Saturday, March 29, 2008

Recurring Revenues and Industrials

Economic uncertainty generally steers investors toward steady eddy businesses such as foods, consumer staples, healthcare and utilities. But what investors should be seeking is recurring revenues, predictable and stable revenues with a high degree of certainty.

Recurring revenues are highly desirable and frequently carry a higher level of margin than capital equipment businesses. Even industrial companies can demonstrate a high level of recurring revenue and a fairly low level of capital intensity, both very desirable qualities for these times.

Manufacturing in the States, largely as a function of the weak dollar continues to progress at a fairly decent pace, especially for export related manufacturing. But industrial distributors can benefit greatly from this strength as well. Uniquely, most distributors end up as significant beneficiaries of inflation on two fronts.

Unlike many manufacturers who largely pass on cost increases dollar for dollar, distributors typically have been able to pass on gross margins on top of cost increases, meaning that these companies don't lose their margin percentage. The second point related to inflation is that distributors can sometimes be fortunate enough to get ahead of the curve in dealing with higher costs. These companies can obtain a shorter-term benefit in terms of a one-quarter or longer pickup in their gross margins if lower cost inventory is sold at the higher price points.

I think one of the better opportunities in industrial distribution exists in MSC Industrial Direct, a company I recently reviewed in

MSC Industrial (MSM) is one of the nation's leading industrial supply distributors. With a network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the company assures its customers same day shipping, at no extra cost, with over 99.99% availability. The company truly recognizes the importance of satisfying its customers' needs. If they fail to meet the service deadline standard, they send their customer $100.

The company's history dates back to 1941 but became a more significant factor as a direct sales organization with the publication of its first catalog in 1964. In 1994, the company began to expand into maintenance, repair and operations (MRO) products, which provide a more stable demand stream of sales and cash flow for the business. In addition to its master catalogs, the company also publishes 123 specialty catalogs tailored to specific industries or products.

The vp-finance of MSM described in the Wall Street Transcript ( required) a couple of years ago the steady demand for this business:

"...we have the ability to reduce the total procurement cost of MRO (maintenance, repair and operating) supplies for our customers. Every business uses MRO. It encompasses everything from abrasives and cutting tools and measuring instruments to lubricants, sanitary supplies, cleaning supplies, chemicals, solvents, hand tools, power tools, hardware, electrical supplies, plumbing supplies, HVAC and more; essentially, if you can think of an MRO item, it's likely that we have it in our catalog."
This is a highly fragmented industry. Again from the interview:

"Why do we grow and why have we grown so fast? Well, the industry that we compete in, the one for industrial supplies, is very, very fragmented. The total MRO marketplace in the United States alone is approximately $300 billion. If you exclude the demand from original equipment manufacturing, you probably have a $150 billion marketplace. that $150 billion represents what we call semi-planned and unplanned needs. Unplanned needs are pretty much self- explanatory ' something breaks and you need to replace it. So you call a distributor and they have the part and you get it. Semi-planned are those things you know you are going to use up over time; you just don't know when you are going to need it and how much you are going to need. Generally, these are things that people stock in tool cribs or in supply
rooms and historically they keep large inventories of these items just in case they need them. They are not things you want to be out of, because you can shut down a machine or a line or an entire factory. I mentioned the industry is very fragmented. There are approximately 150,000 distributors that share the $150 billion marketplace and they employ a sales force somewhere in the neighborhood of half a million sales people. Most of those distributors are very small and have very few SKUs (stock keeping units) on hand. And they generally are niche players. So they may be a safety distributor or an electrical distributor. These people play in a very small marketplace and historically, since MRO in any one particular business has not been paid a lot of attention, people are doing a lot of manual sourcing of MRO
supplies and dealing with a lot of different distributors. MSC is a superior business model because we have 590,000 SKUs in stock compared to the 15,000 or so a small distributor stocks. this allows an individual or a business or an educational institution or a government agency to consolidate their buying to one very reliable vendor that has it in stock and can get it to them quickly. "

The company has a particular competitive advantage in its extensive e-commerce abilities that enable customers to lower their procurement costs. This includes many features such as swift search and transaction abilities, access to real-time inventory, customer specific pricing, workflow management tools, customized reporting and other features. The systems can also interface directly with many purchasing portals such as ARIBA and Perfect Commerce, in addition to Enterprise Resource Planning (ERP) Procurement Solutions such as Oracle, SAP and Infor. Consequently, the firm offers its customers inventory management solutions that reduce sourcing costs, out of stock situations, and inventory investment, all of which become even more important when business slows.

