Friday, August 14, 2015

Research: HTCH Hutchinson - What Does A Commodity Business Look Like?

I will in as fewest words possible, summarize some things that I learned in Macro Economics, but did not really understand at the time.

  • A monopoly can control supply. Their goal is to maximize profit. They will produce the quantity which they will maximize profit. This is where marginal cost and marginal revenue intersect.
  • A commodity business has no pricing power. They are forced to operate where average revenue equals average cost. This implies that they cannot make a real (economic) profit.
  • A company which is losing money must still operate as long as marginal revenue is higher than marginal variable cost. This means that they are losing money while operating, but they will lose more money by not operating.
So what does this actually mean in real life? I was trying to find bad companies for fun. Not average, companies, bad companies. Not unpredictable, unexplored industries, but predictable, mature, and dying ones. I found HTCH, Hutchinson Technology.

I was very pleased to see that HTCH was a poster child for a dying business. This is the first time I've seen a company match up perfectly with the criteria mentioned above. It became apparent after reading about their business model in their 10-K. They make hard drive suspension assemblies. They are very easy to make, very cheap to make, and there are many competitors. HTCH competes against other companies which are located in countries with lower labor costs. In their 10-K, they admit to not having any pricing power. They mention that there is an abundance of manufacturing equipment available for purchase, meaning barriers of entry are low. HTCH admits that their customers can easily purchase the excess equipment and start their own assembly suspension business if they attempt to raise prices. I know of no other description which is closer to a commodity business.

The financial statements were very interesting. We will focus on the year ending 2014-09-28. The main numbers to focus on are net income, which is -40M, Cash from operating activities, which is -1M, and Depreciation / Depletion, which is 38M. Let's briefly go over what types of costs there are. Salaries, electricity, and cost of goods are variable costs. Your factory is a fixed cost. If you've paid for it up front, then the fixed cost will show up as depreciation. If you're leasing or renting, you'd have that same amount (over time) show up in SGA. In a commodity business, you should expect cash from operating to be 0. After all, if your revenues are equal to your variable costs, the expected value of cash flow should indeed be 0. The expected value of free cash flow should be 0 or negative. An expected value of 0 means the industry is staying the same, while you should expect a negative value for a dying industry.

As luck would have it, for the year ending 2014-09-08, cash flow from operating is a measly 1M, which is pretty close to 0% when compared to revenues. If a company is operating where revenues equals variable costs, then they should have a net loss equal to their fixed costs. And here, we see a net income of -41M, which is roughly equal to the fixed cost of depreciation, which is 38M. Over the course of the past 4 years, it's easy to see that free cash flow, which is approximately cash from operating - capex, is negative. This is a very nice example of a commodity business which is forced to operate at a loss due to obsolescence.

HTCH is a drowning company which is trying to keep its nostrils above the water. This is further confirmed by their decline in shareholder equity without cash outflows due to dividends and repurchases. It's tempting to try to short this stock. I admit that I had to exercise immense self control to not do it. The stock price is very low, meaning commissions is higher. This company also has a high borrow rate, making it more expensive to short.

So why does this company even operate? Why don't they just shut down? From the perspective of a risk adverse investor, there's no upside to this deal. Operating at break even means you have potential downside. So why hasn't HTCH shut down yet? You can argue that it is poor management. But I think the real reason is because it's providing jobs. The workers are getting paid. More importantly, management is getting paid. Keeping their jobs means that they have to fight to keep HTCH opened. On the other hand, if HTCH was shut down and liquidated, the money would make its way to a different business. And if that other company makes a profit, it means that company is more valuable to society. It's pretty tiring to hear millennials blame corporate management for making pro investor decisions, which they claim result in the loss of jobs. I think the reality is that there is plenty more of poor corporate management, which makes anti investor decisions, which results in the displacement of better jobs.

