Friday, February 15, 2013
Monday, April 30, 2012
I’ll try and summarize my approach which I have found to be a successful, robust starting point to identify opportunities. I generally run 3 filters:
1) Primary Universe Screen, followed by a more in-depth,
2) Fundamental Screen, and finally a
The primary universe screen I think is a very simple screen that I use across all core strategies (value, growth, dividend) and is just a very basic filter of stock characteristics that prudent investors should demand from any stock they own:
1. Market Cap minimum of $2 Billion.2. Stock trading at earnings yield > than yield earned on 10yr Investment Grade Corporate Bonds. If corporate's yield 3%, this suggests we pay a forward P/E no higher than < 33X. 3. Earnings expected to grow at a rate higher than inflation over market cycle.
4. Company generates Return on Invested Capital exceeding cost of capital (also normalized, 5yr) (I use 6% if WACC is unavailable)
5. Company generates cash internally – positive free cash flow. 6. Earnings Quality > Ranks above bottom quartile
Next, the most comprehensive screen is the fundamental and earnings quality screen. I will typically break out 3 Core Equity Strategies (Core Value, High Quality Dividend, and Core Growth)and if possible, break out by sector in order to make more meaningful comparisons (Financials, Cyclicals, etc.)
Core Value – More emphasis on free cash flow, EV/EBITDA, and price/earnings multiples, especially relative to its historic multiple. Less concerned about ranking within sector, more concerned about ranking vs. market averages.
1. FCF Yield > Market Average
2. EV/EBITDA < Market Average 3. Forward P/E < 1.0X Historic Relative Multiple* 4. P/EG Ratio < 2.0X 5. Historic EPS Growth > 8%
6. Historic 5YR ROIC > 10%
7. Earnings Quality > Sector Average Ranking
*(use P/B, P/S, P/CF if more appropriate)
Growth/Momentum - More emphasis on expected earnings and ROIC growth vs. sector averages. Also, demand higher EPS consistency, and top quartile rankings. Only valuation filter is P/EG
1. Expected LT EPS Growth > 12%
2. Expected LT EPS Growth > Top Quartile of Sector
3. EPS Growth Trend > Accelerating faster than Sector Average
4. EPS Consistency > Market Average
5. ROIC > 15%
7. ROIC Trend > Positive
8. Earnings Quality > Sector Average Ranking
9. P/EG Ratio < 3.0X High Quality Dividend - More focused on historic trends (indicating a willingness to pay), financial strength and consistency (indicating a capacity to pay dividend (FCF & Payout), and expected growth trends 1. Dividend Yield > 1%
2. Expected LT EPS Growth > 10%
3. FCF Yield > Market Average
4. Payout Ratio < 80% 5. EPS (DPS if Possible) Consistency > Market & Sector Average
6. ROIC > 12%
7. Earnings Quality > Market Average Ranking
The last set of screens would be technical (earnings and price momentum screens), which I use as a “trading” overlay as they can provide good insight as to the timing of stock purchase. My personal approach, is to use a somewhat contrarian strategy here, buying value when it moves and buying momentum when it is weak.
Within the value stock candidates, identify weak long term performance coupled with strong near term performance, or a relative performance reversal. Similarly, we want to identify stocks that have been taken to the "woodshed" with negative EPS revisions, and are seeing a reversal in EPS revision trends. This way we avoid “value traps”. Having followed this approach at the beginning of the year, we would have been seeing attractive entry points for homebuilding stocks, which had finally, after 5 years of price and earnings declines, were finally showing strong signs of a price reversal coupled with estimates that had been overly pessimistic. The group is now up over 80%.
Among growth, finding just the opposite, strong LT performance, with weaker short term performance, may provide attractive entry point for a high quality company taking a breather. In this way we are avoiding buying a “top”. If recent YOY EPS trends remain solid, we should be less concerned with sentiment trends, unless there is a dramatic or structural change in the company's future growth prospects. If we were to have followed this approach, high quality, high growth stocks that were in simply in a consolidation phase, such as AAPL would have looked attractive 6 months ago, penetrating its lower bollinger band, on low volume, for no particular fundamental reasons.
Sunday, May 08, 2011
Sunday, February 06, 2011
- In our New Normal world, regime shifts in economic conditions will continue to cause significant challenges for risk management and portfolio construction.
- On average, correlations across risk factors are lower than correlations across asset classes, and risk factor correlations tend to be more robust to regime shifts.
- Risk factors provide a flexible language with which investors may express their forward-looking economic views, adapt to regime shifts and diversify their portfolios accordingly.
