For several years we’ve been watching the emergence of a paradigm which takes common sense investing principles and throws them out the window. We trace the source to Amazon’s Jeff Bezos, whose decades-long effort to convince shareholders to delay their requirement for profits ultimately yielded undeniable success, and inspired a generation of imitators.
Bezos’ “fly-wheel” approach to building a business has been adopted by countless new entrants who in turn have received from enthusiastic “investors” seemingly endless funding for their endeavours.
From the payer’s point of view, a transaction is not an investment unless it is both safe and cheap.
The disruption paradigm, while great for consumers and employees, in many instances carries a negative expected return for providers of capital. Observing from a distance, we note that this is all happening at the same time as the cost of money has been artificially suppressed for many years, leading many to speculate in the hope of achieving higher returns. Is this a coincidence…?
Regardless, a wonderful consequence for us is the diversion of otherwise competing capital away from unpopular, albeit highly sensible investment avenues. It is only here, in real business ventures, that we are confident investing our money and that of our clients.
Western Union is nearing the end of an internal restructuring that will enable it to respond more rapidly to changing consumer patterns – most notably the increasing adoption of mobile as consumers’ choice for sending money. While much is made of Western Union’s apparent vulnerability to new entrants or “fintech” disruptors, we are inclined to think its moat is more enduring.
Recently we noted an interesting divergence in the financial results of Western Union and those of the remittance industry’s number two player – Moneygram – whose management blamed weaker numbers on rising compliance costs. This supports our view in owning Western Union: the regulatory complexity and compliance costs of instantly moving small sums of money across borders is a growing headache for existing players and a significant barrier to any new entrant.
In the past, competition has put pressure on pricing – a major driver of investor apathy to Western Union shares. We suspect this discounting will find a floor as increasingly onerous compliance is mandated by regulators. Existing and would-be competitors must fractionalise these fixed costs over significantly lower remittance volumes than Western Union. As the largest player with a trusted brand that continues to command a 15% premium, Western Union has the clout to set the standard which others must meet. Simply put, pricing will necessarily rationalise and the company’s revenues will reflect the growth in global remittances.
If we are wrong, then we own a highly cash generative business in a mature industry that trades on an undemanding multiple. If we are right then our investment in Western Union will reward us in time.
Despite a particularly poor year for Vale Fertilizantes, Mosaic management has grown more optimistic in its expected cost savings from the imminent acquisition. Inevitably it will appear that had Mosaic waited a little longer, they could have negotiated a better price with Vale.
But in real world investing (like Mosaic does) as well as outside passive minority investing (like we do), the time to buy is on the way down when the right asset is cheap. It is futile and counter-productive trying to pick the bottom.
Mosaic’s CFO puts it well: one needs a certain amount of “intestinal fortitude” when acquiring assets in the down part of cycle. We couldn’t agree more.
For Yara, 2017 marks a peak in industry capacity additions. New investment in nitrogen fertilizer plants in countries with reasonably priced gas feedstock will again be high next year but will fall away completely from 2019. In China, it remains to be seen whether significant plant closures will take place following the phase-in of new environmental rules. Chinese coal-based urea production remains the highest cost producer, effectively setting a floor price in the export market – a floor we think will rise.
Importantly, nitrogen consumption grows dependably, every year by about 3m tonnes or the output from three large production plants. As the excess supply is mopped up, demand growth will eventually shift the market into a demand-driven fertilizer pricing environment.
Yara will soon close its acquisition (announced more than a year ago) of Tata Chemicals’ urea production assets in Babrala in northern India. The price paid will be close to half of what Tata Chemicals first asked for when they put the plant up for sale in 2015. Despite developing this plant and expanding it over 20 years, in the current industry trough Tata Chemicals finds itself over-levered and cash constrained. It would have found it very difficult to fund essential maintenance turnarounds every 24 months.
The Babrala plant is among the world’s most energy efficient and will strengthen Yara’s ability to offer premium products in this growing, albeit highly regulated, agricultural region. This is a textbook example of how well-managed, financially sound companies capitalise on weak industry conditions to grow at the expense of weaker players.
Aflac continues to make progress on the conversion of its Japan business from a branch under US insurance law to a subsidiary. This arcane accounting change will have no impact on operations, but it does highlight the complex regulatory and financial plumbing behind Aflac’s Japanese business and the critical flow of cash profits to the US parent.
An insurance product is worth little without absolute confidence in the issuer’s creditworthiness. The conversion will bring Aflac’s regulatory reporting structure in line with US peers who have foreign operations, making comparisons easier for ratings agencies and perhaps even lowering Aflac’s regulated capital requirements.