MSM's valuation has contracted significantly of late; likely discounting further manufacturing and economic weakness, yet investors may be ignoring the potential benefits from share gain trends. On a trailing P/E basis, the company is as cheap as it has been in the last decade:

1998....32.8 X

The company is currently trading at an EV/EBITDA of about 8 times despite earning 20% return on invested capital last year. In the last five years, ROIC has averaged better than 15%. Here's a look at the ratio analysis courtesy of

Google Docs - msm ratios-marketthoughts

Check out the relatively low level of capital intensity that this company has demonstrated over time. The company has generated over $700 million in cash flow from operations since 2000 and has spent only $128 million in capex over that period. As well, the company has treated shareholders as partners. Share buybacks have returned over $280 million to shareholders. Here is a look at the deployment of cash flow and returns to shareholders since 2000 courtesy of Reuters Knowledge:

Dividends, which were instituted in 2004, have grown steadily from an initial rate of $0.32 per share annually to a current annual pace of $0.72 and have returned $231 million to shareholders. The current yield is about 1.9%.

In January, the company announced that it has authorized an increase in its stock repurchase plan to 7.0 million shares, which includes the approximately 1.9 million shares remaining under the previous authorization.

The company has shown steady improvement in working capital utilization and currently operates on a cash cycle of 98 days versus 113 days three years ago.

Effective voting control of the firm is held by the founder and his sister who cumulatively hold 63% of the vote. Lone Pine Capital, run by Steve Mandel, a well-known hedge fund manager holds about 7.9% of the company.

Overall, this is a high ROIC business with a reasonably steady growth in recurring revenues. It is a business that seems to becoming more important to its customers and is grabbing market share in a very fragmented industry of mom and pop shops. Its competitive advantages come from scale and technological prowess as well as logistics. Some slowdown will occur in economic times such as we have but the valuation appears to compensate adequately.

Disclaimer: I, my family, or fclients have a current position in MSC.

Friday, March 14, 2008

A Lemons Market- Information Asymmetry and Bear Stearns

Asymmetric information gets to the root of today's market problem in Bear Stearns. George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 Nobel Prize in Economics for their work in this area.

Akerlof, who wrote the earliest paper in this area, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" describes the market for used cars as a market that is distorted by quality uncertainty. Owners of decent used cars are unable to get a "decent" price to make selling these cars worthwhile, therefore they don't place these cars in the market. Because "quality" is not readily ascertainable, the quality of traded automobiles should be sub-average.

A lemon market will be produced by the following:

1. Asymmetry of information
- no buyers can accurately assess the value of a product through examination before sale is made
- all sellers can more accurately assess the value of a product prior to sale
2. An incentive exists for the seller to pass off a low quality product as a higher quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
4. Deficiency of effective public quality assurances (by reputation or regulation)
5. Deficiency of effective guarantees / warranties

The market in financial services stocks has become a lemons market. Questions about asset value prevail, liquidity concerns arise, and the true condition of the assets is enigmatic. Despite 225 basis points of Fed Funds rates and co-ordinated central bank liquidity, and a broad Term Security Lending Facility, the impact on market sentiment and credit spreads has been negligible.

There is but one solution to the problem... transparency and disclosure, being more open in what is going on and why. The mystery that surrounds the arrangement between JP Morgan and Bear Stearns contaminates the rumor mill and raises investors' concerns.

Bear Stearns may have $84 in book value which certainly gets the Ben Graham instincts going, but the reality is much more uncertain. Valuation in a financial services stock is wholly dependent on future cash flow streams. There is precious little in tangible assets. There is huge uncertainty about valuation of assets comprised of pyramids of paper assets. Given the uncertainty, Bear Stearns' counterparty ratings are clipped and may be viewed by some as almost toxic.

I cannot imagine how difficult it is for BSC employees as they watch their franchise quake in the crisis. We have friends and associates who either work there or have spent part of their careers there. My thoughts are with you.

But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.

Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own and avoid the expensive distractions of today's tape.

Disclaimer: I. my family, or clients do not have a position in any of the securities mentioned in this post.

Wednesday, March 12, 2008

Beliefs, Perceptions and Reality-Semiconductor Capital Equipment

Growth has a seductive charm. There is a widespread belief that momentum drives growth and that a succession of knocking down challenges and consequent victories is what characterizes a successful business. But sustained growth is seldom straightforward. Sustained growth frequently occurs as a result of changing course, breaking rules, and changing the rules of the game. I think some of the rules have changed for the semiconductor capital equipment companies.

Years ago, within the semiconductor industry, there was a strategy that merging companies would result in a reduction in the historic overcapacity issue. This trend certainly developed as Texas Instruments sold its DRAM capability to Micron and Hyundai and LG merged their operations. Small players would be wiped out or have to find niches to survive.

Last month, the Semiconductor Industry Association (SIA) reported that global sales of semiconductors grew last year by 3.2%. It really is an amazing figure given the fact that cell phone unit shipments grew 20%, that laptops grew 32.2%, that LCD TVs grew 50%, and consumer appetite for electronics seems unabated globally.

