers. Morningstar – and almost every other finance website – calculates the free cash flow of publishers incorrectly. However, this pre-publication item does not cause most of Wiley’s free cash flow excess over net income. In reality, Wiley does turn $1 of reported earnings into $1.50 of free cash flow. In an economy with inflation, $1 of earnings at most companies actually converts to less than $1 of free cash flow. This suggests companies that can be counted on to consistently turn $1 of earnings into $1.50 of free cash flow should trade at 50% higher price ratios. Theory says the EV/EBITDA cap of 8 should become an EV/EBITDA cap of 12 for these companies.

I want to stop here and highlight this fact: What I just said is true. It’s theoretically true. You can actually prove the point. There is no arguing that fact. Now, the question I want you to consider is whether the fact this point makes theoretical sense forces you to concede it also makes common sense. I’m serious. Think about this. Really ask yourself whether what I just said about paying 8 times EBITDA for some businesses and 12 times EBITDA for other businesses is an insight you can safely incorporate into your own investing habits. There’s a tendency for folks to either accept that because something is true it’s useful to them or conversely to start by rejecting its usefulness to them and then feeling obligated that because they’ve rejected its usefulness they now need to disprove its truth. Something can be true and useless. Whenever you think about investing, your top priority should be finding a really useful habit to pick up.

So let’s keep talking usefulness. What limits the usefulness of these ratios? I want to point out the problem with using any one ratio – Market Cap/Free Cash Flow, EV/EBIT, EV/EBITDA, etc. – by using those 3 very different companies (Carnival, Village, and Wiley). Their tax rates range from 1% to 42%. Their earnings to free cash flow conversion rates range from 31% to 184% (really more like 150%). These are make or break differences for an investment.

That is why you need to use common sense. These ratios are not flawed. It is only when they are applied in an obviously reckless way that they become flawed.

I recently exchanged emails with someone who had this sort of problem. He had done the return on capital calculation exactly the way an analyst is taught to – and yet, something was nagging at him.

It turns out the tickle he was feeling was common sense.

Here is what he was asking about:

…sells a very large chunk of their receivables at a discount. That has a very positive effect on ROIC and free cash flow as it reduces working capital without a negative impact on the EBIT - the discount paid for selling the receivables is considered a financial expense.

It doesn't seem very fair to me and I get the feeling I could be overvaluing this company if I don't include the discount into the operating income (and consequently free cash flow) calculations. Selling a great part of their receivables is business as usual for them; they definitely take the discount into account when pricing their merchandise, for instance.

What do you think?

And here is how I responded:

... The key is not to follow the rules you learned for how to do a generic ROIC calculation. It is to describe the specific business you are analyzing. If you believe the factoring of receivables is a core part of how this business operates, then be up front about it. Tell yourself this is a company that is dependent on factors to provide financing for its operations….

…Be as specific as possible. If you then need to compare this company to others, do it two ways. Prepare a calculation of ROIC that is the most favorable to the company and ROIC that is the least favorable. The truth is one or the other or it is something in between. This is the best description of the actual business. It will help your understanding.

Remember, this is real life problem solving you are going to base a buy/sell decision on using your own money. This is not a word problem in math class. The goal is not to get a single, correct quantifiable answer. The goal is to have confidence in your reasoning and have that reasoning be enough to take a money making action.

The truth is that 10 times pre-tax earnings is a perfectly fair price to pay for a business you understand, like, and intend to hold for the long-term.

However, it is always possible to use ratios to lie to yourself. Value investors can find that the EV/EBITDA ratio of an asset heavy company at the peak of its cycle will justify an otherwise dodgy purchase. If you want to buy into an overleveraged company, just focus exclusively on the Market Cap/Free Cash Flow ratio while ignoring enterprise value entirely.

I think guidelines are great. In fact, I think anything that gets investors away from a focus on quantities and toward a focus on reliability is a wonderful tool. A lot of investors would benefit from trying to prove two separate cases:

  1. {C}Is this an above average business?
  2. {C}Am I paying a below average price?

Rather than trying to quantify the precise extent to which the business is above average or the price is below average.

We shouldn’t spend a lot of time worrying about whether we are paying 3 times EBITDA or 5 times. Either will do. Nor should we spend time worrying about whether the business earns a 33% return on capital or a 99% return on capital. Both will get you a better than 20% after-tax return without leverage. That’s better than Berkshire.

The Brooklyn Investor began the post tackling the idea that Buffett pays 10 times pre-tax earnings. Another Buffett quote explains why the exact price paid may not be the most important consideration:

One of the things you will find, which is interesting and people don’t think of it enough, with most businesses and with most individuals, life tends to snap you at your weakest link. So it isn’t the strongest link you’re looking for among the individuals in the room. It isn’t even the average strength of the chain. It’s the weakest link that causes the problem.

For most investors, price is the weakest link in their process. Most investors are not value investors. They simply pay too much for popular stocks. They may have other weak links. They may trade too much. They may be greedy when others are greedy and fearful when others are fearful.


Remember, you aren’t most investors. Most investors aren’t reading this blog. You are. That means price probably isn’t your weakest link.


So, don’t focus on price. Just figure out a way to make sure the price you pay is good enough. And then work on correcting the errors you've historically made.


