Debt or: How I (Tried) to Learn to Stop Worrying and Love the Bomb

Last month I researched a group of companies I normally shun: ones with lots of debt. And despite this group sharing many of the qualities I look for in a business, my concerns over EBITDA valuations, variable-rate loans, and unexpected risks kept me on the sidelines—for the most part. I did wind up investing in one of them—Sinclair Broadcast Group—and at the end of the post, I’ll briefly discuss “why”. But I mainly want to focus on the similar qualities between these highly-leveraged companies, and my concerns about them. 

TRAITS

  • Debt to EBITDA ratios greater than 4
  • Free cash flows exceeding net income
  • Tax rate less than 35%
  • EBITDA based metrics
  • Dependence on variable interest loans
  • Highly acquisitive management
  • PE/LBO history
  • “Outsider” CEOs

The companies I researched operate in stable industries and are run by financially-minded managers. Operationally, they follow the same pattern: use debt to fund operations; take any excess cash generated by the business to acquire other companies, pay dividends, or fund buybacks; rinse, and repeat. By using debt, they're able to magnify returns, yet also lower income (which reduces taxes). So it shouldn't be a surprise that these eight companies have trounced the S&P 500 since 2008.

  • Charter: Second largest US cable operator
  • Transdigm: Aerospace parts supplier
  • Domino’s Pizza: Pizza delivery franchise
  • John Bean Technology: Airport and food processing equipment manufacturer
  • Masonite: Door manufacturer
  • Sinclair Broadcasting: Second largest television station operator
  • POST: Food product holding company
  • BlueBird: School bus manufacturer

While the results would appear to speak for themselves, three concerns still keep me on the sidelines: a heavy reliance on variable rate loans, liberal use of EBITDA metrics, and the inevitability of unexpected risks disrupting business.

CONCERNS

"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

- Warren Buffett

Variable Rate Loans

When a company already has a lot of debt, they're perceived by lenders (i.e., banks) to be higher risk. For which a higher interest rate is charged. But companies are able to reduce these rates through "variable rate loans”, which—unlike traditional loans where the interest rate is fixed—adjust based on the market’s current interest rate (plus some additional amount). So while today's rate may be lower, the borrower is taking on the risk that interest rates will rise in the future. 

Predicting the timing and impact of changing interest rates on a company's prospects falls outside my circle of competence. But with rates at historic lows, odds are they’ll only move higher. I have no idea when this will be, though when it does, companies with which loaded up on variable rate loans may face a stiff increase in their interest expense. This is fine if the business’s prospects increase along with interest rates, but if they don’t, it could spell trouble for leveraged companies. 

The good news is if you believe in EBITDA, interest isn’t really an expense. With this perspective, variable rate loans simply have no impact on the business!

EBITDA

“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it. We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report. People who use EBITDA are either trying to con you or they’re conning themselves… Interest and taxes are real costs.”

- Warren Buffett

EBITDA is commonly used to value companies, and it seems particularly preferred by the managers and investors of highly-leveraged ones. But EBITDA does a poor job of reflecting economic reality. By removing the effects of interest, taxes, depreciation and amortization, marginally-profitable firms are suddenly flush with money. Implicit in EBITDA-based valuations is the notion that these are not real costs. I never understood this. Is the interest paid on a monthly mortgage not a real, recurring expense? To think it’s not, is, to quote Hank Hill “just asinine.”

Unknown Risks

“True wisdom is knowing what you don't know” 

- Confucius

A business can go a long time—sometimes decades—without ever being affected by a recession, natural disaster, act of terrorism, hacking, or other low-probability/high impact event. The infrequency of such events causes investors and managers to make a grave misjudgment: mistaking low-probability events for zero-probability events. This is dangerous thinking for any company, but especially so for a leveraged one. If costs can’t be covered when these situations do arise—and they will, eventually—debt only makes the situation worse. Just ask Long Term Capital Management.

But certain businesses are more insulated from sudden shocks by nature of having stable, recurring revenue streams regardless of the current economic climate. This enables them to tolerate higher levels of debt. So while a maker of luxury goods is sure to hurt during a recession, companies like a Campbells Soup, ConEdison, or even Sinclair Broadcast Group are likely to keep chugging along. 

