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Goodwill

Why I bought CSV

Published on:
January 25, 2019
Last Update:

Carriage Services, a funeral home company, has two lines of business. Funeral homes operations, the first of the two, consists of: (1) ceremony and memorial services, (2) disposition of remains either through burial or cremation and (3) memorialization through monuments or inscriptions. Funeral homes operations are about 80% of Carriage's revenue.  

The second line of business is cemetery operations. Carriage operates 32 cemeteries in 11 states. Cemetery operations generate revenues through sales of internment rights and memorials, installation fees, finance charges from installment sales, contract and investment income from preeneed cemetery merchandise trusts and perpetual care trusts.    

Preneed programs

These programs enable families to establish in advance the type of service to be performed and the products to be used. Preneed contracts permit families to eliminate issues of making death care plans at the time of need and allow input from other family members before the death occurs. The contracts are paid on an installment basis. The performance of preneed funeral contracts is usually secured by placing the funds collected in trust for the benefit of the customer.

Carriage sold about 7,500 preneed funeral contracts over the past five years. As of 2017, the company had a backlog of 93,712 preneed funeral contracts and 63,523 cemetery contracts to be delivered in the future.

The two risks Carriage faces

Two trends are and will continue to hurt companies that operate in the funeral and cemetery business. The first negative trend is that we bury less people today, as I noted last week.

In 2017, the number of burials in the United States decreased by an estimated 0.8%. The burial rate was estimated to be 48.5% and is estimated to fall to 43.3% in 2022. It is estimated that there will be about 1.3 million burials in 2021, declining from 1.36 million in 2017, according to the 10-k report.

The second negative trend is that the number of cremations is increasing. The number of cremations increased by 5% in 2017 following increases of 4.3% in 2016 and 7.4% in 2015. In 2021, it is estimated that there will be about 1.7 million cremations in the United States and a cremation rate of 56.7%. "Nobody is yet writing undertaking's epitaph," wrote The Economist in Great News for dead: the funeral industry is being disrupted", "but the industry will have to adapt."  

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Could Carriage be an exception to the rule?

Carriage has done a reasonable job fighting off these two industry trends. Over the past five years, revenue increased by 4% compounded annually, to $201 million from $163 million. Net earnings, adjusted for non-cash items such as depreciation and amortization, increased by almost 8%, to $36 million in 2017 from $25 million in 2013. Equity balance increased by about 5%, to $198 million in 2017 from $156 million in 2013.

Carriage generates plenty of cash to meet debt service obligation, too. In 2017, for example, Carriage gross revenue was $104 million; it had general and administrative cost of $26 million and $13 million in costs. There was $65 million in cash flow to service the reported interest expense of $13 million, an adequate coverage of about 5 times. 

The company reported $121 million in long term liabilities, compared to tangible total assets of $615 million, a ratio of 20%. To get to the tangible total assets, I removed the intangible goodwill assets of $306 million.

Why I bought the stock

While a faux pas to buy shares in a company whose industry tailwinds are working against, I decided to buy 1,000 shares of Carriage at a total price of $16,000. My investment thesis is as follows: A reasonable market valuation for Carriage, in my opinion, is a price to earnings multiple between 15 to 10 - the average trailing three years earnings per share.

Since the average earnings per share over the past three years were $2, I estimated the value of Carriage to be $20 to $30. My cost basis was $16 per share, and I intend to hold the stock for at least two years. This translates to a 2-year expected return between 12% and 37%.    

Epilogue

The number of deaths in the United States over the past three years increased by 2% each year. This is the result of a rapidly growing and aging population, which is expected to increase the numbers of deaths in the foreseeable future. Americans 65 and older are the fastest-growing segment of the population, with 48.2 million, expected to increase to 55.7 million in 2021, an average annual growth rate of 2.9%.

While many investors would regard the preceding statistic as tailwind for the industry, I would like to point out to the reader that often statistics do not translate to earnings for the investor.

Consider the airline industry, for example. This technological innovation has completely changed how we think about travel and how global trade is performed. And yet, the airline industry proved to be a poor investment vehicle for the investor.

Investors in the airline industry learned, over the past 50 years, of customers’ lack of loyalty to a brand, the rising cost of both labor unions and regulation and the challenging, volatile landscape facing buyers of fuel. Benjamin Zhang, writing for Business Insider, adds that congestion, passenger comfort and pilot shortage are increasing problems, too.  

For the funeral stock investor, a similar investing outcome may prevail. Workers at funeral homes provide a humane service, filled with emotion and empathy. It is important work. 

