Discovery (DISCA)

For this fourth edition of ValueTeddys Snap Judgements we are taking a look at Discovery, which has been suggested to me by a twitter follower. It is also a 5% position in Michael Burry’s portfolio according to Dataroma when I’m writing this.

Discovery

Ticker: DISCA
Market Cap: 20.4 b SUSD
Revenue: 10.6 b USD

Discovery is probably most known for Discovery Channel and Animal Planet, but the more general description is something along the lines of: Discovery provides paid television, free-to-air TV, broadcast TV, content licencing, and direct to consumer subscription services. In other words, they own and create content, and they also own several large networks. I won’t go deeper into all the IP and networks they own, but I suggest you give it a quick glance in the annual report.

Heading straight into the financials, we see that revenues are split between advertising and distribution. Other revenues are relatively insignificant. For FY 2020 total revenues were roughly 10.6 b USD, of which 5.5 b came from advertising and 4.8 b came from distribution. Total revenues are down from 2019 and roughly on par with 2018. The reason seems to be that the advertising revenues bounce around a fair bit, whereas the distribution revenue is relatively flat. Total costs for 2020 were just north of 8 b, which left operational income of 2.5 b. Nothing odd sticks out regarding the costs. All the costs seem to be quite stable during 2018-2020. Interest expenses have decreased from 700 m in 2018 to 650 m in 2020, and after tax earnings land on 1.2 b. I note that net income changes a lot from year to year (600 m in 2018, 2 b in 2019).

Moving on to the balance sheet, there is 12 b of equity, and 21 b in liabilities, of which 3 b is short term. The asset side contains 2 b of cash, and another 4 b in other current assets. What I don’t like seeing here is over 20 b of goodwill and intangibles. To me this looks like a rather thin balance sheet. There is lots of debt and lots of intangible assets, which I generally dislike. The total debt is 1.75 times the equity, and close to 10 times the operational profits.

Looking at the cash flow the first thing I examine in this case is how much of the operational cash flow is used to service the debt. The total operational cash flow was 2.7 b in 2020, and the total interest expense was 648 m. As far as I can tell from this brief overview of the financial statements, it seems like Discovery is revolving a lot of its debt. This is far too brief an analysis for me to evaluate if this is, or could be, problematic. It is however the first thing I would look at if I were considering buying the stock. Stuff like maturities and contingencies is probably the first thing, in order to gauge how bad a theoretical worst case could be. I’m not saying they are in trouble right now, and as long as they can keep refinancing the short term debt it seems fine. But I want to say it again, to me this looks like a stretched balance sheet. Lots of debt, and lots of intangible assets.

With that said, lets look at the valuation. According to Börsdata, Discovery is trading at 5x EV/EBITDA, 12x EV/Operating Cash-flow, and a P/S of 1.9. Ok so yeah, it’s looking kinda cheap. But it is actually close to its 5 year average EV/EBITDA of 4.6. Even looking back to 2011 the highest EV/EBITDA was 5.9 and lowest was 3.6. It actually traded at 4x in 2019. So it has been cheap for quite some time.

So to end this snap judgement, its not that clear cut. I don’t love the business personally, I see lots of competition to linear TV, and most of those options are better in my opinion. However, they are still earning lots of cash, and its not that expensive. They are however operating with what I deem a stretched balance sheet. Also, Dr Burry who happens to be a much smarter investor than me seems to like the stock… So do with that information what you like. I am adding Discovery to my watchlist, and I will take a harder look if they should fall to “distressed” valuation levels. I do see how many of the scenarios you can come up with seem likely. Both the doomy scenario where they simply shrink due to failure to compete with on-demand streaming services, and I see how it could be possible that they manage to keep generating cash and trade at a low multiple for some time. To summarise this case, it seems tricky, far from clear cut. Probably a good learning opportunity to try and take a good look at it, but I will put that off for now.

So that was the fourth edition of ValueTeddys Snap Judgements. I hope you liked it, and remember that none of this is financial advice and I’m not your financial adviser. If you want to suggest stocks for me to look at, you can tweet @ValueTeddy, and do check out valueteddy.com.

GomSpace (GOMX)

It’s Easter and thus this third edition of ValueTeddys Snap Judgements is slightly delayed. I hope you have had a nice holiday, and that you find this letter interesting.

GomSpace

Ticker: GOM
Market cap: 911 m SEK
Revenue: 194 m SEK

I remember a few years ago where space and micro-satellites was the big thing on Swedish FinTwit. GomSpace is one of those very hot stocks at that time, and it has seemingly come back to earth since.

First of all, this is a Denmark based company, but its listed in Sweden. It’s not dual listed in DK as well but its only listed in Sweden. This always raises an eyebrow, and I generally feel suspicious of companies listed in countries other than where their HQ is. Of course there might be cases where this makes sense, but I always feel it should be examined.

GomSpace is provide parts and subsystems for small satellites, as well as whole satellites and control software etc. This is not an entirely uninteresting sector, and its one where I think I could get a feel for the business and its competitors.

Moving to the finances from the full year as reported in the Q4 for 2020, we see a significant increase in revenues and gross profit. Revenues grew 42% from 136 m to 194 m and gross profit grew ~160% from 18 m to 47.6 m. However they are till making an operating loss of 30 m, which is an improvement compared to last years loss of 113 m. Looking at the operating costs, I note something interesting. Nearly every line item has decreased. This causes me to suspect something tricky regarding the sales cycle in this industry, but I might be wrong. In my experience it is challenging to increase revenues while at the same time decreasing SG&A costs. This should be something to look into before investing in this stock, since the decreased SG&A could be foreshadowing an upcoming decrease in sales.

So this is a company I would pass on simply since it is not operationally profitable. As far as I can tell, GomSpace need to double gross profit while not increasing overhead by anything in order to reach operating profitability. For the sake of the letter we are still moving on to the balance sheet and the cash flows, even though this is where I would pass.

