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.

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