New Oaktree Capital Memo: The Race is On

I absolutely love reading Howard Marks Memos and he has released a new one. Here is the opening paragraphs with a link to the rest, his website is littered with additional memos and is a great resource. Also Check The 20 Most Important Things Proposed By Howard Marks (Part I Of IV) 

 Memo to: Oaktree Clients

By: Howard Marks

Title: The Race is On

I’ve written a lot of memos to clients over the last 24 years – well over a hundred. One I’m particularly proud of is The Race to the Bottom from February 2007. I think it provided a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008. I wasn’t aware and didn’t explicitly predict (in that memo or elsewhere) that the unwise lending practices that were exemplified in sub-prime mortgages would lead to a global financial crisis of multi-generational proportions. However, I did detect carelessness-induced behavior, and I considered it worrisome. 

As readers of my memos know, I believe strongly that (a) most of the key phenomena in the investment world are inherently cyclical, (b) these cycles repeat, reflecting consistent patterns of behavior, and (c) the results of that behavior are predictable. 

Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors. In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can’t raise money). This memo is about the cycle’s first half: the manic swing toward accommodativeness. 

An aside: I recently engaged in an exchange with a reader who took issue with my use of the word “cycle.” In his view, something is a cycle only if it’s so regular that the timing and extent of its ups and downs can be predicted with certainty. The cycles I describe aren’t predictable as to timing or extent. However, their fluctuations absolutely can be counted on to recur, and that’s what matters to me. I think it’s also what Mark Twain had in mind when he said “History doesn’t repeat itself, but it does rhyme.” The details don’t repeat, but the rhyming patterns are extremely reliable. 

Competing to Provide Capital 

When the economy is doing well and companies’ profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated. 

When investors and lenders want to make investments in greater quantity, I think it’s also inescapable that they become willing to accept lower quality. They don’t just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things. 

This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn’t always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting…. Article Continued Here

Kimberly Clark Corporation Prepares Another Spin-Off

Background of the Proposed Spin-Off

On November 14 Kimberly Clark announced the board of directors had authorized management to pursue a tax-free spin-off of the health care business, currently planned for 3Q, 2014. A spin-off would create a stand-alone, publicly traded health care company with approximately $1.6 billion in annual sales, 70% of which are derived from North America and net sales and leading market positions in both surgical and infection prevention products and medical devices (the maker of surgical masks, catheters, surgical gowns and drapes and other sterile supplies.) Robert Abernathy joined Kimberly-Clark in 1982 and is currently Kimberly-Clark Group President. He and 16,000 other employees would lead K-C Healthcare globally.

Chairman and Chief Executive Officer Thomas J. Falk had this to say, “While K-C Health Care has been part of our company since the 1970’s, its strategic fit and growth priorities have changed over time and we now think that pursuing a spin-off makes sense for our shareholders. This move would allow K-C Health Care to optimize its performance and flexibility to pursue its own value-creation opportunities. A spin-off would also allow us to further sharpen our focus on our consumer and K-C Professional brands. This announcement is further evidence of our focus on creating shareholder value and how we use portfolio management to run our company.” “I think the two companies will be better run as separate organizations rather than together,” he added.

More Information on K-C Health Care

K-C Health Care sells surgical and infection prevention products for the operating room and a portfolio of innovative medical devices focused on pain management, respiratory and digestive health. The business has the number one or number two market position in several product categories in the United States, including sterilization wrap, face masks, surgical drapes and gowns, closed suction catheters, pain pumps and enteral feeding tubes. K-C Health Care is a global leader in education to prevent healthcare-associated infections. Products are sold primarily under the Kimberly-Clark and ON-Q brand names. Total net sales are split approximately 70 percent surgical and infection prevention products and 30 percent medical devices. The business had more than 16,000 employees at the end of 2012, with a large majority located in low-cost manufacturing operations in Latin America and Asia. Business unit headquarters are in Roswell, Georgia.

Previous Kimberly Clark Spin-Off Performance

Neenah Paper (NP) Spin-off in 2004

Neenah Paper was named after the Kimberly Clark headquarters in Wisconsin and has two primary operations: technical products business and fine paper business. The Company’s technical products business is a producer of transportation and other filter media and coated substrates for industrial products backings and a variety of other end markets. The Company’s fine paper business is the supplier of writing, text and cover papers, bright papers and specialty papers in North America. The Company’s writing, text, cover and specialty papers are used in commercial printing and imaging applications for corporate identity packages, invitations, personal stationery and corporate annual reports, as well as, labels and packaging.