GomSpace carries 102 m in short term debt and 53 m in long term debt, against 247 m of equity. On the asset side they have 65 m of pp&e and 214 m of current assets (of which 135 m is cash). The debt seems to be well matched against the assets. In other words there are short term assets to match the short term debt, and the long term debt seem to have funded long term assets.

Moving to the cash flows we see a net positive cash flow from operations of 43 m compared to a cash burn of 92 m the year before. When a company is like this, it is really important to look at what adjustments cause the operating loss to still provide positive operating cash flow. In this case, the largest adjustments are 1. depreciation and amortisation, 2. change in working capital, and 3. changes in financial items and tax received. If this were a deeper analysis, this is a point where I would put significant time and effort, especially in this case where the operating profits are negative and the operating cash flow is positive.

The D&A change is about same as last year nothing odd here, and the change in financial items and tax is roughly same as last year also. Being a net receiver of tax is not something one should rely on, and if the company turns profitable this is something that will change. Also, reversing financial items only makes sense when looking purely at operations, it is a very real cost. That leaves the changes in working capital, in this statement labelled as change in inventories, trade receivables, other receivables, and change in trade and other payables. It is normal for these line items to fluctuate, but in GomSpaces case the final line (trade and other payables) is a net cash contribution of 33 m, compared to a net cash deduction of 49 m last year. This is something we also can see in the balance sheet as a decrease of receivables and an increase in payables. This causes me to think that the net positive cash flow from operations might be temporary, and it is something one should take a close look at in this case.

With all that said, lets look at the valuation. GomSpace trades at about 250 times EV/EBITDA and a P/S of 4.7. Maybe I’m missing something here, but it looks to me like there is a lot priced in here. There are two big questions in these sorts of cases, 1. when will they be profitable, and 2. how much capital needs to be raised before that happens. In this short and brief analysis I have way too little information to answer either question, but to me it looks to be far out. However, they have cash on hand so they wont need cash immediately, and if they can keep operational cash flow positive it not impossible for them to reach real operational profitability. This does not look like a screaming buy to me, but its nonetheless an interesting case.

Parting words

So that was the third edition of this little experiment. I hope you liked it, and remember that none of this is financial advice and I’m not your financial adviser. If you want to suggest stocks for me to look at, you can tweet @ValueTeddy, and do check out valueteddy.com.

Dividends and Dividend Yield

In this post I am going to tackle dividends, and dividend yield. First I am going to focus on the capital allocation aspect of dividends, and then there will be a brief discussion about dividend yield.

Paying high dividends means that the company uses a lot of the cash it generates to pay dividends to the holders of common equity. Why I dislike this as an investment thesis might become clearer after we take a look at the five ways a company can allocate its capital. These five capital allocation decisions are:

  1. Reinvest in the operations
  2. Acquire businesses
  3. Repay debt
  4. Repurchase shares
  5. Pay dividends

A company with a large market up ahead, or a company in earlier stages will have no choice but to reinvest in the operations, such as developing new products or expanding geographically. An alternative to investing directly into the operations is acquiring another company. This is another topic, but there are both good and bad reasons for acquisitions. This is similar to reinvesting in the operations, since it requires that company thinks there is potential for greater profits if they scale up the business.

The company can also decide to lower the debt burden by repaying loans, or repurchasing bonds. This is equal to distributing cash to debt-holders. This alternative signals that the company thinks the level of debt is impairing the business, either because of bankruptcy risk, or because it hinders the business from taking action. This could also indicate that the business can’t find better investment opportunities than lowering the financial expenses. This is because a net cost reduction of 1$ is the same as a net gain of 1$.

The company can also buy back their own shares. This can either be done in a clever way, where the management believe their company is being undervalued by the market, or in less clever ways. It is quite common for companies to have predetermined buyback programmes, usually to offset the dilutionary effect of options or incentive programmes. There are also companies that use buyback as a part of their dividend programme, usually for tax purposes. Finally, there are buybacks where the company is buying back shares at a price which they determine is below fair value. It is this last option that can add value to the firm, since it is favourable for the company to buy their shares back from shareholders who are willing to sell, at a price that is below intrinsic value. This can also signal that the company is undervalued, given that the management has a history of good capital allocation. The others cases of share buybacks simply redistribute value from the company to the shareholders, and can possibly be destroying value for the company if it’s buying an overvalued asset.

Finally, the company can give the money to the shareholders. There are two downsides to this. First of all, it signals that the company cannot invest the funds at an attractive return within the business. The marginal return on capital within the business it less than the return the company assumes the shareholders can get on their own. Secondly, dividends also trigger double taxation, since the company has already paid corporate tax on the funds, and then the investor has to pay tax on the dividend received.

In other words, companies that pay high dividends in relation to their earnings, indicate that they have no good investment opportunities within the business. They cannot earn a higher return on their money than the investor can. A dividend is simply the company giving you money that you already own. If it is possible, it is better to reinvest it in the business, given that it is high quality, than to give it to the shareholders. In some cases you even see such inefficient behaviour as companies both issuing shares and paying dividends. In other words, taking money from shareholders AND paying out money to the shareholders. It is also not unheard of companies increasing their level of debt while paying a dividend.

Moving to dividend yield. To start, what information does the key ratio “dividend yield” carry? It is the cash dividend divided by the share price. Therefore, a higher dividend yield means that the dividend is larger in relation to the share price. This means that the price of the business is lower in relation to the dividend they pay. This makes it a measure of price, and not a measure of quality.

Buying companies solely because they have a high dividend yield is the same as buying it only because it looks cheap on a surface level. This disregards the quality of the company, and there are usually reasons why a company looks instantly cheap on a surface level. This approach is similar to picking stocks on the basis of a low price to earnings ratio. Low P/E stocks usually have a very good reason for trading at low multiples. Often along the lines of very low expected future earnings. This should lead to the conclusion that only looking at a stocks dividend yield is insufficient analysis of the business.