Yet this humane profession will not necessarily translate into stellar returns over equity ratios or net profit margins. In short, macroeconomic trends should not drive your investing decisions. In Peter Drucker’s own words, “No single piece of macroeconomic advice given by experts to their government has ever had the results predicted.”

Why I am Bearish on United Natural Foods Stock

Published on:
December 22, 2018
Last Update:

Benjamin Graham would be proud. Using Value Line stock screener for stocks trading at less than 5 times the trailing earnings per share, I came across a company that operates in the unglamorous business of food distribution. 

United Natural Foods, I quickly learned, is a fortune 500 company that had earned a profit in each year of the past decade. And yet it was trading at less than 5 times the trailing earnings per share. Was I dreaming?

At at a first glance, UNFI was alluring

The historical operating financials were beautiful. In 2008, earnings per share were $1.38 compared to $3.26 earnings per share as of its most recent annual filing. And this not-to-be-taken for-granted 9% compounded rate of growth was achieved with little dilution of outstanding shares. And participants in capital markets, whether speculators or investors, traded the stock of United Natural Foods as low as $13 (in 2009) and as high as $84 (in 2015).  

The income statement and balance sheet were attractive, too. After adjusting for an impairment expense, I arrived at a three-year average cash flow per share, net of capital expenditures, of about $2. More importantly, there was plenty of income to service the debt: the operating income to interest expense ratio was greater than 14 times during that period.

 And after removing goodwill from the reported assets, I arrived at book value per share of $29 in 2018 and of $26 in 2017. Put differently, priced at $22 per share, UNFI was trading at 25% discount to book value.  

Yet the price of the stock had more than halved this year. In January, common shares in UNFI were quoted at around $50. With the passing of six months, the stock declined to $32 from $42 in less than a month, a drop of 24%. And for those investors that held the stock, at the time of this writing, the stock price is $10.

 UNFI's appetite for leverage

 It will not take you long to learn that Mr. Market is angry with UNFI because of its Animal Spirits. "This transaction accelerates UNFI's growth strategy by immediately enhancing our product range,equipping us to bring an attractive, comprehensive product portfolio to an expanded universe of customers," said Steve Spinner, UNFI's boss.

"The combination of UNFI and SUPERVALUE provides a substantial premium and delivers certainty of value to our stockholders, meaningful benefits to our customers and expanded opportunities to our employees."  

And as somewhat expected from any merger and acquisition transaction by a Fortune 500 company, Spinner used the s-word. Synergy.

The expected, rosy future of the combined entity is the result of a serious gamble. The gamble being the amount of debt UNFI used to finance the transaction, where the cash used to pay out SUPERVALUE shareholders was not from retained earnings, but using the willingness of lenders. 

And in a rising interest rate environment, management decided that adding $1.2 billion in a new revolving line facility, as well as adding $2.05 billion in the form of a term loan. Not a good idea.

The dean of the world distressed debt, Howard Marks, once said that we should not predict future, but instead, focus our attention on the present and what present conditions say about the future.

 In the case of UNFI, certainly we cannot predict what the company’s income statement will look like in five years, but we can understand the significant amount of the leverage taken. Due to the acquisition, United Food increased the right side of its balance sheet by three times, from $1.2 billion as of July 2018 to over $4.3 as of today.

So, not only are current buyers of the stock taking leverage risk and risk related to how successful the merger will prevail, but also,invariably, these traders are taking on risks that the company never addressed previously. 

To name a few: the company is highly dependent on the success of Whole Foods Markets, as it accounted for about 37% of the fiscal 2018 sales. Or that the firm operates in a low margin business where profit margins are expected to decease as the industry is consolidating.

Count me out

I had other, idiosyncratic reasons to avoid UNFI stock. First, I do not shop at Whole Foods. I believe they sell overpriced items that can easily be found elsewhere at a cheaper price. 

And it is absolutely meaningless to me that in some stores you can now shop without taking your wallet from your pocket (I didn’t thought it to be of such an inconvenience).  

Second, I believe UNFI overpaid for SUPERVALUE, which to me is a sign of an overly optimistic, bullish management. In its most recent annual filing, SUPERVALUE disclosed to shareholders that the stock price range was $14 in the fourth quarter of 2018. Yet UNFI paid $32.50 for the same stock.

 UNFI's management must not believe in the Efficient Market Hypothsis.

While I did not buy any shares in UNFI, I did buy an equity interest in other businesses this year. In Make Equity Great Again I wrote why I bought shares in the company best associated with the word "Victoria’s Secret models.” 