SINCLAIR BROADCAST GROUP

SBGI is a boring business. The Maryland company is an old fashioned TV broadcaster, operating primarily in the South and Midwest US. Their revenue comes from two sources: selling advertising time on their 160 channels, and "retransmission fees", which are fees charged to video service providers (e.g., DirecTV, Comcast, etc.) for the right to carry Sinclair's stations. The stock has underperformed because a high debt load and rapid changes to how media is consumed and delivered have made investors nervous.

But the worry that "cord cutting" will ruin Sinclair is overblown, because 1) there has been no evidence of any impact and 2) local news—which is SBGI’s specialty—is still in high demand. So I think the long-term threats are exaggerated. I’m also not as concerned about the debt, because the retransmission fees provide a steady, recurring revenue stream that is unlikely to be interrupted by sudden economic shocks like a recession. And making the company even more appealing is the CFO’s recent pledge to bring leverage down 50%.  

At the end of the day, SBGI is a rather straightforward investment idea. It’s not dependent on any “catalysts”, and no aggressive growth targets need to be be met. The market is simply asking a fair price (9x FCF and 6.5x operating earnings) for a good business, so I made it 10% of my portfolio.  

And yes, it’s cheap on an EV/EBITDA basis too…

CONCLUSION

Despite the many positive characteristics of these eight companies, I was unable to overlook their variable-rate loans, EBITDA valuations, and unexpected risks. But occasionally I’ll make an exception if I’m confident that the business model can sustain a lot of debt—like SBGI. With a stable revenue stream, attractive valuation (on a non-EBITDA basis), and plans to deleverage, Sinclair Broadcast Group looks attractive to me. Time will tell. 

Seritage Growth Properties (SRG)

INTRODUCTION

In 2015, Sears Holdings faced the real threat of bankruptcy. In a move to raise much-needed cash, the struggling retailer spun off 266 store locations into a real estate investment trust (REIT), giving birth to a new, separate entity: Seritage Growth Properties (SRG). As part of the spin-off, Sears and SRG entered into a Master Lease Agreement (MLA) which required SRG to lease the stores back to Sears at rates far below market. 

Currently, SRG is unprofitable. But the MLA they entered with Sears contains hidden value for the REIT—and its shareholders—in the form of “recapture rights". These rights allow SRG to reclaim up to 50% of the gross leasable space currently occupied by Sears Holdings, and then re-lease it to new tenants at much higher rates. By reclaiming existing space—along with the adjacent land—from Sears, and then re-leasing it to new tenants, SRG stands to increase their average rent anywhere from 2x to 5x. 

In addition to the rent/sqft charged to new tenants, SRG’s value will also be determined by how quickly stores can be redeveloped, and the success of opportunities outside the core portfolio (i.e., the “adjacent lands”). Because each element can play out a number of ways, any valuation that relies too heavily on specific predictions is unlikely to be accurate. Instead, investors are best off looking a range of possible outcomes—from “worst case” to “best case”—and how they compare to today’s price. 

Even with pessimistic estimates, SRG is undervalued.

BUSINESS OVERVIEW

SRG’s portfolio consists of 266 properties. Of those, 31 are "Class A” (or "prime”) mall properties. The remaining properties are a combination of "Class B” mall anchors, 89 free-standing Sears Auto Centers, and the surrounding parking lots and land. Sears currently occupies 90% of SRG’s leasable space, at an average rent of $4.30/sqft. 

At a cursory glance, SRG might seem an unwise place to invest money: it offers below-market rents across its portfolio; mall attendance is declining; and its primary tenant, Sears, is on the verge of bankruptcy. 

And yet, four famed Buffett disciples—Eddie Lampert, Bruce Berkowitz, Mohnish Pabrai, and Guy Spier—have substantial positions in SRG. Even Buffett himself recently revealed an 8% ownership stake in the company. So what is it they see that the market does not? 

OPPORTUNITY

Today, only 10% of SRG’s space is occupied by non-Sears tenants, but because those tenants pay rents more in line with market averages, these leases bring in $56m (or 27% of SRG’s total revenue). As SRG recaptures additional space from Sears (which, as a reminder, they’re entitled to 50% of, per the MLA), their overall average rent will only increase—and revenue and profit along with it.

SRG’s portfolio is made up of three main property types—Class A mall stores, Class B mall stores, and Sears Auto Centers—all with differing redevelopment costs, prospective tenants, and expected rents. But even when using conservative estimates, the yield on investment across all of SRG’s core portfolio should approximate a very respectable 12%. 

