The Importance Of Capital Intensity And Thoughts From Einhorn

It seems as though there has been a recent debate on going within the value investing community pertaining to ROE, ROIC and net-nets. At one hand of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating 2) The economic value the business earns is not enough to cover the cost of the capital used to generate it and 3) The company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8000

Accounts Receivable: $5000

Inventory: $2000

Long-Term Debt: $4000

Accounts Payable: $1000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year and you get your equity in the form of machinery. Keeping all variables constant in 5 years the company will have NCAV of $7,500, cash will be $5500, sales will be $10,000 (or less) and income will be $1000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters and it is imprudent to invest blindly in anything.   

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what Einhorn had
to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.”

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE.

There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE.”

ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the Dupont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10-years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would of course depend on the opportunity cost of your $100 during the next 10-years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Discount Rate Capitalization Factor Cash Flow Net Return Break Even Borrowing
6% 1.79 $143.27 $43.27 $55.84
7% 1.97 $157.37 $57.37 $50.83
8% 2.16 $172.71 $72.71 $46.32
9% 2.37 $189.39 $89.39 $42.24
10% 2.59 $207.50 $107.50 $38.55
11% 2.84 $227.15 $127.15 $35.22
12% 3.11 $248.47 $148.47 $32.20
13% 3.39 $271.57 $171.57 $29.46
14% 3.71 $296.58 $196.58 $26.97
15% 4.05 $323.64 $223.64 $24.72

Depending on my discount rate, for every $0.01 above the breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the Triple play. What is a triple play? Most baseball fans will understand the sports reference but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there is many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

The Troika Of Ebola Speculation

In the last week we have witnessed a few low-float stocks become Ebola speculation targets as the first confirmed case in the U.S was announced September 30th, 2014. It is fascinating to watch these narratives unfold and low-float momentum plays be ignited as pools of capital cohesively and strategically buy-in. Understanding how the market operates, how media cycles affect expectations and how market participants influence each other asymmetrically are key characteristic of understanding the manic-depressive nature of Mr. Market.

First you may be asking what in the world is a Troika. It is a harness used for three horses to pull a sled in the 19th century.

[Figure 1: Troika Example]

What is speculation exactly?

Speculation is: “the forming of a theory or conjecture without firm evidence.”

VOLUME

That is exactly the dynamic that seems to be unfolding over the last few days in the personal protective gear makers, Lakeland Industries, Versar Inc., and Alpha Pro Tech Ltd. When a company trades its entire float a few times in one day, it is a sure sign speculation is brewing. Since Oct. 7th, (eight trading days ago) all three of these companies have risen over 150%+ while the float was traded an exuberant amount of times.

Company Float Size
LakeLand Industries (LAKE) 4.2M
Versar (VSR) 8.04M
Alpha Pro Tech (APT) 14.77M

In the last eight days Lakeland Industries float has traded 30+ times and the 30-day average daily volume is now 4.86M shares or 120% of the float. The last example of a low-float momentum theme that is quite similar is Digital Ally, a manufacturer of police cameras. Digital Ally had a 2.24M share float and from Aug. 19th to Sept. 2nd (during the Ferguson fiasco) there was cumulative volume of 114 million shares or 51x the float in 11 trading days. The share price during the period went from $3.70 to $33.50 and is currently trading for $10.60 as of this writing.

chart-3
LAKELAND

The narrative at play seems to be Hazmat suits are needed for the Ebola epidemic, there are bagged shorts in these low-float names and there are concentrated hands holding back supply. The media frenzy does not help and the lack of education behind how the disease is spread (direct fluid contact versus airborne) also fuels the fire. LakeLand Industries put out a PR and the president and CEO Christopher J. Ryan explained:

“With the U.S. State Department alone putting out a bid for 160,000 suits, we encourage all protective apparel companies to increase their manufacturing capacity for sealed seam garments so that our industry can do its part in addressing this threat to global health.” 