Revenue is up a total 65% since 2004 and the share price has appreciated, although not significantly. Ownership has continued to be diluted with an additional 2M shares introduced than was available in 2004, (14.7M vs. 16.5M) and equity has grown at roughly 3.5% for the last ten years, not spectacular value creation.

Below is a chart of the two years after the spin-off and the subsequent price performance of the company.

Midwest Express IPO in 1995 – Taken over by Republic Airways Holdings

Midwest had deep roots within the company and originated as a tool to shuttle executives around the country. Midwest was previously known as K-C airlines and Kimberly Clark sold the company in an initial public offering during September 1995.

A take over bid ensued and on August 14, 2007, AirTran increased its offer to the equivalent of $16.25 a share, slightly more than the $16 a share from TPG Capital investors group. However, Midwest announced TPG would increase its offer to $17 per share and a definitive agreement had been reached late on August 16, 2007.

On August 17, 2007 TPG and Northwest Airlines finalized their bid for Midwest with the final offer of $17 per share and a total deal of $450 million.

On February 1, 2008, Midwest Air Group announced that the US Department of Justice had cleared the acquisition of Midwest by TPG Capital and Northwest. This finalized the acquisition; trading of Midwest Air Group on the American Stock Exchange ceased at the end of the trading day on January 31, 2008, and stockholders in Midwest received the agreed-upon $17 per share. This ended the independent existence of Midwest Airlines.

On June 23rd, 2009 Republic Airways Holdings, Inc announced it would acquire Midwest Airlines for $31 million and is currently operated as a wholly owned subsidiary. The total loss of investment by TPG and Northwest was 93% or $419 million.

I was unable to find concrete data (in the limited time I had to conduct the research) on the performance of the individual subsidiary since acquisition in 2009 compared to the 1995-1997-time period, I would assume it is far worse. This assumption is based on examining the 1995 annual report and options with the nearest strike of $18 compared to the takeover price of $17, twelve years later. The ultimate winner of the Spin-off was Kimberly Clark, divesting a money losing business in an idiotic industry of airlines.

Schweitzer-Mauduit, Cigarette Paper Manufacturer (SWM) – 1995 Spin-off

This is the big winner of the portfolio of spin-offs and logically makes the most sense. The price has increased by around 500% since 1995, not including dividends. The Company manufactures and sells paper and reconstituted tobacco products to the tobacco industry as well as specialized paper products for use in other applications. The primary products in the group include cigarette, plug wrap and tipping papers, or Cigarette Papers, used to wrap various parts of a cigarette and reconstituted tobacco leaf, or RTL, which is used as a blend with virgin tobacco in cigarettes, reconstituted tobacco wrappers and binders for cigars. These products are sold directly to the tobacco companies or their designated converters in the Americas, Europe, Asia and elsewhere. Non-tobacco products are a diverse mix of products that includes low volume, high-value engineered papers as well as commodity paper grades produced to maximize machine utilization.

The company was up over 50% in the two year span after it was spun-off from Kimberly Clark as shown in the chart below.

All fundamentals have had impressive growth since the spin-off and this is the only winner of the three most recent spin-offs by Kimberly Clark.

Conclusion

K-C is 2 for 3 in regards to value creation at the parent (KMB) but they are batting 0.333 when it comes to providing lucrative deals for the capital markets to absorb. It is early, and much of the information regarding the deal will be coming in 2014 so I can not say wether the deal is enticing to me or not, but the health care business priced attractively, could be a big winner by 2017. 

Anytime a Fortune 500 or another high profile company is spinning off a subsidiary, I will take the time to follow the story. Abbott Labs, Liberty Global, and Liberty Media Corporation are great examples from 2012-2013.

The Great American (Ponzi) Scheme – Capital Intensive Businesses And Diminishing Returns

“A growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.” – Warren Buffett

(I will do this experiment after my finals and post an article to follow.)

Above was a small discussion from Warren Buffett in one of his annual letters to shareholders about the pitfalls of investing in yesterday’s winners. This article is based from the small excerpt from John Train’s“The Money Masters” under the first chapter on Warren Buffett, the final entry being “The Great American Jam Tomorrow Ponzi Scheme.”

