Update: PKE – Park Aerospace

This will be a short update. I can’t seem to find time to write lately. I’ll put the refined elevator pitch below. I think people like that. From there, we’ll settle old business (mainly pointing out all my big mistake in the original write-up).

Thesis:

• Company is undervalued if we do not include COMAC C919/ARJ-21, any M&A, special dividend, or meaningful new programs.
• PKE is very likely a double, with multi-bagger upside and limited downside.
• Has makings of a “story stock” given its exposure to A320neo LEAP-1A, Minuteman missiles, Kratos drones, and as a supplier for $SPCE and other space programs.
• There is an inventory ramping cycle to come that will be the catalyst to PKE as a “recovery play”. The inventory ramping is likely to occur in the next 3-9 months.
• PKE is at precipice of high operating leverage and extremely high ROIIC
• Roughly 30% of A320neo planes with Pratt & Whitney engines are faulty. More customers are switching to LEAP-1A models.
• In the recent conference call, PKE CEO (known straight shooter) said MRAS orders indicates a “significant increase in units in calendar year 2021” [relative to 47 A320neo planes produced per month * 56% market share for LEAP-1A].

Model Update:

I’m assuming you read the previous article. The upside to the below is: (1) a large special dividend ($3 to $5 per share would be great); (2) announcing they’ve been added to another program with long-term potential; and (3) an acquisition.

Picking up on the potential upside. If PKE acquired a company for 4x sales at 20% EBITDA margins and high single digit growth (as a rough example) for $50 million or so. This would be ~20x EBITDA, a health acquisition multiple. At this multiple, the acquisition would not add much value according to this model but it would show the market that the company is no longer being too conservative. This would likely lead to a higher multiple in the long-run (current estimate is 17.7x normalized FCF), since a larger company could have more trading volume and allow for larger and larger investors.

Old Business – Correction:

I pointed out last article that PKE would benefit from aftermarket. This was ultimately poorly communicated and a misunderstanding on my part. PKE is an OEM supplier for commercial and military aerospace with little aftermarket potential going forward. However, PKE’s “aftermarket-like” potential comes from its high margins and the ramping of many of the aerospace programs it is currently on. I thought there was long-term aftermarket potential as well, but there is not. A320neo is in the early stages of production and at half of its full-production potential. The Minuteman missile program revamp, Kratos drones, and rocketry programs, among others, are all at early stages of the program. PKE takes the same margins at OEM as they do in the aftermarket. Similar to the KC-10, PKE also has the ability to step in to a program in the late stages for a high margin/return business. This is the “aftermarket-like” potential, though it is not as long-term as actual aftermarket parts. I suppose that’s why PKE’s OEM margins/returns are far higher than others.

Anyway, it was worth pointing out I was wrong and correcting the thesis.

Extra Info on approval elevator thesis:

• PKE is 1 of 5 companies with materials in the AGATE or NCAMP databases. This and the only player in the space to provide small batch services is the moat leading to the high ROIC. Although OEM, in this way, PKE operates in a similar manner to the PMA companies many are accustomed to.
• AGATE database lists known properties of aviation materials such that they do not need to be tested for FAA approval again. This saves more than $150,000 per material.
• PKE’s value-add to the industry (how they earn high ROIC) is two-fold: (1) they are experts on mixing and matching materials to create mixtures that meet a customer’s gear/heat specs; and (2) they are experts in running small batches.
• We saw PKE hit a wall several quarters ago because they had an issue with #2. It is rare we hear about manufacturing issues. Small batches means more changing and cleaning of equipment, which is why PKE is the only one willing to do so (others with scale would be unable to meet demand if they offered custom batches). Thus, PKE has a niche monopoly. I’m always attracted to these companies.
• Pre-COVID, A320neo production had reached 63 planes/month and was expected to reach 90 planes/month by mid-2020’s. During 2019, the 63 planes/month pace had LEAP 1-A deliveries at ~50%, below its 56% order market share. With the P&W issues, we could see LEAP 1-A production account for 55%-65% of total production. Not only would PKE benefit from A320 returning to the pre-COVID A320neo ramping trend, but it could benefit more than others in the space because it is only on the LEAP 1-A models.

Summary:

So where do we go from here?

I didn’t know so many stocks would double or go gangbusters during the last few months so this low-risk double looks paltry by comparison. I imagine few will be interested in PKE as a result.

What I’m looking for is to see increased inventories and then ramping production from the GE program (A320neo). I’m looking for new military wins. I’m looking for a special dividend or M&A in the next 12 months or so. If these things happen, I think PKE will increase meaningfully. If they don’t, I’ll probably call it a day on the thesis. I think all but the special dividend/M&A are highly likely to occur.

This will probably be my last update on this name unless something unexpected relative to the above occurs.

PKE – Park Aerospace Corp.

I don’t know if you’ve heard, but there’s a virus going around. Worse still (for this idea), relatively no one is flying in planes as a result. The graph below shows the year-over-year decline in daily passenger throughput in the US, reported by tsa.gov.

With all that said, I have a new idea. An aerospace supplier, recently renamed as Park Aerospace (f/k/a Park Electrochemical – PKE).

Elevator Pitch Investment Thesis

• liquid in a highly distressed industry (commercial aerospace suppliers)
• Growing 25%+ year for each of the last 3 years (pre-COVID – the future will likely be less rosey in the near-term)
• Displaying operating leverage
• Historical capital allocation suggests the company should do well
• CEO is a straight-shooter that doesn’t whitewash missed expectations
• Prior shareholder communications suggest PKE could surprise with an accretive transaction in this environment

After a little background on the company and management, I’ll address the qualitative aspects of the thesis and how I view the value of the company. It’s important to remember that the future of the commercial aerospace industry is uncertain at the moment. While I think the downside is generally protected, it’s still 2020 and anything can happen.

Company History and Description

PKE was founded by Jerry Shore and Tony Chiesa on March 31, 1954. The company started its operations with five employees in a small factory in Queens, NY. During the first year of operations, PKE had revenue of $124,206.59 and net income of $621.17.

*Since FY 2005, PKE has paid $536 million in cumulative dividends.

Today, PKE’s CEO is Brian Shore, Jerry’s son. You might not be surprised to learn that the company has since moved manufacturing away from Queens. The company’s administrative offices are in Melville, NY and its manufacturing facilities and warehouses are situated in Newton, KS and Singapore.

In 2018, PKE agreed to sell its circuit board business (Nelco Products) for $145 million, or approximately 14x EBITDA (FY 2018). The circuit board business had been in decline and the company wanted to focus its operations on the fast growing and highly profitable aerospace component segment.

In mid-2019, the company broke ground on an expansion of the Newton manufacturing facility, which is now roughly 88,000 sq ft (2x the previous size). The Newton plant was originally leased in 2008, when PKE first entered the aerospace component business. The facility expansion cost $20.5 million and is likely completed or near-completion, as of writing. The facility should be fully operational by the end of FY 2021.

The facility was expanded per its 13-year, long-term fixed price agreement with Middle River Aerostructure Systems (MRAS), formerly a GE-subsidiary, that is now with ST Engineering (“ST LTA”). It will be discussed more below, but the ST LTA runs through 2029.

As of writing, PKE has one segment, aerospace components. The company manufactures sole source composite materials for engine nacelles, thrust reversers, and interior fixed structures. The company generally provides parts for aircraft with GE engines. Below is a few slides from PKE’s latest presentation that discuss these programs.

The natural response when looking at aerospace companies is “That’s great, but what percentage of revenue is aftermarket?” What is truly important is the percentage of critical, sole source revenue. While PKE doesn’t provide that exact figure (safe to say they are not as good at promotion as Transdigm (TDG)), we can see that a number of composite materials and structural components are sole source and that many new products, including adhesives, have a fair chance of being awarded similar contracts.

Back in 2017, TDG posted two slides in an investor roadshow that succinctly explained their excess return proposition to shareholders. I think the same elements are present with PKE.

Based on PKE’s annual report and conference calls, they do have some revenue from selling spares or low volume toolings (not the same as spares but similarly high margin), but it is not yet a meaningful proportion of PKE’s revenue. As PKE matures within its various commercial and business jet programs, I think we can expect an increase in spares or aftermarket sales going forward.

Company Management

I’m not really sure how to show that the CEO is a bit different than your average CEO other than to provide a few examples. Like other companies I have written about on this blog, he comes across as honest and fair both within his communications with shareholders and based on how the company has allocated profits over the years.

When writing about HIFS I mentioned that the first year that the Gaughen family had controlled of the bank, there was a huge increase in employee name and pictures in the annual report. It was little examples that showed up over years and years that seemed to indicate that there was something different about how the bank operated. In 2020, HIFS answered probing questions, in detail, and without any reluctance. It’s rare to find operators where the passion and care for the company and shareholders is as visible. I think PKE has many of those attributes.