I’ve made a lot of mistakes as an investor. I can’t think of any case where my mistake was paying too high a price relative to some measure of earnings. I can’t look at any investment that went badly and say: “Oh, if only I’d gotten that at an EV/EBITDA of 4. That would’ve solved everything.”


I’ve misjudged people. I’ve misjudged societal change. I’ve misjudged solvency. I’ve sold too soon. And I’ve tried to do too much.


Those are potential weak links for me. And so my quality assurance time is better spent carefully checking those problem areas than worrying about price.


This is not true for everyone. I’m very unlikely to get so excited about a business, I’ll pay any price for it. I’ve followed businesses I love trade publicly for 5-10 years and never touched them because of price. If you’re like me in that respect, price is something you shouldn’t obsess about.


Have your standard. Apply it using common sense. But, don’t worry about whether the right multiple is 9, 10, or 11 times pre-tax earnings. If your investment case snaps, it probably won’t be because of price. And it certainly won’t be because you were off by 10%.

Talk to Geoff about Stock Price Guidelines

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.



IMS Health (IMS): 4 Years Later

by Geoff Gannon

I bought shares of IMS Health (IMS) in early 2009. The company went private in 2010. That buyout (involuntarily) ended my investment in the stock. Now in 2014, IMS Health is going public again. I don’t invest in IPOs. So, I’m not interested in the stock. But, I am interested in what has happened with the company. Some things have changed. Others have not.

Here is the S-1.

While under TPG’s control, IMS Health bought a lot of stuff. In 3 years (2011 through 2013), IMS Health spent $900 million on 22 acquisitions, “internal development programs”, and “capital expenditures”.

I’m not sure if they are including “additions to computer software” in that number. I treat it as a capital expenditure when analyzing IMS Health (or any database company) but it is reported on a separate line of the cash flow statement. Additions to computer software is always a bigger number for IMS Health than other capital expenditures. Over the last 3 years, software capital spending has averaged $73 million a year while other capital expenditures have been just $38 million a year. You will notice that capital spending (which we just said was $111 million a year plus acquisitions) and depreciation are totally unrelated. This is a good place to mention that GAAP numbers are irrelevant at IMS Health. You always want to focus on your expectations of normal future free cash flow. The business is very stable, so there’s little need to “normalize” anything on the customer side.  

This quote from the S-1 sums up what interested me in the stock originally:

The average length of our relationships with our top 25 clients, as measured by 2013 revenue, is over 25 years and our retention rate for our top 1,000 clients from 2012 to 2013 was approximately 99%.

This is IMS Health’s moat. It is the one thing about the company you want never to change if you’re going to hold the stock for the long-term.

The new owners churned through the workforce astoundingly fast:

Since the Merger…we added approximately 7,600 employees…and oversaw the departure of approximately 5,200 employees…We estimate that about 60% of our approximately 9,500 employees have joined us since the Merger...

So, IMS Health – a 60-year old company with an average customer relationship of 25 years – is now mostly made up of employees who have been with the company for less than 3 years.

I can’t recommend looking at IMS Health as a possible investment. However, I do recommend reading the S-1. It offers some insight into both a company with a competitive position I really like and what a private equity owner does to a once and future public company.

Talk to Geoff about IMS Health (IMS)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Moody's Downgrades Weight Watchers (WTW) Debt to B1 With Negative Outlook

by Geoff Gannon

Moody's downgraded Weight Watchers (WTW) debt:

Moody's expects a sharp drop in 2014 revenue and EBITDA to about $1.4 billion and $325 million, respectively, even with management plans to initiate cost reduction programs. As a result, debt to EBITDA (after Moody's standard adjustments) may increase to above 7 times, which is high for the B1 CFR. Moody's anticipates Weight Watchers will remain profitable but down considerably from earlier expectations and generate at least $100 million of free cash flow. Lowered free cash flow and in Moody's view financial covenant constraints will limit Weight Watchers access to about $50 million of its revolver, so the Speculative Grade Liquidity rating was revised to SGL-3. Liquidity is considered adequate.

The negative ratings outlook reflects Moody's concern that evidence of business stabilization may not appear in 2014, which could imply further deterioration of financial leverage and cash flow.

(Moody's Downgrade)

The "Debt" section of our notes always assumed Weight Watchers would only have access to $50 million of revolving credit. Interest costs increase 0.25% ($6 million a year) when rated below Ba3 by Moody's (B1 is lower) and Standard & Poor's. See the debt section of our notes for details.

Separately, Morningstar downgraded the "moat rating" for Weight Watchers from "wide" to "narrow". You can find our discussion of free apps (the reason for Morningstar's downgrade) near the end of the notes PDF.

I promised I would tell you if Quan or I changed our position in Weight Watchers. Today, Quan added to his position.


Talk to Geoff about Weight Watchers (WTW)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

G Asset Management Makes 2 Offers for Part of Barnes & Noble (BKS)

by Geoff Gannon

G Asset Management put out a press release announcing 2 different offers for different parts of Barnes & Noble (BKS):

 ...a proposal to acquire 51% of Barnes & Noble, Inc., valuing the company at $22 per share, a ~30% premium to the current market price.