Buffet explained in 1980 that a large portion of American enterprises are at risk and investors should stay clear of them, based on the massive investment that they will have to make. The cause of the large investments these companies must make is regulation, competition, rising labor costs, globalization, pursuit of productivity improvements, higher obsolescence rates than depreciation, etc.

Essentially, these companies need endless amounts of (net) new cash, and of course, this (net) new cash offers interest and dividend payments in the mean time to induce investors to continually partake in the illusory party. Dividends are continually increased to push equity prices higher then further secondary offers commence to pay for additional capex and dividend liabilities, diluting shareholders and ending in most cases with an eventual dividend cut. Other wise investors will continually stake money in mandatory rights offerings to continue to own the same percentage of the company. The chances investors ever actually see their (full) capital returned is slim, let alone with a satisfactory return, either due to dilution, bankruptcy, or take-overs below investors average costs.

Buffett described this process in a simple phrase, “Jam yesterday and jam tomorrow, but never jam today.” Companies that continually issue bonds or offer equity, while paying a dividend or are simply net users of cash (after honest depreciation plus competitive capex) and never actually provide net cash over long periods of time, could be classified as a Ponzi scheme. These companies have an obsolescence rate that is faster than their allowable depreciation, thus creating bottomless capex pits.

Buffett uses an example of Ford Motor Company (in 1980): “Ford doesn’t ordinarily pay enough dividends to give its own shareholders after taxes, the equivalent of 100,000 cars a year out of the 6-odd million that it makes. All that money, that huge plant, those many generations, and still the impact of higher costs, taxes and foreign competition mean that the owners can’t even claim 2% of the output.”

These companies need to retain earnings continually to pay for improvements and new plants, machinery, equipment, etc. Like most of us would know and agree, compounding capital or interest can work in the opposite direction, although asymmetrically (meaning a 50% loss must be made up by a 100% gain).

The key here is increasing your purchasing power in real terms, not absolute values. Buffett provided another three examples of capital-intensive businesses in “heavy” industries. The examples were AT&T, American Airlines and General Motors (ironically GM he now owns).

AT&T can be classified in the “ratchet up” dividend-equity offering strategy outlined above, coupled with large bond offering to finance capex, acquisitions and dividends. General Motors is a similar example to the Ford example provided; scroll up for a refresher.

In regard to American Airlines, Buffett mentioned it only turns its capital (including leased equipment and facilities) once a year. He said on that basis it would need to realize close to 20% pre-tax profit margins on sales in order to net 10% if financed by equity capital. This would put American Airlines at the time at the top of the industry for pre-tax profit margins. (It has gone bankrupt in the mean time and is planning to to exit after a recent federal judge approval).

Buffett when talking to an executive of a capital-intensive business (anonymous) asked, “Why don’t you buy back your own stock? If you like to buy new facilities at one hundred cents on the dollar, why not buy the ones you know best and were responsible for creating twenty-five cents on the dollar?” 

The executive responded, “We should.” 
Buffett: “Well?”
Executive: “That’s not what we’re here to do.”

He didn’t buy the stock.

The 26 Best Twitter Follows for 2013 (Investing & Business)

It is a little early to call it a full year, but heck has it been a quick one. I would like to put together a quick list of people I follow on Twitter for insightful news, comments and articles for people who may be new to the service (after the publicity of the recent I.P.O) or a user simply looking for an enriched feed.

(My Personal) TOP 26  Twitter Followers for 2013, in no particular order:

@Valuewalk

@gurufocus

@oddballstocks

@EddyElfenbein

@manualofideas

@jasonzweigwsj

@dealbook

@Greg_Speicher

@JournalofValue

@basehitinvestor

@GeoffGannon

@valuetakes

@GSpier

@Jae_Jun

@nntaleb

@farnamstreet

@ritholtz

@SajKarsan

@ReformedBroker

@MebFaber

@turnkeyanalyst

@muddywatersre

@jacobWolinsky

@MicroFundy

@CanadianValue

@AswathDamodaran

Competitive Analysis And The Fallibility Of The P/E Ratio

How does one go about systematically comparing companies within a given industry? Do you compare P/E ratios? EPS? Sales growth? ROE? PEG ratios? All are conventional metrics that may seem integral to the investment process, when in fact, they all may be mis-leading.

