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Brian Grosso
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Investment advisor managing SMAs at Rugged Group LLC, an independent, fee-only RIA based in New York that I formed in August 2015. Find out more and follow my blog at email: brian [at] phone: 845.649.3031
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  • Interesting Additional Data On Ruger And S&W

    Ruger (NYSE:RGR) and S&W (NASDAQ:SWHC) stocks have been all over the place since my article was published a little over two weeks ago on Sep 25. On Friday, Ruger stock declined 6% on no significant news! What this tells me is that the market consensus has no clue what this company is worth or what is going to happen with gun demand. I believe my article makes a compelling case for these companies on the long side, but after finding some more data, I think part of my original thesis, summarized as follows, should be emphasized:

    There is no real catalyst for these companies and they will undoubtedly suffer a few more really tough quarters. Accumulating a small position now is reasonable but a cheaper price will likely be available later on, accompanied by more visibility on demand.

    I just found an ATF report showing gun production from 1986-2012. The report shows (a) guns manufactured in the US, (b) gun imports, and (c) gun exports. I took (a) + (b) - (c) to approximate "gun production for the US market."

    While this represents supply, not demand, over the long run supply should approximate demand. As you can see, production fluctuated from 1986-2004 before the trend of growth began. Since adjusted NICS only started being reported in 2000, that is the starting point for the data in my original article, but unfortunately, 2000 is somewhat misleading as a starting point because it paints a picture of consistent growth when, longer term, industry demand hasn't been so predictable. I don't think this necessarily invalidates the thesis; it just necessitates further thought.

    2000-2014 is nearly two complete business cycles… that would normally be a long enough interval to be representative of LT trends… Why has industry demand fundamentally changed? I think a combination of 9/11 and increasing distrust of government, increasing income inequality, and other factors are good explanations, but it is difficult to know for sure.

    I don't really ascribe to the idea that we are in a bubble 20 years in the making. As mentioned in my article, I think demand is still above the normalized level on a LTM basis, but I don't agree with shorts that American demand for firearms is going to decline to, say, 4-5M units/year. There are 85M guns in the US and 4M would only represent turnover of 4.7%. Guns last a long time but new product introductions (which Ruger emphasizes), replacements, new consumers and women, should combine to create turnover of at least 10% or so. Overall, I think 8-12 is about right. Ruger has been taking market share. They had 14.2% sell-through market share in 2013, up from 10.2% in 2011. Assuming this grows to 15% on the low end and 20% on the high end, we can get a sense for what kind of revenue range the firm will see. The only other piece is avg. selling price, which I assume to be $300. With all that, I get a revenue range of $360M - $720M. That my estimated range is so wide illustrates the uncertainty involved in analyzing this stock. It also explains the fluctuations.

    All this leads me to keep my position small until there is more visibility and recommend readers do the same.

    Tags: RGR, SWHC
    Oct 11 12:40 PM | Link | 19 Comments
  • Alliance Fiber Optic Products: Another Business I Dislike, But Valuation I Love

    The goal of Joel Greenblatt's Magic Formula is to identify above-average companies at below-average prices. I would say my focus is a little bit different in that my intent is for my PA to be highly concentrated in 2-5 stocks at any given time (I'm currently fully invested in one company - Express Scripts (ESRX)), and so I am looking for a bit more than above average in terms of business quality and price. I want excellence on an absolute (as opposed to relative) basis in both areas. Of course these two are hard to find in the same place as they are normally highly directly correlated in a largely efficient market, however, there are select opportunities and since I am so concentrated, I don't need to find many. Though my focus is slightly different than Greenblatt's, I continue to find the Magic Formula Screener as an excellent starting place in the search for companies/stocks that fit my criteria. I recently ran the screen with a $147M minimum market cap (random small number to generate unique list). Alliance Fiber Optic Products (AFOP) was one of the results, so I figured I'd take a look.