Aflac remains very well capitalised, and is on track to return a significant amount of capital to shareholders in coming years. Of note, management appears to have a exceptional sense of responsibility to maintain Aflac’s financial strength, to not overpay in buying back its own shares, and to not pursue value destroying acquisitions.
Frank’s International continues to see its share price slide as less patient investors opt to put their money to work elsewhere. We’ve discussed in depth the value we see in Frank’s, and while this remains obscured by cyclical conditions, there is a valuable aspect of portfolio management to holding these shares – as a hedge against inflation.
Crude oil and the energy derived from it form a significant portion of the cost of countless goods and services consumed worldwide. Should oil prices rise, as we think they will, inflation will inevitably accelerate. Oil prices will rise not because demand will unexpectedly increase, but because supply will fall due to the unprecedented underinvestment of the past three years. In such a situation, we think Frank’s will see an influx of new business, but more importantly a return of pricing power.
Americans share an ingrained culture of paying taxes and wariness of the Internal Revenue Service. H&R Block provides its customers with peace of mind that they are paying only the taxes they owe and are receiving all entitlements they’re due, while knowing H&R Block will stand with them in any IRS audit.
H&R Block is a unique marketing driven organisation that uses an entire year to prepare a single campaign, and the new CEO has impressive marketing credentials from retailer Target. Incidentally, he moved from a brief stint at ride hailing company Uber – a prominent disruptor with a great product and a terrible brand – to a less fashionable company with an essential product and a great brand.
The tax reform long touted by the US administration is finally happening. Since 2015 the current US president has been calling for the demise of H&R Block, alluding to its irrelevance should the US tax code be greatly simplified. It is two years later, and the outcome of tax reform appears at worst neutral for H&R Block operationally, and potentially quite positive.
H&R Block’s pricing scales higher with more complexity, so it follows that the prospect of simpler tax returns for individuals will be negative for H&R Block.
But at the same time the legislation increases the scope for tax cuts for businesses. Counter-intuitively it appears this will create numerous options for many individuals who explore ways to restructure their affairs.
Lastly, many of the tax cuts for individuals appear inherently unsustainable and will reverse over time, leading to guaranteed complexity in coming years. While we couldn’t have foreseen any of this detail a year ago, we did have a strong inclination that the negative effects of tax reform on H&R Block were overblown.
Aggreko has not been an exciting investment over our holding period and likewise for all other shareholders in this unique company. So it is understandable that investors with too short an investment horizon would choose to sell their shares now in light of apparently more rewarding opportunities.
We think that would be short sighted. Aggreko’s division serving utilities in developing countries has underperformed due to lower demand and consequently lower pricing. This has not stopped Aggreko from continuing to invest in its global fleet of custom-built modular gen-sets. In this way, Aggreko will be well placed to take full advantage of the next tight pricing environment.
The underlying drivers of demand from utilities are unchanged. Developing countries’ electricity consumption rises with expanding industry and middle classes, while ageing generation infrastructure can be expected to produce more serious and more frequent plant failures and power shortages. The result is a growing, albeit exceptionally lumpy requirement for temporary and semi-permanent power generation.
Aggreko goes to great lengths to ensure it can offer clients the lowest cost per KW/h, chiefly by investing in R&D and technology that provides an efficiency and reliability edge. In today’s low oil price environment, Aggreko’s cost advantage is less apparent, but this will change in time. Today’s low interest rate environment also hides a key reality – the cost of financing new and replacement permanent power will become increasingly prohibitive for many states as the price of money normalises.
As with Frank’s International, Aggreko provides us with valuable portfolio diversification. This can be illustrated by charting its share price relative to equipment and tool hire peer Ashtead – a slightly similar but very different business that is highly geared to the business cycle.
Without reading too much into Chart 1, one can see that leading into and following periods of economic contraction, Aggreko massively outperformed Ashtead. At present, Aggreko has steeply underperformed and is without doubt the stock we would rather own today.
Management at Welbilt (renamed from Manitowoc Foodservice) continues to make tangible progress with their simplification and right-sizing programme, as operating margins have steadily increased in the time since the company escaped its former parent’s neglect.
The company is now about halfway through a multi-year effort to raise profitability to the level of its industry peers. This involves several actions including factory rationalization and headcount reductions of which about 75% of targets are complete. Product line simplification has seen a 65% reduction in SKU’s (stock-keeping units) – a major achievement in inventory management for a manufacturer. Still further profitability improvements are expected from a transition to lean production, strategic sourcing and changes to its after-sales service offering.
