SA Interview: Investing With A Margin Of Safety With Brian Langis

Feature interview

Brian Langis is an investor and a Chartered Business Valuator (“CBV”). He manages Cape May Capital, a private investment company, and specializes in business valuation. He has been publishing articles on Seeking Alpha for almost ten years. You can learn more about Brian at brianlangis.com and on Twitter @absolut_brian. We discussed best practices for a SOTP valuation analysis, the opportunity in stocks that “fell off the orbit” and an under the radar company that should benefit from a key demographic trend.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

Brian Langis: When I look at a new business for the first time, I go straight to the balance sheet. I do a quick read of the balance sheet. By just reading the balance sheet you can learn a lot about a business without actually knowing anything about it. I can tell if it has enough money to pay the bills for the next 12 months. It’s akin to doing a blood test on a stranger. You can learn a lot about a person’s health without ever talking to them.

A quick read of the balance sheet tells me right away if it’s a company that’s worth spending more time on. It tells me how much cash, assets and debt is behind the business. The retained earning line is a number that reflects what happened in the past. You get a feel if this business can stand on its own or not. If the balance sheet doesn’t feel right, I don’t waste time.

The reason I look at the balance sheet first is because I have scars from some of my early days of investing as a teen when I got in trouble with penny stocks. I had no clue what a balance sheet was and that was an expensive lesson. So balance sheet first. It accomplishes two things: 1) It’s time well spent. For 5 minutes it prevents me from wasting my time and 2) It potentially keeps me out of trouble.

Then I look at the statement of cash flow. I like to see how the cash flow moves around. I want to see if it’s generating free cash flow. I want to see if it’s growing and sustainable. I want to see what they do with their FCF. I reject most companies that cannot show enough cash income to care for growth and expansion, capital returns, without resort to continual new financing (there are few exceptions). The statement of cash flow gives you a good idea of their capital allocation strategy.

And then I look at the income statement. I try to answer simple questions like 1) Is it growing? 2) How are the margins? 3) Is it profitable?

Then you piece all of it together. I want to be able to see the cash flow flowing through the business. All I am doing is getting a “feel” for the business. If it feels good, it might warrant that I spend more time on it. If not, or it’s too complicated, I move on.

There’s some classic value investing to my approach. I’m buying a business. That’s the mindset. It’s important that I understand the business. It’s important I understand how it makes money and what it does with it. I try to visualize the cash from the sale, to the expenses, and to the bottom line. If I can’t, I move on.

There’s a test that I need to pass. I try to answer key questions like 1) Would I like to own the whole business? 2) How would I feel about holding it for a really long time, like 10 years? 3) How much would I pay for the whole business? The purpose of the test is to get me in the right mindset when I analyze the business. This forces me to focus on the fundamental drivers of the business and think long-term. It helps you avoid costly errors.

As for the rest of the process,

1. I want companies that are profitable, FCF generators with decent return on capital.

2. I want great management. It’s a point I used to overlook. For the past couple years it has taken more importance in the process. Business is about people. If it’s not about the people, then what is it about? I’m looking for a business that is run with honest talented managers that think and act like owners. That’s very important.

3. I’m looking for capital allocation discipline. What are the reinvestment opportunities? A great business takes money in, invests it, and turns it into more money.

4. Valuation. Can I get the business at a fair price? I want a business that is trading at a significant discount to its intrinsic value. At the end of the day, I’m counting cash and I need to make a decision on how much to pay for it.

When it comes to opportunities, I don’t discriminate. I’m not restricted by sector or asset class. I’ve a pretty wide hunting ground. An opportunity is an opportunity, why would I care if it’s bonds, stocks, or real estate? The only restrictions are things outside my circle of competence. All you want is getting more than you paid for. You are looking for the mismatch between price and value. You often find it where nobody is looking. And if nobody is looking it’s because it’s generally hated. And if it’s hated it might present opportunities for bargains.

SA: How do you identify catalysts, and more importantly, how do you tell if they are priced in already or not? What is the difference between a hard and soft catalyst, and which one is better and why?

Brian Langis: Value investors like me like to focus on fundamentals, come up with a value, and say “look I’m getting all that other stuff for free.” And you know what happens? It stays that way forever. Because the perceived value is trapped.

