Coronavirus: An Opportunity For Returns
Summary
- I can't market time, but it's still worth exploring opportunities in today's market.
- I (though I am not a virologist) also give my take on the biggest risk of this coronavirus event (hint: it's not the virus, but rather the response to it).
- I give 3 companies I've been buying lately: Charter, Stryker, and HEICO.
Veteran fund manager and all-around good guy Terry Smith of Fundsmith has a good saying. "There are only 2 types of people: people who can't market time, and people who know they can't market time." The last week's selloff certainly makes one wish they could market time. I'll say right off the bat: I know I can't market time. The best I can do is think deeply about a business, try and figure out what I want to pay, and then buy the business and hold it. Sounds easy, but in times like this, it's not. So, I thought I'd write a little post here outlining my thought on the virus and what to do about it.
My View on The Virus (#NotAVirologist)
After this week's hullabaloo, it's worth taking stock of a few things. With regard to the coronavirus death rate, I think there are three important considerations. First, China has the world's largest smoking population and one of the highest incidence rates of smokers in the world, particularly among males, where an estimated 47% of males are smokers. As smoking affects the respiratory system, higher rates of smoking are also likely to lead to higher rates of death or complication from a virus that attacks one's respiratory system as the coronavirus does. Second, one has to dig beneath the death statistics to uncover the demographic trends. Without looking at the numbers, I would guess that deaths are higher among the elderly and among males (in part due to the smoking statistics above). Both of these are the case. Third, there is a high risk of unreported cases. Harkening back to 2009, H1N1 had millions of unreported cases that complicated the official statistics at the time. For cases that are not serious, or seem like a "normal flu", people tend not to go to the hospital to be checked. Death rates look much more serious when your deaths are 100% reported, and your disease incidence is not. There is also the issue of not being able to test accurately for the disease. Obviously, if you can't test for it, there are going to be some unreported cases. Finally, in talking with a few medical experts I know, they noted something interesting. There tend to be two types of virus "models": one is the virus attacks swiftly and immediately, leading to a much higher fatality rate and also a lesser ability of the virus to spread because it is immediately apparent in a host and thus quarantine is far more effective. The second is more of a "stealth" approach: the virus can lay dormant for a while, while the host is asymptomatic but able to spread the virus, and then symptoms manifest differently over time. Coronavirus seems to be more in the second camp. The good thing is that the fatality rate is much lower than the first model of virus I mentioned, and indeed coronavirus death rates are much lower than Ebola for example, or SARS. The problem with this more stealthy model is that it tends to be much harder to quarantine and thus it spreads much more widely. Indeed, because it can spread much more widely, a virus of the second type actually tends to be more fatal overall. So, while I'm not a virologist, what I believe anyways is that we have a highly contagious, low virulence disease here that is spreading out of control. As a percentage of overall infected, the death rate is low but high enough that nobody wants this to spread.
The Bigger Risk
While the virus is no small challenge, the bigger risk is to supply chains and animal spirits. China had an abysmal PMI number this weekend, and all sorts of sectors are experiencing huge declines both in sales or in managing their inventories. Indeed, because of just-in-time manufacturing, many companies only have a few weeks of inventories to draw on. This risk is akin to yelling fire in a crowded theater. The risk is not that there is a fire, it's in getting trampled for the exits. I think last week, we saw some people getting trampled.
Where to Go from Here
I count myself lucky to be in the camp that knows they cannot market time. The market might go down another 10% or 20%, or it might not. To be frank, I have no clue. My strategy for these types of scenarios is first, to not be afraid, and second not be greedy. How I've managed to do that is by studying some great companies like TransDigm (TDG) and Roper (ROP). What TDG and ROP do so effectively is this: they identify good acquisition targets, lever up using the cash flow from their existing business, buy the target, and then use the cash flow from their existing business to pay off the debt. I'll let you look at those 2 companies and their shareholder returns over the years on your own to see why their model was worth studying. Now, I have a full-time job, and access to margin and/or a line of credit. "Hmm," I said to myself one day, "couldn't I replicate a TDG/ROP model with my own portfolio?". That is indeed what I've done. I never borrow more than 1 year's savings, just so I don't blow up, but my "rule" is that if the market is down 10%, I add 10% to my portfolio. Market down 20%, I add another 10%. Market down 30%; I add another 10% and so on. Over time, I pay off the debt with inflows from my job. The advantage of this approach, in my mind, is that I can remain fully invested at all times (i.e. NOT MARKET TIMING) while retaining dry power in the form of margin or a line of credit that I can draw on when I need it. This dry powder, unlike cash, has no drag on portfolio results when not in use, but provides the same optionality when I need it. So, with that in mind, rather than pontificate needlessly on specifics as to how to time the market, I'll tell you what I've been buying and you can make up your mind as to whether I'm a fool or not.
