Buying Teva is the classic contrarian position. There are fears because of management turnover. There is an anxiety over declining sales. Mr. Market is now selling Teva at $10 a share because of the pending, opioid lawsuits while I am buying the stock. Paradoxically, both of us feel we got a bargain!
When Erez Vigodman, Teva's former CEO, pitched to shareholders that he wanted to buy Actavis, the generic arm of Allergan plc, he said the combined entity would benefit from a diversified revenue stream, cost synergies, tax savings, and economies of scale. The typical m&a nomenclature.
In a pitch deck titled the 2016-2019 Preliminary Financial Outlook, he estimated revenue to be between $26.7 billion and $27.8 billion by 2019, an Ebitda compounded growth of 14%, and to report on earnings per share of $7.5 to $8.1 per share.
Teva's board of directors bought the story. And no later than three weeks after the initial discussions, Teva announced a whopping, $40.5 billion purchase price. To fund the Actavis purchase, Teva's board gave away 100 million of the common stock  and $33 billion in cash. The right side of the balance sheet mushroomed to $34 billion as a result.
Teva not only leveraged the balance sheet, but Teva had no trouble paying up. The press release noted that "Actavis Generics had net revenues and total direct expenses of $6,184.4 million and $5,367.4 million of expenses."
Actavis reported total assets of $12 billion - of which half of intangibles and goodwill – and total liabilities of $3 billion. Teva, in short, bought Actavis at eight times the sales and four times the book value.
Did Vigodman ever read Benjamin Graham?
"I firmly believe that acquisitions are an addiction, that once companies start to grow through acquisitions, they cannot stop," lamented Professor Aswath Damodaran at the CFA Institute Equity Research and Valuation Conference. "Everything about the m&a process has all the hallmarks of an addiction."
In that presentation, Damodaran brought data from a McKinsey study, showing that "the very best approach of creating growth historically has been to come up with a new product," he noted. "Look at Apple. Between 2001 and 2010, Apple went from being a $5 billion company to a $600 billion company, and they built it on the iPhone, the iPad."
In addition to inventing new products, companies grow by expanding into new markets. For example, with hardly anywhere to grow in the United States, Costco is building stores globally and recently launched a store in China.
The only other option is to grow or maintain market share in an expanding market. "Think of Apple and Samsung between 2011 and 2015 in the smartphone market," Damodaran said. "Apple's market share decreased between 2011 and 2015, but its value increased. Why? Simply because the smartphone market itself was growing."
Teva now faces three challenges: pricing-fixing and opiod-related lawsuits, loss in revenue because the patent behind Copaxone had expired, and a leveraged balance sheet. More on Teva's worrisome future below:
You can't avoid shaking your head when reading about Teva's current troubles. Not only did the pro forma numbers never materialize, but also Teva's lawyers are busy defending the company on price-fixing and opioid-related charges.
(To get a sense of how serious is the U.S opioid crises, read aboutThe Family That Built an Empire of Pain.)
Analysts estimate that Teva will be liable to pay anywhere between $2 billion and $10 billion in the future. According to CNN, an Oklahoma judge approved $85 million settlement with the opioid drugmaker.
"In the first nine months of 2019, Teva recorded an expense of $1,171 million in legal settlement and loss contingencies," writes management in the 2019 third-quarter filing. "The expense in the first nine months of 2019 was mainly related to an estimated settlement provision recorded in connection with the remaining opioid cases."
I wrote about the difference between risk and uncertainty in a prior essay. Wall Street analysts, often with a background in math, attempt to understand risk with probability theory and statistics. But they hate uncertainty because it is difficult to quantify in numbers. So, capital markets are frustrated by Teva's unknown future.
"Our leading specialty medicine, Copaxone, faces increasing competition, including from two generic versions of our product," writes management in the risk section of the annual report. Indeed, the FDA approved in October 2017 and February 2018 two generic versions of the medicine, and Teva's revenue from Copaxone was immediately hit. In 2016, Copaxone's revenue was $4,223 million. It dropped to $2,365 million in 2018.
"Invert, always invert!" says Charlie Munger. And if we invert this data point, that branded drug sales fall when the generic version enters the marketplace, we see Teva's competitive position. The company is world-leading in generics.