While many companies have avoided addressing business conditions and withdrawing guidance, PKE faced the issue head-on to keep expectations inline with reality. In the 4Q 2020 conference call, PKE provided some potential outcomes for the GE engine program revenue going forward (see slide 15 of the 4Q 2020 call). It’s pretty cool that the CEO is upfront about a 50% and 85% decline in revenue over the next two quarters for their largest program.

So, let’s see. Thoughts about GE Aviation program revenues for fiscal 2021. We’ll give you a little bit of information here, but we’re kind of guessing just remember that perspective. Last year, we had about $29 million of GE Aviation program revenue, which if you divide by four, that’s an average of about $7.25 million per quarter. $7.25 million per quarter right just doing the math. That’s for perspective.

Q1, this is kind of a transition quarter, but unfortunately transition all the way down, probably $3.5 million, $4 million something like that. This is GE Aviation program revenue. Q2, it could be $1 million. And what’s the reason? Because all that burn down stuff is coming through, and all that inventory that’s caught throughout the supply chain, is getting absorbed.

This estimate will ultimately be used to help guide my rough 2020 and 2021 projections in the valuation.

In last year’s 4Q 2019 conference call, analysts asked about PKE’s M&A strategy, since it was still sitting on cash from the circuit board sale. The CEO described the company’s M&A strategy as follows:

Thank you, Matt. So good summary. So going through acquisition philosophy, as Matt said, we have about — after we take care of these items, we’ll have about $115 million of cash left. Even though we’ve paid $507 million of cash dividends since ’05, that long-term debt, we still have some cash available.

But we have a pretty active acquisition program, if you will, but our strategy is a little bit different. I think we call it, hit them where they ain’t. We participate in some of these auctions and we think they’re just not usually for us. Why? Because first of all, the prices are — value seems to get bit up and we’re not going to overpay for something and just — we’re looking long-term, we’re not looking to make a splash for two years, and then somebody else’s problem when somebody retires or something like that.

We have to buy — our objective is to buy something that will meaningfully contribute to Park’s value over the long period and it needs to be something unique, something different maybe, something nichey. One of the things we’ve done is we worked quite a bit with a couple of OEM customers that have been very helpful to us in terms of pointing us in the right direction. These are aerospace companies. In other words, let’s say, they like us, maybe love us, but they have other things they buy for the programs which made them not so happy about other products they buy, maybe they’re not so happy with the supply chain in that area.

So they pointed us in those directions. We’ve even found some overlap where — like two OEMs will point to certain areas within our own [Inaudible], maybe something is going on there. Not only they’ve given us the products, they’ve also given us names and, in some cases, many introductions for us. So we’ve made contacts.

Now these companies are not being auctioned or not for sale. So often the response is, what, we’re not for sale. But that’s the process. It’s a longer process.

It will take a little while — longer to get through it but we’ll end up with something better. And how does you plant the seed. You contact somebody, well, are you interested in talking? Well, no, as they don’t only know you. But you plant the seed, maybe have some follow-up discussions, and maybe at some point, he turns and say, well, maybe, we’d be interested in doing something with you.

So it’s very helpful. It’s — I mean, working with the OEMs is very good. We’re looking for things in aerospace. But again, some things which are unique and different and niche-y.

It’s not — the things that are auctioned, and I know their price is high but it’s kind of very standard stuff. Why is that? Because the people who like to bid on these things aren’t going to understand unique or niche-y technologies. They’re going to shy away from it because as I will get this stuff, right, so I’m not going to spend money on something I don’t know yet. So we end up competing with people that don’t really have deep understanding sometimes and after niches and then prices go up not for us.

Little stuff. They are doing all the right things. On the 4Q 2020 call (most recent quarter), Brian Shore addressed the topic once more.

We’ve been looking as we keep telling you for the last couple of years at acquisitions. And we’ve also said it’s very frustrating because the valuations don’t make any sense to us. I mean, we looked at companies where they were sold for six times revenue, six times revenue. And it’s like what, I’m kind of old school, how can that be? And these didn’t have the cure for cancer. They maybe thought they had a cure for cancer, but we didn’t think they had a cure for cancer. So the valuations just got to be wacky out there. But it’s a pattern. Every time we looked at something, the valuations were just way ,way — no I’m not talking about 10%, 15%, 20% higher than we thought. I’m talking about three, four, five times higher than we thought was appropriate.

And we kept getting told by bankers and such that “Look you really got to get in the game. You got to spend your money because you’re missing out.” Well we had discipline and we did the right thing. We took care of our shareholders’ money and we didn’t waste it and throw it away because we got emotionally involved or excited.

At the Needham Conference in January 2020, Brian Shore describes PKE’s history in the following way. There’s nothing special about it but the way the history is described seems to fit a pattern. It’s the little stuff when it comes to trusting people with your money.

In 2014, the Company’s former circuit board unit was experiencing declining revenue for the 4th straight year. PKE’s workers were getting less than a full week’s worth of hours so the CEO took a 20% paycut in solidarity with those employees.

I took a pay cut recently because electronics in the U.S. has been very weak since July,” he said in a phone interview Wednesday. “As a result, our people in Arizona and California are not getting full work weeks. I felt as a matter of solidarity that I should be in the same boat.

This is the best way I could think of to explain why the CEO is likely to be a good steward of shareholder capital.

Investment Thesis Recap

To tie the above background on the company and management in with the investment thesis, we can see:

• The multiple years of work the company has put in to build relationships with OEMs and private businesses in a now-distressed industry to have a better chance of acquiring a niche, value-accretive company
• The company has been both communicated and followed through on its careful approach to allocating capital appropriately
• CEO is a straight-shooter
• The potential for a great acquisition less available to others

If you are still reading at this point, I know what you’re thinking. Get to the valuation already, Moats! One more thing.

Guidance, as of January 2020, now withdrawn

One final thing worth introducing early is that as recently as February 2020, the company was experiencing extreme demand conditions and they were struggling to keep up with orders.

At that time, the company had a revenue CAGR of 23.5% over the prior 3 years and was projecting revenue and FCF growth of 12.8% and 20.1%, respectively. I point this out for comparison to my projections in the valuation to provide context. I think I’m being conservative in my valuation and likely underestimating value.

Valuation

This is one of the trickier valuations since we a missing a few key data points and I haven’t spoken to management, combined with the obvious issues with the aerospace industry. I’m sure I’ll have to do an update post at some point so hopefully this post lays enough groundwork that updates will be short.

Valuation Considerations:

One obvious thing we are missing is segment data for PKE’s aerospace segment. Previously, the company reported two operating segments. Without circuit boards, they have one segment. Hopefully the company will add granularity going forward to improve the ability to forecast cash flows. Today, all I have is hope, so not much I can do other than high-level revenue estimates proportionally applied across the cost structure of the company.

My first thought is that using historic data is probably reasonable, but similar to the ESCC post, I’ll have to consider a near-term lull in earnings. How deep of a decline and how long will the decline persist are critical questions. I’ll show my assumptions and you can make your own adjustments from there.

To determine the near-term decline, I looked to PKE’s public statements. The company’s military revenue hasn’t been affected, thus far.  Further, I previously highlighted that commercial (and likely business) revenues may be down 50% with at least one quarter that could be much worse. In FY2020, PKE’s military revenue was approximately $21m. Commercial and business revenue were an aggregate $39m in FY2020. If we assume revenue is down roughly 65%, we get to a ballpark estimate of $35m in revenue for FY2021. This is a 50% decline from the company’s projected FY2021 revenue guided for in January 2020 (now withdrawn).

For FY2022 projections, all I knew is I wanted to low-ball it with the thought that if all of my inputs and assumptions are conservative and the concluded value is still higher than the market price, it will be a no-brainer to take a sizable position in the company (NOTE: As always, not your advisor, and no-brainer for me may not mean anything to you). I went with $50m which assumes roughly mid-single digit (MSD) growth for military and roughly splitting the baby for commercial and business to represent a recovery but not a full comeback.

From FY2023 through FY2025, I assume PKE grew by the ST growth rate (5%, see the top of the DCF) from FY2020. This and the two-tier growth model are where I think I’m adding some conservatism in my estimates rather than simply assuming an immediate return to projections made in January 2020 as some might. In all these assumptions, we are implicitly underwriting for something akin to Warren Buffett’s bearish tone on the aerospace industry.

In summary, in the base DCF, I assume something close to -50% and -17% revenue decline, relative to FY2020, followed by four years of 5% growth and four years of 8% growth. At that point, the the LT growth rate of 3% is assumed from that now-normalized earnings base.