Charter Communications (CHTR)
Charter is a US telecom company run by its highly regarded CEO Tom Rutledge and its more notable chairman, John Malone. For those who don't know Malone, I'd recommend reading "Cable Cowboy" by Mark Robichaux. Long story short: Malone is the greatest moneymaker in US cable, and he did it by a clever combination of reducing reported earnings and using leverage to maximize the growth in free cash flow per share. The two people running Charter are insanely smart and excellent managers and capital allocators. Charter has 3 main businesses: internet, TV, and voice, and they are developing a fourth: mobile networks. The name of the game really is this: Charter's TV business is shrinking due to cord cutting, and landlines are shrinking as well. Internet is growing, and their mobile business is growing as well. Charter's real focus is to use their TV/Phone business to reduce churn in their internet business.
Now, we all know cord cutting is happening and everyone is moving to Netflix (NFLX). But would you like to take a guess at what CHTR's TV margins are? They're about 20%, versus 75% for their internet business. Charter's consolidated EBITDA margins are ~36%, so the shrinking TV business actually will boost EBITDA margins over time. The net result should be that revenue will be flat to up slightly, while EBITDA should grow quite quickly, and free cash flow should grow in line with EBITDA. Charter takes this nicely growing stream of free cash flow and levers it up to buy back stock. I would recommend reading this to familiarize yourself with the company more (and I may write more on it in the future). One can imagine that US internet subscriptions are unlikely to be changed by the coronavirus, and furthermore, because Charter is buying back so many shares, lower share prices are hugely positive to you as a shareholder. This is why I'm buying Charter today.
Charter Historical Forward EV/EBITDA
Source: S&P Capital IQ
I estimate Charter's intrinsic value at ~$550/share today and $600 by the end of the year assuming flat revenue growth as TV subscribers roll off and internet continues to grow revenue at ~5%/year with basically 100% of that incremental internet revenue falling to EBITDA. $600 equates to ~12x EBITDA on consensus EBITDA of ~$18 billion.
Stryker (SYK)
Stryker is one of the world's largest medical device companies with a tremendous track record. The company is the leader in artificial hips and joints and also has large businesses in things like hospital beds, disposable tools used in hospital rooms, and robotic surgery. Unlike some medical devices such as pacemakers, which have become commoditized, hips and knees and other joints have remained an attractive market that is growing nicely as the population ages, particularly in the developing world. Disposable tools and other operating room essentials are also "mandatory" equipment that is low cost (so, Stryker has more pricing power) and used in every operation. One can understand that this business is fairly resilient, and certainly, I see little risk from coronavirus, though there may be a temporary slowdown in elective surgeries if hospitals become overwhelmed. Where Stryker makes its difference, I think, is in its approach to M&A. Most companies in the medtech space engage in M&A as buying new technological upstarts is often easier than developing everything yourself. Few, however, put as much time and care into it as Stryker. Looking at the companies that are exceptional at M&A (such as TransDigm, HEICO (HEI), Roper, Constellation Software (OTCPK:CNSWF), Boyd Group, First Service, etc.) one thing that stands out is that they acquire small and they acquire often. The advantage of this approach is that the acquirer can build a database about what worked and what didn't when it comes to M&A. This is exactly what Stryker does. The other thing many successful companies (such as all the ones above) do is remain decentralized: each operating entity exists to maximize its own free cash flow, and then send it back to corporate to allocate to M&A, dividends, buybacks, etc. Again, this is what Stryker does: each segment has its own sales force, business development team responsible for scouting and diligence acquisitions, etc.
Stryker EV/Forward EBIT
Source: S&P Capital IQ
Stryker grows ~5-6% organically, with additional growth from bolt-on M&A (and some large scale M&A). Perhaps its largest competitive advantage is their sales force, as Stryker can buy companies struggling with distribution, and then shove the new product through their prodigious sales force. I value Stryker at ~$200/share assuming 5.5% organic sales growth and 50-60bps of margin expansion a year (in line with what management has estimated). That equates to ~20x EBIT, which isn't unreasonable for a company that can grow its topline 7-9% with M&A, and earnings somewhat faster than that.