There are red flags all over the balance sheet, the income statement, and management's turnover. Consider the balance sheet: before the Actavis purchase, Teva reported $8 billion in liabilities on $30 billion in equity, a debt to equity ratio of 25%. After the acquisition, liabilities mushroomed to $32 billion on reported equity of $35 billion, a debt to equity ratio of 91%.
The income statement tells a similar tale. Interest expense went up threefold, from $313 million in 2015 to $1,000 million in 2016. And over the past three years, the annual interest expense remains high, at about $950 million a year. The operating income to interest expense ratio used to be over ten times; it is now in 2 to 3 times range.
And there has been a management shake up: Kare Schultz replaced Erez Vigodman  two years ago and immediately announced a restructuring plan that included reducing the labor force and divesting assets. Before joining Teva, Schultz served as president and vice CEO of Novo Nordisk, multinational pharmaceutical products company.
The ensemble of the three concerns resulted in an over 80% drop in Teva's market price. In 2016, the stock traded hands at $60 a share. It now trades at $10 a share.
You could hardly tell of any fundamental changes to the pharmaceutical industry based on the Dow Jones U.S. Select Pharmaceutical index return. The index shows a total return of about 13% over the past decade and a 10% return over the past year.
Current investors are paying up for this return. If you buy the iShares U.S. Pharmaceutical Index (IHE on Arca) for example, you are buying an equity interest in the 46 pharma companies at a price to sales ratio and price to book value of four times.
But the return is not smooth for individual companies. For example, Akorn, Inc. (AKRX on Nasdaq) lost over 90% in market value over the past five years and halved in price in 2019. It is rumored to go bankrupt because of opioid-related litigation.
Another company caught up in the opioid scandal is Endo International (ENDP on Nasdaq). Its market valuation dropped by over 90% in the past five years, and just in the last year, the stock dropped by 60%. The same market loss can be demonstrated with Mallinckrodt (MNK on Nyse), Amneal (AMRX on Nyse), Myland (MYL on Nasdaq.)
According to statistica.com, there is an increase in the proportion of generic versus branded drugs. In 2005, about 40% of prescriptions dispensed were brand name drugs, and around 50% were unbranded generic drugs. In contrast, in 2018, only 10% of orders were brand-name drugs, while over 85% were unbranded generic drugs.
Other trends in the global healthcare trends include an aging population, chronic diseases, and growing pressures from the government to provide affordable healthcare solutions. It seems those trends are muted compared to the opioid-related charges.
Teva's current challenges, drop in operating margins, and impairment losses, immediately show on the income statement. In 2014, revenue was $20 billion, gross sales were $11 billion, and net earnings were $3 billion. After years after, revenue was $19 billion, gross sales were $8 billion, and loss $2.4 billion .
The drop in revenue is because of increased competition and price pressure in generics and a decline in sales in Copaxone, as I noted in the investor concerns section.
Teva's income statement shows that the business requires little capital expenditures. If we remove the accounting charges (asset and impairment loss) and look at the total 2018 to 2014 pre-tax earnings, we find $17 billion in pre-tax earnings. During these five years, the reported capital expenditures  was $6 billion, less than a third.
(The last time Teva paid a dividend was November 17, 2017.)
From a stroll over TEVA's balance sheet, two items jump at you. The first is the change in intangible and goodwill accounts between 2015 and 2016. In 2015, management reports on $26 billion in total for both accounts. A year after, the number is up over twofold to $65 billion. Long term debt went up fourfold to $33 billion in 2016 from $8 billion the prior year.
One year after, between 2016 and 2017, the goodwill account was cut by $16 billion. Management effectively halved the book value of equity.
In 2019, management reported $4 billion in quarterly revenue with net earnings of one billion. I expect the fourth-quarter results to be similar. So TEVA's 2019 results are likely to be roughly $16 billion in revenue and $4 billion in net earnings, about $3.50 to $4.0 per share 
The Europe segment has the highest operating margin, followed by North America's segment and the International segment. In numbers: the operating margin was 57% in Europe. The ratio was 51% in North America, and 40% in International markets.
In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.