DCF (Base Case):

Other Inputs:

• The WACC is assumed to be 10%. I spelled it out to show you the most probable mode to higher valuation multiples (multiple expansion) going forward. Simply pricing PKE on a market WACC, as opposed to an all-equity distressed WACC, will increase value. If PKE’s qualitative thesis plays out, this may occur (we are a long way from this, but that’s the LT homerun upside).
• The CEO once said he hopes to never lay-off anyone. I trust him in that regard and assuming growing G&A, despite declines in recent years and the current environment.
• Depreciation is based on the January 2020 projections.
• The gross margin expansion is based on the January 2020 projections in that it indicates improving product mix, which is likely still true today.

PKE previously estimated FCF of $17m in FY2024. I project FCF of $10.8m in FY2025. I think we have a buffer built in here.

DCF (base post-CV)

If you read my twitter, the first thing that jumps out is I showed a value of $12.95 and now it’s $15.80. What gives?

Previously I only assumed four years of 5% growth before LT growth of 3.5%. That seemed overly pessimistic in relation to PKE’s prospects a few months ago and their relative prospects within the industry. Odds are, the aerospace market returns to growth at some point in the next 5 years.

Here is the horizon value and where the excess cash comes from:

Sensitivity Analysis

One thing that is a recurring theme in this post is uncertainty with the industry. It’s worth showing many different slices of the above to give you an idea of the upside/downside characteristics of PKE at today’s price (closed at $11.87 on June 2, 2020).

From here, the immediate response may be, “ok, so it’s a good company at a fair price, but there’s not much upside.” Not so fast, my friend. As I mentioned, we built in conservatism all over. The WACC is too high, the discrete 5-year projection period assumes a long and slow aerospace recovery period, with minimal upside in years 6 through 9.

What does the upside look like? Let’s pull those levers!

DCF Valuation – Bull Case

New Assumptions/Inputs:

WACC: 10% – 9% (to reflect recovery and earnings growth)

Revenue: FY2023 – FY2025 uses the projected revenue for FY2021-FY2023 the company provided in January 2020 (this assumes the company’s future was delayed by two years).

2-Tier model: Growth continues at 10% (instead of 8%) for those additional 4 years

Bull Case Model:

Files:

DCF (bull post-CV)

sensitivity analysis (6.2.20 – bull)

Valuation Summary

In the bull case, you can start to see the relatively lower-risk, high upside potential. Further upside is still possible when you consider the Bull Case roughly concludes a 20x terminal FCF multiple, despite a growth rate of 10% at that time. It assumes none of the current cash balance is invested or reinvested, there is no M&A assumed, and there are no new products assumed that lead to stepped growth as opposed to the smoothed growth modeled.

Finally, one aspect unexplored is the desirability of the asset. PKE would obviously be an acquisition target if not for the CEO, who seems unlikely to sell. However, the CEO is in his late-60’s and a lot is possible in life. PKE shares many qualities with Breeze-Eastern (BZC), which was another microcap with sole source products, ultimately acquired by TDG. I consider this a very low possibility, but note it to make the point that this post still leaves a lot of avenues unexplored.

In general, I think PKE is one of those rare microcap opportunities that will probably do well and has a meaningful chance of being a multi-bagger or homerun.

Why Does This Opportunity Exist

Although I have mentioned the aerospace industry issues and the sale of the circuit board business, which caused PKE not to screen well for many years, there is likely one other factor causing PKE to sell at such a discount relative to peers (other than company size). Raging Capital has decided to close up shop in April 2020. At 12/31/2019, they owned 9.15% of the company. They sold 1/3rd of that stake in 1Q 2020 and likely continue to be relatively indiscriminate sellers. This has kept pressure on the stock price and provides a reasonable level of volume for similarly sized funds to take on a position. Among other reasons, I think PKE hasn’t seen a stock rebound similar to other aerospace peers due to the selling pressure that will abate soon.

MLGF US EQUITY – Malaga Financial Corporation (Bank)

This should be a lay-up. Let me try to convince you.

Business Description:

Malaga started in 1985 as Malaga Savings & Loan and is headquartered at 2514 Via Tejon, Palos Verdes Estates, CA. The bank started when a couple of doctors, a dentist, a local construction CEO, and a CEO of a tamper-evident shrink film manufacturer came together to form a savings & loan bank with a focus on local 1-4 multifamily lending. Presumably, they wanted a bank that would serve individuals like themselves with enough money for a real estate business, but the relationship wasn’t large enough to be served by larger banks.

In 2004, the company re-chartered to become Malaga Federal Savings Bank, wholly-owned by Magala Financial Corporation (the bank holding company that is publicly traded).

Presently, Malaga has stayed true to the original premise, with mortgages representing more than 95% of the approximately $1.05 billion of loans. The bank’s 1-4 multifamily and single family loans represented 83.0% and 12.3% of total loans, respectively, at the end of 2018. To support the low risk nature of Malaga’s lending strategy, during the Great Financial Crisis (“GFC”), 1-4 multifamily buildings in Los Angeles generally transacted at cap rates of 6%-8%, when long-term rates were in the 4%-5% range. Since 1-4 multifamily non-owner-occupied mortgages generally require 25% down, very few of Malaga’s loans would move towards a LTV ratio of >100% in the event of a significant upward yield curve shift, were it to happen. In fact, Malaga would likely predominately benefit from an increase in rates. The bank would likely be isolated from a further decline in rates due to its funding and low efficiency ratio (similar in some ways to HIFS, as I previously outlined).

Now we know that the bank is quite conservative in how it lends. However, the best part of the bank is its location. The bank has 5 branches in the Palos Verdes/Rolling Hills, located in the South Bay area of Los Angeles, CA. The Palos Verdes area is a relatively wealthy location in the hills of Los Angeles, near Torrance, CA. In 2017, the median household income, median household net worth, and median property value were $125,000, $250,000, and $1.05 million, respectively. Below is a map of the bank’s branches.

Malaga has a fairly even distribution of deposits, considering the history of the bank. The deposits, by branch, and the bank’s deposit market share in Los Angeles County (as of 9/30/2019) are presented below.

One risk associated with Malaga’s founding and present strategy is that the bank is closely held by its board members and executives. In total, current board members, executives, and spouses of deceased board members own a controlling interest in the Malaga. One of the consequences borne out by this risk is the on-going related party loans to board members and executives, which totaled $10.7 million in 2018. However, related parties paid an interest rate of approximately 4.1% on those loans, which slightly exceeded the banks overall interest rate and was in-line with the bank’s normal lending policies. The bank states that they do not lending at special rates to insiders and I could not find a loan to family members of board members and executives that would contradict that statement. Malaga seems to treat minority shareholders fairly.

Malaga’s most recent proxy statement is included here.

In summary, Malaga is a conservative lending bank operating in a highly desirable location. Malaga is also severely over-capitalized, given the risk absorbed by the bank (as I’ll outline below). Despite the over-capitalization of the bank, Malaga still earns above-average returns on equity while trading near tangible book value (“TBV”). As a result, I believe I can show that Malaga is extraordinarily cheap relative to the bank universe and from an absolute return perspective.

Financial History:

Malaga’s historical financials and other supplemental data are presented below.

Not sure if others have a problem reading these tables, but here are the PDFs:

_00 IS

_01 BS

_02 Supp Data

_03 Ind Specific Data

Historical Financial Summary:

On review of the historical financials, the first thing that jumps out is that Malaga is severely over-capitalized, with a core capital ratio of 13.4% and a risk-based capital ratio of 24.0%. Since Malaga has 95% of its loan portfolio in mortgages, the bank’s 7.6x leverage ratio (total assets / shareholders’ equity), should be closer to 10x to operate efficiently. Despite the over-capitalization, Malaga still earns a 14.0% pre-tax return on TBV and has a 36.3% efficiency ratio.

If Malaga were to increase leverage such that the core capital ratio was 10.0%, Malaga’s net interest income would increase by roughly 32%, the efficiency ratio would decline to approximately 28%, and the pre-tax return on TBV would increase to approximately 21%. Alternatively, if due to regulations or a lack of lending opportunities, Malaga decided to return capital to lower the core capital ratio to 10.0%, Malaga could distribute $25.9 million to shareholders today while resulting in similar operational improvements.

In short, Malaga has an excellent operating location, conservative lending strategy, and the bank has the opportunity to increase returns by 50% over time with simple changes.

One thing to note is that quarterly financial results are based on the bank’s call reports, which report shareholders’ equity as bank capital. Bank capital exceeds shareholders’ equity by ~$10 million for various reasons. At 6/30/2019, TBV is roughly $20.19 per share (as determined by 2018 TBV + 1H 2019 net income – dividends in 1H 2019). Malaga currently trades for 1.15x TBV (see the DCF slide below).

Valuation Method:

Malaga is a stable bank with simple operations. As such, a DCF is the best valuation method.

