Saturday, January 24, 2009

A quick look at Middleby Corp.

The Middleby Corporation (MIDD) is a leading manufacturer of commercial kitchen and food processing equipment that competes with divisions of Illinois Tool Works (ITW), Manitowoc (MTW) and United Tech (UTX). Founded in a merger of two companies in 1985, Middleby has grown by acquiring competitors and complementary brands and, through superior management, improving operational efficiency and sales. The current CEO Selim Bassoul owns 5% of outstanding shares and is well respected as a manager. He has led Middleby from obscurity to a darling stock of Fools (the Motley sort) and small cap investors everywhere. Middleby has had quite a run, with revenue growth averaging 18% annually over the last 9 years, with net margins improving from 1.6% in 2001 to 9.6% as of 9/27/08.

Middleby made 8 acquisitions from 2005-2007 and another 6 in 2008, including the crown jewel of TurboChef. Middleby bought TurboChef in the 4th quarter, 2008 in a combined cash/stock deal. Therein lies the rub against Middleby; To come up with the cash portion of the deal, they’ve increased their debt to approx. $257M on a $497.5M line of credit. According to the most recent 10-Q, they are charged the higher of LIBOR + 1.25% or Prime + the Fed Funds rate, which is currently 3.35%. While this is certainly cheap, many feel it is poorly timed given the economic uncertainty and Middleby’s industry, which is highly competitive and sensitive to economic conditions.

However, the annual interest on the $257M debt is only $8.5M, which is covered 8.5 times by Middleby’s $72.5M free cash flow (FCF) for the trailing twelve months (ttm). Cap Ex is light at $5M, meaning Middleby doesn’t require lots of capital to continue operating. On the downside, Middleby’s balance sheet isn’t worth much. With debt to cap at 68%, limited liquidity and the majority of assets comprised of goodwill from their numerous acquisitions, Middleby has a negative tangible net worth. So what you’re buying is really the strength of their brands and their ability to grow earnings. Mr. Bassoul’s track record on this front is very, very good. Also, Middleby has historically utilized debt in their acquisitions and has paid down this debt quickly from free cash flow.

From a valuation perspective, Middleby is trading at 5.2x FCF (ttm), for a free cash flow yield of 19%. Assuming a normal valuation of 9x-10x FCF, which is reasonable for a growth stock, the market is pricing in a 42%-47% drop in FCF from last year. While anything is possible in the current economic climate, it appears that the bad news is priced into the stock. Even if free cash flow is cut in half to $36M, Cap Ex plus the interest payments on their debt adds up to only $13.5M, leading me to believe that Middleby will survive all but a catastrophic meltdown in business spending. The current price of $22 per share presents an attractive entry point for a long term investor, although considering the present market volatility, the price could reasonably fall another 10%-20% in the short term. Those interested in owning Middleby would be wise to establish a position and buy more as the opportunity presented itself. As always, do your own due diligence.

Disclosures: I have no position in any stock mentioned in this article.

Monday, December 15, 2008

A Long Term Opportunity

Just before the Dec. 17th OPEC meeting, oil sits at $50 a barrel. While the price of oil has fallen 66% from it's summer high of $150 a barrel, those who believe the T. Boone Pickens of the world see opportunity in energy at today's prices. There are few reasons to believe that there are many significant oil discoveries left and that the shift to alternative energy sources will not be quick enough or substantial enough to meet demand. As emerging superpowers like India and China grow, they will use a larger piece of the Earth's energy. Those who control it will prosper; those who do not will suffer.

So what can be done as an investor? Buying an index of oil exploration, production and servicing companies in an Exchange Traded Fund (ETF) like the Rydex Equal Weight Energy Fund (RYE) is a good place to start. RYE holds an fairly equal weight in 40 companies that would benefit from higher oil prices. Or the more research driven investor could research and buy individual companies, like Petrobras (PBR) or CNOOC (CEO). These giants are the state oil companies of Brazil and China and control substantial reserves. Do your own research and weigh the risks carefully. Though investing in energy and it's future scarcity is likely to be a safe bet.

