Thursday, 5 October 2017

More on Coty / P&G

After I published my last piece, a good friend of mine asked me if I thought Coty had overpaid for the P&G brands. I hold this friend in highest esteem as he is a sharp guy.

Here are some follow up comments:

Some rough estimates on the Coty / P&G transaction:
  • Per P&G's 2017 annual report, P&G reported receiving consideration of $11.4B (to be cross checked vs. Coty's 2017 annual report in their business combination note disclosure below)
  • Per P&G's 2015 annual report disclosure on discontinued operations, it appeared that the to be discontinued portfolio sales were $5.5B, but the ultimate revenue resulting from the P&G brands based on the most recently published Coty factsheet was closer to $4.4B. $11.4B / $4.4B = 2.6x sales.
  • Per P&G's 2014 annual report, the entire Beauty segment generated $2.6B net (after tax) on sales of $18.14B. This works out to a net margin of 14.2%.  
  • We can work backwards to figure out the net margin contribution from the 2015 Coty brands: Total NM of 14.2% = $2.18B/$12,608 + 403M/5.5B, puts the Coty brands at around 7% NM, or 1/2 that of the remaining brands. $403M / (1-.35) = $620M pretax
  • $11.4B / 620M  = 18.4x pretax. Not cheap.
  • Did they overpay? Maybe, maybe not. If they can't generate synergies, they paid 18.4x pretax earnings. In 2015, Coty had adjusted pretax earnings of $518M alone, say around $1.43 per share. At an average price of $17.80 per Coty share pre combination in 2015, their own pretax multiple was 12.4x, so it appears they paid a premium to their own multiple in the deal

2015 Coty  / Discops (per P&G)

2014 Coty  / Discops (per P&G)

2017 business combination note, per Coty

Based on Coty's annual report, let’s call the purchase multiple 18.5 x pretax (11.5b / 620M = 18.5x)

Coty is guiding for $750m in synergies. Now it’s, probably aggressive to attribute 100% synergies to just the P&G deal. The potential synergies are a function of company wide optimization, i.e. not just P&G brands, but the entire reshaping of all of the brands under the company umbrella.

Let’s say the deal doubled their size, and P&G pre-combination accounted for 50% of company size. Let’s say $750m is 50% attributable to P&G, so that’s $375m. Next, let’s say synergy realization is a coin flip. 50/50 chance it gets realized. Then realizable synergies are $750m x 50% x 50% = $187.50 (undiscounted)

Ok, so would it be reasonable then to assume that the deal was thus valued at 11.5b / (620 + 187.5) = 14.2x pretax earnings?

Again, it’s possible they overpaid if they can’t realize synergies and increase margins. If they are able to realize synergies and increase margins, then it doesn’t look like they overpaid. They bought a boatload of brands abandoned by P&G for 14.2x pretax, but this is still a premium to their own multiple however you slice the synergies.

Maybe these guys are fantastic brand managers and they will be able to re-market and re-position the brands that P&G gave up on. Maybe it’s a lost cause and the brands are actually crap. I think this uncertainty creates a situation where value "might" exist. Certainly, Coty is unloved, down +40% off its 2015/2016 highs, and a good deal of the +40% may be attributable to P&G shareholders receiving Coty shares as part of the deal and not wanting the shares. This is not a slam dunk by any means, but it’s not a bad idea.

The real research comes in the form of trying to figure out whether they bought a boatload of crap, &/or whether potential synergies are realizable.

Sunday, 1 October 2017

On the subject of who am I (or is it who I am)?, Tim McElvaine, and Coty

I've been noticeably silent over the last little while. My silence has been more a function of trying to say things of substance, rather than just anything at all (fluff).

Over the past few months, I believe I have changed in terms of perspective and approach. I have been avidly reading and studying The Heisenberg Report after discovering Heisenberg on Seeking Alpha, and The Macro Tourist (Kevin Muir), and I have also started studying the writings of David Rosenberg (when I can get my hands on them). When I say Dave's a genius, I mean he's a genius. I've added links to the The Heisenberg Report and to the Macro Tourist on my blog. These are trading blogs, but I dare say that they are important in terms of understanding context.

Basically, all of the above has been a sort of wake up call for me in the sense of developing an understanding of context, of who I am, and what my role is in in the investing universe. The first step has been in my developing a better understanding of what the investing universe is, and it ain't just stocks. It's everything. It's all capital flows, globally. It's FX pairs. It's credit spreads. It's bonds. It's relativity. It's convexity. It's equities. It's commodities. It's volatility (or lack thereof). And it's participant activity, positioning and correlations across everything and anything. And as a participant, I believe it's important to understand my place in all of this. I believe that over the long term, one cannot be successful as a participant in the investing universe without understanding one's place in the investing universe.

On the subject of how my approach has changed: I have come to the conclusion that my prevailing historical biases have gotten in the way of my having objectivity, and as such, I have outsourced the majority of my retirement savings to a professional in order to alleviate pressure on myself. I have maintained control of certain accounts:

1) A small interactive brokers play account
2) My shareowner accounts (automatic DRIPs)
3) My family's RESP account
4) A couple of small RRSP accounts.

