Category: Buys

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 electrode and petroleum coke. I kept 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's company is manufacturing something (more on that 'something' below) 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. It short, pp&e shows that GrafTech makes stuff.  

Specifically the company makes graphite electrodes which is a small-but-integral part of the steel manufacturing process. Graphtech's customers are steel companies. In Graphtech's words:

"Graphite electrodes are an industrial consumable product used primarily in EAF steel production, one of the two primary methods of steel production and the steelmaking technology used by all "mini-mills."  

Here is how Brookfield that boughtGrafTech in 2015, describes electrodes graphite:

"Electrodes graphite 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. Graphtech is the only graphite electrode produce able to produce its needle coke, a significant competitive advantage."

Graphtech'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.  

While GrafTech does not itemize the depreciation expense in the income statement, it is worthwhile data to go over. The total depreciation expense was $131 million in the past three years.

During this 3-year period, the total capital expenditures were precisely $131 million, too. So if you belong to the group of investors that follow the magic formula investing [2], you would be pleased to see in GrafTech a business that requires hardly any capital improvements.

GrafTech Key Operating Metrics 2018-2017
GrafTech Key Operating Metrics 2018-2017. Source: Public filings.

The table above shows that GraphTech had a dramatic revenue increase in 2018, largely the result of the electrode graphite prices increases. (Also, bottom line benefitted from some operational efficiencies.)

The weighted realized price for electrode graphite 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. Now let's look at 2019.

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, GraphTech 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." In the case of Graphtech, we have to look at 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, GraphTech shows future contracts  of 674,000 million ton of electodes graphite at about $10,000 per MT. These contracts represent about 65% of the planned capacity. Graphtech 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 ocntracted volumes have terms exending to 2022.

Electric arc furnace versus basic oxyen furance

There are two ways to make steel, the electric arc furance (EAF) method and basic oxygen furnace (BOF) method.

This is how EAF looks like: 

This is how BOF looks like this: 

GraphTech 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 cost the company about one-fourth to produce the produce compared to its peers. To be a low cost producer is always 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 produce because the company is  the only vertically integrated electrode manufacturer. Which means they control the price of needle coke, the main ingredient behind electrode graphite.  GraphTech writes on page 10 of the 2018 annual report: 

"Seadrift 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 competition

GrafTech has direct and indirect competitors. The direct competition is the four companies mentioned above. With these  companies, GrafTech competes in production capacity, the price of the product, and the cost to produce the product.

The indirect competition to GraphTech business is the BOF steelmaking. While the difference between the steel manufacturing method is probably 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, GraphTech benefits.

If BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GraphTech 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. China was the culprit.

Write to me if you would like a detailed description of the dynamics in the steel industry.

The steel industry 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.

An illustration: 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%. (If you want to spot a liar, ask someone at a party if they made money on steel stocks over the past few years.) 

Because of the reported declines in both revenue and earnings by practically all publicly traded steel companies, the outlook for the steel industry is now gloomy. Paraphrasing Howard Marks [4], there is too much steel chasing too few manufacturers.

There is too much steel chasing too few manufacturers.

"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." 

Earnings will determine GraphTech's future value. We can divide GrafTech's profits on (1) growth in the electrode industry, (2) the price of graphite electrode, (3) the production capacity, (4) the competitiveness, and (5) the cost to produce the product.

Why I bought GrafTech

At a market capitalization of about $3,500 million, GraphTech is trading a multiple of one. As I wrote in the first section of this essay, I estimate GraphTech will report to shareholders of $1,800 in revenue and of $767 million in earnings for 2019.

And since GraphTech 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.

Write to me if you would like a detailed analysis of GraphTech's valuation analysis.

Careful readers of GraphTech'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. Mr.

At about $10,000 per million ton, Graphtech's margins are high. But the operating margins are reasonable at $5,000 per MT, too.

At about $10,000 per million ton, GraphTech'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 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 cheked it was 60 times as much, about 60,000 million ton.  