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In the 1986 letter to shareholders, Warren Buffets explains owner earnings. He writes:
These [owner earnings] represent reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
We can compare owner earnings to GAAP earnings using Teva as an example. I used Buffett's formula with a slight modification. Because Teva has a legal cost - every year - I removed from the owner earnings an arbitrary one billion in legal expenses. The table below summarizes the results:
We can see that between 2014 and 2016, investors paid a premium over the owner-earnings value per share. But their appetite waned in 2017 and 2018 when you could buy the stock less than half the implied value.
Over the next 3- to 5-year period, I estimate that Teva's top line will be $18 billion, with a 25% operating margin, resulting in owner earnings of $3 billion or $3 per share. From that, I estimated the value of the Company to be anywhere from $15 billion (5x the implied value) to $45 billion (15x the implied value). I also estimate the opioid-related lawsuit will cost Teva anywhere from $2 billion to $10 billion, which results in a valuation range of $20 to 28 per share.
Teva sells generic medicine and specialty medicine. Generics aim to provide the same chemical and therapeutic solution of a branded medicine. There are over 300 generics that Teva sells.
Specialty medicine category includes solutions for the central nervous system such as Copaxone, Ajovy, and Austedo, and solution for the respiratory system such as Proair and Qvar. Teva also sells medication such as Bendeka and Trisonex in oncology.
Last year, generics were about 40% of the revenue; Copaxone was about 20% of the revenue, and Bendeka, Proair, Quar, and Austedo et al., were the remaining about 40% of the revenue. Teva manufactures products using 55 pharmaceutical plans in 22 countries. Last year, the Company produced 80 billion tablets.
The best profit margins are in Europe, followed by North America and the international markets. Over the past three quarters, the profit margin in Europe was 57%; in North America, it was 51%; and 40% in International markets. The difference in profit margins is the result of competition, pricing power, and regulatory red tape.
You can now buy the generic form of Copaxone (see more in the investor concerns sections) in North America. Teva's revenue was hurt as a result. The Company reported revenue of $12 billion in 2016, which dropped to $9 billion in 2018; profits in 2016 were $5.5 billion compared to $2.8 billion in 2018, and Copaxone revenue was $3.5 billion in 2016 compared to $1.8 billion in 2018.
In North America, Teva introduced 22 generic versions of branded drugs in 2019. And it was meeting regulatory approvals for about the same number of generic medicines. Two new products that I believe will be important for Teva are Ajovy and Truxima.
Ajovy was approved in September 2018 and is protected until 2026 in Europe and 2027 in the United States. TruixmTruxima was approved in November 2018 
Biosimilar is a biologic medical product highly similar to another already approved biological medicine, says Wikipedia. Teva writes: "Biosimilar products are expected to make up an increasing proportion of the high-value generic opportunities in upcoming years."
There is going to be a lot of competition in the biosimilar medication in the future. And whether Teva will win over its competitors is unknown. But a few trends, working in favor of companies such as Teva, are clear. Our population is aging; there is an increasing amount of chronic diseases that need solutions; governments are pressured to provide affordable healthcare; there are scientific and technical discoveries that require unique manufacturing capabilities.
The first part of this essay is a description of GrafTech (EAF on Nyse), a manufacturer of graphite electrodes and petroleum coke. As much as possible, I keep this part objective, stating facts and not my opinions. But the second part is subjective. Here I give reasons why I bought GrafTech's common stock.
You can tell that GrafTech is manufacturing something (more on that 'something' below) just by glancing at the property, plant, and equipment account (PP&E).
PP&E of $689 million represents about a third of the balance sheet. It is $67 million in the value of buildings, $46 million in land, and $532 million in machinery. The PP&E hints at us that GrafTech makes stuff.
Specifically the company makes graphite electrodes which are a small-but-integral part of the steel manufacturing process. In GrafTech's words:
"Graphite electrodes are an industrial consumable product used primarily in EAF steel production, one of the two primary methods of steel production"
Here is how Brookfield (an asset manager that acquired GrafTech in 2015) describes graphite electrodes:
"Graphite electrodes are 10 to 12 inches in diameter and can be up to nine feet long. They can take up to six months to manufacture, in a multistage process that requires significant technical skill and raw material known as petroleum needle coke. GrafTech is the only graphite electrode produce able to produce its needle coke, a significant competitive advantage."