Welbilt’s systems approach to food preparation is gaining traction with customers, particularly the large fast food chains whose needs are increasingly driven by a desire to save time, space, energy and labour.
Despite an encouraging outlook, Welbilt remains highly levered (Debt/Ebitda of nearly 5x) and in need of every US sourced cent to pay down its inherited debt. Covenants with its lenders require this metric to fall below 4x by the second half of next year, before its high-yield note matures in 2019 – leading to a wide range of outcomes: from refinancing on better terms to seeking additional equity capital.
Management appears confident their US free cash flow will be sufficient to reduce debt to within covenant limits, while offshore earnings will be available for acquisitions. We recently halved our position given this downside but mainly taking into consideration the rather full valuation.
Burckhardt Compression is the world leader in reciprocating compressors for industrial gas applications. Its machines must withstand extreme conditions and operate reliably for around 8,000 hours a year (>90% uptime). A reputation for reliability isn’t built in a day… Burkhardt has been building compressors for over 130 years.
Management believes the market for newly built equipment has bottomed and they will share further information early in the New Year. While the outlook for 2018 is not much better than 2017, from 2019 a return to growth in this division is expected. New system sales add to Burckhardt’s extensive installed base in the field, and since a Burckhardt compressor is overhauled every two years (or 16,000 hours) this in turn benefits its highly profitable and growing services division.
We are inclined to share Textainer management’s optimism about their business and industry.
This is based on such supply-side factors as: stable rental rates due to disciplined ordering of containers by lessors and shipping lines; stable new container prices due to higher steel prices and constraints in production (namely problems with applying water-borne paint in the Chinese winter); low new dry freight inventory; high container utilization and low worldwide depot inventory. On the demand side, container trade growth is projected to be 1.7x global GDP, a reversal in the downward trend in this multiplier over several years.
We have previously noted Textainer’s lower leverage compared with its peers and the financial flexibility this affords. Recently, two major lessors have used higher share prices to issue new equity. Not only has Textainer not needed to go down this road, it currently has actual buying power of US$900m with which to increase its fleet, after already spending US$500m in 2017.
Meanwhile, consolidation among shipping lines continues, increasing their financial heft and lowering credit risk to lessors. In the latest development, from 2018 the three Japanese container lines – K Line, NYK, and MOL – will combine operations under the banner Ocean Network Express (“ONE”), becoming the 6th largest global player.
As the shipping lines grow through acquisition the number of containers they need at any one time increases and this in turn demands greater scale from the lessors – putting large lessors like Textainer at a distinct advantage.
FMC has just closed its acquisition of the R&D and product assets Du Pont was forced to sell by the European Competition Commissioner. In less than a year’s time we can expect to see FMC’s lithium division spun off as a new company. After decades as an innovative conglomerate (originally Food Machinery Corporation), FMC is on track to being a pure-play crop protection company, albeit one up against some very large competitors.
The lithium business still represents a small part of the value of FMC today, but it is very profitable and on track to make significant capacity additions, which all else equal will see profits grow over coming years. We are wary, however, as to whether additional capacity from FMC or new entrants will lead to an over-supplied market and depress prices. Also the sheer pace of technology change in rechargeable batteries – the main end market for lithium – and consequently the threats of substitution and redundancy add to the downside.
Expected earnings from FMC’s crop protection division have been revised higher by management, mainly as a result of a huge boost from the Du Pont assets. We remain comfortable with our investment but recently reduced our position in light of the narrowing discount to fair value.
Vopak is a recent addition to the Fund but a company we have been following closely since 2014. In that year, oil prices began a multi-year decline and concurrently an oversupply of crude increased demand for tank storage.
We saw that users of tank storage fall into two distinct types. A majority of Vopak’s customers have a structural business model serving refineries or end-users. More fickle in their needs are the traders whose main intent is to profit from variations in the oil market’s price/delivery structure (e.g. contango vs. backwardation).
One way to think about Vopak is as a hotel – for oils! Indeed, much as in the hotel industry the occupancy rate largely determines profitability. Vopak is capital intensive and fixed cost heavy – the variable cost of a marginal cubic meter of oil (or hotel guest) is minimal. This creates very high operating leverage, and so changes in occupancy have a large effect on profits.
Yet our hotel comparison drastically underrates Vopak as a business. This is because in many of Vopak’s locations, the ability for someone to throw up another “hotel” is restricted, but more importantly because for Vopak occupancy is only part of the profit equation. Throughput, or the volume of liquids that flow through storage in a period of time, is as important.
We will have more to say on Vopak in future, and that said we look forward to writing to you again.