Molycorp

Posted on by balajithinks

About a week ago, Molycorp, the rare earth minerals manufacturer declared a chapter 11 bankruptcy.

From google finance,

Molycorp, Inc. is a rare earths producer. The Company operates in four business segments: Resources, Chemicals and Oxides, Magnetic Materials and Alloys and Rare Metals. The Resources segment includes its operations at the Mountain Pass facility. The Chemicals and Oxides segment includes the production of rare earths at Molycorp Silmet; production of separated heavy rare earth oxides and other engineered materials from its Molycorp Jiangyin facility, and production of rare earths, salts of rare earth elements (REEs), zirconium-based engineered materials and mixed rare earth/zirconium oxides from its Molycorp Zibo facility. The Magnetic Materials and Alloys segment includes the production of Neo Powders through its wholly owned manufacturing facilities. The Rare Metals segment produces, reclaims, refines and markets niche metals and their compounds.

Often companies get into bankruptcy as they are unable to absorb the burden of the debt that they have undertaken and go through the bankruptcy process and come out stronger with better negotiated debt on the other side. The market that Molycorp operates in is dominated by Chinese firms . When the economic behemoth tried to strong arm the world by controlling supplies, Molycorp and Lynas came up with supplies with some non-Chinese mines. These two companies at one point contributed to 10% of the global consumption. Since then the Chinese have backed down and the world has been more than willing to buy from them at rock bottom prices.

When one looks at the financials of Molycorp, attention needs to be paid to the income statement rather than the balance sheet as we usually do in distressed conditions.

$M 2012 2013 2014
Sales 527.7 554.4 475.6
GP 18.8 -67.2 -99.6
GP % 3.6% -12.1% -20.9%

The company has been reporting net negative gross margins. The company has been losing money just getting metal out of the ground. This is even before the sales force is paid, the corporate expenses are paid and even before the interest payments are serviced on the debt. The only time when the GP’s were positive was during the Chinese induced shortages which resulted in a huge price increased in the market. Just restructuring the debt with lower interests or better terms or financial engineering is not the solution to this problem.

The company has not outlined any measures that can make the investor comfortable that a margin of safety exists in the bond even under distress. Unless there is another attempt to strong arm the rare earth market from the Chinese or the US is determined to use only US made rare earth metals, or the Chinese crack down on the black market,  financial engineering will only go far to stem this tide. A cautious investor will do well to sit this out and watch from the sideline!

What are we reading?

Posted on by balajithinks

Simply knowing isn’t enough to change behaviors (FarnamStreet)

The evolution of a value investor (ValueWalk)

Heinz completes Kraft Merger, Buffett to Join Board (NYTimes)

Our previous post on Heinz Kraft merger and our thoughts (here)

Warren Buffett re-examines Re-Insurance (WSJ)

The education of AirBnB’s Brian Cheksey (Fortune)

How Shelby made $900M in Insurance (Valuewalk) H/T: AlphaIdeas

Be Skeptical; Mantri Developers Assures 100% Return Again with SEBI and RBI watching (capitalmind) H/T: Alphaideas

Persistent Systems: Globetrotter (Persistent)

Sysco and the hubris of buy backs

Posted on by balajithinks

From Google finance:

Sysco Corporation (Sysco) along with its subsidiaries and divisions, is a North American distributor of food and related products primarily to the foodservice or food-away-from-home industry. The Company provides products and related services to approximately 425,000 customers, including restaurants, healthcare and educational facilities, lodging establishments and other foodservice customers. Sysco provides food and related products to the foodservice or food-away-from-home industry. The Company has aggregated its operating companies into a number of segments, of which only Broadline and SYGMA are the main segments. Broadline operating companies distribute a line of food products and a variety of non-food products to their customers. SYGMA operating companies distribute a line of food products and a variety of non-food products to chain restaurant customer locations. The Company’s other segments include its specialty produce, custom-cut meat and lodging industry products segments

Sysco was recently in the news for terminating the merger deal with US foods (link here). At the same time they announced that they would be buying back stock of about $3B from the market.

  • Total market cap of Sysco is around $22B
  • At the last close price it is trading at a PE of 25; earnings yield is 4%
  • Net margin for the business is 1.79% for TTM
  • Debt/equity for the business is at 1.44
  • ROE for the business is at 16.3% for TTM
  • FCF for the business is $868M
  • Shares outstanding for the business is 599M

Let us see what happens as a result of this buyback. For the sake of simplicity, let us assume that Sysco can buyback the stock without significantly influencing the price.

Sysco current price 37.54
Oustanding shares 599
Buyback ($M) 3000
Shares to be repurchased 79.91476
After buyback outstanding shares 519.0852
Net Income 868
EPS before buy back 1.449082
EPS after buy back 1.672172
% EPS Growth 15.4%

So far so good. Current investors can spend $3B at current prices and get a 15% bump on EPS.