Unrelated to the beautify business, but somewhat implicitly related to the business of being and looking healthy, in Lifeway Foods: Why I am long probioticsI wrote about my purchase of a small company that produces kefir products. 

And in August of this year, I described my Tupperware purchase, both of the physical product itself and of the company's stock. You can read more about it in Tupperware Company: A Quality Product but Shareholders Should Beware of The Debt Level.

NAFTA And Core Molding Technologies

Published on:
October 20, 2018
Last Update:

That things are not always what they seem and that first appearance may deceive many was already understood by Plato over two millenniums ago. In this meditation I will describe what at a first glance appeared to be a bargain stock, was an ill-advised purchase upon a careful review. My purpose in writing this meditation is to demonstrate that financial numbers and the prices of stocks are the starting point, but not the final word in stock investing.  

Core Molding Technologies Inc., which trades on the New York stock exchange, appeared to be a bargain stock. Management had increased the number of outstanding shares by one percent compounded over the past decade. In 2008 there were 6.8 million common shares outstanding and today there are 7.7 million common shares outstanding. The average 10-year earnings per share was 93 cents - the stock traded at roughly 9 times the decade-long average earnings per share. The book value per share increased by three-fold during this time. And Benjamin Graham would be proud of my discovery, I thought.      

Its rags to riches story is remarkable. CMT sells a particular niche product called reinforced plastics. The top industries that use the product are transportation, construction and industrial. The company’s major customers include Navistar, Volvo, Paccar, Yamaha and Bombrader Recreation Production. As of the end of last year, these customers were responsible for over 90% of CMT's sales.  

What drove the stock price down

So here is a company with a reasonable product that traded hands at a cheap price. The company's common stock started at $20 in 2018 and had halved recently. The culprit was Mr Market's fear of how changes in the North American Agreement on Environment Cooperation (NAFTA) will affect the company.

NAFTA targets the relationship between America, Mexico and Canada, the same countries in which CMT predominately operates. In 2017 CMT revenue from Uncle Sam’s land was $103.5 million in the United States, $52.5 million from the land governed by Enrique Pena Nieto and $5.6 million in the land of Maple syrup. It also owns and leases manufacturing plants in all three countries.

As many of you know NAFTA is now being renegotiated. And while final details have yet to be published, it will be of little surprise to see red tape and additional costs in the auto industry (in which the majority of CMT’s customers operate.) And business logic dictates that if the customer of a company is suffering, then the company’s business will be hurt too. In short, the expected macroeconomic changes in policy penalized the stock price of CMT.    

But while the looming NAFTA uncertainty is not helping companies like CMT, the is more to the the decline in the stock price. I argue that CMT’s stock price to decline its purchase of Horizon Plastics International, which was announced in January of this year.

Using a combination of cash and debt, CMT paid $63 million for Horizon. "The purpose of the acquisition was to increase the company's process capabilities," explained management. "They will now include structural foam and structural web molding, expand the geographical footprint and diversify the company's customer base."

All nice and well, I thought. But at what premium? Instead of waiting to see whether the future value of companies that operate in Canada and Mexico will deteriorate given the new NAFTA agreement, CMT's management was eager to move forward and paid a premium for Horizon Plastics.

On an increase in goodwill and debt

In CMT’s10-Q filing as of year end 2017, the company recorded $2.9 million in goodwill and intangible accounts. Compare that to the second quarter of this year where it recorded a whopping $40.1 million in intangible assets. Yet what should truly scare current shareholders (yours truly is not included in that group) is the debt level.

Long term debt as of last year was only $3.75 million. Yet as of the second quarter of this year, long term debt was $39.4 million, a little over nine times as much. Evidently, management's appetite for debt affected the income statement. The interest expense this year was 8 times higher compared to the same period last year. In numbers: In June the interest expense was $1.07 million compared to $129 thousand a year ago. So operating income to interest expense deteriorated to 2.37 times, compared to 44.38 times a year ago.

In our rising interest rate environment, it is puzzling why management had added fuel to the fire by taking a variable debt obligation and not a fixed debt obligation. Since management had not addressed the matter in its recent earnings call, I will offer a few explanations for the variable versus fixed debt conundrum.

First, the bankers would not finance the acquisition of Horizon Plastic with fixed debt. Second, management does not consider this to be a rising interest rate environment. Third, the cost of variable debt payments was much cheaper than fixed debt payments. Fourth, management was just careless and does not see the variable-versus-fixed debt as a material issue. Fifth, and most likely in my opinion, management did not have other options.