As a bank, we should always consider whether they should be viewed as a going-concern (based on the financial health of the company, the ownership of the bank, and the highest-and-best use of the assets). In Malaga’s case, TBV provides downside protection but the bank’s highest-and-best use is as a going-concern. As such, I didn’t focus on book value as a valuation method.

Given the high insider ownership and over-capitalization, it appears unlikely that Malaga would consider selling itself to a larger entity, so I am not presenting transaction comps. Malaga could likely sell itself for 1.7x – 2.0x TBV, based on the size of the bank. Given the location and efficiency ratio, 2.0x TBV would likely be a reasonable exit price for the bank. Since this scenario is unlikely, I didn’t use this as a primary method.

Finally, using comps to determine a fair multiple of earnings would seem to be a better method than a DCF, since bank’s a relative homogeneous and there are plenty of small, publicly-traded banks in California. I decided not to go down this route since I didn’t want to spend a ton of time looking in to what adjustments might be necessary to properly address the differences in Malaga’s location, over-capitalization, and business model. Instead, I choose to do a DCF and add-back the excess capital available to shareholders today.

Valuation:

Below is the DCF, based on historical loan loss provisions, a normalized corporate tax rate of 29%, and a discount rate of 10%. As footnoted, the discount rate of 10% was selected as a minimum return hurdle, since the bank cost of capital was calculated to be below such hurdle. The market seems to be requiring a 15.2% return today, as shown in the goal seek version of the DCF. That’s a healthy return given the downside protection!

Approximately 90% of the calculated value ($33.29 per share) is from the operations and 10% ($3.72 per share) is from the bank’s excess capital. The value of the bank would be higher if I projected the utilization of the excess capital through increased leverage over time. I probably should have modeled it out but it would be better if the bank actually increased leverage.

In summary, I calculate Malaga is worth approximately $37 per share today (1.65x TBV), which is in-line with the low end of transaction comps (which assume a control premium not present in this valuation). Always good when the calculated value is reasonable! The growth rate in the sensitivity table roughly models the effect of increased bank leverage (through higher than normal earnings growth for a prolonged period) which is how we arrive at a per share value of roughly $78. Without factoring in drastic capital allocation changes, Malaga is reasonably worth $35-$40 per share.

Liquidity is certainly a factor in the low valuation. When a company is this cheap, worrying about paying 5% above the current mid-point price seems foolish. There is liquidity if you don’t need to purchase at 1.1x TBV.

As always, please do not interpret this article as an investment recommendation. Do your own research and consult your financial advisor before making any investment decisions! I am not your financial advisor.

PDFs:

_05 DCF

_05 DCF (goal seek)

 

Hingham Institution for Savings (HIFS US EQUITY) – Updated DCF Model

I noticed I made a mistake in the DCF model of the HIFS post. I didn’t include an assumption for loan provisions, which had the effect of materially over-estimating value.

In the post, I suggested I wouldn’t purchase HIFS at ~2x TBV despite showing a DCF value supporting greater than 2.5x TBV. This probably should have jumped out at me.

I will probably come back to HIFS at another point in the future. It is taking time for me to warm up to a different regional bank strategy than the high-fee model I’m used to. For now, here is the updated DCF that addresses provisions.

PDF:

02 – DCF update (provisions)

 

EQUINITI GROUP PLC (EQN LN EQUITY)

The goal of this blog has to only write up truly good ideas but I had hoped there would be more posts than there have been thus far. Pending availability, I think there should be a good run of ideas coming. I’ll start with an easy one.

IMPORTANT NOTE: I use “$” throughout this post. All financials are in millions of GBP. I use the “$” out of convenience. Assume every figure is GBP unless I say otherwise.

Investment Thesis:

Equiniti (EQN) is a stable company, projected to grow revenue organically at 3% – 7% over the medium term (p.22), and it trades at a multiple that implies it is a risky company. Although I believe it is less risky than the average FTSE 100 company, if we assume company risk is approximately equal to the weighted-average of the index, there is substantial upside.

That is, I will attempt to show that there is greater than 100% upside (I’ll show 110.4% but don’t kid yourself on my projection accuracy – simply showing it’s cheap is a success).

To prove this, I think it is sufficient to show:

1. That EQN is a high-quality and stable business;
2. That my valuation is reasonable; and
3. The concluded value is substantially greater than the current price such that value exists even in unlikely bear cases.

You can argue (and hopefully some commenter will) that some assumptions are too aggressive here and there. Either way, I expect some multiple expansion is obtainable because of the stability of the cash flows and the reasonable long-term growth expectations that support the returns of future buyers of the stock.

Business Description:

EQN has 4 primary business lines: (1) Investment Solutions; (2) Intelligent Solutions; (3) Pension Solutions; and (4) EQ US. The first 3 are primarily Europe & UK based while the 4th is quite clearly a US-based business. Below is a short description of each. Also, see p.7 of the annual report.

Investment Solutions:

The Europe and UK-based share registrar business is akin to Computershare (CMSQY) or Broadridge (BR). EQN is the share register for ~70 of the FTSE 100, ~120 of the FTSE 250, and the SAYE administrator for roughly 1.2 million employees. Due to the administration of certain client balances, EQN earns interest income on these balances. Thus, EQN stands to benefit from rising rates in the future. Between 2014 and 1H 2019, investment solutions grew at a CAGR of 10.2%. During the 1H 2019, organic growth was 5.0% annualized.

While not very exciting, this business is an incredibly stable (as can be eyeballed looking at CMSQY’s long-term performance). Going forward, organic revenue is likely to grow at low-single-digits but the segment probably deserves a relatively (to the broader equity markets) high multiple in periods of low interest rates, such as the UK is currently experiencing. The ability to continue to expand this line of business is limited by the current market share. I suspect future M&A will occur in the US. More importantly, this line of business provides EQN the ability to cross-sell and up-sell services provided by the Intelligent Solutions division.

Intelligent Solutions:

EQN targets companies with ‘complex’ and regulated activities through enterprise workflows, credit services, customer on-boarding, and data analytics services. That is, EQN provides know your customer (KYC) solutions and analytics. This was a fast growing requirement that is likely nearing some regulatory maturity. EQN’s value proposition is outsourced KYC services (though they do have other services), which is likely a good deal for many financial customers since it is easier for EQN to train and flex their workforce as compared to each individual client.

Between 2014 and 1H 2019, intelligent solutions grew at a CAGR of 15.5%. During the 1H 2019, organic growth was 7.2% annualized.

Pension services:

While you may think this is a dying business, the administration of pensions is continuing to move towards outsourced services, which is how EQN is growing. For US readers, pensions are far more common in Europe and the UK relative to the US. EQN provides pension administration and related software solutions. Pension services is by far the least attractive segment of EQN, but it represents just 22.9% of TTM revenue through 1H 2019. The business should continue to be accretive to EQN and continued M&A in this space may help buoy profitability.

Between 2014 and 1H 2019, pension services grew at a CAGR of 5.0%, but during the 1H 2019, organic growth was -8.6% annualized.

EQ US:

The primary foundation of this business is Wells Fargo Shareowner Services, a leading share registrar, transfer agent, and disbursing agent in the US. The company primarily competes with BR. During the 1H 2019, organic growth was 10.7% annualized. The major clients include GE, Honeywell, JP Morgan, CVS, and 3M. Client retention was 100% in 1H 2019. This US share registrar business will likely be a primary driver of growth going forward due to potential margin expansion and the ability to conduct bolt-on acquisitions.

Overall:

Approximately 90% of revenue is contractually recurring (50% of sales; with clients that have an average age of business of 29 years as of 2018) or practically recurring due to the operational importance or nature of the revenue (30% projects for long-term customers and 10% from interest income and FX on overseas pension payments). Margins in each of the divisions is generally stable in good years and bad. EQN is certainly more of a ‘defensive stock’, if we must label it.

Company Guidance:

EQN outlines medium-term guidance as follows. I believe each has been demonstrated historically, is reasonable, and suggests a higher valuation than what EQN currently sports.

1. Organic revenue growth of 3 – 7% per annum supplemented by capability-enhancing acquisitions.
2. Gradual margin improvement of c25 bps per annum.
3. Progressive dividend policy with distribution based on a 30% payout ratio of underlying profit attributable to ordinary shareholders.
4. Cash tax rate of 13% for 2019 and 17% for 2020 onwards.
5. Average cash conversion of 95%.
6. Capital expenditure of 6 – 7% of revenue post integration of the US business.
7. Net debt/underlying EBITDA ratio of 2.0 – 2.5x post-IFRS 16.

Given the nature of the undervaluation, I will not rigorously model EQN. Close is good when we know it’s cheap. I’m open to any simple suggestions for improved accuracy though!

Financials:

Before we get to the valuation, let’s start with the usual. Here are the financial statements and some other supplemental information.