There are of however some merit to dividends. For example, there is nothing wrong with a business that has inherent lack of scalability or growth opportunities, but that still produces large amounts of cash. In such a case, paying the majority of cash flow as dividends is very wise.

The most important takeaways are the following:

  1. Dividends are not value adding in and of themselves, but they are not categorically bad. It is first and foremost one part of a deeper analysis of the managements capital allocation decisions. Bad allocation of capital can be devastating for a business, and it is one of the most important aspects to consider when determining the value of a business.
  2. Dividend Yield is a measure of PRICE, and nothing else. It is an inherently uninformative number by itself, and the analysis should start on the cash flow statement.
  3. The question to ask yourself should be “How much money is being paid out in relation to free cash flow, is it sustainable, and is there something more profitable they should put the money towards”.

To summarize this post, investing in a business that has an abnormally large focus on paying a dividend is equal to investing in a business that is not correctly evaluating all possible capital allocation decisions. In the long run this should lead to lower return on invested capital, and thus the overall return of the business. Now as I previously stated, paying a dividend is sometimes the correct allocation of capital, but promising a monthly dividend, or an ever increasing dividend can lead to poor decisions in the short term that weighs down the long term returns. The same issue also arises in the cases where companies blindly decide to follow one route of capital allocation without assessing the alternatives. Such as investing too heavily in a declining business, or pursuing acquisitions while disregarding the prospective returns on the target company.

Photocure (PHO), 11 Bit Studios (11B)

For the second edition of ValueTeddy’s Snap Judgements we have Norwegian pharma and Polish computer games.

Photocure

Ticker: PHO
Market cap: 3300 m NOK
Revenue: 250 m NOK

For Photocure we have continuously growing revenues, relatively constant losses, and steadily declining book value of equity per share.

Since this is some sort of pharmaceutical company, I have absolutely no way of understanding the business. Looking at the latest financial statements we see a moderate decrease in sales from 280 m to 256 m, and a high gross margin. Furthermore, there has been a significant increase in sales and marketing costs, which turned a profit of 42 m in 2019 into a loss of 23 m 2020. There are also a very significant increase in both financial income and expenses which should warrant a deeper analysis. Only seeing the decreasing revenues even though sales and marketing spend is up causes me to pass on this stock, but for the sake of this analysis we will take a look at the financial position and the cash flows.

Almost all of the non current assets are intangible, but there is a large amount of cash in the balance sheet. Equity is 508 m, cash is 334 m, and total debt is 267 m. Looks to me like there was recently a new share issue to raise capital.

Moving to the cash flow statement we see a net positive cash flow from operations of 15 m, but a huge cash outlay of 166 m listed as “Payment return of market rights Europe”. I have no idea what this means but it should be top priority if you are looking to dive deeper into this stock. We also see that the capital raise was due to a private placement of 301 m. This is also cause for concern, IF this was done on less than market terms, because then they might be favouring some investors over others. I have no idea if this is the case, but you should look it up if you are interested in this stock.

If you know me, you should know why I am hard passing on this, but I’ll say it for the record. Pharma stocks and any kind of biotech/med-tech stuff is almost always a hard pass for me.

11 Bit Studios

Ticker: 11B
Market cap: 1300 m PLN
Revenue: 90 m PLN

Here we have something way more into my wheelhouse. I love computer games, and I know 11 Bit have created some critically acclaimed story driven games such as This War of Mine, and Frostpunk.

Looking at the numbers we see high growth in book value per share, and a significant jump in revenue per share a few years ago.

The following is all from the latest 10Q which concerns the nine months ended 30 september 2020. First thing I check when looking at video game companies are the revenues. In this case there are no capitalised costs and very little other income. Total revenue for the period is 68 m compared to 49 m same period 2019.

Total operating expenses are 33 m , and the largest line item is “services” at 19 m . This sticks out but these are detailed in the notes as costs related to sales of third party games and royalty payments, which makes sense. Furthermore, both financial income and financial expenses increased significantly, which should require some examination if you are interested in this stock.

Moving to the balance sheet, 11 Bit are well capitalised with about 160 m in equity versus 28 m in total debt. Most of the assets are constitutes 80 m in cash and 32 m of intangibles. The balance sheet looks good on first pass.

The cash flow statement also looks good with cash from operations of 47 m, up from 44 m. However, for the 9 month period regarding 2019 there are significant adjustments, which should be examined. Furthermore, there are highly unusual items in the cash from investing activities, such as loans to employees (~2 m), and some 7 m interest expense, as well as deposits and proceeds of bank deposits. There are also ~22 m of purchase of pp&e and intangibles that are not explained further. Finally, there seems to have been a share issue of about 7 m.

So, to sum up 11 Bit Studios: they make great games, and I’m sure there are more to come. However, there are lots of footnotes that need careful reading in the reporting regarding this case.

Parting words

So that was the second edition of this little experiment. I hope you liked it, and remember that none of this is financial advice and I’m not your financial adviser. If you want to suggest stocks for me to look at, you can tweet @ValueTeddy, and do check out valueteddy.com.

Inari Medical (NARI) and JOYY (YY)

I recently started a new little project on Substack, where I do short snap judgements on stocks selected by you, the reader. Below is the first edititon of ValueTeddy’s Snap Judgements.

For the first edition of this little project I’m taking a look at Inari Medical and JOYY.

Inari Medical

Ticker: NARI
Market Cap 5333 m USD
Revenue 139 m USD

First of all I note that they have Medical in the name, which is way outside my circle of competence. I also note that it seems like they IPOd in May 2020.

