Updated thoughts on Barnes & Noble (BKS)

Please see the below article for my updated thoughts on Barnes & Noble. Quick summary: business performed well in most-significant 3Q, valuation remains compelling at <5x EV/EBITDA, and spin-off of the College business in August provides a hard catalyst to unlock value. I still think the stock is worth $30+ (vs current px $23.3), with bear case assumptions suggesting a mid-$20s stock price. Hence, still quite favorable risk-reward on the long side.


Disclosure: long BKS


When it comes to oil prices, ‘nobody knows anything’

Back in mid-November, when oil prices had fallen ‘just’ 25% from ~$100/barrel to the still-palatable level of $83/barrel, Harold Hamm, the CEO of Continental Resources (one of the largest North American oil + natural gas companies, focused on North Dakotan shale plays), shocked the market by selling all his company’s oil hedges – effectively betting that the bottom for the oil market was in. “We feel like we’re at the bottom rung here on prices and we’ll see them recover pretty drastically, pretty quick,” he mentioned on a conference call with analysts. Thenceforth, Continental would be going ‘naked’: fully exposed to the whims of oil prices, up or down.

Oil currently trades at $43/barrel, so we know how that wager turned out (Continental stock is -30% since November). But the lesson here is not that Hamm made a bad bet that cost him; he has made plenty of bets in a colorful and varied career in the oil business, many more good ones than bad, and his personal wealth, while diminished, remains substantial (many billions). No, this anecdote interests me for different reasons. Firstly, it highlights how little even supposed ‘experts’ know about the forward outlook for commodity prices. Anyone who’s anyone in the oil business will tell you that Harold Hamm ‘knows oil’; his name is often mentioned in the same breath as the great speculator T. Boone Pickens, and among individuals he is perhaps most responsible for the ‘shale boom’ and America’s energy renaissance. Alas, the accumulated wisdom of five decades in the business and numerous boom-bust cycles provided no clarity into the depths of oil’s current plunge.

That leads to the second takeaway from Hamm’s mistakenly-timed wager. The oil business, by its nature, is run by rank speculators, many of whom seem almost spiritually wedded to the gospel of oil (and by extension rising or at least firm prices). Most oil ‘lifers’, indeed most all the whole industry (at least in the US), was massively caught off-guard by the sudden roiling of the markets after many years (post-2009) of robust prices even in the face of rapidly increasing production. The inability to recognize the coming crisis was partly economic (prices remained high for too long, in retrospect) and partly philosophical. The US shale revolution had been doubted by so many for so long that the early pioneers in the field (men like Hamm and Aubrey McClendon, founder of Chesapeake Energy) developed a fierce survivalism that no doubt helped sustain the notion of a ‘shale revolution’ when it was in its infancy but clearly clouded their judgement when the market environment changed. To be so completely blindsided by a move in the markets – and indeed to fight wilfully against clear signals from the dominant market player, OPEC – suggests to me, at least, a mostly emotional attachment to the US shale revolution (a cursory examination of Hamm’s rhetoric over the years confirms this conclusion).

The inability to forecast prices with degree of confidence is why I have always viewed commodity trading (and by extension investing in commodity-linked companies like oil stocks) as much more akin to gambling than value investing. If the cognoscenti like Harold Hamm have no clue, how can I, or anyone else, hope to have an edge in this game? Frankly this doesn’t even amount to speculation – where you accept the risk of losses in the belief that you are wagering from a positive expected value position – in my book. And hence, to apply William Goldman’s famous quote about the vagaries of the movie business, when it comes to oil, ‘nobody knows anything.

This is why, when people ask me what I am doing in oil, the answer is, “not much.” I have tried to short a few busted, third/fourth quartile E&P names with huge leverage (as a bet on restructuring and equity going to zero), with some small success (I am short Afren, for example; see here: http://seekingalpha.com/article/2975446-afren-plc-112mm-of-equity-value-about-to-be-wiped-out). I have also tried to short some of the offshore drillers – RIG, DO, HERO, VTG, etc – since industry capex cuts will obliterate both earnings and fleet values, but the timing and volatility of the underlying stocks makes it a tough racket (having been ‘chopped up’ on a few small shorts I have mostly moved on at this point).