Alternatively, GAM has proposed to acquire 51% of the Nook segment, valuing the segment at $5 per share. GAM  stated in its proposal that it was extremely confident that if the Nook segment is separated from the profitable retail and college business, substantial shareholder value would be created.

(Press Release)


Talk to Geoff about Barnes & Noble (BKS)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Weight Watchers (WTW): Notes PDF

by Geoff Gannon

The main point of this post is to provide the Notes PDF from which The Avid Hog issue on Weight Watchers was prepared:

Weight Watchers Notes PDF

A lot of people emailed me about Weight Watchers (WTW) after the company reported earnings and the stock dropped about 25% last week. Some of the people asking about Weight Watchers were subscribers to The Avid Hog. Others were not. For the first few issues of The Avid Hog (including the issue in which we picked Weight Watchers) we did not put out a “Notes” PDF with the issue.

Since a lot of people said they were “rethinking the thesis” or “considering selling” or “thinking about doubling down” on Weight Watchers at today’s price, I thought we should post some items with information that might be useful.

Those items are:

The “Notes” we used in preparing the issue of The Avid Hog where Weight Watchers was picked (PDF)

The Investor Day Presentation the company put out last fall

The 8-K outlining the company’s credit agreement

Artal’s portfolio (Artal controls Weight Watchers)

Weight Watchers is down 49% from where Quan bought it, 44% from where I bought it, and 35% from where we picked it for The Avid Hog. Quan and I still own the stock. We have no plans to sell it. We’ll let you know if that changes.

The notes have been updated to reflect the most recent (much lower) stock price and to discuss the 3 topics most often asked about in emails: 1) Debt 2) Free Apps 3) Artal.

If you want to know our thoughts on the company, please read the “Notes” above. They capture our thinking better than I could in a blog post. For information about Weight Watchers’s debt please read the “Debt” page of the notes. You should also read the actual 8-K explaining the credit agreement. For management’s thoughts on the company and the “turnaround plan” please read the Investor Day Presentation and either listen to the last 2 earnings calls or read the transcripts. You can find them on the company’s website, at earningscast.com, at Seeking Alpha, etc.

Like I said, if Quan or I change our positions in Weight Watchers in any way – we will update you the moment we do so.

For a negative view of Weight Watchers see Punch Card Investing’s posts:

A Closer Look at Weight Watchers (WTW)


Update on Weight Watchers International (WTW)

Once again, here are the complete notes we used to prepare the Weight Watchers issue of The Avid Hog. They have been updated to include information not available at the time the issue was published (a lower stock price and info from The Investor Day).

Talk to Geoff about Weight Watchers (WTW)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

The Inevitables

by Geoff Gannon

In his 1996 letter to shareholders, Warren Buffett explained his strategy of investing in “inevitables”:

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables."  Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years…however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime.

I happen to have a Standard & Poor’s Stock Market Encyclopedia published in 1967. So, I figured I could check just how persistent the profitability of these “inevitables” is.

Here are the operating margins of 5 such inevitables.

Talk to Geoff about The Inevitables

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Geoff’s Avid Hog Watchlist: Catering International & Services (CTRG:FP)

by Geoff Gannon

The following stock may appear in a future issue of The Avid Hog.

Catering International & Services trades in Paris under the ticker “CTRG”. The company was founded in Marseilles, France in 1992. Two families control 71% of the shares. The founder, Regis Arnoux, controls the majority of the company’s shares. He still runs the company. Catering International provides remote site services (mainly catering) in extreme conditions. Revenue is about evenly divided between serving mining customers (51%) and oil & gas customers (47%). Operating profit – but not revenue (more on that later) – is about evenly divided between Asia/Pacific (54%) and Africa (46%). So, we’re basically talking about a company that caters for mines and oil fields in Asia and Africa.

Let’s start with how I found the company.

I ran a screen at Stockopedia looking for E.U. stocks sorted by their gross profits relative to net tangible assets. I then eliminated companies that either had lost money in one of the last few years or that now traded above 8 times EBITDA. I also eliminated companies where the business description suggested they were far from all 3 rings of my circle of competence: 1) consumer habits, 2) business support services, and 3) industry standards. This left a little over 40 stocks. I then looked for English language information on all 40 stocks. About 14 of these stocks had multiple annual reports in English. Catering International was one of them.

A few things appealed to me immediately about Catering International. The business sounded both mundane (catering) and niche (extreme conditions). It’s a business support services provider. Gross profitability was adequate.

A few things also concerned me right away. Catering International serves mining and oil & gas customers. That means the commodities these companies are extracting – their reasons for being at these sites – are at bubble levels. I’m not saying they are in a bubble. The supply of oil and gas is finite. So you can argue that bubble prices relative to the past could be justified throughout the future. But there is no long-term history of prices being this high. Therefore, we don’t have a relevant record of consumer or producer behavior to go on. We don’t know how marginal – high cost and high risk – some of these sites are. Catering International has been a very fast growing company. Some of that growth was driven by customer interest in more extreme conditions which high prices for commodities like oil and gold have to encourage.

The good news is that you don’t have to expect a lot of future growth to invest in Catering International. Using the most aggressive estimates of EBIT and enterprise value you get a price of 6.5 times EBIT for the company. Using the most conservative estimates of EV and EBIT you get a ratio of 8.2 times. Any price less than 10 times EBIT seems quite fair for a company like this – even without a lot of growth.

