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The following segment was excerpted from this fund letter.
AstroNova Inc. (NASDAQ:ALOT)
In our Q2-2023 letter, I wrote that I expected AstroNova's EBITDA to nearly double sometime over the next 12-24 months as narrowbody aircraft production continued its recovery. Since then, AstroNova has made significant progress towards this goal, and in their most recent quarter, AstroNova went from a run-rate EBITDA of $14.5M ($12.4M at the end of Q2) to $22.5M. However, this significant increase in EBITDA came not on the back of narrowbody aircraft production but instead from AstroNova's traditional label printer business - product identification.
EBIT margins for their product identification segment jumped ~650bps q/q (11.5% -> 18.1%). This was a pleasant surprise and significantly increased AstroNova's intrinsic value since we were giving little credit to this segment initially. However, this significant margin increase left us with more than a few questions. Consequently, we scheduled a call with AstroNova's executive team after the quarter. We pushed them rather relentlessly to try and nail down any one-times that might have contributed to this increase, but despite our prying at the sustainability of these margins, we couldn't get them to budge. Having said that, we couldn't get them to give us a clean bridge on the margin expansion either. They mostly pointed towards mix + pricing for the increase and gave some examples, such as sunsetting one older printer model that they were selling for B/E.
Despite having no clean bridge on the q/q margin increase, we can take some comfort in knowing that there are still several things working against them:
- They've only hit $450k in benefits this quarter from their restructuring initiative, which is expected to be at least $2.4M annually - implying 50bps+ in additional margin expansion.
- They are still working through retrofitting Trojan Label printers that have had ongoing ink issues. Since these printers aren't operating, AstroNova isn't benefiting from their ongoing ink/label sales, which, as you can imagine, are higher-margin products.
- They've had/have higher than normal warranty expenses and extra technical support costs related to the ink issues/retrofitting.
- They guided to similar margins for product identification in Q4, and if there weren't any one-times during the quarter, it seems possible that margins could expand further.
While we remain skeptical about the sustainability of these margins, at AstroNova's current price of $17.00 or ~5.50x normalized EBITDA, it doesn't matter - margins could revert materially, and a substantial amount of upside would still remain. We aren't modeling margins increasing from here, but we also wouldn't be shocked if they did, and any margin decline would more than likely be offset by the puts and takes above, at least partially.
AstroNova now has a clear path to generating $28M in EBITDA or more in reasonably short order (12-24 months). We believe a 10.00x EBITDA multiple (~12.50x FCF) for this business is reasonable and gets us to $34.00/share, and we still see room for additional upside beyond that.
Modeling and Forecasting
Those who know me know that I rarely (never) construct complex models that attempt to forecast next quarter's earnings by employing ten different KPIs to achieve a precise yet ultimately incorrect forecast. It's not about lacking the capability or information to do so; rather, I see such complex forecasting as mostly pointless. When I've decided to take a position in a company, we aren't looking for them to beat next quarter's estimates or even this year's guidance. Usually, when we enter a position, we're looking for the company to materially grow its after-tax cash flows over the next two to three years. Consequently, as a result of this approach, we have little interest in trying to predict whether a company will beat or miss earnings estimates by $0.02. Moreover, we've seen numerous situations where a company reports a good quarter, and the stock actually drops double digits the next day and vice versa - This just isn't the type of game we want to play or are trying to play.
Furthermore, we rarely (never) build three-statement DCFs and usually don't forecast our businesses out more than three years. There are several reasons for both, but we find DCFs to be unproductive. Most of your value in a DCF is typically in your terminal anyway, and they also require you to make several speculative estimates, colloquially referred to as SWAGs (scientific wild-ass guesses). Additionally, DCFs are easily manipulated to output the analyst's desired outcome. As humans, we all fall victim to implicit biases, and by building out a complex model, you routinely risk bringing two into play: 1. Sunk-cost fallacy and 2. overconfidence bias. I generally believe that if I need to build out a DCF or some complex model, the idea should almost always be a pass - the opportunity should be so great that only fifth-grade math is required. I think Peter Lynch put it best when he said, "If you can add 8 and 8 and get reasonably close to 16, that's the only level of math you need to know."