Instead, the main way I have been playing lower oil is through a long position in the US airlines stocks, particularly American Airlines (AAL), which does NOT hedge fuel costs (~35% of opex) and so is a direct beneficiary of falling crude. However, this is more a bet on the airline industry, where consolidation and capacity discipline have created an extremely favorable operating environment, and where – in AAL’s case – the integration of US Airways provides a long runway for de-costing the combined business. In other words, a low oil price is the cherry on top (admittedly, a potentially huge cherry), but not the main investment thesis. AAL stock still looks a value, to me, despite the massive move last year, at ~4.5x FY15E EV/EBITDA. If oil rips back, AAL will trade lower near-term but at current valuations I am still fairly comfortable the stock will outperform medium-term.

My advice for any would-be bottom-fishers in the oil space would be to follow a similar route: look for ancillary beneficiaries of lower US oil prices (US retail? autos? refiners?). Or, if you really want to speculate on a rebound in crude, stick with the low-leverage, more-diversified tier one names (APC, EOG, CVX, etc), and dabble in small size. Leave the speculation to the speculators, and let men like Hamm handle the margin calls 😉

Disclosure: long AAL, short AFR (listed in London on the LSE)

Guilty or not, Lumber Liquidators just can’t win

The latest ‘battleground’ stock de jour is Lumber Liquidators (NYSE: LL), a hardwood flooring retailer based in Virginia. Shorts had historically targeted the company for its seemingly too-good-to-be-true margin profile (much higher than competitors), large inventory build, and questionable supply sources in China; nevertheless the company belied the skeptics, for a time, rising from $20 to $120 between 2011-13 on the back of heady growth numbers and the promise of more. Alas, the wheels started to come off mid last year when growth slowed dramatically, remarking the stock from $80 to $55 in a day. But recent events have been more interesting still: in late Feb, LL reported weak 4Q numbers and guided down, but also warned the company would be the subject of a negative 60 Minutes investigative report in the coming weeks. The stock promptly cratered again, breaching $50 and headed lower before the 60 Minutes report.

About a week later, the report aired, and – for the shorts, at least – it did not disappoint (you can see the entire thing on Youtube here: https://www.youtube.com/watch?v=vUadsOJT24c). In a beyond-scathing attack, the program claimed LL floorboards contained up to 7x the California legal limit for formaldehyde, that Chinese workers falsified laminate flooring composition labels, and that – by extension – thousands of families’ health was at risk. A renowned short-seller, Whitney Tilson, claimed to add to his bet against the company; even senators called for a full investigation of the quality of LL’s floorboards. Of course the company was quick to cry foul, and has published rebuttal presentations and held conference calls. Meanwhile, the stock has tumbled to $35 – ostensibly attractive at just 6x EV/EBITDA.

This scenario piqued my interest for a few reasons, but mostly because in evaluating investments, I try to identify ‘heads I win, tails you lose’ type scenarios: that is, I am trying to find a trade where if I’m right, I do well; but even if I’m a fair bit wrong, I still come out OK. To me, LL may well fit the bill in this regard. Let me explain.

In my mind, there are basically just two outcomes to this story. Either LL’s floorboard really are massively above the legal limits for formaldehyde, or they are not. In each scenario, we can readily speculate what the stock may be worth. Let’s take the ‘guilty’ side first; it is relatively straightforward. Assuming 60 Minutes’ claims are for the most part true, LL would likely have to to replace, gratis, all the relevant floorboard, and would also be exposed to a massive legal liability. It is difficult to speculate on the exact liability but as of Dec 31, 2014, the company has just $20mm cash and a $50mm line of credit (ie, $70mm of total liquidity). Even if we assume just 100,000 affected homes and a class action settlement of $700 each, and assume zero reinstallment costs – these numbers are laughably small, as LL has historically had millions of customers and serves 600,000 per year – this would be enough to exhaust the company’s liquidity. Suffice to say, in the ‘guilty’ scenario, LL stock is likely a zero.

But what happens if LL is found to be in the clear? To my mind, the outcomes for LL would still be dire, since consumer-facing ‘high cost of failure’ businesses cannot afford to have their reputations destroyed – especially when it comes to safety. Consider the example of Malaysian Airlines: after the two horrific accidents last year, the company has seen traffic evaporate to the extent that the airline is being restructured by the Malaysian government. You could actually make a case that flying Malaysia now is likely much safer than any other airline – given the heightened focus on safety, etc – and yet they can’t sell tickets even at fractions of the cost charged by competitors. I understand consumers’ risk aversion – I wouldn’t fly Malaysian either, as it is simply not worth the risk.