– Peter L. Bernstein
Friday, August 06, 2010
Sunday, April 25, 2010
CLEARWATER PAPER (NYSE:CLW)
Although Clearwater Paper's stock has been a significant outperformer and recent tax credits have provide a non-recurring benefit to their earnings, at the current $50 stock price, the shares continue to offer value to investors. We argue that although the most recent 12 months EBITDA of 173mm is an anomaly, its capacity to generate higher levels of cash flow has significantly increased and the company is attractively valued on an absolute and relative basis. The company is well positioned to continue to expand market share in a defensive consumer staple industry and has the potential to increase margins further through growth investments in its toilet paper manufacturing technology. Furthermore, the company has some cost saving opportunities and continues to optimize its investment in the slower growing paperboard business and lastly, the eventual stabilization in housing market correction will reverse the profitability headwind pressuring the lumber segment. The combination of these factors suggest investors appreciate the company's ability to expand its earning power and given industry leading returns on capital, clean balance sheet, and solid free cash flow, may once again, Mr. Market may be mispricing the shares of an underfollowed company in the "not so glamorous" toilet paper industry that could be an attractive private equity target, or a smart investment for a shareholder with long term value orientation.
Clearwater Paper Corporation is a producer of tissue and paperboard products in the United States. The company operates in three segments: consumer products, pulp and paperboard, and wood products. It is the largest private label manufacturer of tissue products including toilet paper, tissue, napkins, and paper towels, sold in grocery stores in the United States. The company's paperboard is sold in the packaging industry and it is used by its customers to make packaging for products, including liquids, pharmaceuticals, consumer goods packaging, such as fast food containers and DVD packaging. The company is vertically integrated and produces most of the pulp required in its tissue and paperboard businesses. The company also manufactures wood products, including cedar and lumber products, a business that has been challenged due to the recent weakness in housing market.
The Consumer segment, Clearwater's core business manufactures household private label consumer tissue products and has the highest margins and growth prospects of the three segments. Its products consist of paper towels, napkins and facial and bath tissue and its strategy to offer non-branded products that offer comparable quality & features to the "premium" and "ultra" brands. CLW is the only U.S. consumer tissue producer that manufactures solely private label products and accounts for 56% of all private label tissue products in the U.S. grocery market, and 90% of private label tissue west of the Mississippi River. There are approximately 8mm tons of tissue per year sold in the U.S., of which about 3mm are sold to industrial/commercial users such as hotels and restaurants, and the remaining 5mm are sold to the "Home" market, which is further broken down by "non-grocery-discount" stores such as Wal-Mart, which sells just over half of the "Home" market tissue. The "grocery" channel sells about 2.4mm tons, and about 1/4 of this market is private label. Clearwater holds 56% market share in this category and is significantly larger than its next largest competitor in this highly fragmented market. One risk we would highlight is a relatively high customer concentration, as its 3 largest customers (Kroger's, Safeway, and Albertson's) comprise over 50% of this division's revenue, and just over 23% of total company revenue. That said, the company has significant relationships with these companies and has been supplying them each for over 25 years (top 10 customers average 19yr relationship), and supply chain is very well integrated, making switching costs, while not insurmountable, relatively high.
Pulp & Paperboard
Pulp and Paperboard segment manufactures and markets bleached paperboard for the high-end segment of the packaging industry and is a leading producer of solid bleach sulfate, or SBS paperboard SBS is a premium paperboard grade that is most frequently used to produce folding cartons, liquid packaging, cups and plates, and commercial printing items. SBS is used to make these products because it is manufactured using virgin fiber produced in a kraft bleaching process, which results in superior stiffness and cleanliness. This segment also produces softwood market pulp, which is used as the basis for many paper products, and slush pulp, which it supplies to the Consumer Products segment. The company has about 13% of paperboard capacity in the United States. Interestingly, while much of the consumer tissue supplying capacity is concentrated in the Western US, Clearwater's Idaho SBS Paperboard facility is one of only two SBS processing operations in the Western US, making it one of the lowest cost SBS producers for Asian importers. Last year international exports drove about 20% of total revenue. Pricing power is somewhat more challenging in this commoditized business, and relative to the consumer business, is much more cyclical and sensitive to volatility in raw material inputs. Wood Fiber drives about 35% of the total costs of this segment, energy costs account for another 15%, and transportation is another 10% of its P&L. Combined with sluggish top-line growth, 20% higher wood fiber costs and triple digit oil prices were a significant headwind in 2008, when pulp & paperboard segment saw its EBITDA drop by 40% YOY and margins down to 6% from 12% the prior year. This business is a slower growing management is focused on cutting costs, leveraging its existing assets to optimize the business rather than investing in top-line growth. This is a cash cow business that requires minimal capital expenditure and just as its pulping operations feed other segments of the business it's free cash flow can feed growth in higher margin higher growth opportunities in the consumer division.