A catalyst is anything that can lead to a drastic change in a stock’s current price trend. It could be good or bad (i.e. buyout, bankruptcy). You are looking for an event or action. Identifying an asset that’s undervalued or not recognized by the market probably won’t lead to much. The market will discount it until action is taken to unlock that value. Otherwise it will most likely stay trapped. Basically you try to take advantage of companies undergoing change.

As for the question “how do you tell if the catalysts are priced in?”, the catalyst investing practice is mostly geared towards undervalued situations.

If a stock is trading on a high multiple basis, it’s hard to tell if any potential catalyst is already priced in. You can assume it is. Let’s say you identify a catalyst that you think the market has ignored, what’s the upside if the stock is overvalued? Unless it’s a massive catalyst, the upside is likely to be marginal. In situations where valuation is overstretched, it is safer to avoid.

As for companies that are perceived to be undervalued, I work with what the market gives me. I reverse engineer the stock price. I try to answer the question “What is the market saying?” The price is the collective view of the market. I might use a reverse DCF. A traditional DCF forecast cash flows to determine value. A reverse DCF starts with the end, the stock price, and works backward. You try to estimate the level of expected performance embedded in the current stock price. For a company with many different assets and businesses, a Sum-of-The-Parts (“SOTP”) approach can help. You are looking for mismatches, a gap between price and value.

Not all catalysts are equal. I don’t know if there’s a preset definition of a hard and soft catalyst (I didn’t find any). Below is my own spin on the meaning:

Soft catalysts are more internal. It could be a change of management, a new strategy, a new product, cost cutting, better execution, hidden or misvalued assets, unique intangibles, key people, tax losses. It could be real estate or excess land just sitting there. For example MSG Entertainment has unused air rights/development rights that could be unlocked. Or a company that’s net cash and it’s just sitting in the bank account doing nothing. That will be discounted by the market. Soft catalysts can have a wider range of outcomes and may be more nuanced in nature.

Hard catalyst is more of an external event. It could be a company getting sold, carved out, a spin-off, an asset sale. It’s very specific. I don’t know if hard catalysts are better, but they are easier to value. A hard catalyst has a more defined outcome and timeline (i.e.merger, spinoff). We know what is getting sold, for how much, and we have a timeline. So they are easier to work with.

SA: What are best practices for Sum-of-The-Parts (“SOTP”) valuation analysis? What mistakes do you see investors make in general using these?

Brian Langis: A SOTP is simply a bunch of mini valuations inside a big one. A classic example is your conglomerates with many different businesses. They all have a different cash flow profile and risk level. So each business or asset needs to be valued separately. Then you add them up. Sometimes the SOTP approach makes sense, sometimes it doesn’t.

For simpler, more straightforward businesses, like Spectrum Brands (Long: SPB), a SOTP is appropriate. The company has four consumer businesses that are easy to understand. You can easily dissect each business, cash flows, and value them.

Where a SOTP doesn’t work as well is when you have companies with complex ownership structures and diverse activities. Sometimes you are dealing with a black box. You don’t have all the information. In that case, then it’s probably better to take the number in aggregate at the surface level. Some of these companies are a rabbit hole and you will go mad trying to figure out the puzzle. You can get so caught up in estimating the values of individual businesses that they sometimes forget to value things like “corporate costs”, which can be a massive drag on value. In these cases, I would avoid a SOTP because the risk that your valuation is inaccurate is high.

When I look at a company like CK Hutchison’s that trades in Hong Kong, you almost need to be a forensic accountant to fully grasp the collection of assets it owns. It’s very diverse. It owns fantastic assets around the world, like ports and telecommunications among other things, and it always looks cheap on a Price to Book or Price to Earnings ratio. But it’s not as straightforward. With CK Hutchison, there’s debt that’s not on the group balance sheet, due to the use of complex ownership structures. It has the effect of making its debt look lower than the economic reality and its valuation more attractive than it really is. Then you always have the governance and capital allocation question. I’m not passing judgment on CK Hutchison. Li Ka-shing, the founder, has done something incredible. The point I’m trying to make is that with very complex ownership structures with diverse assets all over the world, it makes more sense to go with the aggregate.

The main reason to avoid a complicated SOTP is to reduce your estimation errors on a unit basis. For example, you will be more accurate applying a multiple to Berkshire’s Hathaway core earnings than trying to estimate the profit of each of the 65 distinct companies and 200+ subsidiaries or so it owns.