PDFs of the above:

_01 IS

_02 BS

_03 CFS

_04 EBITDA

_05 EBITDA Chart

Financials Summary:

The financial results and operational margins are highly stable. Obviously, times are good, economically speaking, so this may be a false positive. If we look to the 10+ year trends at CMSQY and BR, we can find more evidence that the underlying business is still relatively stable in downturns.

One important point. Over the TTM ended 6/30/2019, I calculate adjusted FCF to be $78.0m while TTM net income was just $24.8m. Part of the reason I believe EQN is cheap is due to the roll-up of various businesses where the true useful life of the acquired assets vastly exceeds the IFRS standard useful life. Thus, reported income is lower than actual (and normalized) FCF. I’m a big fan of good companies that don’t screen well.

As such, I estimate EQN currently trades at a P / Adj FCF ratio of 10.0x and EV / adj EBITDA ratio of 9.9x. EQN is objectively cheap on reasonably adjusted TTM multiples.

Valuation Method Selection:

First conclusion we should make is that given the consistently in the business, margins, and expected capital structure, a DCF is likely the best valuation method. EQN is likely to be a going concern (so book value is not a great method) and a DCF is a better method than capitalized earnings (fancy Price-to-adjusted earnings) if we believe historical results are highly indicative and growing.

One reasonability test is that my simple projections closely mirror sell-side projections, which supports the predictability of EQN. Future M&A may cause this analysis to be worthless but here’s what everything looks like.

Valuation:

Here’s my DCF.

PDF:

_06a DCF – zero

Here’s roughly what I think EQN’s valuation should look like. A 7.4% WACC implies a  FCF multiple of roughly 13.5x.

Below is the implied WACC the market is assigning to EQN, which we can assign to the Industry/Company Specific Risk factor. As I said, I believe EQN is at least as stable as the market as a whole (which is what a 0% factor implies). That’s the long-term investment thesis at least. EQN has previously traded at ~15x EBITDA, so at one point the market agreed with me.

PDF:

_06b DCF – goal seek

Valuation Summary:

My entire thesis is based on the idea that the market is assigning an additional 5.8% required return on equity to own EQN at these prices (determined by goal seeking to the current EV – note the difference in share price is due to including employee benefits in debt in the DCF but not in EV calculation). That’s far too high. I might be willing to sell at some company risk premium not attributable to EQN’s small market cap, but it certainly won’t be a 5.8% annual return premium!

 

DCF Assumptions used:

Revenue Growth: 5% in the projection period and 3% long-term. 5% is the mid-point of medium-term guidance.

Operating Expenses: I assume a decline in operating expenses to the long-term average of 77.5% of revenue.

D&A: I assume 12% of revenue (long-term average).

Capex: same growth as revenue and D&A. The gap between these represents M&A amortization. This is probably the only area of aggressive valuation since some of this amortization will at some point no longer provide a tax shield. I think I cover for this aggressiveness by not including future growth from M&A in revenue/FCF.

WC: Not meaningful so again I won’t bother showing the calculation but it’s simply based on current WC needs at projected revenue levels.

Cost of Capital: 20Y gilts are what they are. The equity risk premium and small company risk premium are estimates based on calculated data from Duff & Phelps and Damodaran.

Cost of Debt: My conservative estimate of future cost of debt.

WACC: Capital structure is what it is and future leverage is projected to be roughly the same.

Hingham Institution for Savings (HIFS US EQUITY)

I like banking because you get to meet your customers on one of the better days in their life, not their worst (like with insurers). They are generally buying a house, a car, or expanding their business. Since the dawn of civilization, a trusted member of society has accepted deposits of goods or specie and effectuated transactions in return ‘for a spread’. There’s something wonderful about the simplicity and necessity of banks.

In this article, I’ll attempt to convince you that the most interesting bank in the US is a small, former mutual savings bank. I want to be the first to detail the enterprise in detail since I believe investors will ultimately conclude that they are something akin to how Warren Buffett would have run a bank, if he had choose banking over insurance. A few have summarized HIFS long history of outperformance, I’ll try to write down the recipe for the secret sauce.

History of HIFS:

One of my favorite parts of researching companies is to learn the story behind them. Where are they located? How do they make money? How do they earn more (or less) than competitors? What are the employees like? The customers? Management?

Sometimes the story of the company doesn’t play a large role on the potential returns of an investment. Consider the Plexure Group thesis that focused on the McDonald’s relationship and failed to rely on historical financial results. Other times, it may be critical. Studying management’s prior decisions and the context they were made in can be the best window a potential investor can possibly get in to the true people behind management.

I think HIFS is one of those companies where the history is instructive for an investor considering the potential range of expected returns going forward. Below is a short timeline of HIFS operating history since going public.

1988: HIFS, which operated as a mutual savings bank since 1834, completed its conversion to stock form on December 20, 1988. Former MA state banking commissioner Paul Bulman was the first CEO. Prior to taking the job, he declared in 1987 that the “state’s [MA’s] banks have never been safer”. Obviously you are reading this quote because the banks were not safe.

NOTE: Annual report in the links. I’m glad HIFS hosts all of these on their site, it’s a great resource to have all of company’s annual reports be easily accessible.

1989: Come to find out, MA banks are not safe. In Bulman’s first year, HIFS recorded a $2.85m pre-tax loss due to a $3.5m provision for loan losses. The $2.4m net loss in 1989 represented 11.6% of shareholder’s equity at 12/31/1988.

1990: The S&L Crisis has morphed in to a classic bank panic. By some miracle, HIFS has managed to grow deposits slightly but shareholder’s equity fell 23.6% to just $13.75m. Since becoming a bank two years prior, HIFS’ shareholder equity contracted 33.7%. If HIFS wasn’t over-capitalized at conversion, they would have been skunked by now.

As a result, HIFS adds three outside directors to the board, including a local lawyer at Gaughen, Gaughen & Gaughen, Robert Gaughen Jr, the current CEO/Chairman.

1991:  The bank managed to shift the portfolio from local residential real estate loans to MBS securities. It is incredible in hindsight how close HIFS was to becoming illiquid in 1990-1991. In 1990, HIFS had $10.1m in REO and losses were surging. HIFS was one small run on the bank away from the FDIC seizing control.

1992: The potential of the bank begins to become apparent. Pre-tax ROE, less net foreclosed property expenses, is greater than 20%. The bank’s portfolio is structured approximately 50/50 loans/MBS.

The CEO’s father joins the board. It foreshadows the Gaughen takeover of the bank.

1993: Robert H. Gaughen Jr. notifies the bank he plans to nominate a slate of nominees to the BOD. HIFS sues Robert H. Gaughen Jr. Robert H. Gaughen Jr. counter-sues for breach of fiduciary duty. The vote is challenged but ultimately allowed to occur and Robert H. Gaughen Jr. is successful in his ascent to CEO.

By the end of 1993, NPAs decline from $9.4m to $2.7m.  The bank begins to originate loans again, with a 20% y/y increase to $30.8m in originations in 1993 ($23.5m of the originations occurring in the 2H 1993). EBT (ex-special expenses) is ~$2.4m on shareholder’s equity of $14m. The Gaughen Era has begun.

1995: The culture of the Gaughen-led bank begins to shine. Starting in 1994, pictures of employees are included at the outset of the report. In 1995, the traditional President’s Message is followed by the bank’s “Primary Assets”, which includes pictures of employees at each of the branches. It’s a nice touch.

HIFS has successfully escaped the S&L Crisis, led by Robert Gaughen Jr., and the future looks bright. Let’s skip a decade or so and get to the next exciting period.

2006: For those around long enough to remember, this is the beginning of something different in the financial markets, though no one has any idea the cliff the U.S. economy is hurtling towards. Despite double-digit volume growth, the yield curve shifted to a yield line (very much a vertical shift from today’s yield curve). As has become standard, HIFS comes right out and tells you why things are bad (but generally only hints at the ingredients of their secret sauce).

As I’ll detail later, HIFS has a model that can sustain most financial shocks due to an efficient operating model, above-average loan origination ability (quality and volume), and a location with secular growth trends in both population and wealth, with just-the-right image to match the area. The downside is HIFS is dependent on market funding to allow for the organic growth that has made them a fortune. At times, like 2006 and today, a flat yield curve can hamper the bank’s ability to generate returns up to their potential.

2006 and 2007 represent the only time in the Gaughen Era of the bank that HIFS earned less than 10% return on equity. HIFS has been profitable in every year since 1993.

2009 and 2010: From the lows of 2007, earnings more than doubled through 2010 and HIFS first eclipsed $1 billion in assets. The bank’s high-quality lending reputation was indeed accurate. Throughout the global financial crisis (“GFC”), impaired loans reached its zenith in 2009 at ~1.5% of total loans outstanding. By way of reference, a little more than 2% of prime mortgages defaulted in 2009.