Next step is to try and figure out what they do. This is cut from the lates 10Q: “Inari Medical, Inc. (the “Company”) was incorporated in Delaware in July 2011 and is headquartered in Irvine, California. The Company develops, manufactures, markets and sells devices for the interventional treatment of venous diseases. The Company received initial 510(k) clearance from the U.S. Food and Drug Administration (the “FDA”) in February 2015 for its FlowTriever system, used primarily to treat pulmonary emboli, and in February 2017 for its ClotTriever system, used for the treatment of deep vein thrombosis.”. In other words, medical stuff. I have no idea regarding this so we are moving on to the financials.

First of all I note that the balance sheet is in VERY good shape, and they are loaded with cash on hand. The liabilities totals 14m and the total assets are 205m, of which 168m is cash.

Moving to the income statement (all figures are for the nine months 2020 and 2019) I note that revenues tripled, from about 31m to 91m. I also note that they crossed the line from a operational loss of less than 1m to operational profits of 11m. Net profit is just shy of 7m.

This is very impressive. growing revenues by 3x while operational costs only doubled is a very good sign, and I do not see any oddities that would cause me to be suspicious.

Moving on to the cash flows, about half of the net income seems to end up as cash (3.5m) which is an improvement from a net cash burn of -4m. Almost all of this cash is used to purchase pp&e. We also get an explanation of the huge cash pile, which seems to be from the sale of shares related to the IPO. Some of those proceeds seem to have gone to repaying 30m of debt. I fail to see anything odd or questionable here.

So with that aside, lets move to valuation. EV/EBITDA seems to be 270, P/S 38, and a P/E of not so shy 405. Assuming revenue per share triples again, we land on a forward multiple of 12x sales. This is a pass for me, 90% because its in medical stuff, and 10% because of valuation. It is however incredibly interesting and worth a look if you feel confident investing in medicals. Note that this is priced for incredible growth in the years to come, in my humble opinion.

JOYY

Ticker: YY
Market Cap 186B USD
Revenue 3.9B USD

This looks to be a Chinese entity listed in the US, which is categorically a hard pass for me personally. The main reason is that I am not comfortable investing in companies where I don’t feel that I can understand the financial reports very well. However, I note steady increase in revenue per share, and in earnings per share. This company description cut from Börsdata makes me wanna think about this as ZOOM in China: “JOYY Inc., formerly YY Inc. (YY), is a social platform that engages users in real-time online group activities through voice, video and text on personal computers and mobile devices.“. I am in no way familiar with the services they offer, listed on Börsdata as: “It owns the domain names of YY.com, Duowan.com, 100.com, Huya.com, Edu24ol.com and Zhiniu8.com. The Company’s YY platform, including YY.com “. This is too far out for me to be able to understand the company in any good sense. The company does however seem to have incredible growth during the last 10 years, and they are priced for continued great growth. According to Börsdata the 10yr cagr in revenue per share is a whooping 50%, and with a P/S ratio of 47 this growth is expected to continue. This is not a stock for me, but if you have some insight into China then maybe this is for you.

*EDIT* Apparently the data I used is not accurate for JOYY, the market cap is significantly lower, roughly 8 B, and the company description has apparently changed. The Chinese parts of the business are divested and they are now mainly providing streaming apps in the south eastern parts of Asia.

Final words

That’s it for now. I hope you found this interesting and maybe there is some takeaway from me sharing a little bit of my process. Note that nothing here is investment advice, and I am not your financial adviser. If you liked this and want to suggest stocks for the next edition, please tweet @ValueTeddy.

Have a great weekend!
-ValueTeddy

Looking for fat pitches

As I was Re-listening to the 1996 Berkshire Q&A, it struck me again how GOOD the idea to look for those fat pitches is. It resonates with the fact that an investor needs only a few great ideas to produce a great track record.

There is no need to swing on everything, but instead look for the things that are in your circle of competence, and then swing for the fences when such an idea shows itself.

The hard thing is also to know what to do when waiting for such opportunities. I think the most important thing is to KEEP LOOKING. It’s probably easy to just give up and buy whatever is popular at whatever valuation, because “everything is expensive” etc. I guess we as investors just have to keep looking. There is always money to be made somewhere, right?

A second question to answer is what to do with your money while you are looking for those fat pitches? Here I might be slightly hypocritical, because what I do is stick some of my excess cash into an index fund, so it earns at least market returns. In some sense this is doing what I just spoke of in the paragraph above, “buying whatever is popular at whatever price”. But I think putting some of my excess cash position in a broad low cost index fund isn’t a too bad idea for me. Since my alternative cost of capital is whatever return I would be getting on my money elsewhere, why not put some of my excess cash position into that? This also pushes me to always compare whatever case I’m looking at with the broader index. Is it of higher quality, is it cheaper, and do I think it will earn a higher return over time?

Remember that you need very few great hits to be a fantastic investor. The hard thing is not to act stupidly while waiting for such pitches, AND to correctly identify a stellar opportunity, AND not to forget to bring a washtub if such an opportunity arises!

Cheers, over and out!

Short on shorting

Every now and then I see one or two questions regarding shorting stocks, and I thought I’d put down some of my thoughts.

First of all, shorting can work for some, for short time periods, but when shorting you are inherently fighting an uphill battle for a few reasons. In order to fully understand these, we should first make sure we understand what shorting is.

Shorting, going short, or short selling stocks (or other financial instruments) is a position that’s negatively correlated with the price of the asset. In normal language, that means a short position is a bet the the price will go down in the future. In practice, this position is achieved by borrowing shares of a stock, then selling them, netting you cash in hand today plus a debt in a number of shares.

Reason 1: Unfavourable risk-reward

When buying a stock (“going long”) the potential upside is thousands of percent, while in the worst case scenario the business goes bankrupt in one day and your shares are worthless. In other words the largest downside (assuming no leverage) is -100%. When shorting however, this risk-reward is flipped on its head. In the best case scenario the business goes to zero tomorrow and you can repay your loaned shares with nothing. In other words, the best case upside is 100%. As you might have guessed by now, the maximum downside is theoretically infinite.