GrafTech's five plants are in Mexico,Pennsylvania , Texas, Brazil, France, and Spain. The company's headquarters are in Brooklyn Heights, Ohio. It also leases five locations, mainly for sales.
While GrafTech does not itemize the depreciation expense in the income statement, it is worthwhile data to go over. In total, depreciation expense was $131 million over the past three years.
Between 2018 and 2015, the total capital expenditures were $131 million, too. So if you belong to the group of investors that follows the magic formula investing , you would be pleased to see in GrafTech a business that requires little capital improvements.
The table above shows that GrafTech had a dramatic revenue increase in 2018, largely the result of the graphite electrodes price hikes. (Also, bottom line benefited from some operational efficiencies.)
The weighted realized price for graphite electrodes was $9,937 in 2018 compared to $2,945 in 2017. The company produced 185 million tons of it in 2018 compared to 172 million in 2017.
Over the past three quarters of 2019, GrafTech showed high operating margins. The average realized price for electrode graphite was $9,976; the average operating margin was 56%, with an average net income margin of 41%.
I estimate the company will report in 2019 an annual revenue of $1,800 million in revenue and earnings of $767 million, roughly $2.5 to $3.0 per share.
"Change is the law of life," former U.S. President John F. Kennedy once said. "And those look only to the past or present are certain to miss the future." Returning to GrafTech, let's focus on future earnings.
On page 45 of GrafTech's annual report which you can download here, GrafTech shows future contracts of 674,000 million ton of graphite electodes at about $10,000 per MT. These contracts represent about 65% of the planned capacity. GrafTech writes:
"We have executed three- to five- year take-or-pay contract, representing approximately 674,000 MT, or approximately 60% to 65% of our cumulative expected production capacity from 2018 through 2022. Approximately 90% of the contracted volumes have terms extending to 2022.
These expected earnings will determine GrafTech's future value. And these expected earnings are dependent on (1) the growth in the graphite electrodes industry, (2) the price of graphite electrodes, (3) the production capacity, (4) competition from BOF manufacturing (more on that below), and (5) the cost to produce the product.
How will you measure your life isn't about the money you make. It's about achieving goals and building the kind of life you want. The cognitive psychologist Daniel Kahneman calls this life satisfaction.
But you will need financial success to achieve life satisfaction. And financial success isn't how much money you make (or the kind of car you drive) - it's how much money you keep. That's a function of how well you're able to save money, protect it, and invest it over the long term.
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There are two ways to make steel, the electric arc furance (EAF) method and basic oxygen furnace (BOF) method.
Visually, this is how EAF looks like:
And this is how BOF looks like this:
"In the EAF method, steel scrap is melted and recycled to produce liquid steel, while in the BOF method, virgin iron ore is smelted with metallurgical coke, a carbon product derived from metallurgical coal."
GrafTech is a low-cost producer. In my view, it costs the company about one-fourth to produce the graphite electrodes compared to its peers. To be a low cost producer is good, it is even better in a tight marketplace, where the top five electrode graphite companies  of the world hold over 80% of total production.
GrafTech is the only vertically integrated electrode manufacturer. Vertically integrated means that they control the price of needle coke, the main ingredient behind graphite electrodes. GrafTech writes on page 10 of the 2018 annual report:
"Seadrift [the needle coke manufacturer] provides a substantial portion of our petroleum needle coke supply needs internally and at a competitive cost and allows us to maximize capacity utilization more efficiently than
competitors, who may be more constrained by petroleum needle coke supply."
There are direct and indirect competitors. The direct competition  are four companies that compete with GrafTech . With these companies, GrafTech competes in production capacity, the price of the product, and the cost to produce the product.
The indirect competition to GrafTech is BOF steelmaking. While the difference between the steel manufacturing method is only exciting to students of mechanical engineering, for this essay suffice to note that if BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GrafTech benefits.
That, at least, has been the historical case. According to the steel statistical yearbook, produced by the World Steel Association, Between 1984 and 2011, EAF steelmaking was growing at 3.5% per year.
