Sold off the rest of my position in EZJ at 14.05. The portfolio now holds 52% cash.
I just increased my Syntel position by 25%. Syntel makes up 15% of the portfolio and my cost basis is now $19.4, or an unrealized loss of approximately 15%. I initially wanted to wait until $15 to buy more, but the general market continues to rise which makes Syntel even more attractive. The portfolio now holds 41.5% cash.
Syntel reported earnings two weeks ago. A few things to note:
- Revenues came in at $225.9m, down 6.5% from the comparable quarter last year.
- Net Income came in at $38.4m, down 27.6% from the comparable quarter last year.
- Total debt down $52.5m or 10.6%.
- Guidance of $1.57 – 1.77.
This quarter was quite disappointing. Top-line volatility for the quarter came from the Banking and Financial sector dropping off 12.75%. The culprit within was American Express — Revenues from Amex fell 23.68%. If one were to exclude the Amex account, revenues would be down 1%. That’s no excuse, but I’m just putting it into perspective. I think management needs to execute and go out there and win more business. There is clearly still growth in the industry, as shown by the competition, so there isn’t much of an excuse for flat or negative revenue top-line growth. Manufacturing makes up only about 5% of the revenues, so volatility within the sector does not have much of an impact on the company.
I thought it was a fairly weak quarter, but Mr. Desai’s long-term track record of growing the company and penny-pinching gives me hope. Valuation is also still reasonable relative to the market, so I’m holding on for now but will trim my position at my break even price of $20.32 to 10% of the portfolio.
Real Time price: GATC 287,44 +2,08 +0,73%
|Purchase Price: £2.84||Market Capitalization: £89.7 Million|
|Price Target: £4.26 (9-12 months)||Upside: 50%|
Gattaca PLC provides human capital services, specifically staffing, within the technology sector across the world. The stock had a volatile 2016 as fears of Brexit mounted in early in the year and carried on until the vote on the 23rd of June.
Recruiting firms generally make money in one of two ways: hourly or one-time fees. Under the hourly scenario, the client outsources its staffing department to the staffing firm. Under the one-time scenario, the client wants to fill a single position and reaches out to the staffing firm. The staffing firm assigns the client to an employee, and the employee has to present qualified candidates to the client. If the presented employee is hired, then the client pays the firm a one-time fee. The relationship is beneficial to the client because the client retains a flexible cost structure by outsourcing. Staffing firms have no moats and tend to compete on price. The larger firms have name recognition advantage and are more likely to land hourly gigs.
Internet job boards such as Indeed have dramatically eased the job application process. One would think that this would eliminate the need for need for recruiters and staffing firms, but the truth is that it has never been different. Recruiters have always been the middlemen in a job search, the difference between today and 30 years ago is online job-boards and newspapers. Unlike most industries that get engulfed by technological innovations, staffing and recruiting firms are fortunate to participate in the revolution though margins are much lower than they were three decades ago.
British economic indicators displayed knee-jerk reactions post the Brexit vote. Employers were on edge — they pushed out imminent projects and delayed hiring. No one truly knows how Brexit will play out, but if history is any guide, markets tend to negatively overreact to events that are not supported by the status quo and remain at ease when events supported by the status quo take place. This error inevitably corrects itself over the long run. We saw the same thing right after the Brexit vote — FTSE and the Pound Sterling crashed as knee-jerk, and then the FTSE subsequently recovered and rallied to all-time highs because the Sterling depreciation devalued British equities. The outlook was that the British economy was heading for an “imminent recession” but we’re nearing the first anniversary of Brexit, and economic growth has been better than expected. The same thing happened after the election of President Trump or even whenever polls indicated that he was closing into Clinton. Markets were afraid; pundits expected a ‘market crash’ but eventually markets came about to pricing in his ‘reflationary’ policies. Markets err all the time but tend to correct mistakes over the long run.