    The first two sentences of the 10-K are as follows:

    Alliance Fiber Optic Products designs, manufactures and markets a broad range of high-performance fiber optic components, and integrated modules incorporating these components, for leading and emerging communications equipment manufacturers and service providers. We offer a broad range of products including interconnect devices that are used to connect optical fibers and components, couplers and splitters that are used to divide and combine optical power, and dense wavelength division multiplexing, or DWDM, devices that separate and combine multiple specific wavelengths.

    These words went WAY over my head and I knew it almost immediately, so I thought a better starting point would be to google the words "fiber optic." One of the first results was a HowStuffWorks explanation of the topic which was exactly what I was looking for and indeed, I found it very helpful. Apparently fiber optics are thin cables of optically pure (extremely clear) glass as thin as a strand of human hair that transmit digital information in the form of light (infrared and in some cases, red visible) over very long distances (transatlantic fiber optic cables exist!). These cables are used most commonly in the telecommunications industry for telephone, cable television, and internet data transmission. Fiber optic cables continue to replace traditional copper wires due to being lighter, cheaper, and more effective. This trend seems to be one of the most significant qualitative positives in the long AFOP thesis. Data and the internet are becoming ever more important. I recall in my preliminary research of China Mobile (CHL) a few months ago, I noted that the company is currently investing heavily in a 4G network rollout in China. The 10-K confirms all this:

    Our future success depends on the continued growth of the Internet as a widely used medium for communications and commerce, and the growth of optical networks to meet the increased demand for capacity to transmit data, or bandwidth.

    One concern I have is that I'm not tech-savvy and industries and technologies evolve very rapidly in tech. I don't know much beyond what I stated above about fiber optics or alternative technologies and I'm not confident that I would be able to detect the decline of fiber optics if and when it occurs.

    I like that the company has significant intellectual property with 68 issued US patents. Needless to say, this is a critical source of competitive advantages for tech businesses.

    I'm concerned with the company's customer concentration. 45.3% of FY13 revenue came from 2 customers and 75.6% of revenue came from the 10 largest customers. The company does seem largely globally diversified though. Only 56% of FY13 revenue came from North America with the remainder roughly evenly split between Europe and Asia.

    My biggest concern is probably the nature of the business and the competition of the industry. The company's named competitors are JDS Uniphase (JDSU), Oclaro (OCLR), Oplink Communications (OPLK), Senko Advanced Components and TE Connectivity (TEL), and the company estimated that over 20 companies compete in the components market. The company warns several times throughout the 10-K that competition is intense and cuts to ASP are frequent. This is concerning, although the trend in gross margin has been quite positive to date:

    (click to enlarge)

    More often than not it seems, in manufacturing industries deep in the supply chain, pricing is based on cost rather than the value to product provides to the consumer. This almost always means lower margins. Further, I don't know that there are many different ways to make a fiber optic cable.

    The company invested 4.9% of revenue in R&D in FY13. This seems in line with other small manufacturing companies I've looked at in the past.

    The company's CEO seems to be paid excessively. CEO Peter Chang has been the company's CEO and Chairman since its beginning in 1995. I'm sure he is very talented, but it is hard to imagine that the $1.7M he made in FY13 - 2.2% of revenue, 9.9% of EBIT, and 20.9% of SG&A - is justified.

    Though it is technically a US company, it has a much more significant presence in Asia:

    As of December 31, 2013, we had 1,514 full-time employees, including 36 located in the United States, 358 in Taiwan and 1,120 in China.

    The company has a substantial manufacturing presence in both Taiwan and China. I'm highly skeptical of Chinese companies due to the numerous instances of fraud of various kinds, so this is a major concern for me.

    In situations where I draw uncertain conclusions about a company/stock, I give much more weight to insider activity and there's been a ton of selling of AFOP stock among insiders:

    (click to enlarge)


    Chang does still hold a $21M direct stake, however.