While less extreme, I suppose, flooring a home is not a trivial expense, and there are some safety concerns for families.  As such, most families will do some research into the company providing the flooring; at this point, even a cursory internet search will turn up the devastating accusations facing LL. As such, I find it hard to fathom how LL maintains much of its current business profile. At the very least they will have to cut prices dramatically (destroying margins) and it’s likely they will also have to spend a lot of money to source much higher-quality floorboards (again, killing their margins). And this presupposes consumers don’t abandon the brand entirely (a possibility).

This brings us back to the stock and the forward for the company’s earnings. The stock trades at $35, and earned $2.31 per share last year; this equates to a 15x multiple. I would be shocked if the company sniffs $2 a share this year, given likely huge sales and margin pressure. But even if earnings fall just 20% to $1.9 per share and we put a more discounted multiple of say 10-12x on the stock – given the huge business risk, this is not really a small multiple, if you look at where other similarly-challenged businesses trade – that implies a $19-$22.8 share price, or about 40% downside from where we are today ($34).

Hence, ‘heads I win, tails you lose.’ There are risks here, of course (the stock is extremely heavily shorted, and the company will try to spin the story their way, which could, potentially, affect sentiment). But to me it seems very much that the risks remain skewed to the downside in this name.

Disclosure: short LL

What’s in the Box? Nothing good, apparently

It’s pretty interesting to follow the first earnings release/conference call for a newly-listed public company: oftentimes you see the first published numbers for a new listing well and truly ‘scrubbed up’ so as to paint the best picture possible to the analyst community. Frankly, Wall Street is as much about marketing and telling a story as any other industry so it’s hard to blame executives for trying to start out on the right foot.

Which is why it’s fairly meaningful when high-flying IPOs really bomb their first earnings report – as Box (NYSE: BOX) did today. The cloud storage/SaaS name IPO’ed to much fanfare in January, selling ~12.5mm shares @ $14 each; the stock promptly roofed it to $24, and before the recent earnings report was selling at $20.5 – a cool 10x sales (forget earnings, operating margins are negative 63%).

But this report really jumped off the page – for all the wrong reasons. Thing is, it’s not as if the bar was particularly high: for 4Q, analysts were expecting net losses of ~$2.25 a share (GAAP) – yes, that’s right, losing $2.25 per share on a $20 stock, in one quarter – but Box managed to lose $2.64 a share. More worrying was the decline in billings (a non-GAAP measure that is a forward looking indicator for out-year sales) growth rate, from 46% in the first 9months of FY14 to just 33% in 4Q (and well below sales growth rate of 61% in the quarter).

This is important because when you are losing money at the prodigious pace Box is managing, you really need to see accelerating revenue and billings growth to justify the increased opex spend. In fact one of my main gripes with Box- and indeed, many other JOBS Act IPOs – is that they haven’t really proven themselves as viable businesses and so have no reason to go public.

Thinking about it more broadly – how do you ‘know’ if you have a viable business or not? Well clearly, viable businesses generate profits and cash flow. But if you can’t make money today, as long as you can see a feasible path to profitability, you may still have something to work towards. What you really want to see is economies of scale and operating leverage: the more of X you sell, the cheaper it costs to produce X, and hence margins expand (often starting negative, then going very positive over time as fixed costs don’t grow with revenues). This is how you justify negative operating margins when a business is small, hoping to grow the business to a point where you can enjoy the benefits of operating leverage.

Now let’s go back to Box. I am not an expert on cloud storage, nor the ‘software-as-a-service’ industry. What I can say, though, is that Box’s business, even as it has grown, is not demonstrating the kind of scalability you need to think it could be sustainably profitable. Revenue in the most recent year was $216mm – this is no longer ‘de minimis’ – and grew 75%, but opex grew 30% too. Operating margins at -77% in FY14 may look like a massive improvement from -128% in FY13, but really this business is not scaling anywhere near fast enough given the valuation. Consider that even if Box grows revenues at ~40% next year and costs grow just 10% – beyond unrealistic – the company will still be running ~-25% operating margins.

Actually analysts are more bearish than this, and project even -20% negative operating margins out to FY18, but you get the point: it is still very unclear if Box has a viable business at all. Any business that is so hyper-competitive that you have to spend 96% of your revenues on sales and marketing (as Box did in FY14), can’t really be called a ‘business‘; ‘money pit’, ‘forest fire’, or ‘black hole’ may be more apt descriptions.