The growth in the EV industry is clear. For example, make lithium-ion batteries was 1,00 million tons. In 2017, it was 60 times as much, 60,000 million ton.  

In short, GraphTech's current valuation and future growth possibilities were enough for me to buy the stock.

Postscript

A reminder for new 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: Graphtech's management and compensation structure, why Brookfield purchased GraphTech, a detailed analysis of the risks ahead, a peer-company review, and a valuation analysis.

If you find any of the above topics of interest, write to me. I reply to emails within a day.

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," noted 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 at least a queen bed; gym members expect Peloton machines and shiny, new barbells. In short, you constantly must reinvest cash in the business

The fitness business is tough. Owners have to reinvest earnings and customers are unwilling to pay for the upgrades with higher membership fees.

Another drawback is that the two largest operating costs - lease payments and labor wages - increase over time. And while these expenses rise, customers are not paying more than roughly $40 a month.

This is because there are plenty of options. People can exercise outside at no cost; they can subscribe to an app [2] for a fraction of the cost or they may simply go on a diet and give up on physical exercise.

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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 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 few publicly-traded fitness companies. A quick 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.

CLUB’s problems are lurking

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 its financial statements key information from readers. For many investors, that act alone would deter investment. Yours truly hopes that management action is simply 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 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 illustrations: 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, 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.
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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 30-year analysis on Town Sports International to see more.

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The remedies

Patrick Walsh, who Forbes Magazine describes as a "Warren Buffett enthusiast" wrote to CLUB's shareholders that "patience is a minor form of despair, disguised as 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 Jewish Community Center across the street 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.

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In their words: "In today's web, the means of production lie in the hands of the few. We want to change that, and help create a more beautiful, diverse web. We want to democratize access to the tools and knowledge required to build beautiful, well-coded websites, web apps, and - eventually - digital products of all kinds."

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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.    

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

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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.

Mednax, Inc.

Published on:
August 16, 2019
Reading Time: 4 Minutes.
Last Update:

"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.

The medical industry's gloominess

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.)

Businesses are taking health insurance costs to their hands.

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."    

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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.

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Mednax dismal performance

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.

Management increased the right side of the balance sheet. Its appetite for leverage is clearly noticed.

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%.

MD's decline in stock price
A Google screenshot of MD's price decline

Three ways to look at Mednax current valuation

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.

The income statement explanation

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.  

MD's premium to revenue over past five years
MD's five-year premium to revenue

The balance sheet explanation

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.

MD's five premium to book value
The five-year premium to book value

The operating statistics explanation

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[1].

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.

MD's growth in key revenue drivers
The growth in key revenue drivers

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[2].    

***

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.  

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FOOTNOTES
[1]Mednax revenue is 36% from Neonatology, 35% from Anesthesiology and 12% from Radiology with the remaining 17% from Maternal-fetal medicine, management services and Pediatric cardiology.  
**Medel holds 1,558,878 shares, which represents 1.8% of the outstanding common shares.

Nautilus, Inc.

Published on:
August 4, 2019
Reading time: 4 Minutes
Last Update:

This week I noticed that Nautilus Inc. (NLS on Nyse)traded at a 5-year low. I knew little about the sports equipment company but thought that a 67% discount to book value was enough of reason to read more.

Why Mr. Market is angry with Nautilus

From Barron's, I read that Mr. Market views sports equipment companies such as Nautilus to be a thing of the past, doomed to be a Blockbuster [1]. Today Mr. Market cheers companies such as Planet Fitness (PLNT on Nyse) and Peloton. They are the future, the Netflix of the industry.

Nautilus' management talks to investors about consolidation.  But Planet's management reports to shareholders with Silicon Valley jargon: "network effect," "economies of scale" and "disruption." 

Nautilus' management talks consolidation. But Planet Fitness' management talks network effect.

Mr. Market also worries about a looming recession.  Recession will first hurt companies that rely on our disposable income. So Nautilus is the opposite of a recession-proof company. Its products are expensive, and largely depend on third-party consumer credit. In short, indoor exercise gear is the last thing on our minds when times are tough.

