On November 12, 2108 Robotti & Company Advisors, LLC hosted its annual investor meeting at the Yale Club in New York City. The highlights below, delivered by MOI Global instructor Bob Robotti, have been edited for clarity.
October was an interesting month and I believe that it presented an opportunity for all of us today. We owned cheap stocks before that and I would say today that they are significantly cheaper. We will talk a little bit about that tonight and try to convey our current thoughts to you. What I will also point out is that today, as always, we are investing alongside you. And that’s a key concept of our investment process – our capital is invested alongside yours.
This is the perfect place to start out since it is November… October stunk! A majority of the companies we are invested in are cyclical. The reason we invest in cyclical businesses is that we attempt to invest in periods of weakness which provides us with a number of advantages. One is that well-run companies going through a cyclical period of difficulty often find themselves in a position to improve their competitive situation – improving the earnings power of the business. Another advantage is that when cyclical businesses go through difficult times their valuations frequently become heavily discounted, so the price that we can pay for the business is significantly discounted to what the normalized earnings power of the business is.
Opportunities in the North American Housing Industry
We think there continues to be a large opportunity in the homebuilding business. Our favorable view on housing originally began in 2009, post the financial crisis, when we invested in a number of companies in the industry. Initially, our thesis was that we were buying businesses at very discounted levels compared to their recurring capabilities. We believed that the homebuilding business wasn’t going away and there would be eventually be a recovery in the industry.
Today, I would say things are somewhat different. We are now in the midst of a significant recovery. When we first invested, we thought our companies would make a lot of money and today that has actually played out in the economics of the businesses which have improved dramatically. Today we think that valuations based on current earnings are as interesting as the business prospects. So now, valuations are modest based on current earnings and the businesses are still growing and improving.
Linear Bias in a Non-Linear World
Investing in cyclical businesses can be an excellent opportunity because when a recovery begins its progression is almost never a straight-line direction. Inevitably the process is two steps forward, three steps forward, one step back, and one and a half steps back. Additional opportunities emerge when the recovery hits an inevitable rough-patch and short-term investors quickly conclude “it’s all over.” So for businesses that you invested in, you often have an opportunity to leverage your understanding about the company and its opportunities to reinvest again as the situation gets repriced.
There are a lot of data points out there on the homebuilding business. And you need to look at all of them because all of them are relevant. At various times, however, the market will hyper-focus in on certain data points and will either get overly excited or, more recently, run for the door. The situation has been exacerbated as more capital flows into ETFs and quantitative investing. These are accelerants to the euphoria or the dismal view that often characterize cyclical businesses and their valuations.
Multiple Opportunities in the Cycle
Investing in cyclical businesses provides a number of other opportunities. In the downturn companies can improve their competitive positions. Scale became important and in, in this case, is an actual differentiator. So, opportunities arise throughout recoveries for Builders FirstSource – this is what happened.
Opportunities can often come in the form of consolidation. Builders FirstSource was a company that had a $650 million market cap and was able to acquire the largest competitor in its business. This consolidation process provided Builders FirstSource with a cost savings of roughly $100 million. For a $650 million market cap company to have the opportunity to make an acquisition that improves its combined earnings by $100 million on an annualized basis – that is very significant.
The other thing that happens in today’s world of low interest rates is that there’s clearly an appetite for yield. We think the one riskiest markets out there today is the fixed income market and the high yield market in particular. Yet, if you are an equity investor like Builders FirstSource, this created an opportunity because they were able to finance the acquisition almost solely with high yield debt. Now the interest rate was still reasonably high, it wasn’t so cheap but more importantly the covenants are extremely light. So therefore, the debt is relatively benign. With relatively limited equity dilution, Builders FirstSource was able to significantly improve the earnings power of the business. The integration has gone well. They have also paid down debt since they generate a lot of free cash and the debt level has gone from roughly 7.8 times debt-to- EBITDA down to maybe 3.5 times at the end of the year.
Today, our investments in the homebuilding industry are really are predicated upon the Three D’s:
(1) Discounted valuations,
(2) De-risked situations, and
(3) Downside protection.
Discounted valuation – Today Builders FirstSource trades at probably seven times trailing, seven times forward earnings. More importantly, the company has indicated its mid-cycle earnings power is between $3.00 and $3.50 a share. Based on our research, we think that mid-cycle earnings will be closer to $4.00 to $4.50 a share. Today the stock is around $11. It was $22 at the beginning of the year. So the market has clearly fallen out of love with it and rushed to the door.