The mistakes that investors make are the same ones that they make when they value anything. Valuation is an art, not a science. Why an art? A lot of judgment and opinions goes into it. Any valuation methodology is only as good as the many assumptions that go into it. Start with the idea that you will be wrong. You will be wrong a lot because to a certain degree you are working with the unknown, you are estimating. So work with the idea of “how can I minimize the chance of mistakes?”

The more complicated the business, the higher the chance of mistakes. I think people are too optimistic when making forecasts. Especially when you use a TAM approach (Total Addressable Market) and predict that the business will get X% of the market. I know they teach you that during your MBA and you are bound to do some bad valuation work. If I see a TAM in a presentation, you help me make the “no” decision quickly.

If you don’t have certitude in the numbers, there’s a few things you can do. You can adjust the cash flow downward, apply a higher discount rate, and apply a higher margin of safety. Be more conservative, don’t try to be precise and work with a range of outcomes.

Another thing with SOTP, and that applies to any valuation approach, is that you need to be patient. And most investors are not and that’s a big mistake. Even if you do great valuation work, it can take a really long time for your thesis to play out. It can take 2-3 years, sometimes more. If you expect the market to suddenly agree with your thesis, you can expect to be disappointed. Unfortunately, when I purchase companies that I believe are mispriced, it’s impossible to determine when the market will agree and close the gap between price and intrinsic value. The goal is to build a portfolio that has the potential to outperform the market over a time horizon of 5-10 years, because nobody is thinking like this. There’s less competition when you think about a long time horizon. Most market participants want nothing better than to beat the market every day, every month, every quarter, and every year. I don’t know how you do that. But focus a couple years out, you have a better chance.

SA: Can you discuss the deep value or contrarian opportunity in stocks where investors have simply “given up” on a name and/or forgotten about it, even as the story has changed? How do you identify them in the idea gen process?

Brian Langis: I had success in the past with companies that “fell off the orbit”. They are off the radar, out of favor, as some would say. These are companies that have been forgotten by the market. Nobody cares or is paying attention to them. Most companies are off orbit and probably deserve to be there. So who’s in orbit? If you look at financial media, there’s only a few companies that dominate people’s attention.

The key here is to find a business that’s off orbit that will be brought back in the orbit. When that happens it will be revalued upward. Usually when a company is casted away, it’s probably because it’s underperforming or is in some kind of trouble. They stay in that zone for a while until some event brings them back in the orbit. It becomes a “show me story.” Prove yourself that you should be back on the orbit/radar.

I’ll give you a good example. A couple years ago I bought Intertape Polymer (“ITP”). I presented it at some event and I even wrote an article for Seeking Alpha but I never finished it (like most articles, sorry). Three years before I bought ITP the company announced it was going on the massive multi-year CAPEX program. Of course the market hates that stuff and punished the stock. I bought ITP as they were finishing their CAPEX program. I went back a couple years to see if management could be trusted on the things they said and you could. They had a good track record. And ITP did exactly what they said they would do. After they were done investing, revenues went up, margins expanded, and FCF grew. Then the market noticed, the stock doubled, and it was taken private by a PE group last July. ITP was “show me a story”, prove to us that you deserve to be back in the orbit.

The key is to position yourself. We know that the market is short-term oriented. Use that to your advantage. If you can see ahead of what’s coming, you can position yourself when nobody is paying attention. You don’t need a crystal ball. Very often management will tell you what they will do. The best evidence that a company will do what they say they will do is the fact that it has done it. Like my ITP example, management told me what they were going to do and they had a track record.

I’ll give you another example, an old one, but an easy one. It was about 9 years ago, 2013, that I bought some WWE shares. At the time the stock wasn’t going anywhere and looked cheap. I remember looking at some quarterly presentations and they were discussing the TV rights that will be renewed the next year and they thought they could triple what they could get based on comparable sports rights. That was clearly not included in the current market price. The other catalyst was the launch of the WWE Network the next year and how many subscribers they believe they could get. I identified two easy catalysts that will be on the radar in a year. Now move forward 1 year. TV rights renewal and the hype around the launch of the WWE Network takes over the narrative. The stock is back in orbit. The WWE stock went on to quickly triple. That was an example of a company that nobody was paying attention to and management told you what was coming.