Total bit shipments for DRAMs nearly doubled in 2007, but total revenues declined by 7.4 percent due to a decline of more than 39 percent in ASPs. NAND flash revenues were up 26 percent but unit shipments grew even faster at nearly 46 percent, while ASPs declined by 13.7 percent.

Increased concentration in the industry simply has fanned the flames of competition and price cutting rather than quell them. To quote Steve Pelayo of HSBC who recently was interviewed in The Wall Street Transcript (subscription required):

"DRAM manufacturing has been in a state of oversupply, which resulted in greater than 75% average selling price (ASP) declines last year. As a result of the significant ASP pressure, many DRAM players today are now reporting operating margins that are significantly in the red, as much as negative 50% operating margins. So clearly too much excess supply in DRAMs and a lack of profitability is causing a massive contraction in their capital spending plans this year."

Post tech bubble, semiconductor capital spending did a face plant, down 40% in 2001 and another 30% in 2002. The equipment companies responded by diversifying their revenue sources into other segments such as solar equipment and flat panel displays. In past cycles, whenever semiconductor demand slowed or caught a sniffle, pneumonia ensued for their capital equipment suppliers. This time may be different!

Growth has slowed but in fact these businesses have improved. Let's look at the capital intensity of some of the semiconductor companies versus that of their equipment suppliers:

Capital spending as a percentage of revenues (TTM)

Micron (MU) 59.3 %
Intel (INTC) 11.25 %
Advanced Micro (AMD) 24.75 %

Applied Materials(AMAT) 5.08 %
ASML Holding (ASML) 7.46 %
KLA-Tencor (KLAC) 5.09 %
Novellus (NVLS) 2.12 %

With this lower fixed cost intensity, equipment companies should not see their margins crater and improved what Pelayo calls their "cyclical resiliency."

All of the semiconductor capital equipment companies I have cited above generated free cash flow in the last twelve months. Pelayo adds:

"The cash flow generation capabilities have proven much more improved too, with some consistently generating 20% plus returns on operating cash flow, and in some cases similar returns even on a free cash flow basis (including cash outlays for capital spending). All of this positive cash flow just continues to add to the companies' treasure chests of cash, which has resulted in many of the larger players starting to pay dividends and buy back stock. The dividend yields are still less than 2% or so, but I think they have the opportunity to increase over time. So far, equipment suppliers have been really focused on buying back their stocks. Companies like Applied Materials have bought back a tremendous amount and decreased their shares outstanding by as much as 15% or so."

The solar opportunity for these suppliers seems to receive very little attention by investors. Solar manufacturing has many similarities to semiconductor production and presumably, can provide significant fewer growth for these companies. As I suggest earlier, getting knocked down, getting beaten up by too high a reliance on traditional customers helped the semiconductor capital equipment companies approach other niches. Changing course and changing the rules of the game has made them better businesses.

Disclaimer: Neither I, my family, or clients have a position in the securities mentioned in this post with the exception of Intel.

Saturday, March 08, 2008

Renaissance and Revival

It has been an extraordinarily long time since I last published thoughts here for which I truly apologize. Needless to say, capital markets have been challenging and clients prefer a higher level of care and attention when markets are rocky. Businesses evolve through these challenges and create opportunities to add skillsets and analytics and establish an even firmer foundation and discipline. Renaissance and revival are frequently the result of such times.

I particularly want to thank a fellow Canadian, Jay Walker, the Confused Capitalist for his gentle cajoling me back into the blogosphere. Jay has just celebrated the second anniversary of the start of his excellent blog and I congratulate him for his terrific work. His understanding of real estate appraisal and investments make his blog a valuable resource in these times.

One especially interesting e-mail from an anonymous reader suggested that I am Geoff Gannon of Gannon on Investing whose publishing frequency has also been impacted by other projects. I am not, nor is he. Geoff, your insightful commentary and wisdom are missed.

A few other friends that I wish to thank for their help and indulgence in this period of absence. Henry To at continues to provide investors valuable reflections on the stock market and the global economy as well as an outstanding forum. I am pleased to be a monthly contributor to his service. David Korn, who with Henry and Kirk Lindstrom publish the Retirement Advisor, a timely resource for people who are either approaching or in retirement has also been kind enough to publish some of my thoughts in his website,

To my loyal readers, I appreciate your patience, your readership, and in particular the continued interest in past topics and posts. I endeavor to improve the frequency in sharing our thoughts.