HEICO
Some may laugh at me for buying an airplane part maker here. Fine. Laugh away.
HEICO makes what are known as PMA parts for both defense and commercial airlines as well as space applications. These are little parts like latches, electronic components and the like that are essential to the functioning of these aircraft: if you're missing a part, you can't fly. They also sell various lasers, simulation equipment and a bunch of other cool gizmos in their Electronic Technologies group. Normally, how parts work is they are designed into a plane, sold often at cost or a small markup into the build of the plane. The real money is in the long-term replacement business: because you need these parts to make the plane work, manufacturers can charge large margins to supply parts for the rest of a plane's 20 year+ life. The result is that companies like TransDigm who supply these "sole source" parts make quite a lot of money. PMA parts that HEICO specializes in are actually cheaper replacement parts that its customers use to cheapen repair costs versus sole source parts. The FAA limits, however, the number of PMA parts approved each year, and the approval process is quite complex. This creates a sizeable barrier to entry that HEICO can exploit. Over the long run, HEICO is effectively a play on more people travelling as only 20% of people alive have ever taken a flight. Its revenues tend to be highly correlated with seat miles flown, and seat miles have extraordinary resilience in downturns and tend to grow 4-5% a year. HEICO is also exposed to the defense market, which can be lumpy, and interestingly, also sells into the space market (so those betting on asteroid mining, take note). Of course, coronavirus may change that resiliency, but on their most recent earnings call, HEICO said the following:
While it's early to tell, that seems fairly positive to me. HEICO added later on that because of Tariffs, HEICO had already worked to move its supply chain out of China, so the complete shutdown of China's manufacturing should not impact HEICO too much. Now, where HEICO excels is in M&A. There are a large number of small part manufacturers out there, and HEICO has a long history of buying these companies for reasonable valuations, and that is part of the reason HEICO has returned 47,500% since its IPO. The combination of a great business with ability to execute on consistent M&A makes a powerful combination.
HEICO Forward EV/EBITDA
Source: S&P Capital IQ
Now, I freely admit that HEICO is not super cheap today. Yes, forward EV/EBITDA looks okay here in the context of the last little while, but there are two issues: longer term, it's expensive, AND I bet consensus estimates haven't come down. That said, HEICO's comments on their call, their solid defense business, and the optionality to acquire make it an attractive business to own long term. In terms of valuation, assuming ~5.5% average topline growth and EBITDA margin expansion to 30% (from 26% today), I estimate HEICO is worth ~$78/share. That's below today's price, right? Yes. But, in this case, I don't model any M&A for HEICO. Paying only $5-7/share for one of the best capital allocation platforms in the world (I'd say Constellation Software, TransDigm, HEICO, and Roper are 3 of the top 10 capital allocators in the world) is a reasonable price, in my mind. I added a bunch at $80, and if we got there again, I'd keep adding. Another company, for those interested, that I've been adding is TransDigm, however, its leverage and higher exposure to the consumer airline segment makes it a somewhat more aggressive pick than HEICO, and I have no idea what the ending impact on the company will be, though 5 or 10 years from now, TDG is likely to have performed well.
Conclusion
I can't market time. There. I said it. However, I think under some reasonable assumptions, some companies now are reasonably valued. Companies with significant exposure to travel, such as Booking (BKNG), Marriott (MAR), Sabre (SABR), and its competitor Amadeus Group (OTCPK:AMADF) are likely to see significant impacts on their businesses. Other companies such as LVMH (OTCPK:LVMHF), Estee Lauder (EL), or Texas Instruments (TXN) that are similarly high quality but derive significant revenues from either travel retail or China itself, or have significant supply chain exposure to China, are likely to see some fairly nasty impacts on their businesses. I have no idea exactly what the impact will be, but I think that perhaps a 10-12% decline for some of these names is not enough to compensate for their risk, particularly considering their valuations at the recent market peak. The businesses I've outlined here, have, I think de-rated enough that they have become interesting, especially considering that their businesses are somewhat insulated from this coronavirus-related selloff, and that's why I'm now a buyer.
This article was written by
Analyst’s Disclosure: I am/we are long HEI.A, SYK, TDG, CHTR, ROP, CNSWF. 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.
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