Tuesday, September 30, 2008

An Instant 10% Return on Investment

I was attracted to ING Direct because a co-worker talked it up to me. They had a good rate on their savings and were offering a $25 bonus for opening an account. My main concern was security, but after reviewing the security features I was satisfied that my information would be as safe as possible. My wife and I opened a joint account and over the last year have proceeded to open 2 more, we’ve liked it so much. ING allows us to get a competitive rate on money we don’t want to lock up in CDs, facilitates saving regularly for specific things like an emergency fund or down payment on a house, and makes everything very easy to use. Some of the features that make ING Direct so good are:

• Good rates on liquid savings that adjust with the federal funds rate. (Currently 3% APY)
• No minimum balance required, no fees or service charges
• It’s linked to our checking account and can link to 2 additional accounts for ease of use
• Deposits are credited in two days
• Automatic transfers are available to make it easy to save
• It downloads easily to Quicken and Microsoft Money
• You can open it online without paperwork

Plus, if you are referred and open an account with a $250 deposit, you receive a $25 bonus. An instant 10% return! I will happily refer you. Just send me an email at The ING Direct Orange Savings account is a great tool that makes saving money easier. Anything that can do that deserves a closer look.

Friday, September 19, 2008

The Real Reason Behind the Global Financial Crisis

This article is an excellent explanation of Credit Default Swaps (CDS) and the role they have played in our current financial crisis.

Monday, September 15, 2008

Quote of the Day

“It’s only when the tide goes out that you learn who’s been swimming naked.” Warren Buffett

Considering the fall of Lehman Brothers and Bear Sterns, and the hustle of other Wall Street brokers, banks and AIG to ‘clothe’ themselves with capital to hide their nakedness, the above quote proves itself insightful and timely. The lack of underwriting discipline on the part of a relative few has impacted the lives of millions of people. It is difficult to make a case for not increasing regulation of the entities that will survive the credit contraction. Their inability or unwillingness to accurately weigh the risk of the investments they made calls for increased capital requirements for investment banks and brokers. If they aren’t able to comprehend or care about risk, they should be limited in the damage they can inflict on themselves and others. Milton Friedman would be very disappointed.

Monday, September 8, 2008

Analysis of Hurco

Hurco (HURC) is a leading manufacturer of computerized machine tools used in metal cutting in a variety of industries that include aerospace, defense, medical equipment, energy, electronics and automotive. They incorporate a proprietary computer control system for use on a PC system that improves the quality of cutting and ease of use. In addition to producing the machinery and control systems, Hurco also provides software upgrades, parts, service and support to customers. Hurco manufactures their cutting machines in Taiwan, and sells their products in Europe, Asia and North America via direct sales and through independent distributors.

Hurco’s competitive advantage appears to be the computer controlled cutting system they have developed. In machine cutting the setup and accuracy of the process greatly affects efficiency and cost. If Hurco is able to decrease setup time and reduce errors via their proprietary software, it would give them an advantage over their competitors such as Hardinge (HDNG) that don’t have the sophistication of the Hurco product. This is reflected in their return on capital of 24.15%, net margins of 11.1% and 5-year sales growth of 22.7%, all of which are higher than any of their peers. In addition, they have $4.50 per share in cash and no long-term debt.

Hurco is not without it’s challenges. According to the most recent 10-Q, approximately 89% of global demand for machine tools comes from outside the United States, and as a result, Hurco’s sales are heavily concentrated in foreign markets, with 73.6% of sales coming from Europe, compared to 20.8% from the United States and 5.6% from Asia. Because of this, the company earnings are sensitive to foreign currency fluctuations, which have a material impact on earnings based on the relative strength of the dollar versus the British Pound and the Euro. In addition, because of the time it takes to manufacture and ship products from Taiwan, Hurco must schedule production based on sales forecasts for 4-5 months in the future. Therefore, they would be slow to respond to a rapid decrease in orders, resulting in excess inventory and a decline in return on equity.

This may be what happened during the last recession in 2001-2002, when cash flow per share dipped from $1.25 in 2000 to -$0.28 in 2001 and -$1.48 in 2002, before rebounding in 2003 and increasing to $3.24 in 2007. In addition to an economic slowdown, rising prices for steel are also a concern, as they may pressure margins for Hurco and its customers. Such conditions have yet to slow growth, as Hurco managed to grow sales by 37% in the first six months of 2008 versus the same period in 2007. Sales in the United States were flat, but sales in Europe and Asia increased 50%, with currency exchanges resulting in a favorable impact of 17% in Europe and 14% in Asia. Sales of machine tools accounted for 89% of revenue with service fees and parts making up the remaining 11%.

The last five years of the falling dollar have benefited Hurco by making its machining tools less expensive abroad, a trend that is at risk of reversing as the European Central Bank and its British equivalent are being pressured to lower interest rates by slowing economies. The prospect of an economic slowdown has hit shares of Hurco, driving them from a high of $60.44 per share in October 2007 to a recent price of $31.00. This has resulted in a trailing P/E of 8, near the low end of its historical range, and an EV/Ebitda multiple of 4.3 for the last 12 months. This is cheap for a company that tripled earnings from $1.04 in 2003 to $3.24 in 2007. The only analyst covering the stock expects 2008 earnings of $3.58 per share with 2009 earnings growing 12% to $4.00 per share. This would result in a forward P/E of 7.87 and an attractive earnings yield of 12%.