But this trend was reversed between 2011 and 2015 because of an increase in blast furnace (BOF) steel production that for the most part came from China.
(Write to me if you would like a detailed description of the dynamics in the steel industry.)
Value Line ranks the steel industry in 91 of 97 possible ranks. ( Why I read Value Line reports.) According to Value Line, you can't find any worse businesses to invest in over the next few years.
Here is how much you would have lost if you bought five years ago any of the following steel companies:
AK Steel Holdings loss was 69%; Posco loss was 42%; Timmenksteel loss 83%; and U.S. Steel loss was 53%. In short, if you want to spot a liar, ask someone at a party if they made money on steel stocks over the past few years.
"The main question is the long-term outlook for the company," writes Sven Carlin. "As the main product is steel, electrode prices will depend on steel prices and demand for it, especially for EAF steelmaking."
Because of the reported declines in both revenue and earnings by practically all publicly traded steel companies, the outlook for the steel industry is gloomy. Paraphrasing Howard Marks , there is too much steel chasing too few manufacturers.
At a market capitalization of about $3,500 million, GrafTech is trading a multiple of one. As I wrote in the first section of this essay, I estimate GrafTech will report to shareholders of $1,800 in revenue and of $767 million in earnings for 2019.
And since GrafTech sold 674,000 million tons at $9,937 per MT, we can estimate total revenue of $6,700 million and earnings of $2,814 million by 2022. Adding $767 million and $2,814 million, we find $3,851 million in profits by 2022.
A p/e of one for a company whose 2018 operating margin was 49% and net profit margin was 45% seemed nonsensical to me.
Careful readers of GrafTech's annual report will see that between 2008 and 2017, the price for electrodes graphite was $4,500, and during the worse year (2016), the price was $2,500 per MT.
At about $10,000 per million ton, GrafTech's operating margins are high. But the operating margins are reasonable at $5,000 per MT, too.
There are also reasons to believe of growth. The first reason is that China will export less steel in upcoming years. In 2019, for example, it exported between 4 to 6 million tons of steel per month. But in 2015, in comparison, China exported about twice as much, between 6 to 10 million tons of steel per month.
There are two other factors, which I cannot estimate their effect numerically. The first factor is the price of needle coke may jump in the near term as a result of the growth in electric vehicles (EV) sales .
And the growth in the EV industry is clear. Five years ago lithium-ion batteries production was 1,00 million tons. And last time I checked it was 60 times as much, about 60,000 million ton.
A reminder for readers: my goal in writing is to share thoughts. None that was said above should be construed as investment advice.
Also, this essay is incomplete; there are many important topics I left out. Among them: GrafTech's management and compensation structure, why Brookfield purchased GrafTech, a detailed analysis of the risks ahead, a peer-company review, and a valuation analysis.
More on that in future essays.
"Gyms need their members not to come, but they can't just lock the doors," notes Caitlin Kenney in Planet Money, NPR's economics podcast. "So they have to rely on consumer psychology to get you excited enough that you'll sign up for a gym membership, but not so excited that you'll get up an hour early to do some crunches before work."
Indeed, ask any physical trainers and Yogis: owning a fitness center is a straight forward business model. You lease 2,000 to 20,000 SF space, buy or lease some fitness equipment and get as many customers signed up.
The fitness industry's rule of thumb is that if you can sign up 20 times the capacity of the studio, you will be in good shape .
But it's a tough business. First, not unlike the hotel business, customers' expectations and standards increase with time. Hotel guests now demand flat-screen TVs and a queen-sized bed at a minimum. And gym members expect Peloton machines and shiny, new barbells. In short, you always reinvest cash in the business.
Another drawback is that the operating costs - specifically, lease payments and labor wages - increase over time. And while these expenses rise, customers are unwilling to pay more than roughly $40 a month.
If gym owners increase prices, there are plenty of alternatives. People can exercise outside at no cost; they can subscribe to an app  for a fraction of the cost, or they may go on a diet and give up on physical exercise.
While the fitness business is competitive with little barriers to entry , I bought a few shares in Town Sports International Holdings (CLUB on Nasdaq), a fitness company with a pygmy market capitalization of $54 million or about $2 per share.