A more recent example is Spectrum Brands (Long:SPB), my last article. The thesis got pushed back because of the DOJ’s involvement in the sale of their Home & Hardware Improvement division. I think it will work out but these things take some time. But the stock is slowly coming back into orbit. There was 1 year between my article and the last SPB article. Then three articles in the last three months. People are starting to pay attention.

This is not about being the smartest person in the room. I’m just a guy that shows up early to the party. You have to be okay with owning unpopular stocks for a while.

SA: Can you discuss the importance of differentiating between what a company “should” do to create/unlock value vs what it is likely to do? Can you give an example?

Brian Langis: If the market prices your business well below what you think it’s worth, you need to ask the question: Who is right? The market or you? It starts by assessing that question.

If you go back to Spectrum Brands (SPB), I think management realized that the market wasn’t going to give them the same valuation as some of their comparables. It’s 4 businesses with 4 different cash flow profiles, risks and capital allocation needs. There’s debt too. It’s easy to get turned off. The two best parts (Global Pet Care and Home & Garden) are not getting the valuation they deserve. Management knows that. They want to simplify the business and focus on their gems. That’s what they told investors and that’s what they are trying to do.

I don’t know specifically what a company “should” do to create value. That’s why a company has a board of directors and management to look after shareholder’s interest. But as an investor that puts capital to work, I know that capital will look elsewhere if you don’t try to get a decent return for shareholders. A company’s north star is to maximize shareholder returns. If they don’t work towards that, the business won’t attract capital (or it will be costly) and its valuation will be impacted. If you have a better idea or a better business, it’s going to win out. That’s how it works.

A great business takes money in and turns it into more money. If those investments make more money than they cost, the company’s value increases. I think the conversation boils down to capital allocation. How the company use its cash is their #1 responsibility. No matter how cheap the security, a bad capital allocation framework will ruin any investment.

If that SOTP valuation is much higher than the value that the market attaches to a business, you may very well find an activist investor targeting the business to do something about it.

SA: Are there any under the radar industries/companies that will benefit or suffer from demographic trends? If so, which ones and why?

Brian Langis: I’m currently looking at some companies/industries impacted by an aging demographic. I’ve started poking around the senior retirement housing space in Canada. I’m also looking at medical equipment providers for the seniors. It’s no breaking news that the amount of seniors will keep increasing. I’m sure the story is similar in the U.S. For senior housing, I won’t name an individual pick because the research is preliminary. For senior medical equipment, there’s one pick below.

For senior retirement housing, here’s the thesis I’m looking at. Basically the senior home space got beat up hard during Covid, especially in Canada due to severe Covid restrictions. Costs went up and revenues went down. Revenues got hurt because of the lack of visits and people not moving in. They also feel the lack of trained labor. Occupation dropped from 85%-90% to 70ish% for some homes and the lost occupation has been slow to recuperate. The combination of revenue drop and increasing cost can be punishing. Higher interest rates obviously doesn’t help. You need to be careful with the space because a lot of these companies took on a lot of debt and are facing short-term pressure. With the worst of Covid behind, occupation should improve. Long term, the senior retirement home space should do fine because of the aging demographic trend. But in the short-term, you need to be picky. The ones with stronger balance sheets are in a better position to take advantage of the trend. The space got the interest of PE groups like Blackstone. They have been expanding their presence in the Canadian seniors housing market in the last couple years.

Overall, the senior retirement home space is not very liked right now. This provides opportunities if occupation normalizes and they fix up their business. The senior retirement home space should do well because 1) you have a growing demographic that will be undersupplied, 2) it’s a real estate play where monthly rent should improve over time 3) the best operator can deliver value as they scale up. 4) the closing of the gap between the NAV and price. The ones that can deliver strong FFO growth and same property net operating income growth will excel.

Another company that should benefit from an aging demographic is Savaria (Long:SIS.to) and I can get into the specifics. This is a company with a CAD$1b market cap with about 64.4m shares trading around CAD$15. Savaria has about $350m of net debt. Net debt to adjusted EBITDA is 3.5x and should trend down to 2-2.5x next year. It’s up because of a massive acquisition last year. Savaria is in the medical equipment space, they make accessibility equipment such as wheelchair lifts, home elevators, all kinds of mobility-assistance products. They have really nice products and it’s very expensive too. The trend at play here is that people want to stay in their home longer as they age. Last year they bought Swedish company Handicare Group, roughly doubling its annual sales and making it a top player in a growing market. People are aging and in need of equipment to keep them in their home longer.