Thursday, August 6, 2015

Why CEO Dan Price of Gravity Payments is my new favorite person

Dan Price is the CEO of Gravity Payments. He is my new hero. He is a brave soul, and I must praise him for standing up against the status quo. All too often, I hear people complain about how bad and unfair society is. It is a travesty when I hear this from people who are well within their power to do something about it. Everyone wants to give off the appearance that they are an outstanding advocate for fairness. But if you point out that they can do their part in donating the excess portion of their salary to those more in need, they are quick to reply that you should take from someone else who has more. It doesn't matter if he makes 50K, or 150K, or 1.5M, a year. He already has big plans for all his money and you should go after someone who makes EVEN MORE in order to reduce all of the unfairness in the playground.

Dan Price is a true hero. He is perhaps the only person that I know of who was in the position to do something about it, and actually did something about it. I mean on a grand scale. I don't mean some guy making $10 bucks an hour donating his weekends to volunteer work. He reduced his own 2 million dollar salary to 70K, and raised all salaries in his company up to 70K. Anyone who was making less than 70K received an instant pay increase.  He put his money where his mouth is, and for that, he has earned a type of respect from me which I rarely give out. I find him undeniably credible in his political stance on fairness, something that I haven't found from everyone else who is all talk and no action. He is a hero, and he has made history.

When I was a kid, I truly believed everything was possible. I believed that I could fly if I tried hard enough. Not flying in an airplane. I mean flying unassisted. I tried over and over again, jumping off the couch while flapping my arms, convinced that every time I jumped, it took a little more time to hit the ground than the last. My parents were convinced that I was retarded. They were scared that I might try jumping from a higher place and really hurt myself. So they told me the story about some kid who jumped off a building trying to fly. They told me the kid died, and that I would die too if I tried it too.

They told me the kid was stupid, and that I should not be like him. Maybe he was stupid, maybe he wasn't. But he was undeniably credible in his stance that he could fly. He truly believed it. He is a hero, and he has made history. No one knows his name, but I cannot count how many lives he has saved when parents tell his story to kids like me. Many times in life, we wonder how badly something might hurt, or if it might hurt at all. Thank god for the people who actually do it, so that we don't become curious enough to do it to ourselves. I am throughly convinced that I cannot fly. I used to wonder if I cut my finger off, whether or not it would grow back. Good thing my parents knew of some other nameless kid who did that. They told me that it didn't grow back. I figured I would just take their word for it and I could always try it later if I changed my mind. I still have all my fingers.

Dan Price wondered what would happen if he raised everyone's salary to 70K per year with complete disregard to their skill and how much work they do. He completely ignore the resentment that might occur in the workers who put in a lot more effort and would not see any wage increase. Dan Price is so broke now that he has to rent out his home to strangers to help make ends meet. He is being sued by his own brother, who owns the minority share of 30% of his company, for disgorgement of investor equity. He has accomplished permanent damage to his company. Good workers have left. It's very hard to fire the workers who are now not only bad, but also overpaid. Clients have left. If the guy handling your money is can't keep his shit together, what's to stop him from disappearing with your money? Last thing you want is for your own doctor to tell you that you can fly if you tried hard enough. He put his profitable company on the road to bankruptcy overnight, because he really really really wanted to see if his finger would grow back if he cut it off.

Dan Price will go down in history. He will become another nameless kid that all the parents will tell their children anytime they want to see what happens when you double all of your worker's salaries with complete disregard to whether or not there is merit. He is the hero who will save countless businesses from jumping off the roof. The damage that Dan Price has done is beyond what you see. Rather than doubling everyone's salary, he could have instead double his workforce. With everyone complaining about how there aren't enough jobs, he could have actually helped to solve a different problem, one that is worth solving, and probably won't put your company into an unsustainable spiral into bankruptcy.

Did you ever wonder why nobody flies? Because the one kid who tried it died. Do you know why you're not supposed to pay someone $15 per hour to do a job that everyone else pays $8.75 per hour for? Because you get a Corporate Darwin Award for it. If it was really a good idea, everyone would be flocking to do it. Dan Price could have read my blog. He might have learned some basics about corporate finance. But he was on this earth to serve a greater purpose.