Hurco holds an attractive niche in the machine tool market. In a world that will demand lower costs and greater efficiency as emerging markets grow, Hurco stands to benefit as a provider of quality, cost-saving manufacturing tools. Given the cyclical nature of this business, buying opportunities will present themselves on a frequent basis, as investors respond with fear to economic news and earnings calls. While I believe the current price to be a good entry point, a return to the $25-$28 range is not an unreasonable expectation. It would be wise to enter a position in thirds, the better to take advantage of declines in the share price in these uncertain times. Doing so should provide a good return for the long-term investor.

Wednesday, August 27, 2008

An analysis of Thor Industries

Thor Industries (THO) is the leading manufacturer of travel trailers ahead of Berkshire Hathaway's Forrest River, and they also make motor homes and buses. Travel trailers and 5th wheels account for 68 percent of sales, with motor homes at 17 percent and buses at 15 percent. It sells under the brand names of Airstream, Dutchmen, Four Winds, CrossRoads, Keystone, Corsair and Citation. Thor's bus division sells shuttle and transit buses to airports, city governments and tourist transport companies.

Thor has benefited from excellent management that started the company more than 25 years ago and the founders still own 36 percent of the shares outstanding. They have a track record of operational efficiency and excellent capital allocation. Thor's return on equity (ROE) has average 19.81 percent over the past 9 years with return on retained earnings of 15.15 percent. They acquire mismanaged businesses that compliment Thor's current operations and make them competitive again, taking advantage of the cyclical nature of the business to capture market share from competitors burdened by debt. Thor's shares outstanding have decreased an average of 0.7 percent per year since 2004, on top of which they have $119.6M in cash and no debt.

Having praised Thor's management, I must note that the bottom is falling out of the recreational trailer and motor home business. Predictably, high fuel prices, the credit contraction, and decreased consumer spending entering a recession-like period are hitting sales. Prices of raw materials have also increased, putting pressure on margins. Sales in the latest quarter ending April 30 declined 10.3 percent from the same period last year, with net income decreasing to $0.50 per share from $0.64 in the same quarter, 2007. The largest decline for Thor was the motor home sector, with revenue decreasing 24.2 percent and operating income falling 53 percent. In Thor's primary business of travel trailers, sales fell 8.4 percent and net income dropped 12.6 percent. Backlog fell 26.8 percent for both businesses to $276M. A strong point is the bus business in which revenue increased 1 percent and backlog grew 16.2 percent versus the same quarter last year.

Fuel prices are likely the greatest challenge to Thor. Motor homes often get around 4 mpg and have 100 gallon tanks. Do the math and the future looks grim for the motor home. Fortunately, Thor specializes in the more efficient trailers that are pulled by trucks and SUVs that get 8 mpg or better. A growing retiree demographic that is more fuel conscience but still wants to travel equals  an opportunity for Thor to gain market share from debt-ridden motor home manufacturers like Fleetwood. In the short term, the lack of available credit should hinder sales. GE Finance recently terminated a partnership with Thor to provide loans for customers; combined with the general credit contraction, this results in a greater difficulty in obtaining financing. 

During the last economic downturn in 2001, Thor had a decrease in net income of 26 percent and ROE fell to 12.9 percent. However, earnings doubled in 2003 and grew from $0.56 to $3.03 per share in six years. Of course, accurately predicting future sales is impossible, as they are dependent on fuel prices, consumer spending, and the price of raw materials. EV/Ebitda is currently 5.695x ttm, a discount to the historical average of about 10-11x. Ebitda would have to fall 43 percent from $206M to approx. $117M to reach an EV/Ebitda multiple of 10x. According to Yahoo Finance, the consensus 2008 earnings estimate is $1.88, falling 27 percent to $1.38 in 2009. At the recent price of $23 per share, Thor is trading at 16.7x 2009 estimated earnings, putting it in the middle of its historical trading range. 

Thor is a best in class business and will continue to excel and gain market share. The challenges it faces going forward and substantial, but management's ability to allocate capital gives them an edge over their competitors. The current environment should provide opportunities for Thor to buy assets at bargain prices as they have always done. In the short term, Thor should be very sensitive to changes in oil prices and economic numbers, and this should provide buying opportunities below $20 a share for the long-term investor.