Back to stocks. Many years ago, I was introduced to Alleghany Corp (Y) by a lucky accident. I had previously worked for the Canadian subsidiary of Lincoln National (LNC) which had just sold off its title insurance subsidiary, Chicago Title to Alleghany at what appeared, at least to me, to be a bargain price. Housing back in the early to mid- 80's was reviled as much as it is currently, in fact, in our mortgage department, we were recipients of people's keys that were being mailed in as people were giving up their homes. Title insurance was considered a terrible red-haired step child at the parent company with little chance of earning a return. John Burns, then the CEO of Alleghany saw opportunity in this distress sale. The payback on this investment was 18 months, absolutely remarkable for what was viewed as a no-growth business. Needless to say, I became a big fan of Burns and of Alleghany. Chicago Title was ultimately spun-off to shareholders and later became part of Fidelity National (FNF).

Visiting Burns at Alleghany over the years reinforced the value discipline that this remarkable gentleman has. He is an avid student of value investing and of course Buffett. His attention to detail, his keen awareness of valuation,and his knowledge of the insurance industry were always very impressive.

Many of us value hounds collect stories of Berkshire, White Mountains (WTM), Leucadia (LUK), and Markel (MKL), yet too infrequently is Alleghany mentioned. The objective of the firm sounds very Buffett-like:

"Alleghany's objective is to create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance. Alleghany is managed by a select company staff which seeks out attractive investment opportunities, delegates responsibilities to competent and motivated managers, defines risk parameters, sets management goals for its operating businesses, ensures that managers are provided with incentives to meet these goals, and monitors their progress.The operating businesses function in an entrepreneurial climate as quasi-autonomous enterprises.Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor."
Alleghany has brought some very unique insurance businesses into the fold. Capital Transamerica of Madison, WI was an insurance company with a magnificent underwriting record in specialty lines and a history of shareholders equity growth that George Fait, its founder and president would remind me at insurance conferences actually outgrew Berkshire's record. It was true!

Another successful specialty insurance franchise was acquired with RSUI, Royal Specialty Underwriting, Inc. , the Atlanta, Georgia-based excess and surplus underwriting subsidiary of Royal & Sun Alliance Insurance Group plc.

Alleghany holds a majority ownership in Darwin Professional Underwriters (DR) a company tightly focused on Directors and Officers, and Errors and Omissions insurance. Stephen Sills, the founder and CEO of DR, was the chief underwriter and founder and ultimately the CEO of Executive Risk, a very highly regarded company in this field. Executive Risk eventually went public. Chubb (CB) acquired this business in 1999 at a very full price. Alleghany, on the other hand, established Darwin with Sills in 2003 as an 80/20 venture as an underwriting manager under Capital Transamerica, as usual, avoiding paying a huge acquisition premium.

Years before Berkshire bought its position in Burlington Northern Santa Fe (BNI), John Burns had accumulated a large position in the 1990's. The cost basis, about $12.07 versus today's $88.00.

Strong executive leadership continues to impress since Burns' retirement (he remains Chairman.) Wes Hicks has extensive experience as a senior executive, capital manager and research analyst in the insurance and investment industries. He joined Alleghany from Chubb Corporation, where he was CFO. Prior to Chubb, he was a senior research analyst covering the property-casualty and multiline insurance industries at J.P. Morgan Securities (where he was also a managing director) for two years and Sanford C. Bernstein & Co., Inc for eight years.

Going through the recent 10-K, results remain quite strong. Ex cats and cap gains they earned $30.29 in 2007 vs. $28.20 in 2006. Cash and invested assets are $4.9b and the company's book value grew by almost 16% yoy. All the insurance subs wrote at an underwriting profit for the Q except CATA, which was due to higher loss and loss adjustments (but was offset somewhat by higher net premium). Overall they did a very respectable 77% combined ratio.

Trading at about 1.1x book value, the company appears very well capitalized if not over-capitalized. RSUI’s (66% of underwriting profit) most admired peers (MKL, RLI, and CGI) command multiples of book value between 1.5x and 1.8x – CGI is the object of $2.3b takeout at 1.6x – and a well run, growing, profitable insurance company should go for more than 1.1x. In addition, the firm carries the Darwin (DR) stake and real estate owned in the Sacramento, CA area at below-market historic price, providing hidden asset value and additional upside to book value. This hidden asset value may in fact equate to the stock trading at book.

In my estimation, the fair value for this business is $425-$475. The potent combination of multiple expansion and book value growth as well as outstanding investment ability could prove very profitable over the coming years. The company also recognizes its value and has recently announced a $300 million share buyback.

One negative aside. Standard & Poor's downgraded slightly Alleghany's credit rating to BBB from BBB+, in my view casting more doubt on S&P's credit ranking abilities than on Alleghany's credit. The slight downgrade was done without any discussion with Alleghany executives perhaps leading some of us to question the degree of due diligence that may have been demonstrated here. Wes Hicks also expressed some surprise and disappointment in this.

In my view, among the financial services stocks, the company stands out for its conservatism, its strong underwriting discipline, and its great executive team which has masterfully allocated capital over the years.

Disclaimer: I, my family, or clients hold a position in Alleghany, Berkshire, and Markel.

< ? Market Blogs £ >