Monday, July 13, 2015

Why Businesses Accept Credit Cards, And Why McDonalds Has ATMs

Every now and then, I notice a few things that just seems so genius. Let me share one with you. I live in New York, and frequently take for granted that I never have to carry any cash. Need a stick of gum? Swipe my card for 50 cents. I pay my balance every month, on time. Credit card companies love me. For those of you who don't know, credit card companies make more money from people who pay their balance in full than those who keep an outstanding balance. How does this work? Every time you swipe your card, the credit card company gets 1.5% to 3.5% of the transaction, and maybe some base fee, depending on the arrangement. Ever watch Shark Tank? Kevin loves royalties. Allowing your customers to pay with credit cards is basically having royalty placed on your top line. It's expensive. That's why many places don't want to take credit cards.

Why would you give a cut to the middle man? There are 3 main reasons. The first is counterfeit money. Unless you actually run a brick and mortar business, you probably don't know how much fake money there is out there. After all, how often does someone give you cash? Most of the time, our cash originates from the bank when we make a withdrawal. After that, we're usually giving cash away, not taking it in. Taking a credit card payment guarantees that you won't take a fake bill. If you have $10,000 in revenue, and you have a net income margin of 10%, and one of your $100 bills turns out to be a fake, your $1000 income just turned into $900. The 1% revenue magnified to be a 10% hit to your bottom line. That's an easy way to ruin your day. You can think of paying the credit card fee as a form of insurance against accepting counterfeit money.

Another reason is time. If you're paying your cashier $9 per hour, it means you're paying him 15 cents per minute. Maybe it doesn't sound like a big deal, but how long does it take to take paper money, count out 46 cents in change and hand it back? It'll be anywhere from 5 to 20 seconds, depending on how smoothly it goes. That adds up. Over the course of a 12 hour day, at 40 transactions per hour, a cashier might spend over an hour of time doing the physical handling of money. Cut out that block of time and you'll need fewer workers to handle the same number of customers. You can have achieve a labor savings by needing to handle money less often.

The last reason is a bit less obvious. If you've read about the Walmart robbery recently, you might figure it out. There's a cost to transporting money. You can't just have a big pile of money in the back room growing forever. You have to get that to a bank. You might get robbed during transport. You can make a hundred trips, carrying small amounts, to mitigate the losses in case of a robbery, but now you have to pay for more labor. Walmart pays for professional couriers with an armored truck. Even if they didn't get robbed, cost of transport is still an additional expense.

That's where it suddenly hit me that McDonalds was doing something very smart. I can't remember a Mcdonalds which didn't have an ATM. They only cost 99 cents, which is a lot cheaper than the $3 that you might get charged using a shady, non bank ATM chained to a pole. Do you see what's happening yet? Rather than McDonalds paying for professional transport of the money, customers are paying to do it for them. Genius! It suddenly hit me that the abundance of ATMs at pharmacies and grocery stores are not completely there for your convenience. It can help reduce the frequency of needing to pay to transport out cash from the business. It's a wonderful system where everyone can end up on top!

Now, maybe it doesn't exactly work this way. Maybe there's a separate company who owns these ATMs and restocks the machines with a different pool of cash. Would be cool to hear from someone in the know. It would be cool to know if these companies would actually benefit more from offering the ATMs for free. I'm guessing not, since they probably would have done it already. But it's pretty cool how everything has been done for a often unobvious reason.

Monday, November 3, 2014

Research: SANM Sanmina. Another Boring Company Which Prints Money

SANM Sanmina is I like, and it's the best kind, the boring kind. Basically, they manufacture circuit boards. They build what's behind the curtain, and most of us will never hear about them, but we definitely use their stuff. They're good at one thing. Printing lots of money. You want to pay as little as you can for a money printing machine that prints as much money as possible. Here's one of the better models. SANM was significantly below intrinsic value a little while ago, but right now, it's right at intrinsic value. Purchasing at intrinsic value has a good chance of getting you that 15% return on investment that we all need to aim for.