FUNDAMENTALS & VALUATION
Perhaps the most compelling aspect of the Clearwater thesis is its attractiveness on fundamental and valuation basis. In absolute terms, as well as relative to its peer group, Clearwater offers a very conservative balance sheet, solid profitability and margins, trading at 3X its earnings and cash flow. Using its "normalized" cash flow generation (5 year average) of $125mm and a market cap of 590mm suggests a slightly higher 5X multiple, although the recent housing crisis combined with high energy and input costs have been considerable pressures on the company over the last several years. Furthermore secular trends in the private label tissue markets, moderating costs, and several company specific initiatives suggest that the last 5 years will soon represent a trough period and earning power and its multiple will expand significantly.
The most recent years cash flow generation was somewhat of an anomaly and investors should look examine the company's earning power over a multi-year period to arrive at an appropriate estimate of the company's ability to generate profit. For example, 2009 earnings should largely be considered an anomaly because the company benefited from a tax rebate that provided a cash windfall of about 175mm in 2009. A by-product of their pulp-making process known as "black liquor" has a renewable quality that enables it to be recycled in the manufacturing process and recent legislation has allowed the company to qualify for a tax rebate based on its production of this alternative fuel. It is not known whether this will be future sources of tax relief so it is not included in future forecasts, but could be a catalyst if legislative laws continue the tax benefits.
GROWTH CHARACTERISTICS: INDUSTRY LANDSCAPE
Attractive Market Fundamentals
Private Label Winning Share from Branded Players: In the United States, about 7.9mm tons of tissues are consumed annually. Of that, about 1/3 is commercial (public restrooms, hotels, restaurants, etc.) and the remaining 5mm tons define the "at home" market, which is further stratified by the discount (Costco/Wal-Mart) and grocery store channel which each sell about 2.5mm tons of tissue per year. Increasingly large supermarket chains are allocating more shelf space to Private Label goods. Retailers are pursuing this strategy because of the improved level of quality that private label goods now offer, and also the increased profitability contribution from private label. The advertising, promotion, R&D, and other expenses that branded consumer product companies incur raise the overall cost structure by 20%-30% over private label manufacturers, whose SG&A lines are not materially impacted by these items. Retailers, on average, earn 10-15% higher gross margins on these products, passing along roughly half the savings to the consumer. Since 2002, private label has won approximately 300bps of market share, growing 8% annually or twice the growth rate of branded segment(4%), and making up 26% of the grocery tissue market (or 19% of total "at-home" market, which includes discount stores, see below). The trend has been to continue to drive quality improvements from private label products, and many of which, such as Clearwater's tissue products, now offer a comparable quality profile to the premium branded products, Charmin© & Cottonelle©.
Private Label will continue to win market share from national brands for the following reasons:
- Economics. Retailer earns 10-15% incremental gross margin contribution on private label
- Negotiating Leverage. Offering non-branded alternatives with comparable quality, provide additional leverage when negotiating with national brands
- Retailer Brand Enhancement & Customer Loyalty. Offering high-quality private label products can enhance brand recognition and consumer perceptions about their grocery retailer
Defensive Product Categories
Toilet paper is one of the most inelastic consumer products sold. For obvious reasons, tissue is usually one of the last things consumers tend to cut back on in a weak economy. Even in very weak economies as the below chart illustrates, demand for tissue continues to expand.
GROWTH CHARACTERISTICS: COMPETITIVE POSITION
- Vertical Integration and High Startup Costs: A typical tissue conversion facility and pulp processing plant with 50k ton annual capacity can cost between 50mm-10mm to build. To maintain cost competitiveness, ensure access to raw materials, and have control over sourcing, manufacturers have vertically integrated operations and most will also invest in on-site pulp processing facilities. Because there are no liquid futures markets or vehicles to hedge price risk of this input, this is an enormous competitive advantage.