The MLA also gives SRG the right to recapture 100% of the space at 21 high-value properties, which should command rents around $25/sqft (versus the $4.30/sqft that Sears pays). If exercised, average rents will net even higher.

Further, in many cases SRG also owns the adjacent land, which provides other development opportunities such as: adding space to auto centers to attract additional tenants (e.g., restaurants, banks); constructing new buildings on top of parking lots, and/or creating new mixed-use developments such as hotels, office complexes, apartment rentals, and open air “villages”. 

But even if investors were to ignore these other opportunities and solely consider SRG re-leasing 50% of the properties in their core portfolio, the stock still looks undervalued. 

VALUATION

Real Estate Investment Trusts are commonly valued using one of four methods: Net Operating Income (NOI), Funds From Operations (FFO), Adjusted Funds From Operations (AFFO), or Net Asset Value (NAV). While each method differs in how they handle certain accounting conventions, NOI, FFO, and AFFO are essentially just tweaked iterations of profitability; and NAV is a rough estimate of the value of the real estate less any outstanding debt. Importantly, by any of these measures, SRG appears undervalued.

At $44/share, SRG’s current price assumes slower-than-expected redevelopment, lower-than-expected rent, and zero opportunity outside the core portfolio. But the chance of SRG failing on all three counts is low. What’s more likely is that by 2025, SRG will have recaptured 50%+ of the space from Sears, and raised their average rent to somewhere in the $14/sqft range. In that scenario, investors would earn ~12% per year at today’s price. Even if they’re wrong—and SRG can only raise rents to, say, $8/sqft—they’ll still earn a solid (albeit not spectacular) ~6%. This implies a healthy margin of safety built into SRG’s stock price. 

Those estimates could also be over-conservative. If SRG can successfully recapture 100% of the space from Sears, increase rents to $16/share, and maybe have some success outside the existing core portfolio, investors could even stand to gain a remarkable 20%+ annually.

But the most likely outcome is probably somewhere between $8 - $16/sqft rents, 50% - 100% recapture rates, and maybe a few successful projects outside the core property portfolio. Therefore, it doesn’t seem unreasonable to expect a still wonderful ~15% annual return. 

CONCLUSION

It’s hard to pinpoint what SRG's proper valuation is with a high degree of certainty. However—and most importantly—we can be reasonably confident that it’s worth more than what the market thinks. If Sears can stay solvent for another 6-8 quarters and SRG delivers even the low-end estimates of recapture rates and rents, investors will do okay. If SRG delivers any upside, investors will do quite well.

LinkedIn (LNKD)

Since Microsoft’s announced takeover of LinkedIn, LinkedIn’s stock has fallen $6 below the software giant’s $196/share offer over concerns of EU regulatory approval. But the likelihood of the EU blocking the deal—which has already been approved by US, Canadian, and Brazilian regulators and the Board of both companies—is remote. In fact, the only example I could find of the EU blocking a merger between two US companies was in 2001, when GE tried to acquire Honeywell for $42b. Since then, the EU has neither blocked a merger between two US companies, nor have they ruled against a deal already approved by US regulators. And there have been no indications that they intend to block the MSFT-LNKD acquisition. This has created a nice little arb opportunity for investors.

If the deal does close in December as is expected, investors would earn a respectable 12% annualized return ([$6/$190]*4). But there’s also a good chance the deal closes earlier, as the EU is expected to decide between Nov 22 - Dec 6. If they rule in favor of the acquisition early in that range, investor’s would nearly double their return. Using conservative assumptions of a 5% chance of the deal falling through, and that upon such news LinkedIn were to drop by ~$100/share, the expected value is still +.70; thus signaling a buy.

($6 * .95)+(-$100 * .05) = .70

Investors also have downside protection, stemming from Salesforce’s interest in acquiring LNKD. The enterprise software company has made no secret that it covets LinkedIn above all other acquisition targets, lobbying both LinkedIn and regulators in repeated attempts to thwart the deal. Now that they’ve passed on buying Twitter, Salesforce would presumably be waiting in the wings were MSFT’s acquisition to fall through. And even in the worst case scenario, where the MSFT deal is blocked by regulators and then Salesforce chooses not to pursue LinkedIn, investors have yet another layer of protection in the form of LinkedIn’s viable—albeit overvalued—business.

