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I have worked as a global buyside analyst doing fundamental research for over a decade. Today, I manage a relatively small (sub <$10 mn) long-short portfolio. I am a long-term (3-5 year horizon) value investor.
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  • Benchmarking Amazon After 21 Years: A Look At Wal-Mart's 1983 Annual Report

    While the stock market still largely believes that Amazon (NASDAQ:AMZN) is still on track, as evidenced by the fact that its stock trades at 500x trailing twelve month operating profit, shares have declined over 26% from their 52 week high (as markets plumb new highs) indicating an increasing level of skepticism over the company's business model and valuation. Bears contend that while Amazon has shown impressive sales growth (expected to be up nearly 20% for 2014), the company's miniscule level of profitability implies that shares are materially overvalued. In addition, the Amazon's decelerating growth rate (midpoint of third quarter guidance of just 12.5% for the fourth quarter) suggest that it may be increasingly difficult to justify today's share price creating the catalyst which has eluded bears since Amazon came public. On the other hand, bulls believe that Amazon's lack of profitability is by choice as the company has chosen to 'reinvest' earnings for future growth which will ultimately benefit shareholders.

    Amazon began operations in 1994, nearly 21 years ago. To get a sense of how Amazon is performing relative to its most comparable competitor, I dug up Wal-Mart's (NYSE:WMT) 1983 annual report (its 21st year in operation) to see whether or not it is reasonable that Amazon is barely profitable more than 20 years into its history. Here is a snapshot of Amazon's trailing twelve month results vs Wal-Mart's performance in 1983:

    A comparison of key metrics - AMZN vs. WMT

     
       
     

    Amazon (NYSE:TTM)

    Wal-Mart (1983)

    Revenue growth

    21.5%

    38.0%

       

    Operating Margin*

    0.3%

    7.7%

       

    Capex to Revenue

    5.4%

    4.9%

       

    ROE

    2%

    25.6%

       

    *For Amazon, $170 million write-down in 3Q14 is added back

    Source: 10-Ks, 10-Qs

      

    These results are somewhat surprising. Not only is Wal-Mart highly profitable 21 years into its journey, but revenue is growing at nearly double the rate of Amazon. Even more surprising, as evidenced by the capex to revenue metric, Wal-Mart's 'bricks n' mortar' business model is less capital intensive than Amazon's 'efficient' internet-only model. With that said, I believe Wal-Mart's growth rate is somewhat overstated vs. Amazon as inflation was running 9-10% during 1983 vs. ~2% today. Adjusting for this, Wal-Mart's growth rate in 1983 is about 40% higher (28% vs. 20%).

    It is also interesting to note that while Amazon is already operating worldwide, Wal-Mart was operating in only 15 states at the end of 21 years, implying a much larger growth runway (as borne out by the subsequent 100-fold rise in Wal-Mart revenue over the next 32 years). However, Wal-Mart's core profitability remained essentially stagnant (flattish operating margins excluding overseas and grocery) for the next 32 years, implying that significant margin expansion may not be in Amazon's future.

    Further, Wal-Mart shares traded at just 13x trailing EV/EBITA (about 25x trailing P/E - tax rates were higher in 1983) while Amazon trades at 500x trailing twelve month EV/EBITA. On a price to sales basis, Wal-Mart traded at 99% of revenue whereas Amazon trades at 160% of revenue. With the benefit of hindsight, we can see that Wal-Mart was undervalued as its shares compounded at faster than the S&P 500 for the next 32 years. On the other hand, Amazon, which has yet to demonstrate that it can sustainably generate an acceptable level of profitability (defined as 10%+ ROE) and is growing at a significantly slower rate (while consuming more capital) trades at a 60% premium (on a price to revenue basis). Assuming Amazon eventually gets to a 4% operating margin, it trades at a 40x EV/EBITA multiple (3x the level Wal-Mart traded at in 1983).

    While I remain a customer of Amazon.com, I believe its shares represent a dubious proposition for investors. I remain short the shares.

    Tags: WMT, AMZN, short-ideas
    Jan 12 2:19 PM | Link | Comment!
  • IEH Corporation (IEHC): A High Return Business Selling At A Bargain Basement Price

    IEH Corporation (OTCQB:IEHC) shares are selling at less than 6x earnings (85% of book value) despite a being well positioned in a stable, growing business with strong barriers to entry, a debt-free balance sheet, and having a current ROE of 15.4%. Further, the company is a designer, marketer, and manufacturer of connectors - an industry which has been consolidating for the past 20 years and continues to consolidate - players like TE Connectivity (NYSE:TEL), Amphenol (NYSE:APH), and Britain's Smith's Group have been gobbling up smaller players while Molex (NASDAQ:MOLX) recently announced a going private transaction. Though shares have risen 59% YTD, if shares were to be valued at 7x EBITDA (or 14x P/E - still a 15-30% discount to industry peers) shares could appreciate 100+%.