2012 (you have to start downloading the annual reports at this point): Patrick Gaughen, the current President and COO and [likely] future CEO of HIFS, is hired by the company and elected to the BOD.

2012-Present: I will review the bank’s financial performance below so here I will focus on the qualitative. The qualitative changes made by the bank over the last several years include:

• The prioritization of improving and/or upgrading the bank’s IT systems. In a story told at the 2019 annual meeting, HIFS first realized they needed to upgrade their IT systems because the largest depositor at the bank, an elderly man, suggested adding mobile check capture capabilites so that he wouldn’t need to visit a branch so often. HIFS seems to focus on their advanced technology offerings, especially relative to the size of their bank, with displays such as their uptime tracker.
• As previously discussed, HIFS added a Washington D.C. lending office based on an internal analysis that suggested the D.C. market’s 1-4 family and apartment building market was similar to Boston’s and an ideal expansion area for the quickly growing bank.
• An effort to reduce the bank’s reliance on fee income (primarily through service fees on deposit accounts). HIFS’ management feels strongly that the only sustainable bank model, especially for community banks, is one that doesn’t rely on fee income or trust income to earn outsized returns (startlingly different than the bank model I was taught to appreciate, but I’m coming around to their view after researching HIFS). Despite a doubling of deposits since 2010, service fee income is down approximately 20% during the period.
• Due to the bank’s legacy charter from their savings bank conversion, as detailed previously, HIFS is able and has finally begun investing in individual publicly-traded equity securities. At 3/31/2019, the bank held $34.8m of equities, or 15.7% of shareholder’s equity. This is the highest ratio of any publicly-traded bank in the country, other than related bank holdings at Southern BancShares (SBNC).

The change in accounting standards that require unrealized gains/losses to be reported on the income statement will likely make HIFS (and SBNC’s) financials more volatile than they actually are. This may provide some opportunities to buy HIFS at a momentary discount due to the small float, low market cap, and new accounting standards. Warren Buffett and Charlie Munger recently focused on this issue at the Berkshire Hathaway annual meeting.

Although it has taken me some time to appreciate the method to their madness, I think I can finally see the logic behind low fees, a focus on 1-4 family and apartment building lending (due to a slight premium in interest relative to mortgages and a steady demand for the underlying space being rented [people always need to live somewhere]), a low-cost loan origination model vs. a high-touch/low-cost of funding model with asset management/trust income-focused banks (as pushed by WEB a la WFC and me with CNND).

An additional focus of the bank that may prove fruitful going forward is management’s attention on small-and-mid-sized (“SMID”) business relationships. HIFS created a specialized deposit team with the goal of improving funding relationships. HIFS is not unique among banks, large or small, in seeking out low cost funding given the current yield curve. What is different is it seems to be working, with non-interest bearing deposit CAGR of 17% from 2014 through the 1Q 2019. If HIFS can lower their core funding costs then normalized NIM (if there is such a thing) may be higher than previously witnessed. Further, the opportunity cost on the SMID relationships is minimal since HIFS already has very low fees per $1 of deposits.

HIFS has taken the low-cost, GEICO-like (well, Progressive-like (PGR), but GEICO’s cost advantage is better known) banking model to an extreme. In 2018, HIFS efficiency ratio was 29.9% (excluding unrealized equity gains/losses), more than 700 basis points (“bps”) below the more infamous Bank OZK (OZK). Further, it cost HIFS approximately 0.82% or 82 bps as a percentage of total assets to operate the bank. All-in annual non-interest expenses for HIFS reached 2.01% as a percentage of total assets in 2018. Best I can tell, outside of single-branch banks, HIFS is the most efficient publicly-traded bank in the U.S.

There are 16 publicly-traded banks in the U.S. with an efficiency rate of less than 60% and expenses as a percentage of assets of less than 1.5%. HIFS has a 20 bps advantage in expenses and a 200 bps advantage in their efficiency ratio (HIFS adj efficiency ratio is 29.9%).

HIFS Financial Summary:

It’s rare I will do a deep dive on a company’s history such as I have with HIFS here. As mentioned, I think the totality of the history is instructive in making the point that HIFS is different. They are not lucky, they are not momentarily or temporarily benefiting from a particularly well-suited yield curve or economic conditions. Assuming that HIFS is able to continue to make decisions in the same manner that they historically have, HIFS will outperform financially. Outside a persistent, negatively-slopped yield curve or a sudden decline in loan origination quality coupled with an economic downturn, I’m not sure what can permanently hurt HIFS.

Much of this is a re-hash of what I’ve previously provided so I won’t focus on explaining what you can see in the above tables.

HIFS Financial Statements and Other Ratios, from 2010 – 3/31/2019:

 

 

 

HIFS Valuation:

When considering how to value HIFS, we have the following options: (1) the asset method (a book value analysis); (2) a market-based method (guideline companies and/or transaction comps); or (3) earnings method (a simple capitalization/multiple or earnings and/or a DCF).

While it seems like book value is the way to go with a bank, in HIFS case, I suspect they will continue to operate. Thus, I suspect they are worth more as a going concern. As such, I will not provide a liquidation valuation.

Due to some of the reasons I discussed previously, including HIFS’: (1) ability to hold equity securities with a bank charter; (2) operational efficiency relative to peers; (3) quality lending practices; (4) ideal geographical location; and (5) IT advantage relative to competitors (local and domestic), especially given their size, I don’t think a guideline company analysis (relative valuation of comps) is all that instructive.

I also don’t think a transaction analysis is indicative of value because I believe it is highly unlikely HIFS would sell itself to another bank. If we know HIFS will only be valued on a minority basis then there is no sense falsely raising our hopes by checking what a controlling basis value might be.

For reference, here is a brief guideline company analysis based on Boston-area banks and nationwide transactions. Again, I don’t think either method is a good indication of value but at least you know I did it and it suggests HIFS is roughly fairly valued to slightly undervalued.

These charts for bank transactions use identical data presented in a slightly different way. I also wanted to test if a premium was paid for banks with higher ROE. There is a slight premium paid but it tapers off, likely due to one-time gains and concerns regarding the sustainability of high ROE.

DCF Valuation:

Since HIFS has not engaged in M&A activity, the business model is unchanged, the business is growing above the projected long-term growth rate, and we are reasonably able to determine future cash flows, I went with a DCF valuation as opposed to a multiple/capitalization of historical earnings.

My DCF makes a few assumptions, which are listed below (and, hopefully, presented in blue in the images below).

• HIFS reinvestment rate of 88.3% is assumed to fall towards 75% over the next 5 years and is estimated to be 20% in the horizon period. The 20% reinvestment rate in the horizon period is based on a LT growth rate of 3% and a projected long-run ROE of 14.3%, assuming roughly unchanged yield/rates and asset/liability construction. I’m trying to be conservative here.
• HIFS leverage ratio is unchanged at 11.3x
• HIFS will shift slightly to interest bearing deposits from FHLB Debt, given the expected rate spread.
• The cost of funds will rise slightly and the yield on assets will decline slightly, relative to the TTM period ended 3/31/2019.
• HIFS long-run tax rate will be approximately 27.0%
• A discount rate of 12%. There was no science behind this assumption. It’s something akin to my required rate of return, plus a few bps due to the size of the bank, the cyclicality of banking, less some bps due to the financial and distribution history.
• Non-Interest Income only includes service fee deposits at 0.05% of deposits (you’ll also notice I address BOLI in interest income – I know this is wonky but it worked out easier to model it this way).
• I assume a long-run rate of return on equities of 9% and that individual publicly-traded equities remains at 15.7% of shareholder’s equity.

If the image above is unreadable you can try the following pdf: 01b – DCF

Return Composition:

In addition to HIFS efficiency advantage, their legacy charter allows them to invest in individual equity securities. I believe this additional allocation flexibility will result in further outsized returns over time. If we assume 9% long-term returns, predominately through price appreciation (as alluded to in HIFS Form 10-K), then I arrive at the following unseen advantage that I tried to account for in my DCF above.

Again, here is a pdf link if the above is unreadable: 02 – Return Composition.

I’m not sure how reasonable it is to separate the bank into shareholder’s equity and bank leverage, but this is my effort to rip them apart and put them back together. I’ve come up with crazier ways to analyze a stock before.

The 6.2% increase in ROA / ROE is due to HIFS decision to forego interest on high-grade corporate or municipal bonds, in favor of unrealized capital appreciation of equity securities.

I would imagine HIFS will be unable to allocate more than 25% – 30% of shareholder’s equity to individual equity securities at any point in the future but the allocation has reached as high as nearly 20% recently. This has previously been an undiscussed nuance of HIFS’ outperformance. Below is the boost to HIFS’ returns if equity allocation reached 30% of shareholder’s equity.