It is a de-risked situation. Today the balance sheet continues to improve, and free cash flow generation is significant. The financial stability of the company is a very important safety factor.
Lastly, we believe there is Downside protection. Homebuilding has recovered from 450,000 single-family homes annually. The 50-year normalized average number of single-family homes built in America is 1.1 million. Contrast that with the number of households in America which have increased from 60 million households to 120 million households over the same period. We are still 30% – 40% below what has historically been a mid-cycle level, so the downside, we think, is relatively modest. Even if there is a pull back, business risk is moderated given the level of activity today.
Differentiated Businesses in Cyclical Industries
The recent headwinds that everybody has identified in the homebuilding business are labor shortages and low availability of homes. Builders FirstSource offers component manufacturing processes that address these issues by reducing cycle time, reducing labor costs and reducing labor experience requirements. Therefore, we think that Builders FirstSource has solutions that will help address both the labor and affordability issues. In the meantime, the component manufacturing segment is a much better margin business. So Builders FirstSource has improved margin potential, high returns on capital and solutions to help the industry solve some of the problems.
The Energy Industry Hits Reset
We view the opportunities in front of us in energy as very significant and clear. If we look back to 2013-2014, large capital projects in the energy business were not economic. Costs had increased significantly, and many projects were uneconomic by the time they were completed. There were issues with delays and cost overruns among other things. As a result, the industry started to pull back on capital spending in the beginning of 2014.
Then at the end of 2014 oil prices went into free fall. Since then, of course, oil prices have improved and gone from lows of $20 back up to $80, before trailing back at $70. What’s important is not only prices of the commodity, it’s also the cost structure of the business.
Costs had expanded dramatically which narrowed the funnel of projects that could make it out of discoveries and get developed while being economic. That funnel became so tight that in 2014 the industry started to retract. Today that funnel has gotten extremely wide because the cost structure has dramatically changed. Some of this is temporary, some of this semi-temporary and some of this is permanent. So what you really have is an inventory of 5, 10 or 15 years of discoveries that had been blocked because of cost inflation and now suddenly look very economic.
Today, there are many projects that are economic at $40 oil. There are projects offshore that are economic even at $30 oil. So, the project inventory of economic opportunities is significant. What you also need is someone with the capability and the willingness to spend the money. The Majors are in a very different situation today versus 2013 – filling their coffers, looking at improved cash flows going forward but also watching production profiles decline. Now that all of these pieces have come together, we are starting to see increasing opportunities.
Subsea 7 is an investment that we have held for a long time. We know its management very well. They have constant dialogue with the majors in terms of multibillion-dollar projects. The inventory of projects is rising and now progressing from tie-ins and brownfield activity. We think that in the next year a significant flood of new opportunities will come forward. So that’s the backdrop for why we think the opportunity set in energy is strong.
Consolidation – A Cyclical Opportunity
In energy, we have two different types of investments. Subsea 7, which is a great business that was opportunistic in the downturn and is recovering, represents one type. Tidewater is different. It went into the downturn with a balance sheet that was poorly structured. As a result, the company went through a major restructuring last year that wiped out all the debt.
Today the company has $450 million of cash and $450 million of debt – zero net-debt. Everybody else in the industry is over-levered. Tidewater is now managing the process of combining with another company, Gulfmark, which went through a similar restructuring process. The merger is expected to go through on Thursday. Dan and I have met with the CEO and one of the board members of Gulfmark and talked about the deal its attributes.
The combination will create the largest company in the business. The company will also be left with a clean balance sheet at a time when every other competitor is extremely levered. With zero debt to service, Tidewater will have a tremendous advantage as its competitors struggle with debt burdens. We think this should force more assets to become available and that will enable Tidewater / Gulfmark to opportunistically acquire cheap assets.
Although this is a cyclical business, at some point, new equipment needs to be put into the field. You know that no one’s going to build a new piece of equipment until it makes economic sense to do that. Day rates have gone from $6,000 a day to $12,000 a day. To build new vessel you need something like $32,000 a day. Profitability is dramatic from here.