I outlined a history of large-scale economic events Britain had to deal with in the past in the Q4 performance post. What becomes apparent is that the consensus argument is always something along the line of “If X event does not play out Y way, then we’re headed for a depression.” In every single scenario, however, economic growth ended up well above-average even though the event did not play out the way the consensus expected. Britain is still excelling, and I believe she will continue to regardless of her European Union membership status. The complexities that Engineering and Technology firms — who seek highly skilled employees — face will remain unchanged in the aftermath of Brexit, be it ‘hard-‘ or ‘soft-.’ So even if the risks that the consensus expect materializes, the company will still exist because its existence is impervious to Brexit. The end game question here is – will Tech and Engineering firms need talent in 5 years? The answer is Yes.
Staffing companies are directly cyclical because they deal directly with unemployment. When the economy turns down, companies decrease hiring, and recruiting firms find it difficult to place employees. The cyclicality of the business is a risk, but I believe the risk is dependent on the price paid for it. Brexit ‘depression’ sentiment is already reflected in the price so this could be a tailwind going forward. The CapEx-light aspect of the business and the highly variable employee compensation structure helps mitigate the severity of its cyclicality. Staffing firms that aren’t over-leveraged will generally survive a downturn. Staffers on the one-time fee model get paid by the client only when they place an employee, so there is almost no downside to utilizing the staffer. Gattaca’s net margin (<2%) is among the lowest in the industry, so there is also minimal risk of margin compression.
EASIER COMPS FROM BREXIT
The company struggled post the Brexit vote because employers chose to delay hiring, but all isn’t lost. GATC reported earnings three weeks ago and said that profits were expected to come in 10-15% below expectations because of one-time overhead expense to support a ‘pan-European’ contract win. Management was a bit ambiguous, but I assume that it is related to post-Brexit preparations. This is positive since the challenge for most companies is top-line growth.
The devaluation of the sterling is a catalyst here because companies will raise prices to adjust for the depreciated currency. The stock has fallen since the devaluation, so there is still hope for easier comps even in a weak macro environment.
The company, which was previously known as Matchtech, acquired Networkers PLC, and subsequently became Gattaca PLC. Matchtech in the process acquired ‘Consumer Relationship’ intangibles and per IFRS rules, has to amortize that intangible. The amortization hits the net income line but is non-cash, and so cash flow is and should continue to be greater than net income for the time being. My estimate adds approximately £2.5 million (after subtracting normalized CapEx and other intangible purchases) in non-cash expenses. There is also the restructuring costs of about £2 million that should dissipate going into next year. My estimate of normalized FCF after subtracting Stock-based compensation and other shenanigans is about £11-12 million, which places its FCF multiple at approximately 7.5-8.2x my purchase price and about 10x its Enterprise Value.
The stock pays an 8% yield on today’s price, and the dividend looks sustainable, IMO. GATC is paying out about 65% of my FCF estimate. Markets seem to be expecting a dividend cut hence the high yield, and so once the market is convinced that the company can sustain the current payout, that could be a catalyst on its own. The competition trades between 15-20x so 50% upside isn’t too much of a stretch. There has been a lot of noise in its financials given the Networkers acquisition, but this should dissipate going into the latter part of the second half of the year. Hopefully, clarity ensues and the stock is revalued to the multiple it deserves.
The portfolio returned 2.76% in the first-quarter of 2016 and underperformed the comparable indices.
The best performer was EasyJet, which returned 12.27% after dividends. The timing of my EasyJet addition to the portfolio in February was incredibly lucky. The worst performer was Syntel, which plummeted after disappointing Q1 guidance. I sold off Target after the disappointing earnings report and its new ‘strategy’. At the right price, I’ll be happy to own Target once again. Cash position in the portfolio fluctuated throughout the quarter but closed out at 45%.