I met the CEO, Marcel Bourassa, a couple years ago. He’s a straight shooter. He’s in a different mold than the typical sophisticated CEO. I liked what I saw. He’s the founder, he understands the business, he’s an operator, and owns a big chunk of the business. Last time I checked he owned like 24%. Shareholder interest is aligned. They don’t do much PR and communication with analysts and shareholders. It would probably help if they did a little bit more. Savaria is “off orbit”. The latest acquisition was massive and takes a while to digest, but you are starting to see the results.

Savaria is positioned to take advantage of a multi-year secular trend with an aging population that wants to stay home longer. Savaria’s long-term goals, given the track record, include expanding sales from $750m (LTM) to $1b by 2025. Savaria can protect their margins through cost pass-throughs. Savaria just increased its monthly dividend 4%, to 52 cents on an annual basis, for a 3.3% yield.

In terms of valuation, SIS historically traded at multiples between 10x-15x EV/EBITDA. It’s currently around 9x EV/EBITDA. Longer-term, management continues to target revenue in excess of CAD$1b in 2025. With 15% EBITDA margins (management expects improvement), you have $150m in EBITDA. At 10x EV/EBITDA, you get a 15% return. I think that’s the floor. Better margins and a richer multiple will get you more. Meanwhile you get to collect the monthly dividend.

SA: What are several ways an investor can build a margin of safety in their financial projections and/or valuation analysis?

Brian Langis: There are multiple ways.

First, a quick refresh. When we talk about the margin of safety, we are borrowing an engineering concept that expresses how much stronger a system is than it needs to be for an intended load. For example, you want to build a bridge that is much stronger than needed for normal usage to allow for emergency situations, unexpected loads, misuse, or degradation. You want to build a bridge to support 15,000 cars vs the intended 10,000 cars.

In finance, a margin of safety is the difference between what an investor pays for an item and the item’s intrinsic value. To qualify as a margin of safety, the market price must be significantly below the intrinsic value.

In layman’s terms, you want a buffer. Why? We are humans and we are flawed. We make errors of judgment all the time. As I explained earlier, valuation means you have to make a lot of assumptions and you will be wrong a lot. You are aiming to get a target range of what the intrinsic value of a company is and paying less. A share is cheap not because it has a low P/E multiple or a high growth rate, but because its market price is below its intrinsic value. This constitutes the “margin of safety”. If we go back to the bridge example, it’s not one of these things where you want to cut it close right? You want trust and confidence that if something goes wrong the bridge won’t collapse. Why not apply the same thinking to your investments?

The reason I’m stating the obvious is that the margin of safety is a core fundamental pillar of value investing. If you look at the market behavior of the past two and half years, a little back to the basics would have helped a lot of investors.

When it comes to valuation you don’t need a more rigorous model. You don’t need a 500 line DCF model. The good news is that, as with most things in life, the Pareto rule applies: 20% of the work will take you 80% of the way. Less is better. You don’t want to drown in details. The 20% needs to be on the core drivers: Revenue growth, operating margins (profitability), and capital reinvestments. Out of that your value is derived from the standard input: cash flows, growth, and risk. That will carry most of the work.

You don’t need to overthink this. Our big problem is dealing with uncertainty. The more incertitude, the higher the margin of safety, and vice versa. Each business has different characteristics and risks. With mature companies, it’s easier to project numbers into the future. Others, like startups, it’s nearly impossible. The more certainty you have, the more reliable will be the cash flow. You don’t need as wide of a margin of safety if you are valuing Coca-Cola versus a company like Peloton, where most of the value rests in the terminal value.

You can also look at intangibles when building a margin of safety, like an economic moat. We have talked a lot about the quantifying aspect of the margin of safety, but something like a great brand can provide a buffer. In fact, a great brand can become one of the most valuable things about a business and thus have no value associated with it on their balance sheet. Intangibles can be hard to value depending if you have data and the quality of it, and brands are not the easiest thing to value. But we know that brands are a unique intangible asset – they are simultaneously capable of increasing revenues, reducing costs, and lowering risks. I recently read that if you bought Pepsi in 1980, you would have made 370x your money. The margin of safety here was Pepsi’s brand moat, which was highly durable.