I have devised an action plan for each of these accounts which I have been following systematically, and which I'm happy to share. For the RESP account and for the remaining RRSP accounts, I have set up a monthly allocation template in excel whereby I have set up target monthly allocations by asset classes, as so:

Each month, I review target actual allocations versus target and I incrementally add exposure in order to get up to target weightings. Over time, I would like to get to 65% / 70% equities 35% / 30% fixed income, and as can be seen from the above, when I started this model in May, my allocations were heavily weighted towards cash and fixed income and zero equities by virtue of holding strip bonds and undeployed excess cash. I believe that my expected annual growth is conservative.

The second piece to the RESP is an annual cash flow all the way out to the years during which my kids are going to attend university. I feel like I'm running a pension in this regard:

This annual cash flow incorporates contribution assumptions, expected ROR assumptions, and cash outflow assumptions. Currently, I've excel goal-seeked the level of cash outflows per year that would make plan assets equal zero by 2034. Suffice it to say, if university costs me in excess of $11,130 per year starting with kid #1, I'm up the creek, so maybe I should bump the contributions now in order to mitigate this risk...

Since May, I have been incrementally units of equities (risk) by way of adding certain mutual funds and exposure to a few individual stocks which I believe have the potential of generating alpha over time. I've spent a lot of time researching compelling active managers, and I came up with the following shortlist of funds to add to the portfolio:

  • Sionna Small Cap Equity Fund
  • IA Clarington Sarbit Activist Opportunity Fund
  • Fidelity Event Driven Opportunity Fund
  • Pender Value Fund
  • Chou Associates Fund
  • McElvaine Investment Trust

For individual equities, I own:

  • 100 shares of Gluskin Sheff
  • 200 shares of Hudson's Bay
  • 100 shares of Guardian Capital 

For fixed income, unfortunately, I was too heavily invested in legacy strip bonds at the time I started really analyzing this account in particular. These are short duration (maturing between Dec 2019 & Nov 2021), but the problem with strips is twofold: a) TD Direct is an absolute pig in terms of spread, so there's really no point in selling what I already own to free up liquidity here. It's not the worst case that I've parked $15K earning between 2 to 2.5% in a tax free account, but it's not the best case either. I look at this as cash equivalent. And b) strips require a minimum initial investment of $5K per, so I unfortunately have $15K committed to H&R Reit, April 2020, Manitoba Tel Dec 2019, and Loblaw Nov 2021. None of these issuers have concerning credit risk profiles, so I'm stuck until maturity. Had I had a better understanding when I first bought these, I would probably have allocated the $15K into a combination of equities vs. bond funds. Heck, I could have added H&R convertibles priced to yield 4% instead of buying the strips. Lower in the capital structure yes, but not likely to have gone un-redeemed come maturity in 2020! Oh well, live and learn.

For the remaining fixed income exposure, I have added:
  • Pimco Investment Grade Credit Fund
  • Pimco Monthly Income Fund
  • Pimco Global Advantaged Bond Fund

Finally, I have stumbled across another asset class altogether, which I believe retail investors (at large) either don't know about or care about because why venture into the realm of obscurity when you can simply buy SPY (or in Canada, a hedged version of SPY) and look like a genius?

The asset class is managed futures, and it's been just about the worst performer this year and over the last two years. It's performed even worse than good old $WTIC, which was in the toilet until just last month when it caught a bid (either due to belief in reflation, or belief in supply restrictions taking hold). Here's a chart comparing two proxies for managed futures exposure in Canada: the Arrow Capital Exemplar Diversified Portfolio Fund vs. Horizons Auspice Managed Futures Index (ETF: HMF):

Pretty abysmal returns and down +25% since January 2016. The last time the Auspice Managed Futures Index had positive returns was between spring 2014 and winter 2015, and then again between summer 2015 and spring 2016. Here's a study of those two periods versus the S&P500 and the S&P/TSX:

So certainly, something to be said about this asset class having the potential to exhibit negative correlation versus equities during periods of equity drawdowns.

The problem over almost the last two years (with the exception of spring 2016), is that there have been no equity drawdowns (and if there have, they have lasted all of 2 days and less than 2%), and as such, anything with a potential working negative correlation to equities has done poorly. I also believe that this asset class performs well the higher volatility is, and it's no surprise that volatility across all assets (not just equities) is at historic lows.

In any case, I have added $2,000 of Exemplar Diversified unit exposure to the account, representing just over 5% of total assets. I want to own exposure to asset classes that everyone hates and while everyone else hates them. Over time, managed futures has generated positive alpha, and we are now into year 2 of a deep drawdown in this asset class.

Onto individual stocks

I attended an investor conference this week run by Tim McElvaine, manager of The McElvaine Investment Trust, in which I hold units in a non registered account. Tim is a really interesting guy and I believe he's brilliant. If you have not heard of him, or had a chance to visit his site, I have added a link to it on the blog. Basically, Tim is a deep value investor in the mold of Ben Graham. He looks for stuff that everyone else hates. You can read about his approach here.