Despite LNKD’s huge stock option expenses, a management team that flouts GAAP accounting, nonexistent profits, and a poor M&A track record, Microsoft is confident that they can harvest enough “mobile enterprise big data social graph cloud synergies” to make their largest ever acquisition pay off. And while it’s hard to argue that LinkedIn was a compelling investment prior to Microsoft’s takeover offer, the merits of the business are of little consequence in this scenario. All that really matters—at least for LNKD shareholders—is if the deal will close by December; and it seems very likely it will. 

No deal is guaranteed until the ink is dry, but there has been no evidence the EU will try to block MSFT’s acquisition of LNKD for $196/share. Investors can now scoop up LNKD for a 3% discount to MSFT’s offer, which is not commensurate to the risk of the deal falling apart, nor the downside protection afforded by Salesforce and LNKD’s operating business. This has created a compelling and straightforward opportunity for investors to earn 12%.  

UPDATE [11/22/16] 

Less than a month later, I sold my position in LinkedIn at $193.90 for a 2.9% gain over my $188.53 entry price—equivalent to ~35% annualized.

Tesla (TSLA)

“I honestly don’t really care about business all that much. It’s not really my first motivation.”

 - Elon Musk

Today, Tesla represents the future of transportation. This is for good reason: the company is led by the brilliant inventor Elon Musk; it creates fantastic products; and it has cheap access to the large amounts of capital necessary to build cars. It’s hard to argue that another company is better positioned to make self-driving electric cars a reality.

This—however—does not make Tesla a good investment. The premise of investing is not betting on whether a company’s product is good or not, or if the founder is right about what the future holds; it’s simply about buying a business for less than it’s worth. And even if Musk does fulfill his loftiest promises, investors wouldn’t stand to gain much, because Tesla’s current value has become wholly detached from economic reality. It trades at 70% of GM’s value, despite selling 187x fewer cars and not generating a cent of profit—a level which is simply unsustainable. Yet most alarming are Tesla’s myriad of red flags: poor corporate governance, quixotic acquisitions, and a financial structure best described as a house of cards—to name a few. I’d argue, therefore, that Tesla is clearly a stronger short candidate than long. But investors have become so enamored of the company’s narrative and promises for the future that they are ignoring these risks with reckless abandon.   

To illustrate, imagine that you have the opportunity to invest in “Tesla Pizzeria”—a local pizza place with the following characteristics:

IT HAS GREAT GROWTH PROSPECTS

…BUT THE BUSINESS BURNS CASH

COMPETITION IS HEATING UP

The pizza market is brutally competitive and dominated by industry giants. For every pizza pie sold by Tesla Pizzeria, the largest competitor sells 200. Companies like Pizza Hut, Dominoes, and Papa Johns have taken notice of Tesla Pizzeria's innovative products, and have signaled their intentions to make similar pizzas. And while Tesla Pizzeria has a similar paper valuation to its competitors, it severely lags behind them in both profit and experience. In fact, every competitor has been selling pizza globally for 50+ years, whereas Tesla Pizzeria has only been selling for eight years, all mostly in one market

Since Tesla Pizzeria publishes all of their recipes and techniques for free, it won't take long for competitors to start making pizzas in the same fashion. To make matters worse, enormous companies in adjacent markets—like McDonalds and Starbucks—think they can make really good pizza too, and are poised to introduce their own products in the next few years. There are even well-capitalized global upstarts gunning for a "slice" of the market. And then there are the companies set on shifting consumer preference to pizza alternatives.

IT SUFFERS FROM POOR CORPORATE GOVERNANCE

AND NOW IT’S BUYING ANOTHER MONEY-LOSING BUSINESS… 

The owners of Tesla Pizzeria have decided buy a tomato farm which lost $192 dollars for every $100 of tomatoes they sold last year. Alarmingly, many of them also happen to own the tomato farm (or are related to someone who does). And it's run by two of the manager's cousins. The sale—which is for a 35% premiumwill net the manager of Tesla Pizzeria and his relatives ~$700m, despite the farm's deteriorating business model. In order to avoid insolvency, the farm recently raised $345m in “tax equity”—whatever that is; and some are even suggesting Tesla Pizzeria is "bailing out" the tomato farm so that its owners don’t lose their shirts. Thank goodness for the synergies!