And we are not talking about small dollar amounts, either. Box – post IPO – has ~$306mm in cash as of Jan’15; according to analysts they will lose ~$148mm in EBIT next year (of which some is stock comp so lets say ~$120mm cash burn). The company has shown themselves to be acquisitive too, and assuming that continues, Box has maybe ~1.5-2yrs worth of cash (again if we take the street’s pretty rosy consensus estimates at face value). As such, current shareholders are likely to get diluted – probably more than once – in the next couple of years.

In the meantime, Box shareholders also need to contend with the ugly reality that just 12.5mm (9%) out of ~144mm shares outstanding are currently in the float, and that a ton of locked up stock, most of it with strike prices $0-$6, will hit the market in the next 6months. Most insiders were happy to sell down at $14, with the business looking better 3 months ago…methinks they’ll pull the parachute hard anywhere north of $10 now. The stock is trading at $17 in the after-market – still a crazy ~9x sales – but likely not for long…

Disclosure: no position in BOX

How to destroy shareholder value – Brother Industries edition

What is the number one destroyer of corporate value?

Most people would say not knowing your customer, missing a secular change in the environment, or something like that. The real answer: bad acquisitions. A poorly-conceived large acquisition is the easiest way for empire-building executives to blow mountains of shareholder capital in a heartbeat. Combining two companies is extremely complex, and paying the wrong price for the wrong asset can take many years to recover from (or ruin the acquiror for good – cf Sprint/Nextel).

And when it comes to stupid acquisitions, Japanese companies have a pretty incredible track record for idiotic purchases at insane prices (cf Panasonic/Sanyo is the best example). Especially Japanese companies acquiring foreign companies, as often there is a cultural clash where the acquired foreign company ends up haemorraging key personnel who cannot jive with a Japanese management style.

Today’s announcement by Brother Industries (6448) to acquire a British label printing firm, Domino, is pretty interesting in this regard. Brother is paying ~1bn GBP, or around 40% of its own market value (and double it’s net cash position), to acquire Domino. This equates to ~16x EV/EBITDA – TRIPLE the multiple where Brother’s own stock trades, and close to 30x cash flow (again, Brother stock trades at ~15x cash flow).

Purely on the above, this should raise eyebrows. But it gets worse: Domino is not a growth business – in fact net income has been stagnant around ~40mm GBP the last 4yrs, and only ~10% growth is expected next year. Since the purchase price is ~5x Domino’s book value, Brother is trading 200bn JPY in cash for ~160bn JPY in goodwill and 40bn JPY in assets – a trade that effectively ruins Brother’s otherwise strong balance sheet and leaves it incapable of acquiring something else that may fit better down the line.

While management may claim there will be ‘operational synergies’, I actually think they will be quite limited given this acquisition is trying to get Brother to move away from home printers and into Domino’s business of labels and packaging. In any case, no amount of synergies will help ameliorate the 160bn JPY goodwill balance.

Who knows, maybe this acquisition will work out, but at this level the odds are strongly, strongly against it. Frankly, Brother management would have been far better off levering up to buy back ~40% of its own stock in the market – a business they presumably know much better, since they run it – and one that trades at a fraction of what they paid to acquire. But that of course would require shrinking rather than growing their empire…

Disclosure: no positions in Brother or Domino

Welcome to Raper Capital!

Hi all – welcome to Raper Capital and thank you for reading. My name is Jeremy Raper (hence the unfortunately-titled name of this blog), and I run a small long/short equity portfolio from Singapore. I grew up in Australia, went to college in the US, and have since lived in Japan as well, working both at buy-side and sell-side firms for 6-7 years before striking out on my own over the past year or so.

Since starting to actively manage my own money full-time, I have also developed an interest in financial writing and sharing my thoughts on companies on the internet – both to force me to cogently and coherently outline my investment views as well as to solicit feedback from other investors. So, for more formal investment theses/company analysis, please follow me on Seeking Alpha at the following link: http://seekingalpha.com/author/jeremy-raper

The purpose of this blog is slightly different: I am starting it at the urging of some friend and former colleagues, who I guess are interested in reading my views on a wide miscellanea of finance-related topics. As such, posts will be sporadic and potentially rambling, but hopefully of some interest to those who follow financial markets.

Feedback – positive or negative, just not personal – is always welcome, so feel free to comment away and suggest this to interested friends 🙂

Thanks for reading!