And PCI Global VP went on to say…

“There’s a very short supply around the world.  We were able to procure these 276 suits through a medical supply company in California, so we bought them up as soon as we could.”  The suits that were procured and shipped were sealed seam garments manufactured by Lakeland Industries.”

So apparently there were only 276 suits available from Lake Land but 160,000 production volume is what is being construed by the market.

The company jumped from 40 million-market cap to 126 million because they sold 276 suits? Unlikely. What is more plausible, is the expectations changed and the market thinks Lake Land will sell 160,000 suits at 6% operating margin (with no CAPEX) using imaginary production capacity. The selling price would need to also be at the maximum of estimates ($10,000 a suit).

In 2014 FY Lake Land Industries had $93 million in sales, a negative operating margin and a loss of just under $4 million. In the last 10 years they have lost a total of about $4 million.

VERSAR 

Does Versar even have Ebola exposure or did speculators mess this one up?

When you word search Versar 10-Ks for “health”, “biological”, “ebola” or “disease”, nothing related is returned. Versar purchased a U.K subsidiary, Professional Protection Systems, ltd that services the nuclear industry. The 2014 sales of the company (bolstered by the Olympics says management) were $2.6 million and included in the Professional Services Segment (PSG). Versar grew $35 million in market cap in 3 days as a result. The argument is that Nuclear suits are a substitute product.

ALPHA PRO TECH

·      The Disposable Protective Apparel segment consists of a complete line of shoe covers, bouffant caps, coveralls, gowns, frocks and lab coats.

·      The Infection Control segment consists of a line of facemasks and eye shields.
These two segments DPA and IC, had combined revenue of $17 million in 2013. The two segments before taxes had earnings of $2.6 million. The company grew $70 million in market cap in the last five days.

chart-4

COMPETITORS 

These three companies also compete with Kimberly Clark, Cardinal Health, Dupont (Tyvek and Tychem) and 3M, among others. Why didn’t these companies jump 5%+ during the same period (they are all negative since Oct.7th) if they are the most likely beneficiaries of protective equipment sales? Because they do not have a low float and are not easily manipulated.

All of these competitors have much higher production capacity and if Hazmat suit supply was a serious issue we would witness production utilization kick up and suit prices adjust upward in the mean time. These competitors have the working capital to finance the growth of the production capacity and they have the ability to buy any of these speculative companies with less than one quarters income.

COMMON THEME
I won’t name any names but it is very likely that the same group that was behind pumping up Digital Ally is also behind the pump in these names. I am not here to condemn people for participating in low-float momentum stocks or for orchestrating the rise. What I am doing is shedding light on the fragility of these underlying narratives. Low-float momentum stocks (on the long-side) have 1 similar characteristic each time they run.

1.     It is about supply and demand, controlling a large portion of the float prior to the share price running. As controlling hands (or market makers) are aware of their influence they watch and test the supply/demand strategically through “nibbling” and level 2. (as shorts accumulate, covers are harder to find, increasing price volatility). Low floats are easier to control with fewer dollars, hence the role of supply and demand. Shorts end up trapped and a short squeeze commences. There is also a narrative underlying why the product will instantaneously be in very high demand, whether Ebola, police brutality or 3D printing overthrowing large batch manufacturing.

Pump-and-dump and low-float momentum stocks are interesting to study and remind me of 19th century Wall Street with Jay Gould, Jim Fisk, Daniel Drew and Cornelius Vanderbilt during the railroad mania days. What can be learned here is that price volatility in the short-run is a function of supply and demand of the float, while long-term value is created through return on invested capital exceeding the weighted average cost of capital. This is what Benjamin Graham meant when he proclaimed “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Ebola won’t disappear overnight and I do want to see the crisis solved as much as everyone else. What will disappear over night is half of the market capitalization of these companies. Which night is up to the market…