BUILT ATOP A FINANCIAL HOUSE OF CARDS

The business is financed with a convoluted web of stock sales, private investments, warrants, convertible bonds, and exotic debt. And by taking out personal loans against his ownership stakes in his various companies, the manager is exposing the owners to significant risk

So, is this a pizzeria you would want to own?

CONCLUSION

Investing isn’t about predicting the future or buying the company that will have the greatest impact on society; instead, it’s simply buying a business for less than it’s worth. And with a market value of ~ $35B, Tesla shareholders are almost assuredly paying more than the company is worth—even if Musk is right about the future. But if he’s wrong, the dubious acquisition, poor corporate governance, and risky capital structure ensure the losses be swift and steep. So whether or not Musk is right about what the the future holds, there’s only one smart move for investors to make: hope and pray he pulls it off, but to short Tesla. 

Associated Capital (AC)

"I don't throw darts at a board. I bet on sure things." - Gordon Gekko

In November 2015, GAMCO—an investment management and advisory company owned and managed by famed value investor Mario Gabelli—moved a substantial portion of its cash, investments, and 4.4m of their own shares into a newly created company named Associated Capital. As of this writing, Associated Capital currently has a market value of $770m, which seemingly indicates that the company’s stash of cash and investments is being fairly valued by Wall Street. 

Yet in addition to the spin off of cash and investments, GAMCO also created a five year $250m promissory note (i.e., loan), payable to Associated Capital at 4% interest.

Despite the note representing a very real economic benefit to Associated Capital, its true worth is obfuscated by the GAAP accounting because it’s a “related party loan”—i.e., a loan between two companies controlled by the same person—thus excluding it from the asset side of the balance sheet. But as the note matures, Associated Capital will receive payment from GAMCO, thereby increasing the company’s cash balance by an additional $9.83 on a per share basis.

Additionally, Associated Capital’s downside risk is relatively low because its other assets are highly liquid and thus easy to value: cash can be taken at face value, and many of AC’s investments have market quoted prices. And Mario Gabelli—who owns 75% of both companies—has a proven track record of creating long-term value. Recognizing that Associated Capital is trading at a discount, the Board of Directors has authorized a buyback of 500k shares, which will help to close the gap between value and price. 

With 25% of its value not yet realized by the market, a value-centric owner in Mario Gabelli, and a highly liquid asset base, Associated Capital makes for an attractive opportunity with very limited downside. An investment in the company would be like buying a house worth $500k for $500k, and then a month later discovering that there’s shoebox buried in the yard stuffed with $125k. The GAMCO note—much like the shoebox—represents hidden value not yet appreciated by Wall Street. 

It’s very likely this accounting quirk has created an opportunity for prudent investors to almost literally buy $1 of assets for $.75, which, according to both common sense and Warren Buffett “is a very good thing to do.”

Douglas Dynamics (PLOW)

INTRODUCTION 

I believe that Wall Street is currently offering Douglas Dynamics (PLOW) at a 30% discount to intrinsic value. 

As North America’s premier manufacturer of snow plows, de-icing equipment, and vehicle attachments, Douglas Dynamics possesses two formidable moats stemming from their ability to produce high-quality products more cheaply than their competitors, and then selling those products through an extensive network of dealers.  

Further, the company has significant advantages in the shareholder-oriented management team, a high free cash flow conversion rate, low capital spending requirements, and a largely variable cost structure. These considerations make Douglas Dynamics a company that can weather most any storm (pun intended). 

An unseasonably warm winter in Douglas Dynamics’s core markets has driven the stock down to $18.50--offering investors the opportunity to buy a great company at only 10X earnings,  a 12.5% FCF yield, and a 19% operating earnings yield! Additionally, management is dedicated to paying a significant dividend (5% current yield) under all weather conditions, without sacrificing near- or long-term liquidity. 

WHY IS IT CHEAP?

The primary factor weighing on Douglas Dynamics’s stock is the psychological tendency to overweight near-term salient factors (what Munger calls the “availability-misweighing tendency"), which in this case is the impact the warm winter will have on the company's core markets. With temperatures pushing 70 degrees on Christmas in much of the Northeast and little indication of snow, it is easy to discount a business whose prosperity presupposes wintry conditions. 

