Category: Buys

Whirlpool: Fully Automatic

Published on:
April 18, 2020
Reading time: 7 Minutes.
Last Update:

Whirpool's revenue grew by 10% over the past 50 years. But at $90 per share, I thought I could earn a higher rate of return. Here's why. 

On Whirlpool's competitive advantage

Whirlpool (WHR on Nyse) operates in an industry that is shared by a small number of producers [1]. According to IndustryWeek, the five major appliance companies are Whirlpool, Electrolux, GE, LG, and Samsung. 

Yet Whirlpool is the only American-domiciled company. Out of its 36  locations in 13 countries worldwide, ten sites are in the United States. And the ability to manufacture products in the U.S. allows Whirlpool to be a low-cost producer, as shown by the better-than-average operating margins. 

Whirlpool 2019 to 2015 business results. Source: company filings.

Between 2019 and 2017, Whirlpool's operating margin [2] was 12% in the United States. In other countries, the company's operating margin was tiny. In Latin America, the average revenue was $3,580 million, with an average operating income of $210 million, a 6% ratio. In Asia, Whirlpool's revenue was $1,547 million, with an operating income of $57 million, a minuscule margin of about 4%. 

Also, LG reports on an operating margin of 2.6% for the home appliance division. Samsung said in 2019 on a 5% operating margin for the consumer electronics division. 

The same ol' business

The top-line has not changed much over the past few years. In 2015, revenue was $20,891 million and pre-tax earnings were $1,306 million. In 2019, revenue was $20,419 million and pre-tax earnings were $1,204 million.

The balance sheet didn't change much, either. In 2015, total assets were $19,010 million, and the assets slightly declined to $18,881 million in 2019. Long term debt was $5,592 million five years ago and grew to $6,394 million in 2019. Reported equity was down to $4,118 million in 2019 compared to $5,674 million in 2015 [3].

What dramatically changed was Whirlpool's market valuation. In yearend 2015, Whirlpool sold at $149 a share. At that price, for every dollar of revenue, investors paid 56 cents, and for every dollar of book value, they paid $2.4. In short, investors paid $15 for every dollar of earnings. 

Today, you buy a dollar of the 2019 revenue for 30 cents. You pay $1.4 for one dollar of book value and about $7 for one dollar of the 2019 earnings per share. That makes all the difference in the world.

You would think something changed about the quality of the business.  But in 2015, Whirlpool generated $617 million in free cash flow, and in 2019, it made $672 million in free cash flow [4]. And long debt represented 30% of the total assets in 2015 and 34% in 2019. 

So, perhaps, the gloomy valuation is because of something else? 

The lack of appeal

The home appliance industry sells a commodity [5] that it is costly to make, with rising labor and retirement costs, and with low, single-digit profit margins. Compared to other businesses, the home appliance business is unappealing. 

Whirlpool revenue breakdown
Whirlpool's revenue breakdown. Source: company filings.

The industry also lacks sex appeal. We describe these products as "useful" or "helpful." But you wouldn't describe your wash and dryer as "disruptive" or "innovative." 

This reminds me how author Bill Bryson once commented of people's fascination with particular machines, such as cars, but that we are completely oblivious to others.

"I can't for the life of me understand why anyone would want to know all this about a machine [car]," he wrote in Notes from a Small Island. "You don't take that kind of interest in anything else. I've been waiting for years for somebody in a pub to tell me he's got a new refrigerator so I can say, 'Oh really? How many gallons of freon does that baby hold? What's its BTU rating? How's it cool?. " 

The home appliance industry is not winning the popularity contest.  But as we deal with the first, large-scale uncertainty in the 21 century [6], the necessity and predictability of the home appliance business is attractive to me. 

In a decade, we will need to clean our clothes and to refrigerate our foods. We will need appliances such as food processors and blenders to help us cook our food. And we will need to replace these items every 8 to 12 years.  

Whirpool's 20-year business track record (from 2000 to 2019)

Between the year 2000 and 2019, the average operating margin was between 5% to 7%, and the pre-tax earnings margin was about 3% to 4%. Since the operating margins will invariably stay the same, to grow earnings, Whirpool will need to increase revenue over time. 

The average 5-year revenue, between 2004 and 2000, was $11,416 million. Revenue almost doubled to $20,863 million between the average 5-year revenue between 2019 and 2015. The company expanded to markets such as Latin America and Asia. 


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Over the past two decades, Whirlpool improved the operations margins. The average 5-year pre-tax earnings between 2004 and 200 were $480 million; between 2009 and 2005, the average pre-tax earnings were $513 million; between 2014 and 2014, pre-tax earnings were $583 million, and between 2019 and 2015, pre-tax earnings were $913 million. 

Whirlpool revenue from 2019 to 2000
A look at business results over a 5-year interval. Source: company filings

The earnings grew while the costs to produce the appliances went up almost two-fold. This is using plastics material and resin price data by the Federal Reserve Bank of St. Louis. Also, visit the cold-rolled steel sheet for data on metals. 

What's it worth? 