Reason 2: Time works against you

Since you are borrowing shares, you have to pay interest. This causes the value of the position to decrease with time, even if the price of the shares does not increase. This negative correlation with time can make the position a losing position even if the share price falls. On the other hand, your time cost on a long position is the alternative cost of capital over the holding period. Thus, you do not face the built in headwind of interest cost on your position when you buy a stock.

Reason 3: Everybody else want your position to fail

The final and most important point, is that all stakeholders related to the business will want it to succeed. Of course, shareholders want the stock price to increase and thus your short position declining. All lenders to the company all want their loan paid back, with interest, so they too want the business to succeed. The board of directors and the management team all want to make money, so they too want the business to succeed. Finally, most of the customers will want deliverance of their goods, and the suppliers want to both keep their client and get paid for whatever goods or services they have delivered. In other words, they too want the business to succeed.

In summary, shorting is incredibly difficult because of these three aspects. If you really want to bet on the price of a stock falling, or hedge some position, put options can be a better alternative than straight up shorting shares. This is of course only given that your position size is large enough to warrant the fees. If we instead inverse these three reasons, we get some good reasons why to be long biased. All this said, I usually like knowing what the short sellers are betting on in any of my positions, and what their reasons are. In most cases, they are smart individuals and may have found something I missed. Over and out.

Charlie Munger’s Investing Checklist

In an interview with BBC, Charlie Munger outlines a checklist for Berkshire investments. It takes him about a minute to run thorough it, but it contains a wealth of information. In this post I hope to dig into the four point Charlie Munger names. The interview can be found here. Charlie names the list about 6 minutes into the video, and it is outlined below.

  • We have to deal with things we are capable of understanding.
  • We have to have a business with some intrinsic characteristics that give it a durable competitive advantage.
  • We would vastly prefer a management in place with a lot of talent and integrity.
  • Finally no matter how wonderful it is its not worth an infinite price. so we have to have a price that makes sense, and gives a margin of safety considering the natural vicissitudes of life.

Being Charlie, he of course rounds it  off with how obvious and simple it is. Also saying the simpleness of it is the reason it hasn’t been copied, even though it has been “out there” for decades.

Simplifying this list once more, I would argue, gives us “Buy quality companies at reasonable prices”. Lots of investors out there claim that they are looking for quality companies, but are unable to put “quality” into other words, or in numbers. This is why I think it valuable to take a good hard look at this list, and what it means and how we can find such companies.

We have to deal with things we are capable of understanding.

This one seems incredibly obvious, but still most of us tend to dabble in stocks in a large number of sectors and industries. I’m not saying that is necessarily stupid, but do we really have the capability of understanding all kinds of companies?

Another interesting bit in this sentence is the word “capable”. We don’t need to know every single in and out of the specific industry, but we must at least have the capability of understanding it. This is the reason why Berkshire have opted out of most of the high tech businesses. This is probably applicable to their holding in Apple. Even though they have opted out of most of the tech businesses, the largest holding is Apple. Apple to most of us is a tech-company, right? I think Warren has re-framed Apple to be a consumer products company, which he and charlie are capable of understanding.

Finally, if we don’t meet the potential investment does not pass this first filter, we are clearly unable to evaluate the next three points on the list.

We have to have a business with some intrinsic characteristics that give it a durable competitive advantage

This point is what I think many investors usually refer to a moat. However, I don’t think most investors have really thought about this statement, what constitutes a moat, and how to find  companies that have a moat? For now, I’ll leave the discussion on what kinds of moats there are, and skip ahead one step. I would argue that companies which have strong moats are able to earn more money than companies who do not have those same moats. That is relatively obvious, but how does that manifest itself? Margins and ROIC. I would state that companies with moats will be able to have higher margins, for a longer period of time. This includes margins all throughout the  income statement: gross margin, operating margin, and net profit margins. This also lets the company earn a larger percent of its revenues in operating cash flow. These higher margins, should also help the company earn a larger return on their invested capital for a longer period.

Finding companies with a moat

Unfortunately we can’t simply screen for “moat”, but we can screen for margins and ROIC! Therefore, sorting through a list of companies who enjoy high margins and have a high ROIC, you might find a few companies that turn out to have a strong moat.

Why do we care about moats?

What we as shareholders care about in an investment are future cash flows. Before there can be cash flow to you as the shareholder, there has to be revenues, and those revenues have to be larger than the sum of all cash expenses. The moat does several things to further this agenda, for example, it lets companies keep prices higher than if there would be no moat. Higher prices equal more revenues, without increased costs. The moat is what enables the business to fight competition, and in turn protect its margins and its return on invested capital.

We would vastly prefer a management in place with a lot of talent and integrity

Given that the two preceding points are met, if the company has incapable and dishonest managers the company is likely doomed anyway. Stupid managers might not realise their own moat, and thus neglect to service it. Thus allowing competitors a chance to build a moat of their own, surpassing this once fantastic business.

Management can play an integral part of creating value in a business. The right manager in the right business can make billion for themselves and for their shareholders. Meanwhile, poor management in a decent business can end in ruin. Unfortunately, discerning the good from the bad is not an easy task.

Some things one might use in order to determine management capability and honesty are their track record, and how you perceive them in their letters, announcements, or interviews. This is one part of investing that is closer to art than science in according to me, and note that many managers do not write their own CEO comments to the reports. Some do, but my guess is that most don’t. One thing I look for when trying to asses the managers honesty is how much of their comments is just fluff, and how much is “real”. I try to create my own narrative of what happened the past quarter or year, and what I think the company should focus on going forward, and then compare that to what the manager is saying. Furthermore, does management admit mistakes, and do a good analysis of what went wrong and how it will be prevented from happening again. And finally, are they correctly assessing the reason for the positive things that happened, or are they simply assigning it all to their own brilliance and genius?

No matter how wonderful it is its not worth an infinite price

Buying a 100-dollar bill is only a great idea if you can buy it for less than 100 dollars. In other words, a great business can make for a horrible investment if you pay too much for it. The opposite is not true for a bad business.