Another type of margin of safety you can use is time. Have a long investment horizon when you build your valuation. The stuff the market price is short-term. Take the Pepsi example above, if you would have relied on any analyst report of the time you would have been poorer. My first article on SA, Dollarama (Long: DOL.to), had 785 stores when I valued it. The market worked with 80 new stores opening. Dollarama said there’s room from over 1,200 stores at the time. Dollarama has 1,462 stores today and aims to have 2,000 in 2031. Just like Pepsi, the mistake was applying standard industry multiples to near term earnings which are completely anomalous to where a business might be in the future. Putting on a multiple of earnings on 80 new stores or whatever, when you can see that Dollarama is going to be everywhere, is of course meaningless. You need a model that can expand a couple years out. Dollarama looked expensive at the time, but looked cheap 5-7 years later.

The margin of safety comes to understanding the specifics of the business. How is value defined? How is it created? What are the potential outcomes?

SA: Can you discuss the advantages and disadvantages of using a simple vs complex financial model? Which do you prefer and why?

Brian Langis: Follow the KISS principle.(Keep It Simple Stupid.) As I said in the previous question, the Pareto rule applies. 20% of the work will take you 80% of the way. If we start with the idea that the intrinsic value of a company is the present value of the expected cash flows from that business, with the discount rate adjusted for risk, then that’s where you should focus your time and energy. And more on the cash flow than discount rate. Most of the data for the discount rate is provided by the market. Don’t spend an inordinate amount of time on it. Yes the discount rate is important, but you’re wasting your time trying to estimate that number to the second decimal point. Cash flow forecasting is dealing with uncertainty. You want to work on that.

You don’t need a complex financial model that captures all the complexities. All you are doing is increasing the chance of making a mistake. You are missing the forest for the trees.

People used to do valuation before Excel existed. Imagine you didn’t have a computer and you had to value a company. You would focus on the essential; The revenue growth, operating margins (profitability), and reinvestment. It’s the back of the napkin approach. If you do it properly, I really think it can capture most of the value. Part of me wants to believe that people did better valuation work before Excel existed.

I don’t believe that complex models with more variables is the answer to uncertainty. There’s just too much noise. Complex models work best when the inputs are reliable, like in engineering. When it comes to valuation, we work a lot with assumptions, a lot of uncertainty, and it’s easy to be off, which brings me back to the importance of the margin of safety.

Simplicity has worked well for me. My best performing ideas were always simple to understand, simple to value businesses. If you look at the performance of my past articles, the ones that really did well were the simple ones. My best performing ideas were the simple ones. Dollarama, Alimentation Couche-Tard, Brookfield Asset Management, ECN Capital, TFI International (ex Transforce), and MTY Food Group. The others, the more complex modeling, the more complicated situations, they haven’t done so well. SNC-Lavalin hasn’t done well, so has Warner Bros. Discovery, and Lumen Technology is down. With Spectrum Brands time will tell.

If there’s a takeaway, like most things in life, simple is better than complex.

SA: What’s one of your highest conviction ideas right now?

Brian Langis: I’ll give you a couple. I already mentioned Savaria Corp in a question above. I want to reiterate the pick of my last article, Spectrum Brands (Long: SPB). The thesis still stands. The sale of their Hardware & Home Improvement division to Assa Abloy is being challenged by the DOJ. It’s a huge amount of money for SPB. They are getting a rich multiple for the business. I believe the sale will go through because Assa Abloy is selling key assets to make sure they are compliant. The sale will make SPB go from net debt to net cash. Yes, there’s some risk but the upside more than makes up for it. I suggest reading the article for a more comprehensive analysis.

I think Lumen Technology (Long: LUMN) deserves a 2nd look. Lumen is another past pick from almost two years ago. You can read the article here. Long story short, it didn’t go well. I’m down 56%. It had a market cap of $13b, it’s now at $5.6b. It looked cheap back then at a FCF yield of over 20%. Obviously it didn’t work out.

We know what happened. They couldn’t grow the business. They just eliminated the fat dividend. Everybody is selling. Nobody is buying. Everybody left town. The stock is in the tank.