Take the given example of company “A” with a price of $10,000, sales of $12,000, net earnings of $1,000 and sales growing at 10% per annum. While company “B” also has a price of $10,000, the sales are $10,000, with earnings of $900 and sales growing at 10% per annum. Both also have $5,000 equity. At first glance you may think company “B” is priced higher based on the conventional PEG ratio of 1.11 versus 1, the P/E of 11.11 versus 10 and equal sales growth (Ceteris Paribus). 

Now you may take the opposite opinion that company “B” is of higher quality due to the net margin percent or how efficiently they convert sales to net income. I would argue that the information is incomplete and we must ask ourselves how much capital was used to produce the sales (working capital) as well as how much capital (capital expenditures) will be needed to sustain the 10% growth in the future. 

 

I would side with both Buffett and Greenblatt on the importance of the working capital profitability ratios (Sales/(Current Assets – Current Liabilities), used in combination with both ROIC and inventory turnover (including fixed assets, says Buffett) when determining companies financial strength in a given industry. Greenblatt does not include goodwill or intangible assets due to the complexity of valuing these assets accurately (brands, patents, excessive purchases, etc.) and uses the following formula:

EBIT / Fixed Assets + Working Capital = Return on Capital

A company’s ROIC may be compared to the company’s weighted average cost of capital as another source of efficiency. When you calculate the ROIC, working capital profitability ratio and inventory turns within a given industry, it is a great heuristic to take the top ranking company and further analyze the cash flow stream expected in the future, finding an appropriate present value of the cash flows.

The company with the highest ROIC and working capital profitability ratio is likely dominating the industry and will probably continue to do so, as this is clearly a competitive advantage. If you think about it logically, the company is able to turn a higher profit for each dollar invested, enabling them to grow at a faster pace than competition. If the growth rates are essentially the same (like in the example above) the company will use less capital to produce the gains thus leaving a larger surplus for shareholders.

Over time, due to the creative destruction of capitalism, margins will compress (higher costs, lower prices) and the most efficient company will be able to pass their savings to the consumer through further price cuts or simply charging more in relation to costs (higher gross margins) than competitors. The company that is the most efficient will prevail, likely gaining a larger share of the market than it previously had. This is under the assumption of a free market, and the companies in the industry do not participate in a monopoly or duopoly and prices are not regulated or fixed.

Back to our example of company “A” and “B.” You may be asking, “Okay, so ROIC is better than P/Es and PEGs, but why are they fallible and what is wrong with ROE?” Well, simply stated, due to the effect of depreciation, taxes, and other cost cutting, income can be easily manipulated and over-stated/under-stated depending on managements’ incentives. In our example, company “A” had $1,000 net income and company “B” had $900, assuming both have equity of $5,000 the ROE of company “A” would be 20% while company “B” would be 18%. Well, it just so happens company “B” has higher deprecation charges (due to a previous acquisition), sheltering some of the taxes with a non-cash accounting entry, had a $100 NOL carry forward and is a royalty-based businesses (uses no or very little additional capex and working capital) to produce its income. Essentially, company “B” had higher net income when we account for the higher depreciation and $100 NOL, as well as a clear competitive advantage, efficiently allocating capital. The choice is an obvious one now… or at least I hope.

Finally (for this post) it is important to understand the elasticity of demand of a particular product or service. Essentially, what are the alternatives and at what price will a consumer make the switch. Take a recent investment of Berkshire in Heinz, a well-known brand of ketchup in almost every house in North America. It is a globally recognized brand and if they decided to raise the price 2% to 5% above their competitors each year, it is unlikely a large exodus would occur. Like they say, “Heinz and no other kinds.” Another great example is toothpaste brand Colgate. When a product is being used in an area as sensitive as my mouth, I want a product I know and trust. I am not going to buy mystery brand “X” to save myself 10 cents on a $2.50 purchase. Colgate could actually raise the price a quarter, maybe even 50 cents and I would continue to pay it, also known as a low elasticity of demand or inelastic. Contrast a pair of socks: I really don’t care what brand I put on my feet and want the absolute cheapest per unit price I can find. Demand is elastic.

In “The Money Masters” there is a small excerpt I would like to end with from John Train provided below:

When a media executive asked a friend of the Wall Street Journal why it did not tie its ad salesmen’s compensation more closely to their productivity, the friend replied, Well, the salesmen would just go across the street.” The executive answered, “There ain’t no across the street from the Wall Street Journal. These types of businesses make for excellent investments.