    Overall, there are probably more qualitative reasons to dislike AFOP than like it and I can't say I was genuinely impressed. I would not be surprised if this company does well in the future as there are major secular tailwinds and the company has a lot of potential, but the risks and concerns would prohibit me from sleeping at night owning a significant position in this stock.


    I calculated ROIC here as EBIT / (Total Assets - Cash, ST Investments - LT Equity Investments - Current Liabilities). Using invested capital data from 12 months ago as I normally do, I got 111% pre-tax. Even using the most recent balance sheet data I got 86.2% pre-tax. In either case that's absolutely excellent. 15% or so pre-tax is probably average, meaning many companies don't even achieve that. Since I consider ROIC to be, by far, the best quantitative metric of business quality, this bodes very well for the long AFOP thesis. Normally the ROIC I calculate aligns well with the qualitative conclusions I draw, but that is not the case here. Maybe, I've been a little too critical in thinking about AFOP's business.

    Over the last 5 years, the company has grown at the following CAGRs:

    • EBIT 85%
    • Revenue 25.2%
    • FCF 50%

    The growth rates are outstanding, the growth has come rather consistently meaning few declines though there's been a big surge in the last 1-2 years, and there still seems to be a lot of potential for further growth with the current revenue base still <$100M and the aforementioned secular tailwinds. Indeed, analysts estimate 25% annual earnings growth over the next 5 years.

    There's been some share dilution, but for a company with such ridiculous ROIC, growth, and growth potential, a very high multiple seems warranted. 20-30x could easily be justified as there are far worse companies (according to ROIC and growth) trading at such valuations. The stock actually trades at a much lower valuation at:

    • EV/EBIT 9.8
    • EV/EBITDA 8.9
    • P/FCF 15.8x
    • P/CFO 10.8x
    • P/E 12.2x

    Such low teens multiples seem to drastically underestimate AFOP's quantitative profile. I believe the stock is very cheap.


    I think AFOP stock is extremely cheap and would not be at all surprised if the stock delivers multi-bagger returns over the next 2-3 years, but I just cannot bring myself to hold a concentrated position in a business I qualitatively dislike so much. CEO pay seems excessive, the product is very tangible, meaningful competition is in place, there are customer concentration risks, companies with substantial Chinese ops scare me, there's been lots of insider selling of late, etc. There are just too many concerns I am unable to come to terms with.

    Disclosure: The author is long ESRX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

    Aug 05 2:17 PM | Link | Comment!
  • Wells Fargo: Best Of Breed, Best Investment Too?

    In a prior article, I detailed why and how I would begin performing one hour of preliminary research on potential investments, with an emphasis on reasons not to invest before delving any further into the idea. In this article, I will organize my findings on Wells Fargo (NYSE:WFC).

    Best of Breed

    In my mind, Wells Fargo is the best company of the TBTF banks by a wide margin and beyond banks, one of the best companies in the world. That's not to say the company is the best investment right now. There are two elements to any purchase or investment - what you pay and what you get. Independent of price, I think you get a lot more with Wells Fargo than any of the other banks.


    80% of the company's funding is through low cost deposits. Bank assets are limited by their equity through capital requirements. Non-interest expense can largely be managed as can prices and other components of profitability, but it is far more difficult and slower to manage/manipulate interest expense. You either have the deposits or you don't. You can do things to increase deposits but they take exceptionally long to make a difference. Because WFC has the deposits, it has an edge over its competitors that cannot be removed in the short run.


    The company also has intangibles like:

    • seasoned management- CEO John Stumpf has been with the company 32 years, CFO John Shrewsberry 13 years
    • a strong, friendly brand that has 150+ years of history backing it up and that many liken to a hometown bank instead of a big corporation, kind of like Starbucks' (NASDAQ:SBUX) image

    Profitability & Risk Management

    Name a banking metric, WFC probably has the best number among its immediate peers. ROA, ROE, net charge-offs, allowance for credit losses, nonperforming assets, long-term growth in earnings, deposits, and so on. I will not go into much more detail because the many of the numbers are available here. A counter-argument I expect to receive is that the company's capital ratios are top notch, but I think there is more to it than that.