I’m actually writing a review on Lumen Technologies. Hopefully I can finish the article and publish it. With Lumen we know the past. The question is where is it going next? What’s the future?

At the moment I believe there’s excessive selling. Most investors held the stock for 1 reason: the fat dividend. We can argue back and forth if it was a good idea to cut it. But if you have to ask the question every quarter, I think you know the answer. Now that the main reason for holding the stock is gone, you have excessive tax loss selling. And you are exchanging one kind of shareholder (the dividend folks) for another (deep value?).

I’ll make this very short. For Lumen to work out, they need to have growth. It’s hard to be a public company if you don’t grow. That’s all Wall Street cares about. You can do buybacks, sell assets, pay down debt, invest, and yes Lumen has good cash generating assets but the Street wants to see the top line grow. Show sustainable growth, and this stock turns around on a dime. That was my mistake in my original article. I expected growth and didn’t come. I was wrong.

The good news is they have a new CEO that’s pro-growth oriented. Kate Johnson, the new CEO, had success in growing revenues everywhere she worked. It might not happen overnight, but I’ll give her the benefit of the doubt. Also, by eliminating the dividend, you are liberating $1b in cash and she’s not anchored to any previous expectations. I haven’t sold my stake in Lumen. I’m waiting to hear about their 2023+ plans.

Another stock I like is Stella-Jones Inc. (Long:SJ.to). I’ve been a shareholder for about two years. It has rebounded from its recent lows. SJ currently trades for $49 a share. It has a market cap of $2.9b and there’s 59.3m shares outstanding. SJ is not a sexy business. They produce pressure-treated wood products. They operate in three segments: Railway ties, utility poles, and residential lumber. They operate in Canada and in the U.S. This is a defensive stock. Railroad operators need to maintain and upgrade their railway ties. Meanwhile, utility poles have to be maintained, replaced and installed.

They have good disciplined management. They are also very conservative with their guidance. For example, on railway ties, a lot of railroads announced massive CAPEX programs this year, when management was asked if their guidance included the massive spending announcements they said nope.

Stella-Jones does it all. They reinvestment in the business, they do acquisitions, they do buybacks, they pay down debt, and they distribute a dividend. I like the combination of a shrinking share count and a growing business. They are focused on growing the per-share value.

SJ had $2.9b in sales in the LTM and $413m in EBITDA with EBITDA margins of 14%. Return on average capital employed is 13%. It has a solid balance sheet with a net debt to EBITDA ratio of 2.3x, trending downward. The balance sheet should allow management to do more M&A or buybacks. With EBITDA estimated to grow to $438m next year, at a 10x multiple, that gets $58 a share for a 18.5% return. It’s currently trading below its historical average of 11x EV/EBITDA. On FCF approach, it’s currently yielding 10.7%, or $5.22 FCF per share. It should be lower, around 8%, but some argue even less. A 12.5 FCF multiple (8% FCF yield), you get an implied target price of $65.30, for a 33% return. If you blend both methods, you can expect a mid-20% return over the next couple years.

I’m also looking at Haleon (HLN). Haleon trades in London and New-York. I don’t have a position at the moment. HLN was part of GSK. GSK received 3 offers from Unilever to buy the business. The latest offer was at $68b and GSK said no, the price was too low. There were also several private equity firms poking around. GSK instead spun-off Haleon, their consumer health business. Haleon is strong in the oral care and vitamins and food supplements categories. They have a bunch of brands we are familiar with like Centrum, Aquafresh, Sensodyne, Tums, Advil…

Last July Haleon became a standalone company. Haleon is trading at $7.75 a share and has a market cap of $35.5b. It has about $12b of net debt, or 4x net debt to EBITDA. The stock has rebounded recently but it was trading below its spin-off value of $29b. HLN is trading at a lot less than what Unilever wanted to pay. Haleon is also trading a lower EV/EBITDA multiple than Unilever (14x) and Procter & Gamble (18x). One factor that weighs on the stock is the 4x net debt to EBITDA and it’s slightly smaller. What Unilever wanted to pay presents a floor, maybe minus a premium even if GSK thought the price was too low. GSK said at the time that the bid “fundamentally undervalued the Consumer Healthcare business and its future prospects.” While some discount is warranted, even if you adjust it downward, there’s still upside. And if you adjust it for comps, there’s upside there too, of at least 15%-20%.