10-K for reference
https://www.sec.gov/Archives/edgar/data/897723/000089772313000023/sanmina10-k.htm

Overview

Sanmina Corporation (“we” or “Sanmina”) is a leading global provider of integrated manufacturing solutions, components, products and repair, logistics and after-market services. They provide these comprehensive offerings primarily to original equipment manufacturers, or OEMs, in the following industries; communications networks, computing and storage, multimedia, industrial and semiconductor capital equipment, defense and aerospace, medical, clean technology (CleanTech) and automotive.

Two segments
-Integrated Manufacturing Solutions (IMS). IMS is a reportable segment consisting of printed circuit board assembly and test, final system assembly and test, and direct-order-fulfillment. This segment generated 80% of our total revenue in 2013.

-Components, Products and Services (CPS). Components include interconnect systems (printed circuit board fabrication, backplane and cable assemblies) and mechanical systems (enclosures, precision machining and plastic injection molding); Products include memory and solid state drive products from Viking Technology, defense and aerospace products from SCI Technology, storage products from Newisys and optical and RF (Radio Frequency) modules; and Services include design, engineering, logistics and repair services. CPS generated 20% of our total revenue in 2013.

Notable Risks
-Top 10 customers account for over 50% of net sales from 2011 to 2013
-Alcatel Lucent is more than 10% of net sales
-Seasonal business, 2nd half of year has higher sales
-Certain employees have access to, or signature authority with respect to bank accounts or other company assets. (page 27 in 10-K)

Notable Accounting Issues
-158M of valuation allowance attributable to deferred tax assets and net operating losses were released in 2013. This resulted in a large jump in net income needs to be taken into account in order to accurately estimate future earnings.
-DSO for collectibles is 55 days for 2013
-No off balance sheet arrangements
-defined benefit pension underfunded by 22M
-Only a 3.78% discount rate is used, which seems lower than peers
-No goodwill / intangibles balance

Stock Ownership
-Invesco owns about 10% of stock
-directors as a whole own 4.26%

Valuation
-Modified Shareholder Equity - I've given SANM a value of 678M for their modified shareholder equity. This is calculated as the full value of cash plus a 20% haircut to their non cash assets, minus the full value of their liabilities. This is 467 + (3313 - 467) * .8 - 2066 = 678. This compares to the Shareholder equity of 1246M on their balance sheet and gives a significant margin of error.
-Value of profitability - I've given SANM a value of 1460M for their ability to generate money. SANM has a free cash flow of about 219M in the most recent year. By turning this into a perpetuity using a 15% discount rate, we get 219 / .15 = 1460.
-Intrinsic value - The intrinsic value is the value of equity plus the value of profitability, which is 678 + 1460 = 2138M

Conclusion
-Intrinsic value per share - $25.40.  The calculated intrinsic value per share with the embedded 15% discount rate and a 20% discount on assets is 2138 / 84.15 = $25.40. This is a very conservative estimate to accommodate a reasonable margin of error and compares with the current market price of 25.12.

Disclosures
-I currently hold a long position from Oct 3rd at $20.97

Friday, September 26, 2014

Research: BBSI Barrett Business Services, and how I was misled

Every now and then, if we are so lucky to, we come to a moment where we become completely humbled and humiliated. Feeble minds may get discouraged and see this moment as a sign to back down or give up. I'd like to believe that it is an opportunity to learn where my weaknesses are.

The company is BBSI, Barrett Business Services. It is a staffing company. A quick glance at the financials shows pretty solid numbers. The only thing that raised my eye was that net income was a little small relative to it's operating cash flow - capital expenditures. (This is my proxy fore free cash flow) This did not bother me. Generally it's not a bad thing to see net income to be less than operating cash flow - capital expenditures. It can mean that they are using very conservative depreciation methods, which can be beneficial to the investor because it results in a larger margin of error. I did notice that shareholder equity was not rising, but I attributed this to their large share repurchase in 2012.

I didn't find anything that I thought was a red flag in the 10-K. This was a company which was ripe for me to invest in. Until that is, I came across this article here. At first, I thought I was looking at a different company. The article says that BBSI is essentially an insurance company. That's quite far off from a staffing company, and insurance companies are in an industry where I know for a fact that I do not have the expertise to evaluate. The things that I read in the 10-K did not alert me to BBSI operating as anything close to an insurance company. This was quite alarming to me, as I've completely incorrectly classified BBSI's business model.