- Geography: Because tissue is a bulky, lightweight product, sold at a relatively low price, its freight costs are significant relative to the volume and dollar value of product transported. A $10 case of toilet paper usually has a freight cost of about $1 when distributed to retailers within a 200 mile radius. Delivering the same unit to a retailer over 600 miles away adds $3 in freight costs. This additional surcharge would result in a 20% higher net selling price, significantly reducing merchandise margin. Because of Clearwater's existing conversion facilities in the Midwest and its low cost access to pulp supply (295k ton pulp capacity in Arkansas) are in relative proximity to the Southeastern United States, the economics of entering that market are attractive, and barriers relatively high as new entrants without existing capacity in the region will be at a cost disadvantage (higher freight costs, higher raw material costs)
- Consolidation within Branded Segment = Rational Price Umbrella: This is an attractive market structure for several reasons. Because the Branded producers are generally the price setters and private label producers are subject to their "price umbrella", an oligopolistic market structure promotes pricing discipline. The top three players in Branded category, P&G, Kimberly Clark, and Georgia-Pacific are unlikely to engage in a price war, and have a fiduciary duty to shareholders to maximize returns on capital. It is doubtful that Proctor & Gamble would wildly discount its premium brand "Charmin" in the hopes that they drive Kimberly Clark's "Cottonelle" out of the market. Rational pricing is good for the entire category
- Fragmentation within Private Label Segment: While Branded Segment that makes up 70% of tissue sales is dominated by 3 players, the Private Label segment, dominated by Clearwater, is a much more fragmented market. This places Clearwater in an advantageous position for several reasons. Having more than double the market-share of the next private label producer, it has much greater economies of scale, and likely will have production cost advantage over the smaller players. Additionally, its dominance in the private label market presents many M&A opportunities, should Clearwater decide to expand its capacity in other regions of the country
Company Growth Strategy & Potential Catalysts
- Geographic Expansion: Company exploring growth investments is the underserved southeastern US region: CLW announced it will build two tissue converting lines in the Southeast, expanding existing production capacity of 210k tons per year, by another 20k tons, or about 10% production growth. This has been announced and likely baked into earnings estimates. This region of the country is significantly underpenetrated and the private label market tends to be much more fragmented and the company believes they can take significant market share in the region by being closer to the customer. As a rule of thumb, customers located outside of 500 mile radius will see freight charges of up to $3.00 per $12.00 case (25% higher end cost), because of its shipping inefficiency (bulky & cheap). In addition to freight costs for finished products, having access to a reliable, low cost source of pulp supply is also key competitive advantage. The 295K ton capacity pulping facility in Arkansas & its relative proximity to Southeastern US, is a key competitive advantage as Clearwater expands in the region
- Mix improvement: The company is also growing its capacity at the high end "ultra" soft market, which will contribute nicely to the segments sales mix, as high end tissue can sell at prices 2x the price per ton of single-ply budget tissue. Specifically, the company is also evaluating the purchase of a TAD paper machine (through-air-dryer technology is required to generate high end tissue) to incorporate into the southeastern expansion. This machine has a capacity of 70k tons per year, which would require an additional 5 conversion lines, in order to ensure the TAD machine is not underutilized, and the fixed costs of the investment are leveraged effectively.
Through Air Drying investments will increase capacity in higher margin "ultra" tissue products, contributing favorable to Clearwater's revenue mix. TAD Technology enhances tissue softness & absorbtion properties by air drying wet tissue rather than the traditional method of pressing & creping together tissue ply
Kimberly Clark, Proctor & Gamble and Georgia Pacific have made enormous investments in TAD technology over last decade. Procter & Gamble and Kimberly-Clark whose product lines are focused on Cottonelle© Premium Charmin© Ultra brand categories have converted 100% of their manufacturing capacity from traditional "Yankee Drum" to "Through-Air Drying"
TAD (THROUGH-AIR DRYER)
injecting hot air and weaving wet tissue ply
traditional method "pressing & creping" wet tissue ply
Management Integrity, Shareholder Orientation & Accounting Transparency
Business is simple to understand and accounting systems are transparent and relatively straightforward. Furthermore, management appears to be focused on creating shareholder value. In evaluating capital projects management maintains a strict policy of requiring a 9-10% investment hurdle rate, and prioritizes its capital spending in a way that maximizes ROI. Additionally, management's prudent balance sheet minimization during a period of uncertainty shows a disciplined, shareholder friendly use of cash flow during a period of credit contraction. A net cash position puts it at an extremely advantageous position relative to competitors who may now lack to the flexibility to finance growth projects, or be forced to pay much higher rates of interest to finance growth initiatives. With its financing now in order, the company is making a measured, thorough evaluation of various growth alternatives, and will soon make more calculated strategic decision about its southeastern growth initiative.
Valuation: Wide Margin of Safety, Conservative Inputs
Our DCF Analysis assumes a sharply downward sloping growth rate from 10% to a terminal growth rate of 2% as well as a Discount rate of 11% and terminal multiple of 10X. We also used consensus estimates for 2010-2011 and management guidance for capital expenditures. Given these inputs, we arrive at an intrinsic value of $73 for the shares or about 35% premium to current trading price
In conclusion, I believe at the current stock price of around $50 per share, CLW shares offer investors a considerable upside opportunity and also some significant downside protection.