All roads lead to Rome. And no matter the justification, current shareholders should be appalled by CMT’s management's past business decisions. To pay a premium for a company that operates in Canada and Mexico was wrong. To finance the acquisition using variable debt was wrong. And to reduce the cash balance to practically nil was wrong too.

Free Cash Flow Is Superior to EBITDA

Published on:
July 28, 2018
Last Update:

It took over ten years for people to get used to the idea of an automatic elevator; over 30 years to feel okay about eating shrimp [1]; and 20 years passed before passive investing, tracking the movement of an index such as S&P 500, was accepted [2].

This essay reflects whether it is time that we change how we look at the
operating performance of a business.

What's wrong with EBITDA

Earnings before interest, tax, depreciation and amortization (EBITDA) allows management to boast on theoretical, imaginative financial results. It is similar to a marathon runner explaining that he or she finished a marathon in less than four hours, if only they had not taken a 25-minute rest in the second hour. 

EBITDA figures are always higher than free cash flow numbers and result in a higher valuation for the company and a greater ability to take on debt. It should be of little surprise that it was popular in the ‘80s - the era of leveraged buyouts.

Net earnings are suspicious too. This is because management is acutely aware that Mr. Market [3] watches net earnings like a hawk. In addition, net earnings are subjective because expenses such as depreciation, goodwill and amortization  are dependent on management decisions. As a result, it is hard to compare the net earnings of one company to the next. 

EBITDA numbers are higher than net earnings. Little surprise they are popular in leverage buyouts.

While net earnings are influenced by management’ decisions, reported book value measurement is dependent on the accounting convention. And while intentions may be innocent for both the accountants and management, the reported book value often results in nonsensical numbers for the investor.

Consider goodwill as an example. This asset category represents the excess purchase price above the net fair value of the company acquired. While it is considered an asset, the chances the reported value will be realized is as real as the chances that another purchaser will price the goodwill account as reported on the balance sheet. That rarely happens.

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Free cash flow definition

The classic definition of free cash flow is cash flow from operations less capital expenditures. Investopedia.com provides guidance how to calculate free cash flow. With free cash flow, it is easier to compare the profitability of a real estate firm to a company that sells dairy products.

Both companies collect and spend cash and both companies require cash to maintain their operations. A real estate company will repaint the buildings it owns and a dairy products company will upgrade the manufacturing plant. For the investor, in both scenarios, there is really only one concern: how much cash will be left at the end of the day.

Free cash flow provides the true picture of how a business is doing. Free cash flow aims to answer one question: how much cash is left to the owner of the business after all required expenses and taxes have been paid.

If we can estimate how much cash flow a business will generate in the future, we can decide whether the current price of the stock fairly represents the expected future cash flow. (There are other uses of free cash flow. credit issues. Read on the importance of free cash flow here.) While this is a simple, fundamental concept to stock investing, it is also one of the hardest ones.

It is hard because the future is unknown, and because the future
economics of a company are dependent on many immeasurable variables.

Consider the case study below where I describe a company that sells dairy products. Its profitability is dependent on a consumer's preference; on the cost of raw milk; on changes in the competitive landscape; and on its distribution system and manufacturing capabilities.

Free cash flow example

Observing free cash flow was the reason why I bought the stock of Lifeway Foods (LWAY) a few weeks ago. Between 2017 and 2008 the company earned a total of $32 million.

But the reported earnings included $22 million of depreciation expenses. So I added those back. I also removed capital expenditures [4]  and the working capital expenses (such inventory). These were $38 million. The result was that Lifeway earned a total of $17 million in free cash flow over the past decade.

I estimated that over the next ten years the company's free cash flow will be $17 million too. And so we can say that on average the company's free cash flow each year will be $1.7 million.

(For simplicity sake, I assume no change in shares outstanding and used the current number of 16 million shares in my calculations.)

At the price of $4 a share, I bought $2 of tangible book value and an expected ten cents per share of free cash flow over the next decade. Grab your HP12C, and you will find this is an expected free cash flow yield of 10%.

FOOTNOTES
[1] Shrimps were considered the ocean’s cockroach. 
[2] In the ‘90s passive investing was said to be "unAmerican."
[3] Mr. Market is an allegory created by investor Benjamin Graham. It was first introduced in his 1949 book, The Intelligent Investor.
[4] capital expenditures is reported in the cash flow statement, not in the income statement.

A ratio to examine profitability and performance

Published on:
May 25, 2018
Last Update:
October 6, 2019

Barbara Tuchman wrote in the The March of Folly, “Wisdom, which may be defined as the exercise of judgment acting on experience, common sense and available information, is less operative and more frustrated than it should be.”