There’s also some concern over the 200 vessels that have been completed that are still sitting in the shipyard. We estimate that half of these vessels will never come out of the yards in China. We think that a fraction of the other half will end up coming out of the shipyard and will likely be purchased by an opportunistic buyer who will only be able to use them for a limited number of mandates from a narrow customer base. Most likely, these boats will not be competitive in many of the world’s markets.
You already see the path to realization of the opportunity for significantly higher earnings. Today Tidewater has an enterprise value of roughly $1 billion. The replacement cost its vessels is closer to $3 billion. We think the earnings power potential of the business is dramatic, it’s in the process of recovering and even if we are wrong its balance sheet will allow them to be a survivor while competitors continue to disappear. So, the question isn’t whether we win, the question is whether the outcome is now or a little bit later. We think it’s more likely now than later.
Plenty of Values Elsewhere, Too
Of course, I talk about housing and I talk about energy, but more than 50% of the separate account portfolio is not in housing or in energy. There are securities from many industries that are really important and somehow I get focused on certain topics and I go on my rants.
So, the portfolio is a lot more. Finning and Toromont are two Canadian Caterpillar dealers that we think are very compelling. RadNet is a medical service company that is in a good position. Westlake Chemical is a large chemical company that has a 70% shareholder family (who have proven to be great capital allocators) and a very discounted valuation. Western Digital is leading manufacturer of data storage solutions with strong free cash flows and a mid- to low-single digit PE multiple.
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The transcript of the Robotti & Company, Incorporated Annual Meeting held on November 12, 2018 should be read in conjunction with the following disclosures: The information, data and opinions contained in the transcript referenced above (“Transcript”) are for illustration and discussion purposes only and are not intended to be a recommendation, or an offer to sell, or a solicitation of any offer to open or buy, as applicable, a separate account or an investment in a private fund managed by Robotti & Company Advisors, LLC (“Robotti Advisors”). Any such offer or solicitation will be made only by means of delivery of a presentation, offering memorandum, account agreement, or other document or agreement relating to such investment and only to suitable investors in those jurisdictions where permitted by law. Furthermore, the Transcript should not be construed or used as investment, tax, ERISA or legal advice. The Transcript is provided “as is” and is provided without any warranty of any kind, either express or implied. Robotti Advisors does not warrant the accuracy of the information, data and opinions provided therein and expressly disclaims any warranties of merchantability or fitness for a particular purpose. Robotti Advisors will not be liable for any direct, special, indirect or consequential damages, even if expressly advised of the possibility of such damages, arising out of or in connection with the use of the transcript. The Transcript should not be relied upon in substitution of personalized investment advice. The Transcript is furnished as of the date shown and the views of the participants therein are subject to change and to updating without notice. No representation is made with respect to the Transcript’s accuracy, completeness or timeliness and it may not be relied upon for the purposes of entering into any transaction. The Transcript is not intended to be a complete performance presentation or analysis of any security, transaction or outcome discussed therein. None of Robotti Advisors, as investment adviser to the accounts or private funds, or any affiliate, manager, member, officer, employee or agent or representative thereof makes any representation or warranty with respect to the information, data or opinions provided therein. References to past holdings of a separately managed account or private fund and matters of related historic fact must be seen in context (as would have been apparent to investors in such account or fund) and are not intended to refer directly or indirectly to specific past recommendations of Robotti Advisors. Any reference to a past specific holding or outcome is not intended as representative. Certain statements in the Transcript, including but not limited to (a) statements of things that “are well known” to be the case (other examples include: “In hindsight people often say, “I should have known better,” and “more often than not, they did”), (b) statements with the phrase “always”, and (c) certain similar statements, are not intended to represent absolute literal fact, but rather represent certain colloquialisms/mannerisms expressed by select market participants. Investment results are subject to risks that include, among others, adverse or unanticipated market developments, issuer default, general and specific economic conditions, management execution risks, exchange rates and illiquidity. Past performance is not indicative of future results. The investment advisory services and specific recommendations Robotti Advisors provides to separately managed accounts and private fund clients and their results may differ materially. This disparity is due to various reasons including, differing investment objectives, investment amounts, investment timelines and strategies among clients. The Transcript is confidential and proprietary and is, and will remain at all times, the property of Robotti Advisors, as investment adviser, and/or its affiliates. The Transcript is being provided for informational purposes only. A copy of Robotti Advisors’ Form ADV, Part 2 is available upon request. Additional information about Robotti Advisors is also available on the SEC’s website at www.adviserinfo.sec.gov.