Conclusion:

One thing I didn’t include above is the usual sensitivity tables and a deeper dive in to the various outcomes of the bank. For one, I don’t think I can add value to readers by projecting future net interest margin (“NIM”) spreads. I also think a continued NIM spread contraction, held in perpetuity, based on the presently flat yield curve is a historically conservative estimate. Whether the yield curve actually experiences some lift in the future and whether yields (or inflation) ever rise at some point in the future is anyone’s guess, but it should only improve an investment outcome in HIFS. Thus, the above estimate of value of approximately $275 per share seems reasonable to me. That is to say, in general I think HIFS is undervalued, but my confidence interval is likely wide and includes today’s price ($188.00 on 6/19/2019).

In my opinion, HIFS bank model is built to generate 10%+ and, at times, 15%+ returns on equity. In certain rate environments, I could imagine HIFS generating returns of more than 20% for short periods of time. This seems especially if they continue to expand their SMID relationships and increase the proportion of non-interest bearing deposits as a percentage of total funding. The primary reason is the spread between high-quality 1-4 family and multifamily loans (approximately +150 to +300 bps) and HIFS’ consistently low cost of bank operations (expenses plus funding as a percentage of assets). Scale should only make that exercise more easily repeatable in more diverse economic outcomes than they were previously prepared for. The most easily visible example of HIFS advantage is their 15% return on equity in 2018, despite a flat yield curve like 2007 and lower nominal rates (the resulting lowering NIM offsets the higher provisioning in 2007). While I suspect returns on equity will fall some if the present yield curve persists, HIFS is capable of making the best of the challenging bank environment.

However, HIFS P/B multiple is near an all-time high and continued outperformance is a necessity at HIFS current valuation since at 1.8x P/B, HIFS is unlikely to benefit from further multiple expansion. As a result, the possibility of more than 20% returns over my holding period is quite limited and the possibility of negative returns over a short-term period is greater than I’d like with such limited upside. If HIFS trades closer to 1.5x P/B, I would feel more comfortable going long, regardless of HIFS earnings at that time (assuming there was no major change in loan underwriting quality). Note, I am only trying to describe my basic thought process around owning HIFS for a short-term and/or long-term period. I am not recommending any reader go long or short HIFS or any other security. I’m not your advisor.

I suspect that over the next year or two, HIFS annual meetings will become more popular as investors realized that HIFS is what investors generally perceive Markel Corporation (MKL) and GEICO to be or what a WEB-run bank may have looked like. Not withstanding the above, for truly long-term investors, HIFS is one of the best financial service companies to invest in.

Risk Factors to be Aware of:

Despite the laudations above, HIFS management is not perfect. I will say, in my experience at the annual meeting watching HIFS management interact with staff, attendees, employees, and other senior management, I came away impressed. However, I fully intend to question management’s judgement, when warranted.

An example of some risks is the structure of the BOD. Given the relationships of the individuals, it would be difficult for even independent members to object to any plans or strategy made by current management. Further, one board member is the daughter of the CEO and does not have banking experience. Bank management and directors takes reasonable compensation and rarely issues stock to themselves. This behavior supports a limited concern for these risks, though they are worth watching.

Another risk factor is the bank’s concentration in Boston- and Washington D.C.-area multifamily and apartment loans. This asset class trades at low cap rates in these geographical locations. Further, benchmark rates are generally near historical lows. An increase in yield/rates without a commensurate increase in rent inflation could cause many loans to fall in to default. The current CEO has proven an ability to oversee quality loan origination throughout cycles but the current COO and [likely] future CEO has yet to prove this ability.

Evans & Sutherland Computer Company (ESCC US EQUITY)

First, some housecleaning. I noticed that the links in my last article open in the same tab instead of creating a new one. That should be addressed in this article and going forward. In general, if you happen to notice any issues related to my work or the formatting just let me know. Now on to the show.

In honor of Berkshire’s recent annual meeting (and due to the fact that it’s taking me too long to finish other planned write-ups and I don’t want dead-air on this blog), I propose an old-fashioned, Ben Graham-style investment. While it looks like a stump, I think this cigar butt is fairly dry and only half-finished. A decent-enough puff is still to be had.

Corporate History:

The history of ESCC is quite interesting and completely irrelevant to an investment in the company today. You aren’t missing anything if you skip this section.

ESCC was founded in 1968 by David Evans and Ivan Sutherland.

David had a background in EE and a PhD in physics prior to working on computers at Bendix in the 1950’s. He took this background and began working on Project Genie at Berkeley in the 1960’s, which was sponsored by DARPA. Also working on the project was the eminent Ivan Sutherland.

Ivan had a BS, MS and PhD in EE, with the latter coming from MIT. His doctoral thesis was the invention of the Sketchpad drawing application in the 1960’s, supervised by Claude Shannon, which later won him the Turing Award. He then went to the NSA and became the head of DARPA. Following Project Genie, Evans convinced Sutherland to move out to Utah and start a computer graphics firm.

In the 1970’s and 1980’s, ESCC made a name for themselves by inventing top-of-the-line flight simulators for military and commercial applications. They invented a line of graphics workstations known as the E&S Picture System, which was ultimately used to do the CGI in the original Star Wars.

By the 1980’s, ESCC starts to work on the core of their remaining business, planetarium projection systems and content! However, in the 1990’s, the firm starts to struggle and spins-off its molecular compound manipulation software and its CAD/CAM software. In 2006, ESCC sold their simulator business to Rockwell Collins (now part of UTX). All that’s left today is the planetarium projector business.

A longer history of ESCC can be found here if you are so interested.

ESCC Business Description:

According to ESCC, the company focuses primarily on digital planetariums and digital cinemas worldwide. ESCC offers Digistar, the world’s leading digital planetarium system, fulldome programs and production services, giant screen films formatted for fulldome theaters, premium-quality projection domes and theater design services.

According to ESCC’s 2017 Form 10-K (p.4):

We continue to maintain a significant share of the overall planetarium and full dome digital theater market. We estimate that the size of the market for digital planetarium systems is approximately $65 million annually and varies, of which our market share has ranged from 35% to 70% depending on the specific market size and time period.

There’s not much more to say. ESCC sells both hardware and licenses shows to planetariums (similar to the razor-and-blade model). ESCC has only reported licensing revenue for 1 year, which makes it impossible to do any analysis on. I may be underestimating ESCC’s business, but I will ignore all top-line breakouts for this post.

Just know that the breakout exists and you may disagree with this simplifying assumption.

ESCC Ownership:

Worth noting is that ESCC has NOL Carryforwards (“NOLs”) of $35.5 million. With NOLs comes restrictions on ownership changes.

Further reducing the chances of ESCC ever being acquired or taken private is the fact that the two largest shareholders: (1) Stuart Sternberg [owner of the Tampa Bay Rays] (~10.2% stake); and (2) Peter R. Kellogg [whose family made their money at KBR oil company, not the cereal] (~36.1% stake). Both owners and company executives have purchased at the end of each recent fiscal year, but generally insignificant amounts. Relative to their total wealth, the Stuart and Peter’s ESCC stakes are trivial.

This is a long way of saying that I will assume a trivial tax rate (2.5%)  in to perpetuity and shareholders of ESCC will likely only do as well as the company does. There is no buyout, liquidation, or other financial engineering to save us from our mistakes here.

Analysis of Financials:

I know what you’re thinking.

“This is a tech company with world-class IP and a stranglehold on their niche market, it must be selling for more than 15x EBITDA!”

You are in luck, reader. You can purchase this storied company for the low, low price of 2.1x TTM EBITDA or 2.4x TTM EBIT.

There must be a catch, and there is.

1. ESCC’s backlog is down precipitously and a review of the historical relationship between backlog and future revenue is worth exploring.
2. Since ESCC’s backlog is down, is there still value if ESCC is operating at break-even or losing money in the short-run?
3. ESCC has historically lost money. What, if anything, is different?
4. What is the upside/catalyst or why will anyone purchase this from you at fair value?

Let’s review some numbers.

A summary of ESCC, as of 5/8/2019.

An overview of the (1) Income Statement; (2) Balance Sheet; (3) Cash Flow Statement; (4) Other Metrics; and (5) a Summary of EBITDA and FCF.

 

 

 

 

 

It is worth pointing out to readers that the FCFF summary implicitly adjusts back the $3.6 million loss due to the Pension Settlement in 2015. I think that is a reasonable adjustment (since it is truly one-time), BUT it also makes ESCC look more stable than they actually reported. This may be the correct view (I tend to think it’s a more accurate view), though you can decide for yourself.

A further adjustment to operating expense pension expenses was made to create a pro forma history that reflects the current variable and fixed pension expenses, based on that 2015 settlement. The as-adjusted FCFF suggests that a future decline in ESCC’s revenue may not be as destructive to FCFF going forward as it was in the past.

With that said, we are left with the elephant in the room, Backlog, and what it portends for the future.