    IEH is the smallest listed player in the connector industry. The company is based in NY and 40% owned by 72 year old Chairman Michael Offerman. While the industry is dominated by heavyweights Tyco, Amphenol, and Molex, IEH is somewhat insulated from competition as its products are primarily used in defense (55%), civil aerospace (35%), with other (including medical) comprising the remaining 10% of sales. While there are concerns about potential defense spending cuts, the business has been able to hold relatively constant over the past three years and shown growth over a five year horizon -see below:

    Year ended March 30,

    2008

    2009

    2010

    2011

    2012

    2013

    Revenue ($ '000)

    7,805

    10,718

    12,141

    13,823

    13,292

    13,330

    Revenue growth

     

    37.3%

    13.3%

    13.9%

    -3.8%

    0.3%

    Operating Profit ($ '000)

    625

    1,409

    1,965

    2,941

    2,167

    1,780

    Operating Margin

    8.0%

    13.1%

    16.2%

    21.3%

    16.3%

    13.4%

    Gross Margin

    29.2%

    30.7%

    32.6%

    37.1%

    33.9%

    31.9%

    While defense spending (highest margin category) has been somewhat soft, commercial aerospace has been strong (second highest category). In fact, in the first quarter, commercial aerospace strength more than offset weakness in defense spending:

    Quarter ended June 30,

    2012

    2013

    Revenue ($ '000)

    3469

    4090

    Revenue growth

     

    17.9%

    Operating Profit ($ '000)

    559

    895

    Operating Margin

    16.1%

    21.9%

    Gross Margin

    34.6%

    39.2%

    In fact, this was the strongest quarterly report we've seen from IEH in several years. As we've seen from other suppliers to Boeing/Airbus, the commercial aerospace sector is strong. That said, I wouldn't get too excited about any single quarter or even year, particularly for a company like IEH which has a somewhat lumpy component to its reported results. IEH focuses on developing connectors suitable for harsh environments - mission-critical products that will not fail even in extreme circumstances. For instance, it can take the company several years to get added to a new platform in both the defense and civil aerospace business. Not only is there a lengthy design phase but there are multiple testing phases. All in development time for some projects can be as long as ten years! During this time, the company has to spend on both research and development initiatives as well as marketing - all with no promise of revenue. This is actually a beautiful aspect of the business as it keeps competitors out. Given the time spent designing the product into the project and the associated testing, customers almost never change suppliers. It is also worthy to note that aerospace & defense platforms are very long-lived which means that once IEH has cleared the hurdles to be added to platforms it has a little monopoly (in some cases a duopoly as some customers dual source) for many, many years.

    While IEH has generated strong operating margins, other niche connectors companies have done even better. For instance Deutsche (owned by private equity firm Wendel and sold to TE Connectivity) consistently generated mid-high 20s EBITDA margins. Again, this is a function of providing a mission-critical component suitable for harsh environments where it is locked onto customer platforms and not subject to competition. Further, during the marketing phase, customers are not super concerned about price given that connectors are a very small percentage of the total cost of the project/end product. Note that Deutsche was acquired by TE Connectivity for $2 billion in late 2011 which represented an enterprise value to revenue multiple of 3x (12x EBITDA). Here is a breakdown of operating margins for other connector companies:

    Comparable Operating Margin

    2010

    2011

    2012

    TE Connectivity

    13.6%

    13.4%

    13.3%

    Smith's Group

    17.8%

    14.7%

    14.9%

    Amphenol

    19.3%

    19.0%

    19.6%

    Molex

    12.4%

    11.8%

    10.4%

    Smith's (UK listed conglomerate) is the best comparable of the publicly traded company as it is also focused on hyperboloid connectors. TE Connectivity and Molex are the least similar competitors as they sell to tougher end markets - autos and consumer electronics, respectively. These are lower margin segments given low margins at customers as well as having shorter platform lifecycles subjecting manufacturers to more competition.

    I estimate a normal level of sales for IEH is somewhere in the $13-14 million range (may be higher this year given strong first half but I'm going to use $13.5 million to be conservative, more consistent with the past several years). Applying a 15% operating margin (1 point below 5 year average of 16%) brings me to operating profit of $2.03 million. The company has no debt so we shouldn't see much in the way of interest expense. Taxing operating income at 37% gives me net income of $1.276 million or $0.55/share. Here is where other connector companies are currently trading:

    P/E Multiples

     

    TE Connectivity

    16

    Amphenol

    20

    Molex

    24

      

    P/E Multiple Sensitivity

    Share Price

    10

    5.5

    12

    6.6

    14

    7.7

    16

    8.8

    18

    9.9

    I didn't include Smith's as their connector business is a small % of the overall company so the multiple at which it trades isn't necessarily reflective of the market's appraisal of the connector business. The Molex multiple of 24 isn't particularly meaningful as the new owners are looking to significantly improve the company's operating profitability. Amphenol and Tyco average out to a 18x P/E. Using 14x (22% discount) which reflects the company's small size, IEH shares look to be worth $7.70, or 100% upside. In a situation where IEH were acquired, something in the $9-10/share range is probably more appropriate, suggesting even larger gains.