I need to explain the “estimates” issue for both EV and EBIT. The company has two noteworthy items. First, it has money losing operations in South America. Today, that is Peru and Brazil. South America contributes 18% of the company’s revenue. However, those operations actually cost the company 3 million Euros in losses. We need to consider those losses in our analysis. But, we certainly should not capitalize them. For example, if we assume Catering International is worth 10 times pre-tax profit – we should not lop 30 million Euros off our valuation for contracts the company can simply stop bidding for in the future. So, this raises the question of whether EBIT is 21 million Euros (companywide) or 24 million Euro (profitable segments only).

And now the cash question. Catering International has 16 million Euros of cash in Algeria. The Algerian government does not want Catering International to transfer that money to a subsidiary that would allow us to consider it net cash at the corporate level. If you count all Catering International’s cash around the world – it comes to 38 million Euros of net cash. If you count all the cash except what’s in Algeria – it comes to 22 million Euros.

So, if you value the company at 10 times pre-tax profit, your decisions on how to treat South American operating losses and the Algerian cash could change your valuation of the company by 46 million Euros. Catering International’s market cap is 192 million Euros. So, the questions are significant. But, an analysis for The Avid Hog, could simply present the best and worst cases. It would almost certainly write-off the Algerian cash entirely because we have no ability to predict court cases in Algeria.

All this talk of Algeria – which is Catering International’s largest market at 22% of revenue – is a good place to tangent toward the special headline risks present in owning Catering International. These risk (mostly) don’t concern me. However, they greatly increase the risk of negative publicity for the company. And some of the potential headlines could make investors – especially investors far from both France and the sites where the company operates – quite uncomfortable.

First, there is the special risk that Catering International’s employees could be violently killed. The company’s largest single subsidiary is Cieptal in Algeria. Over 130 local workers – and one French citizen – of this subsidiary were among the 800 hostages taken at the In Amenas gas facility when it was attacked in January. None of Cieptal’s employees were executed. However, the French employee was hidden and presumably would have been killed if found. About 39 foreigners were killed. They worked for or with Cieptal’s customers at the site: Sonatrach (Algeria’s oil company), Statoil, and BP.

This brings up another risk. Catering International works with companies like Sonatrach that are controlled by governments like Algeria. In fact, local investors have minority stakes in some of Catering International’s subsidiaries. The countries Catering International operates in are often corrupt. Catering International is run from France by French citizens who – in very small numbers – rotate through these countries for short periods of time. So there is a risk Catering International’s French employees will bribe people in these countries. When you consider that Catering International bids for contracts and that they have a stated goal of 500 million Euros in revenue by 2015 (up from 316 million Euros in 2012) the incentive to bribe is high. Furthermore, these are French – not local – employees dealing with local (not French) decision makers in a country where bribery is more common than in France and where the French employee will not be living permanently. This is a good recipe for justifying your own bad behavior.

Of course, as I’ll explain in a moment, many of Catering International’s direct customers are multinational oil and mining companies. But in all cases, Catering International has to set up local subsidiaries in these countries. They may sometimes have to take on local investors in these subsidiaries. And there will always be issues like whether they can access their Algerian cash. So there will be constant temptations to bribe.

Finally, there is simply the public relations problem of a French company doing business in very different parts of the world from where it is headquartered. About 9 out of 10 Catering International employees are local men. In France, the company employees equal numbers of men and women. In the rest of the world, it’s about 9 to 1 men versus women. French employees are paid anywhere from about 4 to 11 times more than local employees. They receive plenty of benefits. They work less. And their employment is more secure. Local employees have a very different situation. To a large extent, this just reflects the relative power position of workers in each country. Workers in France have a lot of power. Workers in the countries where Catering International does its catering have very little power. And women are excluded from much of public life.

On an annual – which is not how local workers are employed – basis, wages are about 3,816 Euros a year in Africa, 5,256 Euros a year in Asia/Pacific, and about 10,284 Euros a year in South America. Catering International makes all its profit in Africa and Asia/Pacific. These are places where employees make less than 6,000 Euros a year.

So, you have the special headline risks of terrorism, bribery, and exploitation. Any coverage of these – or any topic about Catering International – are as likely to have a political angle as a financial angle. So, the experience of holding Catering International may feel a little different than other stocks you own.

With that out of the way, let’s get some basic information about the company. They have 11,600 employees (of which about 88% are local, low-paid men). The company operates at 170 sites in 41 countries. They serve about 120,200 meals a day. Their biggest single market (22% of sales) is Algeria. The subsidiary that now handles all Algerian operations is called Cieptal. It has a website (in French) that you can see here.

Catering International was founded in 1992. It went public in 1998. It has compounded revenue at 40% a year since its founding. Growth in recent years has continued in sales. However, the operating profit picture is fairly mixed (losses in South America have widened). In the latest annual report, the company mentions a sales target of 500 million Euros in 2015. With sales of 316 million in 2012, that would require sales growth of more than 15% a year. If profit growth was anything like that, you’d obviously be paying a very low multiple of 2015 EBIT. Enterprise value – excluding the Algerian cash – is 172 million. EBIT – including losses in South America – is about 21 million Euros. If operating profit grew 15% a year, you’d be paying 5.4 times 2015 EBIT. That’s a very good deal. The reality – because of the South American losses and Algerian cash – might be even better than that. Of course, we don’t know that operating profit will track sales or that sales will grow as expected. However, you can see that by any growth at a reasonable price measure – this is a very, very cheap stock.