Individual Security Updates
I added EasyJet this quarter; the thesis is available here for anyone interested. The Pound Sterling sits at $1.29 today. I am no forex expert, so I don’t know where the Sterling is headed. What I do know, however, is that if the pound remains stable (~$1.23), EZJ can recuperate some of the Brexit-fueled-Sterling-depreciation lost income when the $1.23 level laps in the October quarter. If the Sterling runs higher, the company would recuperate the lost income and then some because it receives the money ahead of time and would hence end up with lower expenses. In summary, falling pound ($1.13), profits remain stable relative to last year; medium pound ($1.23), lost income from the past year is recuperated; stronger pound ($1.3+), profits rise significantly because of the income/expense characteristic of the consumer airline which I outlined in the EZJ thesis.
EasyJet Traffic Statistics (Source: EZJ IR)
The traffic stats so far this year are quite compelling — load factors and Passenger numbers are all higher y/y. The stats would mean nothing, though, if the company used overly promotional tactics (i.e. unreasonably lower ticket prices) to attain them. The company’s first-half report is due in the second week of May.
Mind CTI reported earnings and I penned an update for that ER as well, and its first quarter report is due in the first or second week of May.
Rocky Mountain Chocolate Factory
I added Rocky Mountain Chocolate Factory to the portfolio this quarter, and the thesis is available here for anyone interested. The Trump administration laid out its tax plan this week with a proposed 15% corporate tax rate. RMCF’s tax rate is among the highest in the country so it stands to benefit significantly from tax-reform.
I sold off target after its ER. Management’s new strategy didn’t make much sense to me, so I decided to cut my losses and part ways with the stock. I’m willing to take a new position at a lower price, though. The update is available here for anyone interested.
Syntel reported Q4 earnings report was quite disappointing. Mgmt guided to lower earnings because of the uncertainty its clients in the Healthcare and Financial industry are facing. It was disappointing, but one would be hard-pressed to find a business with defensive characteristics in this market that trades at a reasonable valuation. It recently reported earnings for the second quarter — I will publish a post regarding Q2 this weekend.
I sold off Walmart for modest gains. Blue-chips such as Walmart tend to be efficiently valued; mild deviations from fair value self-corrects rapidly. I’m willing to take another position if the stock treads the low 60s again.
I’m still working on a post for Gattaca PLC, which I added last month. Syntel and Mind CTI have also reported earnings. I should have all those up by this weekend if time permits.
I posted my RMCF article on Seeking Alpha and got a great question about my valuation of Hersheys and Mondelez. I adjusted RMCF’s forward P/E for taxes at 13x while seemingly ignoring Hershey and Mondelez’s potential tax benefits:
The chocolate business can still generate $4 million per annum but with President Trump’s tax cuts (15% tax rate assumption), it goes up 25% to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.
The actual TTM P/E’s for Hershey’s (HSY) and Mondelez (MDLZ) are 30x and 40x. The multiples above for HSY and MDLZ are Pro-forma or ‘adjusted’ earnings, which are inflated, whereas their GAAP earnings are significantly lower. So the multiples above are more than already inclusive of a tax discount even though MDLZ doesn’t deserve it — the real valuation discount is much higher than 25% when one compares apples to apples. Investors and sell-side analysts have come to expect ‘adjusted’ earnings from those two. HSY and RMCF have similar historical tax rates (about 35%), and MDLZ’s tax rate is much lower so the discount shouldn’t change much in a post-tax adjustment scenario. Hence why I was comfortable comparing the adjusted earnings to RMCF’s tax-adjusted forward net income. The scale and brand advantage that MDLZ and HSY have over RMCF indicates that it should certainly trade lower — the question is how much lower? Hence why I have a price target just 20-25% higher than my purchase price.