    As for the downside, with no debt and a book value of $3.95/share, and a net current asset value just greater than today's market cap, there doesn't appear to be much downside in the shares making IEH a highly asymmetric investment at these prices.

    I am long IEHC.

    Disclosure: I am long OTCQB:IEHC.

    Tags: IEHC
    Oct 08 1:17 PM | Link | 1 Comment
  • Investor Expectations May Be Too High At Sprouts Farmers Market (SFM)

    Since its August IPO, Sprouts Farmers Market (NASDAQ:SFM) shares have soared +158%. Even assuming Sprouts is able to grow sales 20% per year while achieving 7+% operating margins, at today's prices Sprouts is selling for a whopping 53x 2014 EPS and 42x 2015 EPS. It's enterprise value to expected 2013 sales is a whopping 2.9x. At this valuation, shareholders are assuming that 1) Sprouts can grow at a very fast rate for the next 5+ years and (2) that Sprouts can maintain its industry leading margins. Are these reasonable assumptions?

    To be sure, Sprouts has fewer than 170 stores - located mainly in the Southwest (California represents 44% of stores today) versus nearly 400 at Whole Foods and Trader Joe's and over 1,000 for Safeway. Thus the company has a long way to go before it has fully saturated its market. Similarly, the company has had a strong tailwind of same-store sales (which management says have been positive for over 6 years) and registered a whopping +10.8% YoY in the second quarter and expects to be up 8.5-9% for the 2013 full year (management guides to 6% thereafter). Another positive is that there seems to be no end in sight to healthy eating trends - this is Sprouts' target market.

    While margins were just 2% or so prior to acquiring Sunflower and Henry's stores, in 2012 Sprouts reported 4.5% margins (though there were likely some acquisitions costs embedded in this figure) and has done 7% in the first half. In a recent management presentation, the company guides that it expects further operating leverage and increased margins going forward. While 7% is a far cry from the 2-2.5% earned by traditional grocers like Safeway (NYSE:SWY) and Kroger (NYSE:KR), it is in-line with health food grocers like Whole Foods (NASDAQ:WFM) and The Fresh Market (NASDAQ:TFM).

    The competitive environment for grocers, even natural food grocers like Sprouts appears to be getting significantly more competitive. While Tesco recently sold the struggling Fresh & Easy chain to Yucaipa, a private equity fund focused on retail, it seems that there is a strong possibility that these stores will be converted to a natural food concept under the Wild Oats brand. These stores which would be targeting precisely the same consumer Sprouts is pursuing. To make matters worse, 2/3 of these stores are located in California - creating a credible new competitor in Sprouts' largest market virtually overnight.

    Similarly, Wal-Mart (NYSE:WMT) introduced its neighborhood market concept into California starting in 2012 and is already operating more than 30 stores in the state. Neighborhood market is also expanding in other key Sprouts markets such as Texas and Arizona. The Neighborhood Market concept is a small box, low priced offering featuring low priced produce. Sprouts uses low cost produce to draw customers into its stores in hopes of selling them other higher margin items.

    Whole Foods is a threat as well. While Sprouts has long competed against the upmarket chain, WFM has announced that it is looking to nearly triple its store count (by adding up to 50 stores per year) and is continuing to add stores in Sprouts key markets. Potentially worse, Whole Foods is working hard to change it's 'Whole Paycheck' perception and is reinvesting purchasing savings into lowering prices. Additionally, The Fresh Market opened five stores in California earlier this year and is adding another three by year end. This company offers customers a very similar proposition to Sprouts and is trying to maintain a rapid growth rate to appease its shareholders (note that when it failed to meet expectations earlier this year shares plummeted - falling 42% from their 52 week high achieved just 6 months prior).

    In addition there are numerous private chains in Texas and the Southeast catering to healthy eaters which are expanding their numbers at a good clip. With 0% interest rates and a bubbly equity market, this is a great time for these companies to raise capital to fund a more rapid expansion (and indeed more than a few have).

    While Sprouts may well achieve its financial objectives in the next 3-12 months, looking out 2-3 year the competitive landscape promises to be more difficult both in its existing markets as well as new markets (which are needed to meet long-term growth objectives underpinning the stock's valuation). Should competitive conditions cause same store sales to slow and force the company to lower prices to maintain competitiveness, we could see growth falter and operating margins decline. A decline in growth and margins would likely cause investor's to put a lower multiple on the stock. Were growth to be 15% per year and operating margins closer to 5%, it is unlikely investors would be willing to pay much more than 20x EPS (still a 50% premium vs. the 13x at which Safeway and Kroger trade). This could result in stock price of $15 which represents a 68% decline from today's prices. If things go perfectly, the stock looks fairly valued. In my view this is a highly asymmetric situation - it represents return-free risk.

    I am short SFM.

    Disclosure: I am short SFM.

    Tags: SFM
    Oct 07 1:45 PM | Link | Comment!
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