Business is conducted in the local currency. Most customers are excellent credits. In fact, legal risk (like the Algerian cash) are probably as meaningful as the risk that a customer would fail to pay due to insolvency. Catering International paid 1.4 million Euros to settle a customer’s claim last year. I imagine this is a company where you will be seeing a lot of items like that from time to time. Last I checked, the company’s Algerian subsidiary was still being prevented from transferring a dividend (of 16 million Euros) out of the country. They filed a claim with the Algerian Supreme Court.

Catering International has a huge list of its subsidiaries. Many are inactive. In the annual report, there is a couple sentence business commentary for many of the active ones. If you’re interested in the company, you should read this list of subsidiaries in the annual report. It’s the highlight of that document.

Instead of reproducing it here, I’ll just focus on a few examples where we know both the name of a Catering International customer and the country where they serve that customer. For a full list of customers, see the back of the 2012 annual report. Almost all are multinational companies active in mining or oil & gas. There are a few exceptions (Nestle is on the list). The exceptions aren’t meaningful contributors to sales.

Examples of customers and countries where Catering International operates are Bechtel in Guinea Conakry, Kinross Gold in Mauritania, Total in Yemen, and Avocet Mining in Burkina Faso.

I think the Yemen business is small. It sounds like they just want to work with Total and show off what they can do outside of catering. Catering International has almost no business in the Middle East. Although they hope to one day do meaningful business in Iraq. Like I said, all profit really comes from mining and oil and gas sites in Asia/Pacific and Africa. None of the other stuff is meaningful.

The company has money losing businesses in both South America (meaningful at 3.8 million Euros in operating losses) and the former Soviet Union (not meaningful). South American operations seem to be ongoing in Brazil and Peru and pretty much just inactive subsidiaries elsewhere. The former Soviet Union includes subsidiaries in Kazakhstan, Turkmenistan, and Russia (the arctic).

The company refers to its employees in New Caledonia (part of France near Australia) in a way that makes it sound like they may be organized. It’s unclear to me whether this “dialogue” has to do with New Caledonia’s special status (and Catering International being a French company) or some past problem with these employees. Generally, my impression of the worldwide workforce is that they are local, low paid men who are not unionized.

So what’s the verdict?

It’s unlikely Catering International will make it into The Avid Hog. The stock is statistically attractive in both a “magic formula” and “growth at a reasonable price” way. It will probably perform well. And it would make an excellent addition to a diversified value portfolio.

However, there is not enough information on how a customer decides to go with Catering International. The company’s customers are very large multinationals who do not provide details on such information in their own reports. The business is far from the consumer. And I do not know a lot of people in this industry or these countries.

This is a research problem. I don’t have – and am unlikely to get – enough info about the actual purchase decision. I don’t see a way to gain enough confidence in the future behavior of customers when it comes to their catering needs. And I know nothing about Catering International’s competitors.

Basically, the annual report wasn’t informative enough about what I most need to know. So, unless someone emails me after reading this to tell me they know a lot about Catering International specifically or catering at these sites generally – I just don’t see a path forward for this company.

So, I’m suggesting Catering International as a stock blog readers should be interested in. But I’m also passing on it for The Avid Hog. This one is a “no”.

Talk to Geoff about Catering International (CTRG:FP)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

New Value Investing Blog: Moatology

by Geoff Gannon

There’s a new value investing blog called “Moatology”. This post on Pulse Seismic is a good example of what the blog does best. Moatology brings you good businesses you haven’t heard of. If you’re looking for a value investing blog to add to your reading list, check out Moatology.

Talk to Geoff about Moatology

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

Quan’s Avid Hog Watchlist: Berendsen (BRSN:LN)

by Quan Hoang

The following stock may appear in a future issue of The Avid Hog.

Berendsen provides textile cleaning and supply services in Europe. Berendsen’s textiles include uniforms for customers from fire fighters to doctors, road workers and chefs. Berendsen provides mat for facilities and linens for hospitals, hotel, restaurants, etc.

The company operates in 15 countries throughout Europe. Most of its business comes from the U.K., Germany, and Scandinavia. Berendsen purchase textiles and then rents them to customers. They then maintain and launder these textiles periodically.


3 Layers of Durability

I think Berendsen is among the most durable businesses I know. Berendsen’s durability has 3 layers.

First, I think in 30 years, people will still need uniforms and linen. You must stay close to customers to collect, launder, and deliver textiles regularly. So, there’s no threat from low cost providers in China.

Second, the local nature of this rental business means Berendsen’s durability is equal to its customers’ durability. Most customers are service providers like hotels, hospitals, and fire departments. So they will stay in Europe forever.

The third layer comes from diversification. Berendsen serves customers from 180 plants. Each plant stays close to a major center of commercial activity and serves customers within a radius of 100 km (62 miles). So, if something happens to a plant, it has less than 1% impact on the company.