Nautilus revenue and pre-tax income 2018, 2014 and 2009
Nautilus revenue and pre-tax income

The change in Nautilus senior management was worrisome too. Bruce Cazenave, Nautilus' boss since 2011, resigned early this year [2]. Since Cazenave was mostly in charge of the company's growth over the past seven years, Jim Barr, its new boss,  is stepping into big shoes.

I also saw that the stock price lost 87% over the past year. NLS traded in 2018 as low as $10 and as high as $17. In 2017, it traded as low as $12 and as high as $19. It now trades at less than $2.

Cooke & Bieler, a value cap manager I admire, sold the entire position. Their portfolio managers sold 1.9 million shares (about 6% of the outstanding stock), which they bought for about $16 a share.

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Nautilus' exposure to consumer debt

"To facilitate consumer sales," writes management on page 3 of the 10-k report, "We partner with several credit providers. Credit approval rates are an important variable in the number of products we sell in a given period."

In numbers: Over half of Nautilus customers borrowed money to buy the products. In 2018 and 2017, 54% and 51% of customers bought using credit, respectively. 

When over half of the sales are dependent on capital markets, if anything interrupts the credit environment, then sales decline. 

Also, at times of economic duress, common sense is that consumers will not buy the product in the first place. Perhaps management will propose investors that recession time is the time we should exercise even more – but it would be hardly a convincing argument and one that does follow the historical record. 

When over half of the sales are dependent on capital markets, if anything interrupts the credit environment, then sales decline. 

In the Great Recession, Nautilus' revenue declined to $284 million in 2008 from $501 million in 2007. During the last five years, the interest rate climate has been artificially low. That means it was easy for Nautilus's customers to load up on debt and to pay the monthly debt obligation.

Yet as soon as the interest rate environment returns to historical levels, the cost of debt will increase. It will be challenging to justify a personal exercise machine when one could quickly go to the local gym, at half the price. 

NLS balance sheet
Nautilus price to book value

Nautilius 2019 first-quarter results

January is the time we promise ourselves that we will be in better shape than ever in the upcoming year. And this annual resolution affects the earnings of companies such as Nautilus. So the first quarter results for sports equipment or wellness companies often show the highest quarterly revenue.

Yet Nautilus' first-quarter results were dismal. If you annualize the first quarter, you will find $338 million in expected revenue for 2019, remove $144 million for the cost to manufacture and deliver the machines. And after marketing, research and development and general and administrative expenses of $183 million, we estimate an operating loss this year of $39 million or $1.1 loss per share - the first (expected) loss since 2010.

There are also accounting irregularities that I have yet to understand. In 2018, the company reported $38 million in cash and $25 million in marketable securities. But as of the last public filing,  cash was down to $11 million, and marketable securities dropped to $12 million. Management also added a new line-item called "operating and finance lease rights." The classification of the asset, worthwhile to note, is not a short-term asset, such as cash and marketable securities, but long-term.

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But I couldn't resist buying a few shares. I will rationalize the purchase as follows:

(1) The company has not diluted shareholders. Ten years ago, there were 30.66 million shares, roughly the same number of shares are outstanding today.

(2) The company hardly carries debt, which results in an operating income to interest expense ratio greater than ten times, allowing the company to experience "dry spell years."

(3) The current valuation of $43 million in market capitalization is less than the pre-tax earnings in 2015 of $51.4 million.

Finally, when the cost of sales is half of the revenue, management has a lot of room to improve operations. Management can focus on becoming leaner, reducing overhead, or perhaps utilizing better marketing strategies, which I will explore in future essays.

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FOOTNOTES
[1] Blockbuster was a provider of home movie and video game rental services. Competition from Netflix and other video-on-demand services led to its bankruptcy filing in 2010. 
[2 ] Cazenave landed a gig at the direct-to-consumer retailer, Bluestem Group Inc.