I recently added Rocky Mountain Chocolate Factory (RMCF), my cost basis is $10.99 @10% of the portfolio. The company manufactures and sells premium chocolate and has a long history of profitability. The company makes money by wholesaling chocolate to its franchisees and collecting revenue-based royalties. In 2013, the RMCF took a controlling interest in Yogurt maker, U-Swirl (SWRL). SWRL made some debt-financed acquisitions and defaulted and so RMCF took over SWRL and effectively guaranteed its debt. The takeover proved to be expensive as SWRL is still losing money, and in dissent, outspoken shareholders sold off the stock while management maintained its confidence in SWRL.
As consumers, specifically millennials, become more health conscious, confectionery will likely stagnate. I don’t see the stagnation as much of a big deal because the pace of a decline, if so, will be negligible and people will still eat chocolates in 100 years. If anything, the industry is likely to be stable over the long run and even with a zero growth, RMCF still presents an attractive entry point.
- Management has historically been shareholder friendly (paying quarterly dividends and repurchasing shares)
- Management made a mistake but has realized that the assumptions for the yogurt business were a bit optimistic, and as of Q3’s earnings call in January, the CEO acknowledged that. Given that franchisees control the majority of these stores, it only makes sense that they exit the business if it remains unprofitable which is evident in the chart below.
- RMCF’s current and historical tax rate is about 36%, and the company will significantly benefit from President Trump’s expected tax cuts (more so than the general markets).
- 50% of products sold at the stores are produced on premises, 45% of products sold are manufactured in the company’s Colorado factory, with the remaining 5% being purchased from third-party suppliers. In essence, the company relatively immune from President Trump’s border tax.
Source: RMCF SEC Filings
The chocolate business can still generate $4 million per annum, and with President Trump’s tax cuts (15% tax rate assumption), it goes up 25%, to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.
Syntel reported earnings last month and guided below analyst expectations. Analysts were expecting 2017 EPS of $2.32 while Syntel’s guidance came in at $1.7 to $2.0. I had mentioned that the analyst expectations looked a bit too optimistic in the 2016 performance report and was quite frankly surprised when the stock took off and ran up 17% prior to the earnings report.
Could markets be pricing in something I ignored? Such as the concentrated nature of its clients? I don’t know, but I don’t think so. I believe it has more to do with growth — the customer concentration is, to a great extent, priced into the stock. I also believe management may have been a bit disingenuous with analysts from what I can see. It is clear that President Trump will ease banking regulations which should be a positive development for the financial sector, so what uncertainty is there? the election is over and the path to deregulation has never been clearer. What I do understand, however, is the uncertainty arising from Healthcare. Given that no one knows what the healthcare environment is going to look like in two years, uncertainty in healthcare makes sense. I think management needs to up the marketing/ad budget and execute to win more business.
I came close to selling SYNT to buy Infosys after INFY reported earnings and fell while Syntel ran past $22. I made the emotional, mistaken decision to carry on with SYNT. At the price of $22, INFY made so much sense. It’s a mistake I almost regret but bad decisions and mistakes are usually the lessons that stick.
Even under the worst case scenario of an EPS of $1.7-$2.0, the stock is still cheap at these levels relative to competitors and general markets. We’re paying, as of Friday’s closing price, between 8.8 and 10.3 times earnings which is reasonable. For Q1, my goal is to figure out if growth is lagging because of the volatility coming from one of their large clients or if it some other variable. Top-line volatility from one of the large customers should be expected given the nature of the business, the less dependent Syntel is on one client, the better off they are because it decreases future volatility. Determining the reason for the revenue volatility is integral to determining if I hold on to the position or sell.
One other interesting point is that Mr. Desai increased his stake. I thought that was bullish but I was wrong.. my question, though, is — why would one buy more shares of the company if they were expecting more bad news and thus, a lower stock price? It still has my head spinning..
Because I take large, concentrated positions, I require larger discounts to average down. I am willing to increase my position if I can do so at the $15 level. I had initially mislabeled a line-item which was why I was so comfortable running the position at a large percent of the portfolio. I cut my position immediately after I realized my mistake, but I do wish I had given myself room to buy more shares.