Wide Local Moat from Economy of Scale

I think Berendsen has a wide moat thanks to economy of scale. Local scale is important as the management mentioned Berendsen has the highest return where it has density and scale. Local scale maximizes plant utilization and asset turnover.

Also, it’s costly to collect and deliver textiles to customers. Distribution cost is 20% of Berendsen’s sales. A new competitor without local density may have to spend 30% of sales on distribution cost and therefore make little profit.

High plant utilization and good profit margin allow Berendsen to make about a 25% pre-tax return on net tangible assets.

It’s impossible for a new competitor to enter a local area where Berendsen is already big. A competitor must sign contracts with a lot of customers to gain scale. Berendsen has 250,000 contracts around Europe. That’s close to 1,400 contracts per plant. And these contracts last 1 to 3 years. Assuming that a competitor can sign up a new customer whenever a contract expires, it still takes at least 3 years to build up scale. That competitor will surely lose money during the ramp up period.


Capital Allocation Creates Value

Berendsen is really a capital allocation story. The company changed its name in 2010. It was formerly The Davis Service Group. The Davis Service Group acquired Berendsen in 2002. Davis was originally a car dealership in the U.K. They entered the textile rental business through the acquisition of Sunlight Services in 1987.

The company entered and exited different businesses over time. They made a lot of acquisitions. But on average, they created value for shareholders. Since 1998, Berendsen compounded sales and EBITDA by 6.5% and 6.1% respectively. They achieved that by retaining only half of free cash flow. So, Berendsen effectively made 1a 2% return on investment over the period.


A Perfect Candidate for Defensive Investors

The share price is not cheap but is relatively good. At 995 pence per share, the market cap is now £1,650 million. Net debt is £476 million. So, EV is £2,126 million. Berendsen made £146 million EBIT last year. EBIT grew 13% in the first half of 2013. But based on 2012 number, the EV/EBIT ratio is 14.6. That’s about 5% after-tax earnings yield.

A 14.6 EV/EBIT ratio is too high for most companies. But for a predictable company like Berendsen, long-term investors can still make an adequate return.

Berendsen’s growth is tightly related to GDP growth. The company targets 1-2% organic growth ahead of GDP growth. That makes perfect sense given that there’s a huge market potential from customers who have never outsourced. So, organic growth can be 3-4%.

Berendsen makes 25% pre-tax return on net tangible asset. So, they need to retain less than 20% of earnings to grow sales by 3-4%. Therefore, at today’s price, investors can expect about a 7-8% return.

Berendsen won’t actually return 80% of earnings to shareholders. Berendsen historically returned 50% of earnings. They made bolt on acquisitions. I expect those acquisitions to create value as proven in the past. Berendsen usually acquires small competitors that are family-owned. The reason for sales of those businesses is usually generational shift rather than economic factors.

So, I don’t think it’s aggressive to expect Berendsen to grow sales by 6% in the future as they did in the past. Along with today’s 3% dividend yield, the expected return would be 9%.

Investors should also keep in mind that earnings can grow slightly faster than sales. I think margins tend to increase over time in this business. That didn’t happen in the past at Berendsen. But the company is focusing on improving margin in the near term. So, margin expansion can be a nice surprise.

Berendsen is not cheap, but it’s among the most predictable businesses I’ve ever seen. It’s a perfect candidate for defensive investors. At today’s price, I wouldn’t buy the stock. However, Berendsen is definitely among my top candidates.

Talk to Quan about Berendsen

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.

How to Quantify Quality

by Geoff Gannon

Someone who reads the blog sent me this email:

I kind of understand the quantitative part of stock analysis (such as number crunching, valuation) but really struggle to understand the qualitative aspects which determine quality. What kinds of questions to ask yourself in order to gain more insights into the qualitative?

A qualitative analysis does not have to be any less evidence based than a quantitative analysis. However, you do have to gather the evidence yourself.

What counts as evidence? How can we separate our own biases, speculation about the future, etc. from actual observations of quality? Evidence is fact based. Facts come in several flavors.



Example: Tiffany’s New York Flagship Store had $305.54 million in sales in 2012. That is $6,671 per square foot. Based on calculation made from data given in Tiffany’s 10-K on percentage of sales at flagship, worldwide net sales, and gross retail square footage of flagship.



Example: John Wiley, Reed Elsevier, Springer, etc. have bargaining power with their customers.

The largest (academic journal) publishers wield the power…as a former colleague of mine once said, ‘the more journals you have, the higher your usage stats are and the more money you can charge.”

Based on discussion with a university press editor.



Example: Over the last 10 years, I have placed an average of one order every 4 to 10 days with Amazon. At no point in the last 10 years, have I ever made less than one order every 10 days. I have been a member of Amazon Prime since 2006. The number of orders made each year has roughly tripled from 2003 to 2013. It doubled after I became a Prime member.

Based on information found in my own order history for 2003 to 2013 at Amazon.



Example: The 4 most successful periods in animation were at 3 companies: Disney (twice), Pixar, and DreamWorks. At the time of their success, these companies were run by Walt Disney, Jeffrey Katzenberg, John Lasseter, and Jeffrey Katzenberg (again). All worked at Disney at some point in their career.

Based on more than half a dozen books on Disney, Pixar, and DreamWorks.