Looking at a small sample size, snowfall amounts indeed appear to be highly varied and unpredictable. But by widening the sample to Douglas's 66 core cities, we get a consistent rolling ten-year average annual snowfall of 3,100 inches. The market appears to be over-focusing on the short-term catalyst of heavy snow fall (or lack thereof), and overlooking longer-term factors, such as the high quality of the business and management's record of prudent capital allocation. 

With an estimated 600K units in use, and an average 7 - 8 year replacement cycle (at $5K - $9K each for light-duty mounted plow), Douglas Dynamics can count on a continual demand for products---even if that demand may be uneven. Because snow poses a grave and immediate threat to public safety and productivity, there will always exist a critical need to quickly remove it from roads. In short, it is not a matter of if customers will buy Douglas Dynamics products, but when. 

Despite the ill effects that a mild winter will no doubt have on Douglas Dynamics, the market has likely overreacted in the short term---presenting patient investors an attractive opportunity to buy a high-quality business trading at a 30% discount to intrinsic value. 

WHAT DOES DOUGLAS DYNAMICS DO?

Douglas Dynamics designs, manufactures, and sells snowplows, sand and salt spreaders, and complementary accessories, which they sell through an extensive network of 2,200 dealers throughout the US/Canada and an additional 40 dealers internationally. 

The main costs for the company are raw materials (e.g. steel), employees, amortization oftheir dealer network, interest expense, and from time to time, acquisitions. The operations are astonishingly light, with the current operating earnings yield at 19%! As the company is funded by both debt and equity (1.13 debt to equity ratio), interest expense weighs on margins, but the ability to quickly turn income into cash provides Douglas Dynamics with enviable capital flexibility and hard cash at the end of the year.   

Through organic growth of core products and the timely acquisitions of Blizzard, SnowEx, and Henderson, revenue has grown at a 7.7% CAGR since 2008, while profit has increased 248% over the same period. 

While Douglas Dynamics has been slowly growing their marketshare of light-duty truck mounted plows (currently 50 - 60%), their $95m acquisition of Henderson Products in 2014 will add $83m in annual sales, and provide entry into the heavy-duty truck mounted equipment market. Gross and operating margins have stayed impressively stable at 34% and 17%, which are a product of Douglas Dynamics’s aggressive employment of lean manufacturing principles, though these will come down for FY 2015 due to the Henderson acquisition.

The straightforward nature of the company’s operations are reflected in the simplicity and candor with which their financial statements are presented. It is here we can see a few key characteristics of the business essentially jump off the page, requiring further analysis and exploration.  

ADVANTAGES

For any business to be worthy of investment, it must be able to maintain certain competitive advantages over competitors for long periods of time. These advantages, regularly referred to as “moats”, are often the difference between a failed or mediocre business, and a sensational one. Therefore, an investor’s aim should be to identify businesses fortified by a significant moat, and attempt to acquire it at a reasonable price. If that business happens to require little reinvestment and/or is tended to by capable and honest management—even better—but these cases are tremendously rare. 

“I don’t want a business that’s easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle to be honest and hard working and able. And then I want a big moat around the castle, and that moat can be various things.”

- Warren Buffett

If Douglas Dynamics’s strong management team is able to continue their focus on operational efficiency while strengthening the dealer network, all with very little capital, their moats will widen and the intrinsic value of the company will continue to grow.  

1. Operations are lean and nimble

For a vertically integrate manufacturing firm, Douglas Dynamics has a surprisingly variable cost structure (15% fixed vs. 85% variable) and low capital spending requirements. Their manufacturing operations are lean and exceptionally nimble, contributing to a consistent 34% average gross margin since 2008. And with 10% - 15% of their workforce being seasonal and demand-driven, they have the added benefit of further flexibility should the weather not play out in their favor. 

The company continually optimizes their manufacturing operations, resulting in the fastest lead times in the industry (3-5days, down from 2-4 weeks in 2004), and a 61% reduction in the total number of suppliers since 2007. This ability to operate efficiently and flexibly with little overhead and low fixed costs enables the company to maintain gross (and net) margins across all environments. Impressively, the lowest that gross margins have ever dropped (during 2012, which saw the lowest snowfall in company history) was to a still-healthy 31%. It appears unlikely that a few consecutive years of light snow will put the company at operational risk or make paying the dividend a challenge. 