In Common Stocks and Common Sense, value investor Ed Wachenheim writes: 

Our conclusion was that the company's [Whirlpool] revenues and operating profits could be about roughly $25 billion and 10 percent, and thus its operating profits could be about $2,500 million. We estimated that the company's 2016 interest costs, effective tax rate, and diluted share count would be $275 million, 28%, and 80 million, respectively. Given these educated guesses and projections, Whirlpool would earn about $20 per share in 2016. 

Five years passed. And we can now update our expectations, following Wachenheim's logic. 

Here is how the prior paragraph would read in 2019:

The 2019 company's revenues and operating profits were $20 billion and 7%. The interest costs, effective tax rate, and diluted share count were $187 million, 23%, and 64.2 million, respectively. Given these reported numbers, Whirlpool earned $1,184 million or $18.4 per share in 2019. 

How should we value the $18.4 earnings per share? Again, let's follow Wacheniem's logic. He writes: 

On balance, my best guess was that Whirlpool was not worth more than 12 times its earnings, and therefore that the shares might be worth $250 to $300 in 2016. However, I finally decided that my current valuation made little difference. If Whirlpool came close to earning $20 per share in 2016, the shares (which we were selling at about $80 in the spring of 2011) would be an exciting investment regardless of whether they were worth 15 times earnings or 12 times earnings or even ten times earnings. 

In sum, and let the record show, that I believe that over the next 3- to 5- years, assuming earnings are between $18 to $20 per share, the market will value the shares at about $200. 

I believe that over the next 3- to 5- years, assuming earnings are between $18 to $20 per share, the market will value the shares at about $200. 

The risks

I see three concerns. The first issue is the lack of revenue growth. Second, the fierce competition. And third, the Grenfell saga. A brief on the three points follows. 

Lack of growth: Since 2015, the top-line at Whirlpool hadn't changed. The 2015 revenue was $20,891 million, and the 2019 revenue was $20,419 million. The same can be said for the operating margins of $1,560 million in 2015 and $1,391 million in 2019. Since 1949, Whirlpool compounded revenue growth at about 11% [7]. 

The competition: It is difficult to distinguish one brand of washer and dryer to others; they all have similar cycle times, size, features, weight, and pricing. And practically all of them break within 8 to 12 years.

It is also likely that the industry will experience a disruption. Think Casper's penetration to the mattress business. Think Harry's or Dollar Shave Club to the razor blade business. I don't know when and how the disruption to the home appliances business will arrive, but it is a matter of time.

The Grenfell Tower: In June 2017, London's Metropolitan Police released a statement that it had identified a Hotpoint-branded refrigerator as the initial source of the Grenfell Tower fire in West London. "The model in question was manufactured by Indesit Company between 2006 and 2009," wrote Whirlpool's management in response. 

While Whirlpool bought Indesit five years after the incident, they are likely to be liable. And indeed, the saga is not helping Whirlpool win the popularity contest in the U.K. Read this Insurance Journal article as an example. 


Pen&Paper is never about stock recommendations or trade ideas. Instead, it's about sharing business stories and attempting to understand what they can teach us about life. There are three lessons behind the story of Whirpool that I would like to highlight. 

The first lesson is that price matters. A lot. Investors often chase popular names such as Netflix or Amazon. But I doubt you can earn a reasonable return over the long term when you buy a company at a multiple of 63 times the trailing earnings (Netflix) or 60 times the trailing earnings (Amazon). Why a hefty price will result in an unsatisfactory rate of return will be a topic for future discussion. 

The second lesson is that predictable, understandable businesses bring comfort at stressful moments. One of my dearest friends bought ProShares Trust Ultra Vix Short three years ago, expecting the ETF to go up as capital markets would cool. But now that markets not only cooled but froze, the ETF is down 90% of its value three years prior.  

If Whirlpool will halve in market price, I will not sell the stock. Understanding a business removes the need to react to market conditions. Also though the price of resin and metal, the main cost ingredients, was volatile in past decades, the company slowly grew earnings. Whirlpool shows that it is better to rely on business fundamentals than on capital markets. 

The more you understand the business, the less you need to react to the market.

Finally, the third lesson is that cultivating patience is one of the great tools they don't teach you in business school. In the stock market, you are not awarded for making fast decisions. You are awarded for good ones. As Charlie Munger said, "The big money is not in the buying and the selling, but in the waiting." 

FOOTNOTES: [1] An oligopoly in business nomenclature. [2] Operating income divided by revenue. [3] Even after a hefty goodwill impairment charge. [4] The average 5-year free cash flow was $620 million. [5]  I have yet to see a shopper that treats a home appliance product to an Apple product.  [6] The effects of COVID 19. [7] An impressive growth rate for investors who are looking for a rate of return of 15% to 20%. 

Drinking The Kool-Aid?

Published on:
February 8, 2020
Reading time: 9 Minutes.
Last Update:

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!  

Buying Actavis was wrong

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 [1] 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?

How companies grow

"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."

What is worrying about Teva

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: 

The lawsuits

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.

The financial statements

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%.

While risk in investing is difficult to define, let alone calculate precisely, it is not good when the debt to equity ratio increases by three times.