It turns out that BBSI was not just a staffing company. It was more specifically a PEO, or Professional Employer Organisation. I thought this was just fancy wording for a recruiting firm / staffing company, and it did not occur to me to do further research. Apparently, PEO's have been used to conduct State Unemployment Tax Arbitrage (SUTA), and are sometimes associated with defrauding state governments out of tax money.

Fortunately, I did not enter into a position, so no money was lost. However, it does make me wonder about my other potential investments and how the company might not be what I think it is. This is a wake up call for me. I plan to re-read the BBSI 10-K, to see what exactly I missed. If anyone is able to point to something specific that I should double check, or share similar experiences, it would be greatly appreciated.

Monday, August 18, 2014

How to read SEC filings on your iPad / iPhone by increasing font size

Up until yesterday, I've only been able to read filings off of the SEC Edgar site on my computer. While it shows up in my iPad and iPhone, the font is very small and zooming doesn't actually adjust the text wrapping. Reading with my iPad 3 inches from my face was not very convenient. Safari and Chrome browsers on IOS do not have the ability to adjust the font size.

I did some digging and turns out Atomic Web Browser is able to change font sizes. The Lite Version is free and will let you change the font sizes too. The Paid Version will let you save the filings to your iPad so that you can read without wifi. It uses WebKit for rendering so the pages load acceptably fast. I'm a big fan of saving time, so I've been looking for this so that I can sit on an exercise bike while reading. I highly recommend this for all of your html reading needs.

Thursday, August 7, 2014

Case Study: EZPW - Beautifully Deceptive

I recent came across EZ Pawn (EZPWN). It showed up in my filters after a big drop in the stock price. From what I knew about pawn shops from watching reality tv about pawn shops, they're basically brick and mortar shops, and not financial companies. A quick glance at the financials and it was love at first sight. I estimate free cash flow by subtracting capital expenditures from cash from operating activities. Not an exactly the same as free cash flow, but it's easy enough to do in my head from google finance statements, meaning I don't have to open up the 10-K, and it's a good enough estimate to tell me whether or not to perform more research. So here's what I saw.

EZPW Cash flow statement
There's a significant, noticeable drop in net income, partly due to an unusual expense item, but we can look into that. If the reasons are temporary, it could mean the price drop was unwarranted and this could be a very good deal. Let's crack open the 2013 10-K and see what we find.

Page 4 - 107 company owned stores were closed in 2013, which is about 9% of the total number of stores. This is significant percentage of stores, but better late than never to close unprofitable stores. business model of pawning is to give a collateralized loan. If the borrower cannot pay, EZPW effectively has bought the collateral and will then sell it to recover principal. Yada yada about fees and interest, which obviously equate to triple digit APY's in order for making small loans to be economical, and about ~80% of the loans actually get repaid as cash.

Page 6 - Credit enhancement services - Didn't see how they're making money off this but I suppose they're charging fees. Since EZPW is effectively guaranteeing loans, I'll be looking for some kind of liability to account for it.

Page 18 - Phillip E Cohen beneficially owns all of the voting stock - This is a bigger deal that most people realize. When one person controls the company, they can make the company engage in behavior which is beneficial to him and detrimental to all other shareholders. This section also explains that common stock which is publicly traded do not have voting rights. This may or may not be a good thing, depending on who runs the company.

Page 25 - This stock does not, and will not pay dividends.

Page 30 to 31 - breaks down most of the 46M unusual expense. Looks ok, mostly from closing the locations.

Page 33 - Pawn Loan and Sales Revenue Recognition
We record pawn service charges using the interest method for all pawn loans we believe to be collectible. We base our estimate of collectible loans on several factors, including recent redemption rates, historical trends in redemption rates and the amount of loans due in the following two months. 