Screen Shot 2016-01-14 at 12.23.35 AM.png

By vertically integrating the selling, designing, manufacturing, and sourcing of raw materials into finished goods, the company is able to deliver high-quality products to their customers cheaper than any of their competitors. 

“To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.”

-Warren Buffett

2) Extensive and entrenched dealer network

Perhaps the company’s greatest advantage is its extensive and entrenched dealer network, which has grown from 720 distributors in 2010 to over 1,100 today (plus an additional 570 and 125 for SnowEx and Henderson, respectively). For end-users, a major factor influencing purchase decisions is not only how easy it is to buy and install the snowplows, but how easy it is to service them. This makes the end-user’s relationship with the dealership critically important.

The ubiquity of Douglas Dynamics’s brands, coupled with the reinforcing nature of the dealership’s network effects, has historically driven stable pricing power of 2% above the inflation rate, and the reason is simple. With over 600K products in use---which are in constant need of upgrade, repair, and maintenance---dealers are incentivized to support this massive existing install base to avoid losing out on substantial revenue, providing Douglas Dynamics with compelling pricing power. If we assume a 7-year replacement cycle of Douglas Dynamics's existing install base at an average price of $6K per plow, each dealership stands to sell an additional $250,000+/yr---a substantial sum for the majority of small independent dealers! 

And to end-users, dealers are more than just point of sale locations; they also offer immediate access to post-sale service and support during mission-critical periods of snowfall. If a plow operator were to miss a storm due to a product needing service or waiting for a part, it would directly result in lost revenue for him. This results in dealers needing to keep Douglas Dynamics products in stock, strengthening the network effects, and further widening the company’s second substantial moat.

3) Low reinvestment requirements

Another advantage the company enjoys: for a design and manufacturing firm, their reinvestment requirement is surprisingly low (only 1.38% of net sales, and 26% of FCF). This enables their sustained profitability, and even more importantly, generates significant cash---to reinvest in the business, to make strategic acquisitions, and to compensate shareholders via a generous dividend. 

It is not uncommon to find a business, especially ones requiring the manufacture of heavy equipment (e.g., auto, airplane, machinery, etc.), that shows an accounting profit at the end of the year, while having very little leftover cash due to the reinvestment requirements of the business, just to maintain its current operating level.

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”

- Charlie Munger

Douglas Dynamics faces no such dilemma. Since 2008, the company has generated $99.68MM in profit, and a remarkable $98.72MM in free cash flow---even accounting for acquisitions.

4) Management

With this surplus cash, management has elected to provide generous dividend payments to shareholders, reduce outstanding debt, and make strategic acquisitions. By remaining disciplined and forgoing expensive or distracting acquisitions made solely for the sake of growth, they’ve focused on maximizing shareholder return and only reinvesting in the business when value can be added. If a wise option doesn't exist, management is happy to cut a fatter dividend check to shareholders.

Management, led by CEO Jim Janik, has a history of acquiring good businesses, which fall within their circle of competence, at fair prices (e.g., Blizzard, SnowEx, & Henderson). Avoiding the common trappings of empire-building that often ensnare executives flush with cash, management has remained laser-focused on their stated goal to consistently produce high-quality products while driving shareholder value. 

Shareholders may be tempted to interpret Douglas Dynamics's high dividend payment as a sign of a lack of growth options, rather than a sign of prudent leadership that chooses only smart growth options. But taking a closer look at their record of acquisitions, it's clear that the latter is true.

OPPORTUNITIES

At first glance, the company’s growth opportunities seem limited. While an investor may expect to earn a mid-to-high-teens ROE while collecting a large dividend, there doesn’t appear to be much more the company can do other than to keep selling to their existing (and stagnant) customer base and return any excess earnings to shareholders. After all, total snowfall amounts haven't changed much in 50 years, large swaths of the population aren’t exactly rushing out to become professional snowplow operators, and despite the very real threats of global warming, snowfall patterns likely won’t change in the foreseeable future. 