I calculated the 2018 free cash flow to be $15.1 million or $0.57 per share and the 2017 free cash flow to be $18.9 million or $0.73 per share. In other words, if the last two years serve as a proxy, Town Sports' cash flow will pay back investors their original investment in less than four years.
There are a few publicly-traded fitness companies. A glance at Planet Fitness shows that buying Town Sports is for the bargain hunter.
In 2018, Planet Fitness traded as low as $29 and as high as $57. The company generated pre-tax earnings of $131.8 million, or $1.51 per share, which translates to price to pre-tax earnings ratio range of 19 times to 38 times.
Compare that to Town Sports, which earned $38.6 million in pre-tax earnings, or $1.45 per share. CLUB's stock traded as low as $5 and as high as $15 - a range of 10 times to 3 times the price to pre-tax earnings. Today, at about $2 per share, CLUB is trading at 1.4 times the 2018 earnings.
CLUB's bargain stock price comes alongside serious red flags. The list of concerns includes:
(1) The company's CFO, Carolyn Spatafora, has been selling the stock. She sold about 96 thousand shares this year , over 60% of her vested interest in the company.
(2) The company's debt matures in August 2020. Read: if the U.S. economy is in recession in a year, it is questionable whether lenders will finance the operations.
(3) Two-thirds of CLUB's gym members are on a month-to-month basis. To me, this shows that there is hardly any brand loyalty and that customers are unwilling to commit.
(4) Management decided this year to hide critical information from the financial statements. For many investors, that act alone would deter investment. I hope that management action is because it would like to hide information from competitors.
But that is probably wishful thinking. Michael Shearn, who wrote the excellent The Investment Checklist: The Art of In-Depth Research would be appalled by my action. In his words:
I have learned that if the strategy of the business is based more on hiding information from competitors rather than outperforming competitors, it is far less likely that the business will have a long term success.
Careful readers of CLUB's prior annual reports would detect a deterioration in key metrics. So, it is little surprise why management would want to hide them.
A few examples: in 2013, the average revenue per member was $78 per month. As of 2017, the metric dropped by 24%, to $59. In 2013, the annual attrition  was 41.9%, while in 2017, it was 47%.
Finally, in 2013, the revenue per weighted average club was $2.97 million. The revenue dropped to 11% in 2017 to $2.64 million.
Patrick Walsh, who Forbes Magazine describes as a "Warren Buffett enthusiast," writes to CLUB's shareholders that "patience is a minor form of despair, disguised as a virtue."
I take a less cynical approach and estimate that there are few things good happening now and a few things worthwhile to be patient for.
First, Walsh is fiercely buying the stock. He bought 643 thousand shares this year at a weighted cost of $2.5. This amount was added to his already 3.1 million shares, which represent about 14% of the common stock outstanding.
Second, managing gym clubs does not require sophistication or expertise. I believe it is a matter of time before financial results return to a net profit margin of 10%, with Walsh in leadership or without him.
A year ago, the sports center across the street from my office, increased by almost two-fold the monthly membership rate, from $32 to $57. Infuriated by the price increase, I said to Jillian, the members' relationship manager at the time, that I would take my business elsewhere.
I never did. The convenience of having the JCC across the street from my office, and the community of people I became friends with, far outweighed the price hike. It is my hope members of CLUB fitness centers have the same experience.
It is a matter of time before stock investors bet on what they believe is right. Warren Buffett bought Burlington Northern in 2009, at the height of the financial crises. He called the acquisition, "an all-in wager on the economic future of the United States." Another example was the bet placed by Bill Ackman in 2012. He called Herbalife (HLF on Nyse), a nutritional supplements company, "a pyramid scheme that would eventually go to zero" and shorted the stock.
The purchase of Hyster-Yale Materials Handling (HY on Nyse) is my bet on the future of global trade. I begin this essay with an attempt to explain why HY is now trading at a five-year low price. It is not only market sentiment that penalized HY but also deterioration in the reported financials. In the second part of this essay, I discuss why the current operating results are transitory and why I bought the shares.