After a good, or maybe even a great business has been identified, with strong competitive advantages and an able and honest management, we want to buy it. But if we want to make it a good investment we should be very careful not to pay too much for it!

Mr Munger does not say what a good price is, and neither does Mr Buffett, but we know that its relative. When using multiples, the fair multiple varies with the industry, the predicted future growth rate, and the predicted future return on invested capital. In other words, a multiple that is too high for one business might be a great price for another. Its not easy, and it shouldn’t be. What I do is in general, that I use a multiple, and I compare it to what I think the future growth and ROIC will be. Then I also make rough comparisons to peers, in order to see how its priced compared to competitors.

As Aswath Damodaran says, valuation is a skill best learnt by practising. So go practice!

Final remarks

I really like this list of criteria Charlie has for us here. Its short and relatively high level, while each point can be elaborated on for pages and pages on end! They are a decent starting point for aspiring investors to start looking for in businesses, and its something I try to look for in the stocks that I buy.

As the final section, I want to summarise the list in one sentence: Find businesses you can understand, that has some competitive advantages and an able and honest management at the helm. Then buy it without paying too much and sit on it until something better comes along.

I hope you enjoyed this post, we owe a lot to Charlie Munger and Warren Buffett and I am forever thankful for them sharing so much knowledge and wisdom!

Analysis of Catella

Overview

Catella is a relatively small corporate finance, real estate investment manager, and hedge/mutual fund manager focused on the Nordic market.

Skärmklipp.PNG

This is an interesting case because Catella are currently winding down some of their businesses, namely Banking (wind down to be completed in Q1-2 2021) and Catella Fondförvaltning AB (CFF). This is why Catella might be a special situation, and those can often be mispriced by the market.

Business description

Currently Catella is divided into three parts: Corporate Finance, Property Investment Management, and Funds. Catella also has a banking business which is being divested and reported separately. According to IFRS this segment is not included in group figures.

Skärmklipasdp.PNG

Catella are active in most of Europe, with offices also in Hong Kong and New York.

Case description

The thesis in this case is that the wind down of some of the parts in Catella can let the value in other parts of Catella be shown. With the wind down of Banking and Catella Fondförvaltning, Catella are now focusing on real estate and property management. This simplification and scaling down of business can let Catella have a better focus, which might give better future returns.

The parts in brief

Catella’s Corporate Finance department provides capital market and advisory services on property related transactions.

The Property Investment Management part focuses on property investments, offering professional investors exposure through property funds, asset management services, and through property management in the early phase of property development.

The Fund business offers actively managed funds with a focus on the Nordics, and systemic funds with a global focus. This is split into Catella Fondförvaltning (CFF) which handles the mutual funds, and Informed Portfolio Management (IPM) which deals with systematic funds.

Catella also has a banking segment that is being wound down and is being sold off since september 2018. Catella reports this segment separately according to IFRS as a disposal group held for sale.

The Parts in numbers

In the latest quarterly report, Catella reports two segments: Corporate finance, and asset management. See this formulation in the report: “Catella
has defined Corporate Finance (consisting of the Corporate Finance operating segment) and Asset Management (consisting of the combined Property Investment
Management, Equity, Hedge and Fixed Income Funds, and Banking operating segments), as the Group’s reportable segments”.

Here is a condensed income statement for the segments from the Q1 report, with some of the main points highlighted.

Skärmklippas.PNG

From this overview we see that the corporate finance carries a loss, and that the profits come from the funds and property management. Furthermore, I notice a large decline in operating profits in the fund business, that is largely compensated by an increase in the property management side.

The value of the parts

Corporate Finance
corp
This seems like the least valuable part in Catella. It has way lower margins and several quarters with a net loss in the segment. Furthermore, CEO Knut Pedersen indicates that transaction volumes are way down in the wake of the global pandemic. Depending on how flexible Catella can be with regards to their costs in the segment, I expect the second quarter of 2020 to be very bad for Catella’s corporate finance segment. For Q2 I’m going to assume a decline in revenue in Corporate Finance of another 20%, with the same cost basis of Q1. This gives us 87 m SEK in revenues and costs of 125 m SEK, leading to an operating profit of -37.8 m SEK. Assuming some sort of return to normal for Q3 and Q4 in this segment, let’s assume 10 m in Q3 and 20 m in Q4. This lands us on an operating profit for the rest of 2020 in Corporate Finance of about -8 m SEK.

Funds
funds
The funds also show some unfortunate signs, and in the CEOs statement Pedersen tells us that the fund segment has been seeing outflows in the first quarter. Catella had a decrease in assets under management of 23 Bn SEK in Q1, leaving them with a total AUM of 48 Bn SEK. For the fund business we are not given any guidance regarding Q2, but I am going to assume no abnormal outflows or inflows in the remaining fund business. The total income for funds totalled 57 m SEK in Q1, however the sale of CFF makes this segment really tricky.

According to the announcement related to the sale, 70% of  CFF is sold for 126-154 m SEK with an option to sell the remaining 30% for 60 m SEK in January 2022. With the argument of conservatism, I’m going to assume a price that lands at 130 m and that the option is exercised. Discounting the sale price of 60 m in Jan 2022 with a 10% discount rate we get a present value of ~50 m SEK. This gives a total sale value of 180 m SEK for CFF. However the fun does not end there. Because of this transaction, a write down of 70 m SEK will be incurred in the second half of 2020. Finally, Catella expects an effect on earnings of -13 m to +15 m SEK. Again, in the name of conservatism I’m going with the lower end of this spectrum and assuming a loss of 10 m SEK. This leaves us with a one-time net effect of +100 m SEK after the sale of CFF.