The likeliest source of growth will not come from selling more plows to their existing users or praying for more than average snowfall, but from the 2014 acquisition of Henderson. The acquisition not only adds $83MM in annual sales, but will also open up new markets for the company, with growth potentially exceeding Henderson’s 11.7% 10year-CAGR due to Douglas Dynamics’s existing distribution network and continual grab for marketshare. While the demand for snowplows has a very fixed upper limit (pending drastic weather changes), Henderson’s position in the heavy-duty segment gives Douglas Dynamics access to significant new customers such as municipalities and the Department of Transportation. Though the market leader, the market is somewhat fragmented, and Henderson only has 25% marketshare, giving considerable room for expansion.  

Because government contracts are less dependent upon the total amount of snowfall than professional plow operators, the addition of Henderson will make Douglas Dynamics less reliant on snowfall amounts for overall profitability. From 2010-2014, Douglas Dynamics shipped 10% of their unit volume in Q1, 34% in Q2, 26% in Q3, and 30% in Q4. Henderson’s shipments on the other hand, are much more evenly distributed at 22%, 23%, 27%, and 29%, respectively. Even in 2012, which saw the lightest snowfall in 50 years, still saw Henderson’s revenues increase 13.5% from $59MM to $67MM (whereas revenue dropped 33% for Douglas Dynamics). 

The only thing not to like about the acquisition is that Henderson’s margins are below those of Douglas Dynamics. As a result, gross and net margins dropped from 36.9% to 33.9% and 13.2% to 10.3%, respectively, for the nine months ended September 30, 2014, compared to the nine months ended September 30, 2015. 

As Douglas Dynamics further integrates and refines Henderson’s operations, margins should improve, although it is likely they’ll remain slightly below their historical averages in the future. 

RISKS

As with any business, there are risks that prospective investors must be mindful of. A major factor in Douglas Dynamics’s cost of goods is the price of steel. Recently, steel has been very inexpensive, and accounted for around 13% of revenue each of the past two years. However, steel prices have begun to rise, and in the most recent 9 months have accounted for 18% of revenue. Further increases in steel prices will undoubtedly weigh on gross margins, and while the company has historically been able to pass along the increase in component costs to customers, there is no guarantee they will be able to do so in the future, especially if costs increase drastically. 

Additional risks are obviously weather related, even though the company has been able to effectively manage these for the past 50 years. However, if snowfall is significantly below average for longer periods of time than the company is used to (i.e. many consecutive years), both profitability and solvency could very well be tested. An acceleration of global warming could threaten the total level of snowfall across the globe—significantly impairing Douglas Dynamics’s business—however, the probability of a short or mid-term impact on results is remote.

Notwithstanding these risks, investors should feel comfortable investing in such a high-quality business given the comfortable margin of safety, which our valuation shows us we have.

VALUATION

  • Discount rate: 10%
  • Constant growth rate: 4%, (2% annual price increase + 2% annual organic growth)
  • Slight decrease in gross, operating, and net margins due to acquisition of Henderson
  • Pays out 75% of earnings as dividends (based on Douglas Dyanmics's “normalized dividends estimate” as stated in their Spring 2015 investor presentation) 

The nearly identical net income and free cash flows makes valuing Douglas Dynamics a relatively straightforward exercise. There aren’t any strange accounting treatments or red flags to get tripped up on, and the fundamental principle that “the value of any business is determined by the cash inflows and outflows–discounted at an appropriate interest rate–that can be expected to occur during the remaining life of the asset” easily applies when using DCF, Dividend Discount Model, or Residual Income Models.

Using a Residual Income Model to account for the cost of equity with the above-mentioned assumptions, we get a value per share of $26.94—31% above the current price! 

This margin of safety, estimated using conservative assumptions about the future, provides investors significant protection should any seen or unforeseen risks appear. 

CONCLUSION 

Historically, demand has been driven by the level of the prior year’s snow (which result in wear and tear from heavy use), rather than the snowfall of the current year. Even if this winter does wind up resembling the winter of 2012 (lightest snowfall in 50 years), resulting in a worst-case 30% drop in revenue, Douglas Dynamics’s long-term intrinsic value will not be significantly impaired. 

Obviously snow will be the ultimate catalyst, but it’s anybody’s guess as to when it will fall and how much. All we can be certain of is that when it does fall, Douglas Dynamics, and their shareholders, will be rewarded handsomely.

UPDATE [7/8/16] 

I sold half my stake in Douglas Dynamics at $25.46—which is about equal to my estimated intrinsic value—for a 45.26% gain in 6months.