    A comment from my BAC article:

    Banks had capital ratios of about 17% just before the 1929 crash… Early on in the depression banks failed with almost double the ratio of BAC's so I think the new fed requirements are a smoke screen, a band aid if you will, probably more political than anything.

    I do think capital ratios are meaningful, but I also don't think all capital ratios, risks, etc. are equal. The purpose of the stress tests is to see how capital levels hold up in periods of distress. Wells Fargo's tier 1 common ratio holds up better than all the other TBTF banks:

    (click to enlarge)


    The company also did better during and immediately following the financial crisis.

    Competitive Advantages

    I mentioned in a prior article article that I really like the economics of large banks:

    It seems to me that much of the underwriting, deal structuring, pricing, etc. of banking operations (most of the work, besides that of the retail bank teller and manager) scales very well. A $100M private placement probably takes a lot more work than a $1M one, but I doubt it costs 100x the cost to execute. This likely gives large banks significant cost advantages in a business where customers are probably more price-sensitive than any other. The large banks also have underrated brands, in my opinion.

    Best Investment?

    Warren Buffett and Charlie Munger seem to think so. Berkshire Hathaway (BRK.A, BRK.B) has an 8.8% stake in the company worth $23.4B. It is the company's largest public equity stake. It also seems to be their favorite. Apparently they've been comparing all other potential investments to Wells Fargo. It is their opportunity cost or highest expected risk-adjusted return idea right now.

    I am not so sure, however.

    In the 5-6 years prior to the financial crisis, WFC averaged about a 15 ttm PE and ROA of 1.75%:

    (click to enlarge)

    Obviously these were very good years for big banks, but in my opinion this offers a decent picture of what WFC would earn and trade on a normalized basis. If I apply these to the stock right now, it looks very cheap:

    • Current asset base is $1.55T
    • Assuming 1.75% ROA and 15 PE, market cap 406.875B
    • Shares out 5.35B
    • Implied price $76.05
    • Current quote 50.55
    • Upside 50.45% and more as asset base increases

    However, in a recent investor presentation, the company offered guidance on normalized profitability going forward:

    (click to enlarge)

    Assuming the midpoint of the ROA guidance of 1.45% and still a PE (NYSE:TTM) of 15x, I get a price of $63.01, still 25% above market.

    However, with the lower profitability and earnings growth power, I would also expect a slightly lower PE. Assuming a PE of 13x, I get $54.6, 8% above market.

    Keep in mind that this represents what the company is worth now in my opinion, but the company pays a 2.77% dividend and will continue to grow its asset base. The company will probably generate 10% returns annually going forward just from the dividend and appreciation in value.

    Wells Fargo stock is at a 52 week high and 32% off its 52 week low. The stock does not seem timely at all.

    (click to enlarge)

    I realize that other investors have lower personal expected returns from their investment than I do, and many don't care about where a stock is on its chart either. However, I am looking for a little more in the way of current undervaluation and timeliness to consider the stock a conviction buy.


    There is no doubt in my mind that Wells Fargo is the best major bank in the US and one of the best companies of any kind in the world right now. It also seems to be a reasonable investment right now, especially for conservative investors looking for yield without the need for high total returns, and little regard to the chart, but due to the way I invest, WFC is not up to snuff right now. I invest very concentrated amounts in 1-3 stocks at a time, so everything I buy needs to be an absolute conviction buy. At a 52 week high and seemingly only slightly undervalued, WFC isn't there right now. I am setting a price alert at $45, where upside would be significantly larger, and moving on for now.

    Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in WFC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: SBUX, WFC, long-ideas
    May 28 12:50 PM | Link | Comment!
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