Note that this sale does not include Informed Portfolio Management (IPM) which is the second fund company under the fund segment in Catella. In the Q1 report Systematic funds amounted to 100 m in revenue. applying the same operating margin for the whole segment in Q1 we should get that IPM provides 35 m SEK in operating profit. Apparently most of the decline year-over-year happened in the systematic funds, which is why I’m going to assume no growth in this segment for the remaining quarters. Note that Catella’s total ownership in IPM is 60.6%, thus the estimated operating earnings benefiting Catella are roughly 22 m per quarter for 2020.

Property management

pim
This is the only segment that shows an increase in assets under management. The AUM was 108.5 Bn SEK, an increase of 8.5 Bn since Q4 2019, and the operating profit for this segment as 41 m SEK in Q1. compare this to the same quarter last year which sported 141 m SEK in income and a big zero in operating profit. Looking at the operating profit per quarter since 2018 we can see that Q2 seems to be the significantly largest contributor to operating profit in this segment. The reasons seem to be large variable incomes from their European residential fund. I have a really hard time estimating the income for this segment, so I’m going to assume the same development for operating income as in 2019 but 20% lower in Q2 and 10% lower in Q3 and Q4. This gives us about 53 m SEK in Q2, 13.5 m SEK in Q3 and 21.5 in Q4.

One-off items are mainly the sale of CFF which is mentioned above, but also the finalisation of the wind down of the Banking segment. According to the pm that the wind-down will be completed, Catella estimated that 350 m SEK of value will benefit Catella when the process is complete, and 80 m SEK of costs will be reserved in Q2. The wind-down is estimated to be completed in the first half of 2021.

Catella also have a bunch of interesting investments on their balance sheet that should be mentioned. Consider this asset side of the balance sheet from the Q1 reports.br.PNG

Some of these investments are analysed below, they are all described in Notes 3, 4, and 5 in the Q1 report.

The property developments carried on the balance sheet at a value of 428 m + 90 m SEK. There are four residential projects, three in Germany and one in Denmark, briefly summarised below:

  • Name, expected transaction volume, started on, further plans/process
  • Grand Central, 500 M Eur, 2015, divestment ongoing. Expected effect on Q2 earnings +155 m SEK, which i have taken into account in the estimates above.
  • Seestadt MG+, 700 M Eur, 2017, producing blueprints.
  • Düssel-Terrassen, 250 M Eur, 2018, producing blueprints.
  • Kaktus, 130 M Eur, 2017, construction initiated, plan to finish and divest asap.
  • Announced 250 m SEK investment in logistics property, estimated construction start in Sept 2020

The first thing I note is that most of these are really far out in the future. There are no time estimates, but only Grand Central seems to be under divestment currently. I am not a specialist in building, but there can probably be several years from blueprint to finished project, and in most of these projects the blueprints are not even finished.

loans

The loan portfolio contains securitised European loans primarily exposed to housing. The portfolio is carried at a value of 123 m SEK. This loan portfolio has, as far as I can tell, not performed well at all. Out of nine loans, six have been written down to a value of zero. The remaining loans have a weighted a duration of 3.8 years. There seems to be an option for the issuer to repurchase the loans Lusitano 5 for nominal value 3.3 m EUR, which according to Catella would cause an  impairment of 2 m EUR. The odds of the issuer exercising the option is estimated to increase in Q2 2021 according to Catella. I’m going to assume Catella’s assumptions are correct and that the loan portfolio is correctly valued. It should be noted that only Pastor 2 is expected to have cash flow in 2020. This stated, I assign no positive or negative value to the loan portfolio, but let it be as is. In other words, no write ups or write downs in 2020, and noting the expected 20 m SEK (2 m EUR) impairment in 2021.

Adding it all together

envelop.PNG

Lets add everything stated above into this rough projection of operating and other profits. This gives us expected operating profits plus some one offs totalling 158.5 m SEK. Catella managed to pay an amazing 47% in taxes for 2019, and judging from the tax in the first quarter of 2020 it seems like they are still paying close to that amount. This lands us on roughly 84 m SEK of net profits for 2020. If we use a slightly lower but still high tax rate of 30% we get 111 m SEK in net profit. (Edit: The reason Catella pay such a large percentage in tax is due to gains in some countries that cant be netted against losses in other countries.)

There are way too many things that can happen before 2021, so I won’t make a prognosis that far out.

Price

With a price per share at 21, the current market cap is 1370 m SEK, and current EV is 1120 m SEK (86.3 m shares outstanding)

ev

EPS with 47% tax is 0.97 SEK, and with 30% tax it’s 1.28 (2020e).

This gives us P/E(2020e) 21 and EV/E(2020e) is 16 using a 47% tax rate. with 30% tax the P/E is just above 16 and the EV/E is just above 12.

Conclusion

Phew, this is a big one. First of all, some remarks: it’s messy and there are many things going on at the same time. Here is a summary list of things going on:

  1. Several divestments of relatively large sections of the business are ongoing.
  2. The property projects are really far out in the future.
  3. Catella are paying unnaturally high taxes.
  4. The Corporate finance segment is not doing that well, and should be hit very hard by Covid-19.
  5. The funds are seeing declining AUM.
  6. Lots of management changes (CEO leaves Nov 2019, CFO leaves Dec 2019, Chairman appointed CEO and a new interim CFO and a new interim chairman is appointed in March 2020. That CFO quit in June 2020.)
  7. Largest owner is an investment company, Claesson & Anderzén (acting CEO Johan Claesson). Other notable owners are Strawberry Capital (Petter Stordalen), and M2 Asset Management (Rutger Arnhult). Acting chairman also has stocks and bonds in Catella)
  8. Lots of cash and short term assets on the balance sheet (925 m cash minus 108 m pledged funds.) Also might be reduced by another 500 m due to an investment in a logistics facility announced in June. (Correction, after a short email to IR this has been clarified. Catellas part in this investment is 50%, so their investment is 250 m SEK, not 500 m SEK as I previously stated.)