Haleon is a classic Joel Greenblatt investment type spin-off opportunity. Greenblatt talks about the spin-off opportunity in his book “You can be a stock market genius”. Usually, the smaller spin-off entity finds its way into the hands of investors who can’t own it or don’t really want to own it and the stock is immediately sold. In this case GSK investors selling their shares, Pfizer (a partner) selling their stakes. They own 45% together and the lockup expired last month. What often happens following a spinoff is a dislocation. Usually the smaller spun-off entity, in this case Haleon, finds its way into the hands of investors who can’t own it or don’t really want to own it. Because of short-term pressure, HLN is undervalued and the market price should re-calibrate over time. It’s a great company.

I’ve been a shareholder of Activision-Blizzard (Long: ATVI) and Microsoft (Long: MSFT). The narrative around ATVI is their sale to Microsoft being challenged by the FTC. This is an arbitrage play. First, the stand alone value of ATVI is around the acquisition price of $95. It has $9 in cash per share and growing. So even if the acquisition fails, there’s upside. Second, I believe Microsoft will win in court. MSFT already addressed the FTC concerns by saying that the games will be accessible to all gaming platforms. Plus it’s a business decision. The economics of the transaction has to make sense. If you spend $69b, you want to sell as many games as possible, not limit access. I also think it will be hard for the FTC to prove their case in court. The FTC has to make a lot of assumptions about the future, like accurately nailing down the future effect of a vertical acquisition. Blocking a deal on the basis of what the game market will look like in the future would be hard for the FTC to defend. They will talk about the strength of Microsoft’s cloud and how the transaction will make Game Pass more valuable. But it’s unclear how, when, or whether the merger could tip the market in MSFT’s favor. We are looking at a 26% upside. Deal or no deal, I like it.

Here’s the last one. I’m currently invested in Primaris Real Estate Investment Trust (Long:PMZ-UN.to). PMZ was spun-off from H&R, another REIT in Canada. H&R has been divesting non-core assets to be more focused on industrial and residential. PMZ is an owner of enclosed shopping centers. The business is doing well. Rent is going up. People are still going to the mall; they are packed. PMZ has good locations, like the Dufferin Mall in Toronto. They have good tenants like Walmart, Canadian Tire, Dollarama, Winners, Loblaw…tenants that pay their lease. Debt to total asset is 30% with interest coverage of 5.3x.

PMZ became public on January 5, 2022. PMZ is a high quality REIT that offers long-term growth potential and potential growing distributions. They just recently raised their distribution. It’s yielding 5.44% with a FFO payout ratio of 48% (62% AFFO). Insiders have been buying frequently. PMZ is also repurchasing shares at a discount to NAV of $21.86 per share. That’s a gap of 49%. Even if you don’t trust the NAV, there’s plenty of margin of safety.

This opportunity exists for multiple reasons: 1) It’s a new spin-off. 2) High interest rates make their distribution less attractive 3) Higher interest will impact debt cost 3) The whole REIT sector has been slammed. I’m not usually a fan of REITs, but right now I see value. A lot of REIT are trading at a discount to their NAV of at least 40%. When PMZ does buybacks below NAV, it’s increasing the NAV per unit. Pre-Covid, the REIT space was trading above NAV. In Canada, Summit Industrial (SMU-UN.to) just received a buyout offer for 19.5% above its NAV. Yes it’s an industrial asset vs retail malls, but does PMZ warrant a 49% discount to its NAV? If PMZ keeps buying back units and being profitable, the gap will only get bigger. Like I said, I’m not super crazy about REITs in general, but in the current sector carnage, there are opportunities to pick some gems among the rubbage. PMZ is delivering improving FFO per units and same property net operating income. With an horizon of more than 12 months, there’s upside in PMZ by closing the NAV gap, and growing the NAV.

***

Thanks to Brian for the interview.

Brian Langis is long: Spectrum Brands (SPB), Savaria (SIS.to), Lumen Technologies (LUMN), Stella-Jones (SJ.to), Primaris REIT (PMZ-UN.to), Dollarama (DOL.to), Activision-Blizzard (ATVI), Microsoft (MSFT)