"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."
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.
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.
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 . 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."
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.
The change in Nautilus senior management was worrisome too. Bruce Cazenave, Nautilus' boss since 2011, resigned early this year . 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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"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.
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.
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.
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 Nautilus to see more.
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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The economics of the furniture business is not rosy. Sift through the financials of any publicly- traded furniture company and you will see that for every $100 of sales, $80 is consumed by building and delivering the furniture, $15 is paid to managers and about $5 to $8 are left to pay taxes to the U.S. government. Common shareholders are left with $2 to $3, a minuscule profit margin.
Outlook for the furniture business is gloomy, too. Recent tariffs enacted by the U.S. Congress raised the price of furniture imported from China by over 10%. And it is questionable how likely companies will succeed in passing the extra cost to consumers. How ecommerce will shape the future of buying and delivering furniture is a guessing game, too. What is certain is that the demand for furniture will weaken should the economy soften.
It is simply a tough business to be in. A typical furniture-maker must keep up with current consumer trends, work with few distributors that have bargaining power (think Home Depot, Costco and Amazon) and deal with many unforeseen challenges. One visible challenge is that selling furniture online is not easy, as management teams had thought. This year, for example, Flexsteel (FLXS on Nasdaq) took a $18.7 million impairment charge due to "software integration difficulties."
Whether you visit the website of Bassett Furniture (BSET on Nasdaq), Hooker Furniture Corporation (HOFT on Nasdaq) or La-Z-Boy Incorporation (LZB on Nyse), you will not find any visible difference in their product offerings - neither in price nor in style. Popular today is the rustic, natural wooden feel, compared to the slick and modern style of the early 2000s. For the untrained eye, the furniture business is a commodity business.
In numbers: Ethan Allen’s (ETH on Nyse) growth in revenue over the past 5-years was less than 1%. The company traded hands for $25 five years ago and now trades at $24 per share; Bassett Furniture’s 5-year CAGR growth was 6%, but shareholders who bought 5-years ago at the stock price of $13 can now sell their positions at $14. Flexsteel showed a 2%, 5-year CAGR growth and its stock price has halved over the past 5-years, from $35 to $18.
At a low price, even the most depressed company can become attractive. Flexsteel is now trading at less than 60% of the reported book value. It is trading slightly less than 10 times the 10-year average earnings per share of $1.98, and it’s yielding 5%, exactly 3 times higher than the yield on a 5-year Treasury (Flexsteel has consistently paid dividends to its shareholders since December 15, 1988).
So, why did the stock market slash by half its value? Two causes, I believe, are at fault. First, when Flexsteel closes its books for 2019 this month (its fiscal year ends June 30, 2019), it is likely to report a decline in revenue. So, the stock market fears that the unfortunate trend will continue. Second, management will report at least $27 million in expenses related to impairment losses and costs related to exiting the commercial office and the custom-designed hospitality products as management explained in May 15 of this year link.
For a company whose average 5-year, pre-tax income was $32 million and in June 2018 pre-tax income of $25.1 million, the expected $27 million in losses will completely wipe earnings for 2019, and the company is likely to report a loss, the first to be reported since 2009.
In addition, there's been a shakeup in management. Jerald Kittmer, Flexsteel's President and CEO, joined the company less than 6 months ago; Marcus Hamilton, Flexsteel's CFO, joined the firm in January 2018, and it is still uncertain how well the two will get along.
I plan to patiently wait a few years. Kitmmer is a veteran in the furniture business and Hamilton has over 20 years’ experience in finance, accounting and supply chain management. I also don't foresee any changes in the near term, because Flexsteel hardly carries any debt. As of March 2019, its third quarter filing, the company reported total assets of $265 million and total liabilities of $39 million, a 15% debt to asset ratio.
Competitors who offer similar products are trading at much higher valuations. For example, with a stock price of $27, Hooker Furniture is trading at 1.3 times its reported book value. With a stock price of $31, La-Z-Boy stock is trading at a whopping 2.4 times its reported book value. If Flexsteel was to trade at par, its stock price would be about $30.
While Flexsteel is trading at a ratio of 5 times the pre-tax income per share, the average price of pre-tax income per share ratio for its peer group is 10 times. If Flesteel was to trade at 10 times the pre-tax income, the stock price would be $35.
Flexsteel also passes the "four-proxy rule" coined by Charlie Dreifus of RoyceFunds link. When buying shares of publicly traded firms, Dreifus looks for management compensation metrics that are tied to GAAP earnings and not adjusted earnings (check). He also looks for folks with deep financial backgrounds that serve in the audit committee (Eric Rager meets his definition - check). He also reviews how often the audit committee meets (Flexsteel’s audit committee meets quarterly - check). And he verifies that senior management does not have extreme executive perks (check).