377 participants were assigned to (Weight Watchers), of whom 230 (61%) completed the 12-month assessment; and 395 were assigned to standard care, of whom 214 (54%) completed the 12-month assessment. In all analyses, participants in the commercial programme group lost twice as much weight as did those in the standard care group.

Based on a journal article appearing in The Lancet.


As you can see, there is no need to be less evidence based when analyzing a business’s quality than you are when analyzing its price. However, you have to impose an evidence based discipline on yourself. You have to go through the primary sources and extract the relevant facts on your own. They will not be presented in as easily digestible form like an EV/EBITDA ratio on Yahoo Finance. When it comes to quality, you need to gather the evidence yourself.

Talk to Geoff about How to Quantify Quality

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Quan’s Avid Hog Watchlist: Q-Logic Corporation (QLGC)

by Quan Hoang

Geoff and I actually decided to drop Q-Logic (QLGC) from The Avid Hog’s list of candidates a while ago. Q-Logic doesn’t fit the kind of business The Avid Hog is looking for. But I think it may fit the taste of some readers of the blog. That’s why I’m writing this post.


Parent and Child Turned into Competitors

The story started in 1994 when Emulex spun off Q-Logic. Q-Logic was then focused on disk controllers that help CPUs communicate with disk drives. Emulex focused on its networking business.

Servers in data centers used to have disk drives that are attached directly to them. But as the number of servers deployed in a data center increased, it became more difficult to manage isolated storage resources. Therefore, a new storage architecture named Storage Area Network (SAN) was developed.

SAN allows data center to centralize storage into one place. Servers get data from the storage pool through a network. SAN helps reduce cost because it reduces excess capacity required for each server. SAN also makes it easier to manage storage or add more storage.

A protocol is required for servers to talk to the storage pool. Fibre Channel (FC) is most popular protocol for SAN. FC to SAN is like Ethernet to Local Area Network (LAN).

The development of SAN means the convergence of storage and networking. Emulex with its core in networking made experiments with SAN. Q-Logic with its focus on disk controllers made an early investment in SAN. The parent and child turned into competitors. But that was a lucrative rivalry.


High Switching Cost Results in a Wide Moat

Both Emulex and Q-Logic produce FC adapters. FC adapters sit in servers and help servers talk to the SAN. As is the case in any hot industry, there were dozens of competitors. But the industry eventually settled, and Q-Logic and Emulex together have held over 90% of market share over the last decade.

Both companies’ margins are very high. Q-Logic has about a 67% gross margin. Emulex has about a 64% gross margin. That’s incredible! That means Q-Logic can consistently charge giant customers like IBM, HP, and Dell three times what it cost to make a FC adapter. That’s a good indicator of some competitive advantage.

It turns out that the competitive advantage comes from high switching cost. FC adapter accounts for less than 7% of total SAN cost. Yet, it’s critical to the SAN’s performance. And people who manage the storage are conservative. Their job is to provide reliable and consistent availability of information. They just want to maintain the robustness of the SAN. My discussion with an industry expert illustrates this switching cost:

Expert: For storage environments, companies need to fully test interoperability and performance of a driver with the applications. The testing and validation of a new driver can take over 6 months, so there is a disincentive to change adapters. The operational expenses of managing the environment and maintaining the robustness of the stack typically outweighs any capital costs.
Quan: Are these tests performed during OEMs qualification or performed with each end-customer (enterprise customers)?
Expert: The vendors/OEMs do product interoperability (adapter/server/switch/storage), but customers need to bake their full software stack (applications). This is a per-customer basis.
Quan: When customers upgrade to 16Gbps FC, do they need to install new drivers and a new test that would take 6 months? Or do Q-Logic and Emulex produce new HBAs or CNAs that work with old drivers that customers already had?
Expert: While the 16Gb FC HBAs do have the same drivers, large enterprises typically will still do the testing. There is no "standardized" application stack, so while the OEMs do plenty of testing (enough for some customers), the big customers that buy the bulk of the adapters will still need to verify. From the time that a new generation of adapter is released, it usually takes at least 3 years before 1/3 of sales are the new generation. Baking out the end-to-end takes time (16Gb FC still isn't on most storage arrays today), negotiating new contracts, running through old inventory, etc. The HBA business is an arcane one...
Quan: When large enterprises upgrade their SAN and do the testing, does the testing interrupt the data center's operations? And would they upgrade all components of the SAN (HBAs and switches) at the same time or would they upgrade switches before HBAs?
Expert: Switch upgrades (transparent to the application, no driver) are much easier than HBA. Typically new HBAs are put in new servers, so there is the waiting for a refresh cycle to do it. The whole environment is usually tested in a sandbox.

Once a customer successfully tests a FC adapter, there’s no incentive to switch. Q-Logic wisely make new adapters compatible with existing drivers. So, customers naturally stick to Q-Logic through each upgrade cycle. Also, Q-Logic has a reputation of being the first to market. They were always the first to introduce a new adapter in each upgrade cycle. That helped them gradually increase market share.


Q-Logic Repurchased a Half of Its Shares

The FC adapter business became Q-Logic’s cash cow. Since 2001, Q-Logic generated $1.8 billion of free cash flow, averaging $139 million a year.