Further Reading: A very interesting case study on another pump and dump

Pivoting within the Value Chain: Vanderbilt, Rockefeller, Carnegie and Beyond

Brief History: 
American culture is built on the backs of Cornelius Vanderbilt, John D. Rockefeller, Andrew Carnegie, J.P Morgan, and Henry Ford, among others. These are the men that helped build America and transform it into what it is today. How were all of these early tycoons all so wildly successful one may ask? Some may say timing had everything to do with it. Others luck. I believe as we begin to peel back the onion, examining these men from a historical business context, one striking reoccurring strategy runs deep through them all. They were all adaptable, hyperopic thinkers that dominated one industry and moved to the underdeveloped and underserved segment in the value chain where expectations were not being met and installed capacity had not met demand.

Cornelius Vanderbilt started his business adventure as a regional steamboat entrepreneur actively working in the Boston, Albany, New York, California and New Jersey areas. He soon discovered railroads were being built to transport goods from these coastal areas inward toward the west. Because Vanderbilt served so much of the market by the 1850s he was able to compete directly with New York, Providence and Boston Railroad (Stonington) by dropping fares, but he had much larger plans than a price war. Vanderbilt was able to gain control of the company as
the stock dropped in value and took over as president shortly after, the first of many railroads he would control. He began to sell his interests in steamboats and continued to buy railroads, eventually ending up with a near monopoly on the Northeast freight.

Vanderbilt was able to adapt to change, seeing a potential threat as an opportunity. He was able to shift upstream to the underdeveloped segment (from steamboats to railroads), and underserved segment in the value chain where expectations were not being met and installed capacity had not met demand.

Vanderbilt moved from the point of inbound logistics to the point of outbound logistics, understanding the common theme of westward expansion and that he belonged to the transportation industry, not just the shipping business.

John D. Rockefeller saw the oil revolution unfolding, electing to build a refinery instead of joining the wildcatter’s exploration and drilling endeavors. Rockefeller was moving towards where the puck was going, not where it was. He began refining oil into kerosene, chasing his vision to light every home in America and beyond. He made a deal with Vanderbilt (as well as the other railroads) for freight rebates on both his own shipments and his competitors, consolidating the Cleveland refineries in the process. The railroads knew how important the oil freight was, allowing themselves to be played against each other in the process. John D. placed himself in the position of the bottleneck and began to use it to its full potential. In the meantime railroad mania had been unfolding (reason behind the panic of 1873) and John D. Rockefeller knew that the railroads had been overbuilt. He used his muscle (50%+ of the railroads freight volume) to enact further price cuts on his freight while receiving rebates from his competitor’s freight. John D. was able to control over 80% of the kerosene market in the U.S, but the birth of the automobile motivated him to pivot. John D. moved upstream in the operations segment, beginning to refine gasoline for America as Edison began wiring American houses with electricity and constructing the central station generation facility, an obvious threat.

Carnegie started in the railroad business and moved upstream into iron working, supporting the railroad industry through the service segment in the value chain. He made steel for railroad lines and bridge girders while vertically integrating all raw material suppliers. It was the birth of the Bessemer converter (new rolling process) that allowed Carnegie to leapfrog early competition. He brought production time down from two weeks to 12 hours and by the later 1880s, Carnegie Steel was the largest producer in the world.

Michael Porters Value Chain
value chain

Elon Musk announced he would be building a Gigafactory to support lithium ion battery production the day after he also opened all current Tesla patents for use to the public. This is another example of moving to the underdeveloped and underserved segment in the value chain where expectations are not being met and installed capacity has not met demand.

 

Owners or investors should examine their strategy from a holistic perspective, analyzing what value is available to the value chain and how it can be improved going forward. Are there bottlenecks that can be improved on? Bottlenecks are usually waiting points reliant on a previous input that has not been fulfilled and within the operations, inbound and outbound logistics segments.

Apple Teardown and Supply Chain Value

Below is a graph representing the estimated costs of an Apple iPhone by component. It seems as though an Apple iPhone 6 Plus will cost $242.50 in intermediate goods. We need to also include Foxconn’s gross margins of roughly 12%, brining Apples intermediate material cost to about $272.