Dreifus, the 51-year stock picker veteran, was one of the reasons why I bought Flexsteel stock. His Special Equity Fund link owns 775,000 shares in Flexsteel. (RoyceFunds owns a total of 1,126,078 shares, 14.3% of the outstanding stock per the latest proxy statement). Perhaps, Dreifus, like yours truly, saw something beyond the gloominess of the furniture business.
"Four bucks a gallon - that's insane!," said Jim, a colleague. "My commute is over 25 miles each way. Let me tell you Noam, and I did the math, my monthly gas bill just increased by $300."
I had no idea that gas prices were up. I often cycle to work and when I do drive a car, I rarely pay attention to the gas bill; the Subaru is gas-efficien enough. Intrigued byJim's lamentation, I went to the local gas station in California and saw that a gallon of gas, indeed, now costs $4.55.
A raising gas price is a business problem for certain industries. So I returned to my desk and looked for publicly-traded companies that explore, develop and sell the commodity.
The initial results were unexciting. WPX Energy (WPX on Nyse), a natural gas liquidity company with market capitalization of $5,230 million, traded at 23 times the trailing earning and at a 20% premium to reported book value.
Cabot Oil & Gas (COG on Nyse), with a market capitalization of $11,000 million, traded at a more reasonable, 15 times the trailing earnings but at a whopping 5 times the reported book value.
QEP Resources (QEP on Nyse)market capitalization of $1,760 million, was slightly at a discount to book value. But QEP reported losses in 2018, 2016 and 2015.
So did Oasis Petroleum (OAW on Nyse). With a market capitalization of almost $2,000 million, the company traded at par but reported losses in 2018, 2016 and 2015.
Frustrated for wasting two hours of sifting through the financial statements of natural gas companies, I screened for companies - without a specific industry in mind - that traded at 90% below their-5 year stock price high.
One of the first companies that appeared on the list was Gulfport Energy Corporation (GPOR on Nasdaq). The stock traded as high as $75 in 2014 and was now exchanging hands for about $6 a share, a drop of over 90%. Curious to understand the reason for the sharp decline, I downloaded the 10-k report.
I learned three of three things: First was the reason for the decline in stock price. Over the past ten years the price dropped for all the commodities sold by Gulfport: Oil price per barrel is down to $49 from $68; natural gas price is down to 53 cents from 96 cents; and gas price is now $2.47 from $6.90.
The second issue was that the company's assets wildly grew. Gulfport's total assets increased to $5.8 billion from $2.7 billion five years ago, a compounded growth of 16%. But the equity increased to $3.3 billion from $2.69 billion, a compound growth of 4% .
Third, management had repurchased the stock at $8.81 at the end of last year and had budgeted to buy additional stock, up to $200 million worth, in the next two years.
I estimate that the company may buyback the stock without incurring any debt, simply by using free cash flow and perhaps selling non-core assets, such as the 9,829,548 shares Gulfport owned in Mammoth Energy (TUSK on Nasdaq.)
A back of the envelope calculation tells us that just the share repurchase program may result in an increase of 30% to 50% from the current price of $7 (write to me if you would like to see how I calculated this).
Yet what stands between the investor, yours truly now owns 1,500 shares, and the income from the natural gas and oil reserves is a board of directors that could easily win the worse capital allocator award, if there ever was one.
Since 2010 Gulfport’s board issued 138 million shares (read: diluted shareholders) at weighted price of $30. Since 2010, the company added to its equity base $3.19 billion; now the entire company can be bought for $1.19 billion, about a third of the price.
Surprisingly, perhaps, half of the board, four of the available eight board seats, is still running the show. Mr. David Houston has been a director since 1998. Mr. Ben Morris has been with the company since 2014. Mr. Craig Groeschel has been with the company since 2011. Mr. Scott E. Streller has been with the company since it became publicly traded in August 2006. As I wrote in A Docile Animal in Captivity, it is not easy to replace the gatekeepers - even ones with such dreadful track records.
In an industry fraught with technical terms such as "Proved Reserved" (page 3 of the recent 10-k report) and "Midstream Gathering"(page 62 of the recent 10-k report), natural gas investors, by default, know less about the business than the gatekeepers.
There are also uncertainties that management cannot plan for but only react to. Among those include supply and demand imbalances and future regulatory and political changes.
Why is there such a wide gap between GPOR's market price and value? Why did investors not complain about the board’s dismal performance? The advent and popularity of passive investing, I believe, is at fault.
Blackrock, via its iShares ETF product, owns 24 million Gulfport shares. Dimensional Fund Advisors, another ETF provider, owns 15 million Gulfport shares. The quantitative firm, LSV Asset Management, owns 9 million shares. In total, over 58 million shares (about 36%) of the available 159 million shares are owned by passive investment funds.
It is little surprise they haven't noticed the gap.