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 [2] 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.


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The pharmaceutical industry

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, 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.

Trends in prices of generic prescription drugs
Trends in retail price of generic prescription. Source: AARP Public Policy Institute.

A stroll over Teva's past five years (2018 – 2014)

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 [3].

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 [4] was $6 billion, less than a third.

(The last time Teva paid a dividend was November 17, 2017.)

Teva's 2019 quarterly earnings.
Teva's 2019 earnings. Source: public filings.

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.  

Financial results (first three quarters of 2019) 

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 [5]

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.


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Teva's owner earnings

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.

In February 2020, at about $10 per share, Teva trades at a quarter of the implied 2018 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's owner earnings 2018 to 2014.
Teva's owner earnings. Source: My calculations.

Teva's generic and specialty medicine

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 [6]

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.

FOOTNOTES: [1] In 2016, the stock traded at about $60 a share. [2] In contrast to Vigodman, Schultz has pharmaceutical background. [3] Teva recognized $5.6 billion in non-cash, impairment losses. [4] Does not include business acquisitions. [5] I took out non-cash expenses such as asset impairment loss. [6] I couldn't find until what year Truxima will be protected.

A Multiple of One?

Published on:
December 7, 2019
Reading Time: 13 Minutes
Last Update:

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.

GrafTech's business

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 [1], Texas, Brazil, France, and Spain. The company's headquarters are in Brooklyn Heights, Ohio. It also leases five locations, mainly for sales.

GrafTech's income statement

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 [2], you would be pleased to see in GrafTech a business that requires little capital improvements.

GrafTech Key Operating Metrics 2018-2017
GrafTech's key operating metrics 2018-2017. Source: public filings.

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.

The price of electrode graphite is up threefold. The price was $9,937 in 2018 compared to $2,945 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.

GrafTech's future earnings

"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.

GrafTech cumulative profits until 2022
GrafTech cumulative profits until 2022. Source: public filings.

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.


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Electric arc furnace (EAF) v. basic oxygen furance (BOF)

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: 

GrafTech writes:

"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's competitive advantage

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 [3] of the world hold over 80% of total production.

GrafTech is a low-cost producer.

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."

GrafTech's peers

There are direct and indirect competitors. The direct competition [3] 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.

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.)

The steel industry's gloomy outlook

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 [4], there is too much steel chasing too few manufacturers.

There is too much steel chasing too few manufacturers.

Why I bought GrafTech

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.

At about $10,000 per million ton, GrafTech's margins are high. But the  margins are reasonable at $5,000, 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 [5].

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.  

The growth in the EV industry is clear. For example, lithium-ion batteries production was 1,00 million tons in 2014. In 2017, it was 60 times as much, 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.

FOOTNOTES: [1] The facility in St. Mary's is warm-idles according to GrafTech. [2] Magic formula investing an investment technique outlined by Joel Greenblatt which puts emphasis on companies with high return on capital. [3]  These five companies are Showa Denko K.K., GrafTech, Graphite India Limited, Tokai Carbon Co., Ltd., and HEG Ltd. [4] For more information, read his 2018 memo titled The Seven Worst Words in the World. [5]  The EV industry uses needle coke for the production of lithium-ion batteries.

Town Sports International Holdings, Inc.

Published on:
September 22, 2019
Last Update:

"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 [1]. 

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.

The fitness business is tough. Owners have to reinvest earnings and customers are unwilling to pay more for the upgrades.

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 [2] for a fraction of the cost, or they may go on a diet and give up on physical exercise.

Buying a few CLUB shares      

While the fitness business is competitive with little barriers to entry [3], 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.

Town Sports International: income statement snapshot
Snapshot of CLUB's income statement

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.

Trading at four times the enterprise value to free cash flow, Town Sports is for the bargain- hunters.

Where's the catch? 

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 [4], 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.

Town Sports International debt to assets ratio is high
CLUB's alarming debt to assets ratio

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 [5] 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.

Management decided this year to hide key information from readers of its financial statements. The action alone deters investment.

The remedies

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.   

FOOTNOTES: [1] No pun intended. [2] I recently downloaded XPT Life, an app designed by legendary waterman Laird Hamilton. [3] Barriers to entry are the obstacles that make it difficult to enter a given market. [4] If the shares are, indeed, such a bargain at $2, would she not have preferred to hold them?[5] Page 37 in the 2017 10-k report notes that annual attrition is total member losses for the year divided by the average monthly member count. Read: the higher the ratio, the worse it is.

Hyster-Yale Materials Handling

Published on:
September 7, 2019
Reading time: 3 Minutes
Last Update:

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.

The bad news on Hyster-Yale

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.[1]

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.

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.    

HY's earnings over past three years
HY's earnings over past three years

The good news on Hyster-yale

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[2], we arrive at $719.6 million in equity or $43 per share.

HY equity balance
A breakdown of HY equity balance


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."
FOOTNOTES: [1] The price of these copper and steel increased in 2018 compared to the year prior. [2] Read Howard Schilit's Financial Shenanigans for illustrations.