The selling price of the phone is $860 in Canada for the iPhone 6 Plus, or roughly $780 USD. Looking at these numbers we may jump to the conclusion that Apple is making over $500 per phone sold, but this is misleading. Apple must also pay for transportation and labor costs, post sale services (warranty), capitalized R&D, marketing, advertising, sales, administration etc. while selling at a wholesale price to distributors who in turn sell it for a mark-up. Apple uses over 200 suppliers, all of which earn a markup on components provided.

 tear down apple

The point being, there are many different levels in which inputs of value are provided and revenue shared by many different players working together. Apple is a world-class company and has diversified the suppliers it uses as demand grows, standardizing components and auditing production factory’s for both TQM and efficiency reasons. Where can Apple improve? Where can Apple remove bottlenecks that are inhibiting value and add ones that create value? We see that Apple currently believes IT is moving in a general trend towards new payment transaction technology and digital healthcare diagnostics, both underserved with minimal expectations. Would vertical integration of hardware suppliers be beneficial or should they continue the organic software build out? Apple nonetheless dominates the value chain.

Hindsight is 20-20, How Can We Forecast Value Chain Movement?

Divergent problem solving and thinking about how industry segments intertwine as well as where the convergence is likely to take place, using history as our guide, is a starting point. Divergent problem solving is exploring many possible solutions and picturing the scenarios of each but within a limited scope, much like chess or poker. It is best to probe many alternatives opposed to probing one or two in great depth.

For example, the solar industry went through a point of manufacturing saturation where panels were differentiated primarily by price as standardized supply flooded the market. Both the manufacturing point of panels in the value chain as well as the primary service of installing the panels have become commodity businesses with the odd exception. There are now three areas within the value chain that are underdeveloped, underserved, and have low expectations going forward.

1) Pre and Post Installation Services (Energy usage monitoring and evaluation systems)

2) Storage, distribution and battery technology (Maximizing capacity of energy that can be held and minimizing energy loss)

3) PV panel conversion efficiency (new technology)

Installed capacity versus demand

We can see using the example above that SolarCity is currently the only integrated provider and is moving upstream aggressively to alternative 1 while Chairman Elon Musk takes Tesla into alternative 2. The spread between demand and actual performance for battery technology is massive, a clear bottleneck within the value chain framework. Pre and post installation services are also actively being sought by consumers that are moving off the grid, using renewable energy sources or simply looking to save money through subsidies.

What is underdeveloped?

Underdeveloped meaning very little competition, a small market that is growing quickly and where quality is poor. Competitors are not enticed by below average ROIC (above average does not exist yet) and when competitors do begin to enter the market, the intensity of rivalry is mitigated by the capacity-demand spread. When installed capacity meets or surpasses demand and the quality demanded begins to continually rise, the market is likely developed.

Where is the Industry Currently?

Using Porters 5 forces framework and adding growth, size of the industry and complements is a great way to conceptualize the “starting state.”

  • Size of the industry?

  • Growth of the industry?

  • Substitutes and compliments?

  • Bargaining power of suppliers
    – Concentration of suppliers (dominated by one or two large companies or spread out?), are the goods supplied critical to the buyer’s success? Are substitutes available? Is the product standardized? Is forward vertical integration a plausible threat?
  • Bargaining power of buyers
    – is a large portion of industry output bought by a few individuals? Are switching costs high or low? Is the industry product standardized? Is backward vertical integration a plausible threat?
  • Intensity of rivalry
    Numerous or equally balanced competitors? Growth of the industry? Cost structure (high fixed costs and storage?) Low switching costs? Exit barriers? Reliance on performance or strategic stakes.
  • Threat of new entrants
    Barrier to entry, economies of scale, product differentiation, capital requirements, switching costs, access to distribution channels, expected retaliation, government policy, cost disadvantages independent of scale.