Moreover, there are usually many puts and takes when forecasting a business's future - several of our portfolio companies don't even provide guidance! For example, maybe segment A's margins expand faster than you expected, but the segment you liked is growing slower than expected, or perhaps the company's restructuring ends up netting them more savings than initially anticipated or less. With plenty of moving parts at most businesses, I prefer to look for situations where I can answer "Does it matter?" to most questions and concerns other investors might have. For example, does it matter if AstroNova's product identification margins normalize at a lower level?
The answer to this question is no, it doesn't. Would that take away from the upside? Sure, but AstroNova would still be worth somewhere in the mid-high twenties if that were to happen (compared to $17/share today), so it doesn't matter. This same "Does it matter?" theme rings true with many of our investments.
I've spoken about this before, but at the end of the day, we are outsiders acting on imperfect information and making assumptions from afar. There will always be things we aren't aware of, no matter how much research we do or how intimately we think we might know a company. As minority shareholders, we are not in control of these businesses we invest in and are essentially outsourcing the business's management and capital allocation to someone else. This isn't to say we don't know our investments well; we do, but I prefer situations where I can answer "Does it matter?" to most questions instead of situations where I have to make aggressive assumptions about the future or build intricate models.
Upside Optionality
I like my ideas with what I call "upside optionality." Other investors might commonly refer to this as a bull case, but I don't like to think about it that way, and it doesn't have much pull in my purchase decision or valuation (I never probability weigh anything). When I "model" out a company, I tend to lean toward the draconian side of things, and if my low expectations still lead to an attractive amount of upside in a name, that's usually when a purchase decision is considered.
I try to find ideas with substantial amounts of free upside optionality. These situations are scarce, and in most cases, the upside optionality is either unlikely to materialize or we have to pay up for it - and I wouldn't say I like paying up for the chance of outsized returns! In an ideal scenario, I'll get to purchase a company for much less than its current value today, and I won't have to rely on overly optimistic assumptions to generate significant returns. If a company's upside optionality comes to fruition, great; if not, well, I still make money. Put simply, upside optionality is the cherry on top, which we give no credit for but is still nice to have when possible.
For example, when we first bought Bel Fuse (BELFA), we did think that 20% EBITDA margins were a possibility. Still, we didn't model the significant margin increase Bel Fuse saw over the past year, but we didn't need to - the name was attractive regardless, and this upside optionality was free. Fast-forward to today and Bel Fuse has captured that upside and is now worth far more than what we initially modeled it at. While Bel Fuse has exceeded our expectations (and continues to do so), we knew from the get-go that something similar to what Bel Fuse has accomplished was a real possibility (not just a dream or 1% chance), and those are exactly the type of upside optionality situations we look for.
While no one could have predicted (with any certainty) that AstroNova's product identification margins would expand so quickly or Bel Fuse's consolidated EBITDA margins would do the same, it was always a possibility, and when you invest in good businesses with good leaders, situations like this seem to be recurring in nature - good ideas/businesses will surprise to the upside, and when such opportunities arise, it's prudent to place a significant bet.
| Disclaimer: This letter expresses the views of the author as of the date cited, and such views are subject to change at any time without notice. The information contained in this letter should not be construed as investment advice, and Atai Capital Management, LLC ("Atai Capital") has no duty or obligation to update the information contained herein. This letter may also contain information derived from independent third-party sources. Atai Capital believes that the sources from which such information is derived are reliable; however, Atai Capital does not and cannot guarantee the accuracy of such information. References to stocks, securities, or investments in this letter should not be considered investment recommendations or financial advice of any sort. Any return amounts that are reported within this letter are estimated by Atai Capital on an unaudited basis and are subject to revision. Atai Capital's returns are calculated net of a 1.50% annual management fee and reflect a client's performance who would have joined the firm on its inception date. Actual Individual investor returns will vary based on the timing of their initial investment, the impacts of additions and withdrawals from their account, and their individually negotiated fee structure. Atai Capital believes showing returns net of a 1.50% management fee better reflects actual performance as of 01/16/2024 since no account that Atai Capital currently manages is charged a fee more than the stated 1.50% management fee. Past performance is no guarantee of future results. Index returns referenced in this letter include the S&P500 and Russell 2000. Atai Capital's returns are likely to differ from those of any referenced index. These returns are calculated from the respective provider's websites, S&P Global Homepage for the S&P500, and FTSE Russell Indices, Insights & Data for the Russell 2000, and include the reinvestment of all dividends in both cases. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