Wall Street is now bearish on companies that trade with China. Consider the stock of Flexsteel Industries (FLEX on Nasdaq) that dropped over 40% this year. So did the stock price of Micron Technology (MU on Nasdaq) fell as one of the company’s suppliers was banned from trading with the United States. Hyster-Yal, our topic of discussion, showed an even steeper fall lately - it dropped to $44 from $66 in less than a month.
Uncertainty of trade wars affect Hyster-Yale in two ways. First, Hyster-Yal's operating profit is sensitive to the price of steel, lead and copper. And it is the nature of these commodities to be volatile in terms of uncertainty.
Second effec comes from the price of foreign currencies which is now widely swinging. Any loss in foreign currency value will be reflected in the Other Comprehensive Account (OCI). Hyster-Yal reported $88 million of currency translation devaluation, 16% of its equity balance.
There are not only concerns with the materials-handling industry macro factors but Hyster-Yal's operations declined as well. Gross profit is down to $126.2 million from $132.1 million the prior year; operating profit is $3.4 million from $19.2 million the prior year; diluted earnings per share are now 20 cents compared to 90 cents a year ago.
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Operating margins are down, too. Five years ago, the company reported pre-tax earnings of $150 million on $2,767 million of revenue, a 5% ratio. The ratio more than halved in 2018 when the company reported on pre-tax earnings of $13.8 million on revenue of $3,174 million, a 4 basis points ratio.
In addition, the reported ratio of total liabilities to total assets was 62% in 2014 compared to 68% as of the latest annual public filing. In short, the company is facing trouble ahead.
Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.
GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. Visit the Hyster-yale page to see for yourself.
Yet in the long run, the lift truck market is expected to grow. Consider, for example, data from the World Bank's website, the World Integrated Trade Solutions (WITS). There were 546,832 orders in 2009; there were 1,093,961 orders in 2014 and 1,460,000 orders in 2018.
Another point of interest to those who are interested in Hyster=Yale is that insiders to Hyster-Yal are buying the stock. Last month insiders placed 271 buy orders compared to a single sell order. Visit form 4 filings for reading.
And HY's management is aware of the operating challenges and has a plan in place. Management is focused on achieving 7% operating profit, which it plans to reach, over the next three to five years, by increasing prices and reducing operating expenses. Assuming no growth in revenue, that may translate to pre-tax earnings of $211 million or $13 per share. Since eight times pre-tax earnings valuation is reasonable, management is, in effect, targeting a $104 stock price.
Yet the stock market hates uncertainty so the stock traded for $45 when I bought it - this is roughly the adjusted book value.
As of the first quarter of 2019, Hyster-Yal reported equity balance of $551.4 million or $33 per share. If we adjust the equity balance by adding back the foreign currency devaluation, which was $88.2 million or $5.51 per share, and if we add back the pension adjustment, which to me was an accounting shenanigan, we arrive at $719.6 million in equity or $43 per share.
Throughout history, there were bad and good ideas. It was a bad idea to define people by their race, color or creed. It was a bad idea to have a central authority to control the economy and to dictate prices. In the 20th century, the two ideas miserably failed - at a devastating price.
But global trade belongs to the good ideas list. While the argument for global trade gained influence by David Ricardo in the 19th century, it has been practiced since ancient history.
There is evidence, for example, of the exchange of obsidian and flint during the Stone Age, estimated to have taken place in Guinea around 17,000 BCE . It is too bewildering that in the 21 century, we have to defend the idea of global trade.
While Ricardo argued for global trade using utilitarian reasons (how each side would eventually gain from the trade), to me, global trade is much more than that. Global trade allows countries and citizens to live in peace. As Voltaire once wrote:
Enter into the Royal Exchange of London, a place more respectable than many courts, in which deputies from all nations assemble for the advantage of mankind. There, the Jew, the Mahometan and the Christian bargain with one another as if they were of the same religion, and bestow the name of infidel on bankrupts only… Was there in London but one religion, despotism might be apprehended; if two only, they would seek to cut each other’s throats; but as there are at least thirty, they live together in peace and happiness."
"The presence of lower prices, not surprisingly, is frequently associated with a relatively poor, near-term outlook for an industry, company or country," wrote Matthew Fine and Michael Fineman of Third Avenue Value Fund. "So this approach [bargain stock shopping] requires a multi-year investment horizon."