The conclusion is that Catella is cheap, and that there are lots and lots of uncertainties. First the divestments have to go according to plan without incurring extra costs. Secondly, a permanent CFO and possibly a permanent CEO has to be found. Finally, the property investments have to be completed and moved to management or be sold off.

There is also the possibility that Catella can lower the very high tax-rate closer to 21,4% which is the Swedish tax rate on corporate earnings, which will have a large impact on the net earnings. Even if they reduce the effective tax rate to 30% this will have a huge effect on net earnings.

My analysis leads me to believe that there might be a turning point in the relatively near future. As more and more “non-property-related” businesses are being divested, more and more focus can be brought to refining and growing the property management business. In conclusion, Catella looks like a fairly priced bet given the current question marks, but as more and more things get figured out, the risk gets lower, and the potential upside  increases. These estimates are in my view quite conservative, and with some tailwind Catella are likely to perform way better than my estimations. There are however quite some years ahead before I would label Catella a great business. If Catella manages to stabilise and build this up to start showing stable annual returns, good returns are sure to come. It’s VERY important to note that there are several stones that must fall into place before any of that can happen!

Note that my estimates and prognoses are very conservative, and a small positive deviation from my prognosis will have large effects on the bottom line. Main point is that I do not calculate the properties under development apart from the estimation made by Catella regarding Grand Central.

I think Catella is a fairly priced bet, that has large potential for future profits. However this requires good cost control and streamlining in the coming years.

I own shares of Catella, and nothing I write should be taken as financial advice, and nothing you read here should be taken as a fact. Do not make any investment decision based on what you read here, always do your own research.

Sources: Catella press releases and financial reports, Börsdata.

Some edits that have been done based on feedback:

  • Catella does not own 100% of IPM, Catella owns 60.6% of IPM according to note 20 in the annual report 2019.
  • I did not deduct group overhead (costs were 20 m SEK for Q1, and I’m assuming them to stay the same for the rest of 2020)
  • Claesson & Anderzén is owned by the acting CEOs holding, so insider ownership is very significant.
  • EV is way too high since is not adjusted for divestments
  • Explanation for tax

Kort Analys av INVISIO

Översikt

Bolaget utvecklar och levererar specialiserad kommunikationsutrustning för militär personal. Kunder är till exempel militär, polis, brandkår, och säkerhetsbranschen.

  • Börsvärde: 6.8 miljarder SEK
  • Enterprise value: 6.9 miljarder SEK
  • ROIC: 45%
  • EV/EBIT: 45
  • Omsättningstillväxt 5-år CAGR: ~20%

Företagsbeskrivning

Enligt årsrapporten 2019 håller bolaget på med följande: “INVISIO develops and sells advanced communication systems with hearing protection that enable professionals in noisy and mission-critical environments to communicate and work effectively. The systems give operational advantages and increased security for the users, such as military, police and security personnel. Protection against hearing loss helps to reduce individual suffering and costs to society”

Enligt samma rapport står Europeiska och Amerikanska försvarsindustrin för ca 90% av omsättningen, men man menar att stort intresse finns inom brottsbekämpning och andra geografiska områden.

Beskrivning av caset

Bolaget har mycket goda marginaler och hög ROIC. En tes skulle kunna vara ökad oro leder till mer behov av militär och polis i fält som har behov av INVISIOs produkter.

Bolagets Kvalité

Kollar man på Börsdata ser det onekligen ut som att bolaget är av mycket hög kvalité.

asdasdasdadad.PNG

INVISIO har mycket goda marginaler och fantastiskt hög avkastning på investerat kapital. Bolaget har dessutom en sakta men säkert ökande bruttomarginal.

asdasdasdadad

Därtill kan vi lägga en mycket stark balansräkning, med väldigt lite immateriella tillgångar och låg skuldsättning.

Dock ska man notera att bolaget verkar stundvis drabbas av otroligt dåliga kvartal, exempelvis Q1-2019 var rörelseresultatet rasade till nära noll.

Pris

Att bolaget verkar ha hög kvalité är jag tydligen inte ensam om att tycka, då INVISIO är väldigt högt värderat. EV/EBIT 46 är inte särskilt billigt. I relation till tillväxten i EBIT som är ca 25% årligt de senaste 5 åren får vi en (EV/EBIT)/EBIT-tillväxt multipel på drygt 1.8.

Givet bolagets höga lönsamhet och snabba tillväxt är de antagligen värda en premie jämfört med ett index. Eftersom man handlar med stater och deras försvarsbudgetar ligger det eventuellt mycket politisk risk i caset, och det tycker jag man bör ha i åtanke. Eftersom en stat, kommun, eller liknande inte handlar eller genomför affärer på exakt samma sätt som ett “vanligt” företag kan det hända att inköp varierar mer.

Slutsats

Tar man de otroligt fina marginalerna och ROIC in i beräkningarna, plus den starka balansräkningen tycker jag spontant att EV/EBIT 30-35 ser attraktivt ut. Jag ser således inte någon säkerhetsmarginal i nuvarande värdering. Anledningen att jag vill ha bolaget till en lägre multipel än vad som erbjuds idag är dels den politiska risken, och dels att man militären som motpart. Jag kan med andra ord inte ha lika bra koll eller förståelse exakt hur kunderna (försvaret/militären) agerar. Jag antar att de drivs oerhört hårt av budget och sittande regering, och således inte av deras “faktiska” behov. Något som är positivt är att INVISIO verkar försöka diversifiera sin kundbas, men samma gäller såklart polis och annan statlig verksamhet. Den bransch jag ser som skulle agera mest “marknadsmässigt” är antagligen säkerhetsbranschen, men det är inte tydligt hur snabbt bolaget expanderar till de branscherna.

För att summera, oerhört bra lönsamhet och stark balansräkning. Man verkar inom en knepig bransch, och värderingen lämnar inte väldigt mycket margin of safety.

Jag äger inte aktier i INVISIO i skrivande stund.