Unlike management of most tech companies, Q-Logic’s management just focused on protecting the core. They made some investments adjacent to the core but couldn’t find a new cash cow. Most of free cash flow was used to repurchase shares. Since 2001, they spent $1.9 billion in share repurchase. The share base declined from 185 million in 2001 to 89 million today.


Mr. Market Is Extremely Pessimistic about Q-Logic

Q-Logic currently has $433 million of cash. The market cap is $1,080 million. So, they can buy 40% of the company immediately. The reason they didn’t do that is most of the cash is offshore. But it’s totally possible that they would borrow money in the US and repurchase shares like most tech companies. Given potential FCF from the core business, it’s safe to expect that if share price doesn’t go up, Q-Logic can eventually repurchase half of the company.

Q-Logic made only $83 million FCF last year. But they’re in the low point of a cycle. 40% of their business is from the government and financial sectors. Capital spending was weak in those areas in the last year. And it will be weak in the near future. Q-Logic is also spending a lot of money in some new products. R&D is higher than normal. But it’s for growth. Q-Logic can always cut back R&D and improve FCF.

So FCF may one day return to about $139 million a year. That translates into about $3.12 FCF per share. Even at 10x FCF, the stock price in 5 years would be $31.20. If that happened, it would provide a 21% CAGR from today’s $12 per share price.

It seems that Mr. Market doesn’t pay attention to Q-Logic’s cash balance. Q-Logic’s EV is $647 million. That’s close to Emulex’s EV of $586 million. However, Q-Logic has more market share than Emulex and is much more profitable.


The Core Business Is Declining

So, why did we drop Q-Logic?

It’s because of durability. I don’t have a clear view of Q-Logic’s future. There are two main threats to Q-Logic.

The first threat is from iSCSI. iSCSI is a protocol for SAN but using the LAN network. It’s cheaper and more convenient than FC. But it’s not as robust. iSCSI is strong with small enterprises that have fewer than 100 servers. Although iSCSI didn’t make a dent into FC, it did block FC’s growth.

The second threat is from cloud computing. It’s widely accepted that enterprises are shifting computing to the cloud. Unfortunately, cloud service providers may use different storage architectures. Big cloud providers like Google, Amazon, or Facebook use commodity storage instead of the expensive SAN. Other solutions might be iSCSI, network-attached storage, etc.

I think Fibre Channel will stay for many years. Q-Logic’s customers are big enterprises. There’s a huge institutional inertia to move their computing to the cloud. Sequoia’s discussion on IBM shows they have the same expectation:

IBM has said that the cloud is probably its biggest threat. IBM has said it is a $7 billion revenue opportunity but that $4 billion would be a shift of revenue that the company could lose to the cloud. So the management thinks it is a $3 billion opportunity over the current roadmap. That shift would happen — and that is obviously what you would be most concerned about — that shift would primarily happen in hardware because cloud vendors would buy a lot of commodity servers, put them all into a pool and sell by the drip again. Their scale could really further commoditize that business. Luckily, IBM is relatively small in that area. There are also some services that could be obviated. IBM does provide a lot of services to build the internal IT infrastructure, which could be outsourced to the cloud. But typical large enterprises have not just one or two applications, but thousands if not tens of thousands of applications. Today, they often rely on IBM to manage them. Even if a lot of these applications moved to the cloud, they would still require the ones that remain onsite to be able to communicate with the ones that they have moved to the cloud. Companies would still need integration and training to make sure that their business processes work with the new applications. So while there may be some shift away, we still think that IBM services will have work to do even in an era of cloud applications. We think that the trend is quite long-term. As I said, the spending on cloud computing is nascent right now. IBM is cognizant of the fact that over time this will be a more desirable way to consume corporate IT. Recently management has said that outside of a couple of core applications, things that are unique to a company and the company would want to keep in-house, up to 90% of the rest of the applications could be in the cloud, but it will take a very long time. In the meantime customers will want IBM to help them with that transition. IBM, by the way, sells ... you should think of it as, to a significant degree, a software company because 45% of the profits are coming from software. IBM is going to offer that service or all that software as a service over the cloud itself. So IBM will be able to take advantage of that opportunity as well.

Roughly speaking, 90% of servers in big enterprises will be moved to big cloud over a very long time. Meanwhile, small companies or companies growing big wouldn't build a big in-house data center. So, Q-Logic's core business will decline gradually.


The Avid Hog Wants Almost Risk-Free Investments

Q-Logic is definitely not a good buy and hold investment. It might be cheap. A turn in spending cycle may give investors some last (good) puffs. But it may or may not happen.

So, an investment in Q-Logic has high potential return but also high risk. It would fit a diversified investment portfolio perfectly. But it doesn’t fit The Avid Hog. The Avid Hog is interested in investments with almost zero risk. So, we want a sustainable moat. We want durable products. And we avoid “unpredictable” declining businesses.

Q-Logic is in an “unpredictable” declining business. The Men's Wearhouse (MW) might be in a declining business but it’s not unpredictable. There is always demand for suits, and surviving companies don’t necessarily decline. But for Q-Logic and Emulex, we don’t know how fast the demand for FC will decline. And in tech, declining really means dying.

Talk to Quan about Q-Logic (QLGC)

Try Before You Buy: To sample the current issue of Geoff and Quan’s newsletter, The Avid Hog, just email Subscriber Services and ask for a copy.