In her seminal work, she provided a plenitude of examples to prove her point: from the story of the Trojans and the wooden horse to a detailed description of how Renaissance Popes provoked the Protestants.  She showed how government clearly acted against its self-interests when there were other options to choose from. And that it was a collective of individuals who took the wrong path and just one despot. Alas, she coined the situation: a folly. 

A folly can be seen in the world of stock investing too. For example, a simple but useful profitability ratio, called return on invested capital (ROIC) ratio has been used for decades by gurus investors such as Bruce Berkowitz  and Joel Greenblatt. Yet not only is the ratio rarely discussed today, there is even confusion on how to properly calculate it.

A folly can be see in the world of investing. Return on invested capital is often used by guru investors but there is great confusion on how to calculate it.

Return on invested capital ratio formula

Some use net operating profit after taxes (NOPAT) in the numerator while others use earning before interest (EBIT). In the denominator some investors use tangible equity (effectively removing the other comprehensive income (OCI) component and other intangible items, such as goodwill. And others use year-end figures, or they average the begin- and year-end book value. You can also use this return on invested capital calculator.

Similar to most of our terminology in the stock investing world, there are no clear definitions and each approach has its advantages. Two important things are consistency and logic: choose in the numerator a cash flow measure and in the denominator a number that best describes how much capital was invested in the business.  

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A real world example

To find the return on invested capital ratio, I take free cash flow and divide it by the average stockholder equity balance. For simplicity’s sake, free cash flow is the cash flow from operations less capital expenditures, and the average stockholder equity is the sum of the beginning and year-end balances divided by two.

We can use the operating financials of Caesarstone Ltd., (CSTE), a quartz surfaces manufacturer, to illustrate the math.

In 2017 CSTE cash flow from operation was $61 million and its capital expenditures were  $23 million which gets us to $38 million in free cash flow. The company had 34 million dilutive common shares or $1.11 free cash flow per share.

Its book value per share was $13.66 at the beginning of 2017 and $12.59 at year-end.So the average book value per share was $13.13 and the 2017 ROIC was 8.45%.  

What return on invested capital ratio means

The return on invested capital ratio provides an estimate of how successful the managers of the company are in deploying capital. Or simply put: how profitable the business is.

The ratio also gives a rough estimate how one company compares to the other. Let's compare the return on invested capital ratios of the highly admired Apple Inc., (AAPLE) and GE Electric (GE).

In 2017, using the definition above, Apple's ROIC was 40% and its five-year average ROIC was 45%. Compare that to GE's ROIC of 4% and its five-year average ROIC of 6%.

Unsurprisingly, perhaps, Apple's stock trades today at $187 compared to about $70 five years ago, while GE's stock trades today at $15 compared to about $24 in 2013. In short, capital markets favor companies and industries that demonstrate high, double-digit ROIC. And calculating the ROIC also allows you to compare among companies operating in the same industries.

Capital markets favor companies that demonstrate high, double-digit ROIC ratios.

Let us return to Caesarstone and compare its ROIC to other companies that operate in the building material industry. Headquartered in North Carolina, United States, Martin Marietta Materials (MLM) ROIC was 5% in 2017 and its five-year ROIC was 11%.

Another company is Vulcan Material Company (VMC), an American company based in Birmingham, Alabama, that engages in the production, distribution and sale of construction materials. VMC’s ROIC was 4% in 2017 and its five-year ROIC average was 4%.

From that we can deduce that CSTR’s profitability lies roughly between the two firms.

What is a good return on invested capital?

In my view, a reasonable return on invested capital is 20%  on average over the past ten years. With no year less than 15% return on invested capital. This standard of economic excellence is not my invention. Here is what Warren Buffett wrote about economic excellence in 1987: 

Only 25 of 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

Further resources on ROIC ratio

 Now that you know what ROIC is and what it represents, I invite you to further explore the ratio and its implication. Visit Magic Formula, a website that ranks companies based on their return on invested capital. And if you download the publicly available financials of the companies listed, you can examine why the website ranked the companies as it did.

Another free stock screener can be found at https://fintel.io/screen/roic-return-on-invested-capital-screen. Similar to Magic Formula, the exercise here would be to determine whether you agree or disagree with the stock screener. Write to me if you would like to see some examples of my work.

From there, you can visit Gurufocus. In the article Return on Invested Capital in 2 Easy Steps, Dave Ahern mentions a different methodology to calculate  ROIC. His article is well detailed with excellent examples.

Finally, over the next few months, I will meditate on other investing concepts that are hidden from the investing jargon but can bring a lot of value. If you would like to be notified when I post these essays, write to me.