So the way pawning works is that you walk into the pawn shop with an item of value, let's say market value of 100 dollars. The pawn shop gives you a loan of up to let's say 50% of the value, so you get a loan of 50 dollars. 2 months later, you will be required to pay back the loan, plus interest, plus fees, which will probably be around 80 dollars. If you do not pay it back, then the pawn shop sells your item for 100 dollars, and pockets the difference. This covers the interest, fees, and risk of obsolete inventory. The fees (not talking about interest) are a significant portion of the revenue. There's a good chance that it will go unpaid (~20% of loans are not repaid). The pawn service charge is what they're saying they're using the interest method for, meaning they will recognize revenue over the course of the loan, even though they will only receive the cash if the borrower does not default. I did not think this was a big deal, granted that most loans were under $1000.

Unsecured Consumer Loan Revenue — We accrue fees and interest in accordance with state and provincial laws on the percentage of unsecured loans (single-payment and multiple-payment) we have made that we believe to be collectible. Accrued fees related to defaulted loans reduce fee revenue upon loan default and increase fee revenue upon collection.

EZPW records the revenue from the fees first, and then reverses it when the borrower defaults. This is a little earlier than I'd like to see, but as mentioned before, with most loans being under 3 months and under $1000, this doesn't seem to bad.

Page 42 - There is a 42.5M imparement on their ownership of Albermarle & Bond. If you try to look up this company, you'll see that it's been delisted. EZPW basically lost their whole investment in the company. This is pretty bad. It reflects a very poor acquisition decision.

Page 51 - Off-Balance Sheet Arrangements - This is where we finally see something which is less neutral and more bad. Those loan guarantees from earlier are addressed here. The liabilities for those loans do not show up on the balance sheet. It says the maximum loan exposure is 28.8M, which is not the end of the world (yet).

Page 61 - Cash flow statement - This is where it gets really bad. This is the official cash flow statement, not the generic one which google and morningstar parse into a watered down form. In the screenshot above, you may have noticed a -113M Other Investing And Cash Flow Item. This is a bucket which generally contains the amounts used in acquisitions and purchasing stocks and bonds with spare cash. 113M is significant proportional to the 126M Cash from operating. If you look for "Loans made" and "Loans repaid, you'll see -923,103 and 597,528 for 2013. 237,717 is the recovered amount on selling collateral. So in net, we have -923103 + 597528 + 237717 = -87858 (everything in thousands). This means that 87M is outstanding loans + loans which have not been repaid. This is ok if we see an influx of money from prior years in the Other Investing And Cash Flow Item line, but this is not the case. This is a leak in the money flow. Money is leaving the company and it is not coming back into it. This is a big red flag. This is as dangerous as a company can get for our style of investing. We have a company which not only shows positive net income, but also positive free cash flow. This is a clear example of a company where the rules for calculating net income does not properly capture the financial health of EZPW.

If we redo our calculation of Cash from Operating - Capex - 87M, we get 126M-46M-87M = -$7M for 2013. This is a stark comparison with the 126M-46M = ~80M cash flow that we thought we had. This is the where you can safely stop researching the company, but I decided to skim through the rest of it.

Page 88 - Related Party Transactions - $7.2M is spent on "consulting services" from Madison Park LLC. Madison Park is wholly owned by Phillip E Cohen. Phillip E Cohen..... hey that's the guy who owns all of the voting stock! As if not being able to run a profitable company was bad enough, there's a shareholder who has prevented all dividends to other shareholders, but gives himself a $7.2M dividend. This is the danger of a company where control resides with one person. He can make the decision to pay himself and no one else via a related party transaction.

This is where I stopped my research. This company will only ever benefit Phillip E Cohen, and no other shareholder. I can't really say it's a bad company, because I imagine that this company will continue to run. However, any real money that it can generate will be sucked out by Phillip Cohen. This is his cash cow and I know that he will figure out how to ensure that EZPW stays in business. With that said, I am still learning. Researching companies is time consuming, and this is the first time I came across such a company. It's the first time I really understood why a majority vote is so dangerous in someone else's hands. I've read about that many times, but I never saw a clear example. I hope that you might have benefited from reading this case study. Needless to say, EZPW is not a stock that you should own. However, you'd be a fool to short it since the very viability of the company seems to be entirely under someone's control. If you have this stock, get rid of it.