You won't find much in the way of positive write-ups on morningstar about the The McElvaine Investment Trust, and the fund isn't highly ranked. Over the last 10 years, it has a morningstar two star rating and has underperformed the S&P/TSX TR Index by -6.24%. Included in this year 10 year period were a couple of really bad years in 2007/2008 where the Trust suffered drawdowns along with everything else, but it didn't rebound in 2009/2010/2011 the way everything else did. Tim was apologetic at the conference regarding these years and was optimistic that he had learned some valuable takeaways from this period which he's not going to repeat.

If there's a real life case for evidence of active management underperforming pasive indexing over the last decade, The McElvaine Investment Trust is it. Now that we're closing in on the 10th year of this running passive bull, I wonder if it isn't time to give obscure active managers using unfashionable approaches a good look.

Tim also discussed a few of his current holdings, one of which is Coty Inc. Coty has fallen on hard times this year, the stock is down 11% this year versus +18% for the S&P, but more importantly, it's down +40% since the closing of their deal to acquire P&G's beauty brands for $12.5B in 2016.

The short elevator pitch is that the company is misunderstood and that there are technical reasons for the relentless selling of the company shares irregardless of fundamentals in lieu of the P&G deal, which saw P&G shareholders receive Coty shares which were unwanted. Tim hasn't been the only proponent of buying the shares. It's my understanding that Mike Burry also owns (or owned) shares based on a published 13F, albeit very outdated as the last 13F seems to be from Q3 2016.

In any case, there are some smart investors who have taken an interest in the stock, so I attempted my own valuation.

First a quick background, from the most recent investor factsheet, found here:

  • After buying P&G's beauty brand portfolio (for $12B) in 2016, the combined company now has approximately $9B in pro forma revenue, 3rd in global sales behind L'Oreal, and Estee Lauder
  • The investment thesis surrounding Coty is predicated on their being able to capitalize on synergies from the merger in order increase margins and cash flows
  • Management has heavy ownership in the combined company
  • Revenue distribution: 31% luxury beauty, 47% consumer beauty, and 22% professional beauty

Management has guided on synergies as follows:

  • Expected synergies of $750M cumulatively through 2020
  • +$500M working capital benefit through 2020
  • One time integration costs of $1.2B through 2018, 70% incurred through 2017
  • One time capx of $500M over four years, 50% realized through 2017

I've attempted to work all of the above into my cash flow model as follows:

Key assumptions:

  1. Revenue growth: based on most recent investor factsheet, I'm assuming pro forma 2018 revenues are approximately $9B. I have grown revenues at 2.225% commencing in 2019 dropping to 1.95% terminal growth in 2023. I believe 2% is reasonable given that cosmetics should grow at or slightly below GDP growth
  2. 2017 through 2020 operating cash flow adjusts for management's own published integration costs and synergies, $1.2B x 70% x (1-.36) integration costs in 2017, and $1.2B x 30% x (1-.36) integration costs in 2018, and synergies of $750M x (1-.36) spread across three years until 2020. From 2021 on, I've assumed operating cash flows grow at 2% p.a.
  3. FCF assumes level capx and no further acquisitions. While the factsheet outlines one time capx of $500M, I wanted to be conservative and model future capx using the actual average capx/revenue %ge since 2013, say 5.38% of revenue
  4. I have assumed that the relationships hold in OP CF / Revenue & Capx / Revenue in order to estimate prospective OP CF's and Capx.
  5. I have calculated a proxy for FCFF by adding back the interest tax shield in each year
  6. I have used increasing discount rates starting at 7% in 2018 through 9% in 2020. I've used a terminal discount rate of 9% - 2% to value cash flows in perpetuity beyond 2023

I know my discount rates are arbitrary, but I believe they are high enough to build a margin of safety into the model (especially in the terminal year)

Finally, my over/undervaluation matrix (my favourite part of this excercise) which gives me an idea as to what the market is currently pricing in terms of growth / discount rates:

At discount rates of between 7% and 9%, zero growth , my matrix suggests that the business is worth between $23.11 & $16.84, all higher than current. The business looks more interesting (and more undervalued) at higher rates of growth obviously.

The key here (I think), is in successful execution. They paid close to $12B for P&G's beauty business, and it's unclear whether they can grow this business as originally planned &/or achieve their synergy targets as originally planned, or boost operating margins as originally planned. 

It may be a function of working things through in the short term, or maybe not. But in the meantime, as doubt has cropped up surrounding these questions, the market seems to have punished the stock which is not atypical of wall street groupthink. 

I think this is where Tim sees value, not just in the potential undervaluation, but in the actions of everyone else selling doubt while chasing the accepted paradigm of “certainty” in flocking to must own “sure bets” like Facebook, Netflix, and Tesla. I believe his edge is in having the foresight and the patience to buy assets selling at less than their estimated intrinsic value, waiting for potentially temporary issues to get worked out, and for his ideas tend to mean revert.

Aspiring value investors can learn a lot from his approach.

Full disclosure, I own shares of Coty