Investing in the common stock of Signet Jewelers (SIG on Nyse) is not for the faint of heart. While the price to adjusted earnings ratio is less than 10 times and the price to adjusted book value is less than half, to buy the common stock of any jewelry company is to put a leap of faith that management will never mention (truthfully or jokingly, as it may) that the product is "total crap". Instead management must convince us that diamonds are forever.
In this essay, I write why I bought the common stock of SIG at $21 per share and why I believe the value of the stock is nearly twice as much.
The company trades at 7 times the adjusted earnings per share. Let's assume that a year from today, the company will report on $5,950 million in sales, a 5% decline in sales compared to the latest financial filings.
We use ratio of cost of sales to revenue of 65% and a ratio of SG&A to sales of 30%. Signet's management expects that the interest expense this year will be $42 to $46 million, so we use a higher amount of $50 million to be on the conservative side. We arrive at pre-tax earnings of $247 million. After a 30% federal tax rate (we use a higher tax bracket that the 2019 tax bracket of 21%), the 2020 net earnings are $173 million or $3 per share.
Compare to both Signet's peers and compared to the company's market valuation in past years, a 7 times earnings ratio is cheap. Tiffany's (TIF on Nyse) and Fossil Group (FOSL on Nyse) trade at 20 times the earnings. Foot Locker (FL on Nyse) and Capri Holdings (CPRI on Nyse) trade at 12 times the earnings. Over the past decade, SIG’s earnings ratio was between 11 to 18 times.
The company is trading at a hefty discount to adjusted tangle equity book value too. While management reports to shareholders on tangible equity of $1,255 million, or $22 per share, investors are encouraged to adjust the equity balance. The adjustments are for deferred revenue and treasury stock.
The reported $966 million in deferred revenue, viewed as liabilities by the accountants, are a non-cash outlay. Signet offers its customers Extended Service Plans (ESPs) that are in effect lifetime warranty agreements. It collects cash from the customers when ESP is sold but reports the income slowly over the years (55% of the revenue is recognized within the first two years).
In 2019 the company sold $395 million of ESPs and the deferred cost (read: the cost to service those warranties) was $99.2 million. There is, in my opinion, about $666 million or $17 per share to be added back to the equity.
In 2019 management reported on a deficit of $1,027 million in the equity balance associated with the 18.1 million shares in treasury stock (read page 68 of the 10-k report.) But just as Signet bought back the common stock (the company a weighted average of $56 per share) Signet can sell the stock again. I consider Signet's treasury balance an asset. So I adjusted the equity the balance by adding back the 18.1 million common shares that Signet can sell at, say, $15 share. So $271 million or $5 per share can be added back to the equity.
Adjusting for the deferred revenue and for the treasury stock, we get an adjusted equity balance of $2,192 million or $42 per share. At $21 per share the stock traded at half the adjusted equity book value.
Before we move on to the Signet's risks, consider a comparison of peer companies’ valuation and Signet's past valuation. TIF trades at over 25 times the book value (an stark example of how the stock market values its remarkable brand). FOSL trades at 1.3 times the reported book value. FL trades at 2.7 times the reported book value. And CPRI trades at 3 times the book value. Historically, SIG traded at two times the reported book value.
A terrific book by Gerald Ratner's The Rise and Fall...and Rise Again is the true story of how a prosperous company, run by a dedicated manager, fell into oblivion. It is also the story of its demise largely because of Ratner's two words spoken to crowd in the Institute of Directors. The two words were Ratner’s description of one of the company’s products - a cherry glass that cost 4.95 pounds - and was "total crap" according to him. In short, In an industry where branding matters and customer perception is everything, the biggest risk is the one we have yet heard of.
In the final part of this essay, I will mention a few risks that we can understand and foresee.
The first risk is Signet's executive management's turnover and executive compensation. The two 'shake ups' in management were the departure of the CFO and the entrance of a new CEO, Gina Drosos. While she has been with the company since 2012 (on the board of directors), her compensation is just too much. She is paid 252 times the company’s median salary - a whopping $8.89 million per year. Only time will tell if she is worth it.
The second risk is that the industry is changing. Wall Street analysts deem buying diamond jewelry by visiting a local shop a thing of the past. And millennials are delaying marriage which hurts jewelry sales according to WSJ. E-commerce sales are only 11% of Signet's reported sales.
The third risk is Signet's Animal Spirits, which I will write more on next week. Signet acquired (and managed to write off) two large transactions in the past five years. It bought Zales in 2014 for $1.4 billion of which $1.2 billion was borrowed. It also bought Re2Net in 2017 for $365 million and borrowed $350 million. It also raised preferred equity of $619 million last year and sold the entire receivables portfolio. So to predict the journey the board will take current investors is a guessing game.
The fourth risk is the litigation risk. Over the past decade, CNN reports that the company has been charged with gender racial charges and of misleading consumers. The claims have yet to clear.