The description above of the relationship between cheap price and business outlook, nicely describes why I bought Mednax, Inc. (MD on Nyse) this week. In this essay, I describe the key reasons for the gloominess for the U.S health care and how they drove down the price of Mednax.
Mednax and peers now face three uncertainties. First is U.S. Government's tracking of medical costs which force hospitals to disclose prices. Read more under the Centers for Medicare and Medicaid Services' price transparency law. From health-care companies perspective, hospitals, their customers, are becoming price-conscious buyers, which will hurt future earnings.
The second concern comes from the The Affordable Care Act (ACA) which contains provisions such as establishment of health insurance exchanges that adversely affect the earnings of health-care companies (unsurprisingly the ACA risk is listed second in the risk factors section of the MD's annual report.)
The third worrisome trend is that businesses are taking health insurance costs to their hands. CNBC reports that Amazon, Berkshire Hathaway and JP Morgan partnered to improve health care for their 1.2 million employees. Branded under the name Haven, their partnership aims to "create new solutions and work to change systems, technology, contracts, policy and whatever else is in the way of better health care."
Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.
GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. See how easy it is to review Mednax financial position.
Yet it was not only uncertainty fear that halved the price of Mednax over the past year. The drop in price was also because of the company's own doing. This is because pre-tax earnings and net earnings fell each year since 2015.
Four years ago Mednax reported $599 million in pre-tax earnings and $336 million in net earnings. In 2018 it reported $468 million in pre-tax earnings and $268 million in earnings.
Also of concern is that Mednax has been increasing the right side of the balance sheet. In 2015 for every dollar of equity it carried 86 cents of liabilities. But as of the first quarter of 2019 Mednax reported that for every dollar of equity it carried a dollar and five cents of liabilities.
And management's appetite for leverage is clearly noticed if we use a wider (time) lens. In 2009 total liabilities to total assets ratio was 30%; the ratio increased to 37% in 2014 and to 48% in 2018. It is now 51%.
So given the gloomy U.S. health care industry landscape and the company's lackluster operating performance, Mednax share price today should be lower than it was a year ago.
But how much discount should we require? a price tag of $22 was enough for me to buy the stock. In the remaining part of this essay, I explain why.
In 2018 Mednax reported on revenue of $3,647 million. Now its market capitalization is $1,820 million. In other words Mednax now trades at about half the 2018 revenue. More impressing, perhaps, is the fact that over the past decade Mednax market capitalization was never below the company's prior year's reported revenue.
The highest premium was 1.56 times in 2010 and the lowest premium was 1.1 times in 2017. To put in perspective, even in 2009, in the Great Recession, Mr. Market valued Mednax at 1.3 times its revenue.
The same argument, of current valuation significantly below the historical valuation, can be seen by glancing at the balance sheet too. At $22 per share Mednax is trading at two thirds of the book value as of its most recent filing.
This is a ten-year low as during the past decade Mednax shares traded at premium to book value. The 10-year average range premium to book value was as low as 0.95 times and as high as 3.27 times.
Without diluting shareholders (there were 92 million outstanding shares a decade ago while today there are 89 million shares), management had done reasonably well in increasing its revenue resources.
The number of physicians increased by 11% compounded annually, from 1,484 physicians in 2009 to 4,213 physicians in 2018. And the number of anesthesia operations increased by 22% compounded annually, from 244,127 in 2009 to 1,844,451 in 2018.
Over the past decade, revenue increased to $3,647 million from $1,288 million and reported assets grew to $5,706 million from $1,689 million. And the company's boss and co-founder, Roger Medel, still holds 1.6 million of the outstanding shares.
On page 2 of the quarterly report to shareholders, the portfolio managers of Third Avenue summarize their portfolio: P/E ratio is 12 times. Price to book is 0.87 times. Price to sales is 1.05 times. And price to cash flow is 5.83 times.
Mednax, at current valuation, would nicely fit their portfolio: P/E ratio is 8 times. Price to book value is 0.74 times. Price to sales is 0.60 times. And price to cash flow is 7 times.