Backlog vs. Forward Revenue Analysis:

The following slides are a summary of a five-year analysis of ESCC’s backlog vs. future revenue analysis. In summary, backlog is loosely correlated to 6 month, 9 month, and 12 month forward TTM revenue, with an R^2 range of 0.536 to 0.574. Backlog is surprisingly not as correlated with future TTM revenue as I expected prior to the analysis.

However, that is not to say that there is no relationship between backlog and forward revenue. The current decline in backlog and the nature of the current backlog (heavily weighted to 2019 deliveries) suggests ESCC’s revenue will experience a sharp decline in the next 3-9 months. The last time ESCC’s backlog was below $20 million, the global financial crisis (“GFC”) was starting and revenue declined from more than $37 million to roughly $25 million. Then it took ESCC 7 years to recover to pre-GFC revenue.

 

 

 

I believe the above, combined with a review of ESCC’s common-sized income statements, suggests that ESCC’s revenue could fall to the $25 million to $30 million range.  with decreased gross margins. This estimate is based on the assumption that backlog remains in the range of $15 million to $20 million range for multiple years. If backlog furthers declines then ESCC’s stock price will sharply decline and they may even be challenged as a going-concern. If backlog stabilized above $20 million or returns to the $25 million to $30 million range then an investment in ESCC will do quite well. It is that simple.

There is only one sentence in ESCC’s 1Q 2019 10-Q filing that will matter.

ESCC Valuation:

For ESCC’s DCF-based valuation, I will try to present a base case that assumes revenue falls to $27 million immediately and takes approximately 4 years to recover. I believe these are reasonable assumptions based on the above analysis. Simply put, my analysis suggests revenue will decline by 25% – 30% in the near-term and take multiple years to recover, so what is ESCC worth? Am I being rewarded for the uncertainty or risk that I’m absorbing?

For ESCC’s earnings capitalization-based valuation, I will look at ESCC’s adjusted FCFF and look to the sensitivity analysis to determine what the margin of safety is. Basically, we are trying to find out what does ESCC’s current price imply about the market’s long-run expectations and is it reasonable to think they can outperform those expectations? If they do outperform, what is our reward?

Additional DCF Modeling Assumptions:

1. Gross Margins = 35.7%
2. ST Revenue Growth Rate = 7%
3. LT Revenue Growth Rate = 2%
4. ST Expense Growth Rate = 1.5% (based on historical I/S review)
5. D&A steps down to average CapEx of $205k per year

 

Additional Earnings Capitalization Assumptions:

1. I assume additional working capital needs (ex-Distributable Cash) is roughly $110k per year, escalating at the long-term growth rate (2%) used above. It’s not that interesting and easily replicable by yourself to see how I got there so I won’t show my work for that assumption.
2. The other assumptions are obvious.

 

Before moving to the conclusion, it should be obvious that negative valuations per share suggest that ESCC is worthless in those scenarios. In many of those situations, it is likely that a more complex (and probably not time-worthy) analysis is required. ESCC is not necessarily worth $0 in each of those scenarios (much like ESCC cannot growth revenue above $50 million or in the near-future due to that being implausible relative to the total available market (“TAM”) of the planetarium projector industry).

Conclusion:

It goes without saying that I think ESCC is an interesting investment opportunity at the moment. The investment float is no more than $4 million and liquidity is measured in $10,000’s per day. Many readers will not able to invest even if they would like to. Further, it is not certain that there will be liquidity when  you want to sell or, more importantly, that there will be liquidity if ESCC’s operations turn south.

After ESCC reports an update to its backlog, I might be able to comment more. For the time being, ESCC is a high risk investment. The results of this investment will likely be due to luck. I am just trying to figure out if this is a profitable bet or not.

I am long ESCC at this time but readers should be particularly careful with this post since the market cap is so small and liquidity is so low.

Plexure Group (PLX NZ EQUITY)

Business Description and Background:

Plexure Group was formerly known as VMob Group Limited. In 2012, Scott Bradley, the former CEO, took over VMob Group when it had nearly $0 in revenue. He shifted VMob towards mobile loyalty application development at that time. In 2016, VMob Group was renamed Plexure Group and Phil Norman, the founding Chairman of Xero, was brought on to be PLX’s Chairman. By mid-2017, PLX’s auditor had concerns of whether PLX could continue as a going-concern. In September 2017, Scott Bradley stepped down after taking PLX from $0 to $7.3 million in revenue in 5 years, but with no profits to show for it. He was replaced by Craig Herbeson, a former executive at Bank of New Zealand. Scott Bradley remains the single largest shareholder, though he is no longer a director or executive at PLX.

Plexure Group is a third-party mobile application developer (think contract developer-like business model). They own the code and license its usage to customers. PLX focuses on loyalty or rewards applications for quick-service restaurants (“QSR”), retailers, convenience stores (“c-store”), and fuel retailers. As of this post, PLX’s largest clients are McDonalds (MCD), 7-11, and Ikea.

The applications are built on a nebulous, Plexure Platform, which is a fancy way of saying that PLX integrates their country-specific or region-specific apps so that they can be more easily customized by for local menus, deals, product offerings, ect. Essentially, PLX offers enterprise UI apps and specializes in organizing retailer data in ways that allow for high-level customization. An example of the customization that PLX provides at improved ease is regional or location-specific coupons, customer-specific coupons, push notifications based on location, and so on. That’s the value-add of PLX’s business, as I understand it. It’s not impossible to replicate PLX’s Platform, but it seems to me it would cost more than what it cost PLX to do.

PLX makes money by charging recurring license and support fees (borrow PLX’s code and pay for on-going and timely help in customizing features of the code). In addition, PLX has frequently earned deployment and integration and consulting fees on a one-time basis. This revenue comes from each additional region that MCD or 7-11 or Ikea adds to the PLX platform. PLX is likely to collect integration and consulting fees at or above current levels for the foreseeable future. MCD has restaurants in 48 countries connected to PLX’s platform, with Japan and Italy being the largest markets. MCD’s UK, US, and developed EU restaurants will be the big prize going forward for PLX. PLX’s Ikea relationship appears to be developing faster than 7-11’s (mainly Australia, at present) but both are a fraction of the MCD relationship.

Financial History (as reported, unless otherwise noted):

Note that the present USD:NZD ratio is 1.48. I use NZD and $NZ interchangeably.

Valuation Process:

PLX is valued as a going-concern since it is now profitable and assumed to still be in the future. Since it is a going-concern, I will not consider book value to be a meaningful valuation technique. PLX’s prior financial results are not expected to be indicative of future results, thus a DCF was used to value the company. Below is my summary of PLX’s enterprise value, as of this post, and the basic DCF used.

The below working capital requirement calculator was used. Note that this is to estimate the short-term and long-term working capital needs.

In this post and going forward, values highlighted yellow are either estimates or noteworthy. In the above, yellow highlighting is used to point to the values within the sensitivity table that were explicitly used in the DCF (for ease of reference).

Other Events Affecting Valuation:

On April 2, 2019, MCD purchased a 9.9% stake in PLX at $NZ 0.39 per share, or an enterprise value (“EV”) of $NZ 41.9 million.

McDonald’s will buy 13.8 million shares of Plexure, a New Zealand-based company, for about $5 million, according to reports. McDonald’s last week said it would acquire Dynamic Yield, the Israeli digital startup, to improve the customer experience, particularly during the drive-thru.

Plexure already provides a global app for McDonald’s in 48 countries outside the U.S. and other markets, including Italy and Japan. The app provides discount vouchers and loyalty offers to McDonald’s customers.

The deal will give McDonald’s “enhanced access to Plexure’s technology in the quick service restaurant space, including access to greater back-end and front-end features, customer functionality and customer targeting, among others,” McDonald’s said in a statement.

“Across all of our markets, we’re using technology to elevate and transform the McDonald’s customer experience,” said Steve Easterbrook, McDonald’s president and CEO. “Our mobile apps play a key role in our digital acceleration, allowing customers to interact with us on their terms in a personal, customized way. This investment is a testament to our belief in Plexure’s ability to deliver strong results for our business as well as the talent and technology they’ve cultivated.”

At purchase, PLX’s EV summary looked like the below:

Valuation Conclusion:

I believe PLX is reasonably worth $NZ 0.90 per share today (approximately 73% upside), with an upper bound valuation of roughly $NZ 2.00 per share. The upper bound would only be feasible if PLX can continue to generate increasing levels of free cash flow (“FCF”) from the MCD relationship and others.

The value of $NZ 0.90/share does not directly consider the strategic or control value that MCD may place on PLX. I’m not sure how to value PLX’s IP but I can imagine MCD buying PLX for meaningfully more than $NZ 0.90/share. Whether that makes sense or not will probably depend on MCD’s deployment of PLX’s Platform in the US.