Any company can spend the money it generates in four ways

  1. Dividends to shareholders
  2. Buybacks to return money to shareholders
  3. Inorganic growth through  acquisitions
  4. Fund internal programs

At any given point, the CEO, whose prime job is capital allocation, is deciding where to allocate the money.

The current ROE of Sysco is 16%. Let us explore option 4 and see what happens if Sysco is able to generate half the ROE that it generates with the new programs on which it would spend the $3B on without diluting shares by using internal cash generation and debt to generate an incremental ROE of 8%.

To be invested in additional internal project ($M) 3000
ROE 8%
Additional to FCF and Net Income / year (simplified to assume the same number for both) ($M) 240
Net Income after re-investment ($M) 1108
EPS 1.84975

The EPS growth in this case is 27% significantly higher than the buyback scenario. The ROE of internal projects needs to be 4.4% for the buyback option to make sense over the re-investment scenario which is also a possibility and we can assume that the CEO has done his due diligence.

The questions that begs to be asked are as follows:

  • What is a stock doing trading at 25 times PE when it cannot find re-investment projects at one-fourth of the ROE that the company generates today?
  • Is the management being prudent is buying back stock at 25 times earnings? Even at 20 times, the EPS growth generated will not be as lucrative as the re-investment option.
  • Is the CEO doing his job of optimal capital allocation?
  • Is the market rational and efficient when it either rewards a stock that cannot find a project at 4% ROE or is taking sub-optimal capital allocation decisions?

Not all buybacks are created equal. A conservative investor needs to be cautious before rewarding businesses blindly that buyback shares in the name of shareholder value creation.

Dun & Bradstreet (DNB) — a value trap

Posted on by balajithinks

As per DNB’s 10-K (2014)

The Dun & Bradstreet Corporation  is the world’s leading source of commercial data, analytics and insight on businesses. Our global commercial database as of December 31, 2014 contained more than 240 million business records. We transform commercial data into valuable insight which is the foundation of our global solutions that customers rely on to make critical business decisions.

  • DNB has a market cap of $4.5B
  • Trailing PE of 18.5
  • Revenue has grown from $33.2/share in 2010 to 45.8/share in 2014
  • EPS has gone up from 4.99/share to 7.09/share
  • DNB has negative equity and ROE is infinity
  • Very strong GP margins with 66.8% which has remained flat over the last four years
  • Net margin has expanded from 15.5% in 2010 to 17% in 2014
  • LT debt to total assets has gone up from 0.5 to 0.7
  • Shares outstanding is down from 50 million shares in 2010 to 36.4 shares in 2014
  • FCF has remained flat around the $250M/year mark for the last four years

Below table shows the underlying EPS change adjusted for buybacks.

2010 2011 2012 2013 2014
Shares Outstanding 50.4 49.3 46 39.5 36.9
-2.2% -6.7% -14.1% -6.6%
Theoretical Net Income 50.4 50.4 50.4 50.4 50.4
EPS 1 1.02 1.10 1.28 1.37
Actual Net Income 252 260 296 259 294
EPS 5.0 5.3 6.4 6.6 8.0
EPS change 5.5% 22.0% 1.9% 21.5%
Underlying EPS change 3.2% 13.8% -12.5% 13.5%

The underlying business shows strong improvements in the underlying EPS except for 2013.

This is a very interesting case where so far we have seen shows a very strong underlying business. It is almost a Warren Buffett type of company.

Let’s look at the entire business from another perspective

$M 2010 2011 2012 2013 2014 4 Year CAGR
Revenue 1677 1759 1663 1665 1682 0.1%
Gross Profit 1119 1171 1142 1105 1112 -0.2%
Operating Profit 409 425 432 437 422 0.8%
Net Income 252 260 296 259 294 3.9%

So, revenue, gross profits and operating profits have not moved at all in the last four years so where is all the underlying EPS change coming from?

% 2010 2011 2012 2013 2014
Tax Rate 35.55 29.67 21.97 34.22 15.09

2013 EPS was -ve when DNB paid a full tax rate and 2014 EPS growth was all driven by lower tax provisions. So, what is driving this different tax rate? In page 140 of the 2014 annual report is the answer.

DNB IT

in 2013, when the company had no tax benefits from restructuring or legacy tax matters, the tax rate was full 35%. The underlying EPS change was (12.5)%. There was a $66M legacy tax in 2014 without which might not be available in 2015 and forward.  So, what was driving the $66M legacy tax benefit?

IT_2 IT_3

It definitely looks like a non-recurring tax benefit. The company does however comments that it might benefit from more sales into lower tax states but does not quantify the same. Can a conservative investor count on tax benefits to help drive free cash flow in the future?

A zero sales growth, negligible operating profit growth and free cash flow growth company is trading at 19 times earnings in the US…  With competition intensifying from low cost search aggregators and a changing landscape in technology services, Investing in DNB today does look like a very speculative bet. While the underlying business drives strong ROE and has great products, a shareholder investing in the common might not see the benefits of the same in the long run.

Disclosure: No position