With the current pullback, I thought it'd be good to review the recent positions discussed:
VOYA's financials continue to improve. while not a home-run quarter, a positive GAAP result and improving operating ROE points to the normalization of business. The fee-based retirement services that VOYA provides are actually more stable (and marginally sticky given regulations, etc.). Compared to AIG, which is essentially a highly levered fixed income fund with relatively stable funding (due to ~100% combined ratio), VOYA should trade at a higher book/earnings multiple. I'm long both because both are cheap - but VOYA is more so relative to the underlying business. I have kept the same positions in each as a month ago.
The counterpoint to this is that GAAP financials still look weak on a TTM basis - underlying economics should show up more in subsequent quarters for the above thesis to be valid.
IBTX's growth makes it more expensive. A friend recently emailed about IBTX's most recent acquisition (BOH Holdings) at 2.5 tangible book - not cheap given that other regional banks range from 1-2.5x tangible book and large caps often at ~1x (e.g. BAC). Management was fair in paying with IBTX's own stock at 2.5x tangible. I, like many investors, remain wary with acquisitive managements because they often overpay for subpar assets. Size alone is not usually not a durable competitive advantage, especially when you are a community bank competing with WFC. Any advantage would be local, given relationships in the area and regional differentiators.
More generally, the portfolio has grown in size considerable due to more opportunities, and I have unfortunately ended up on margin (net long >100%). As a result, days like today can become problematic as I have little dry powder to buy. Nonetheless, nearly all of my positions have near-term catalysts and/or are compelling at current prices. The mental stops I have in place per position are still wide enough that the portfolio can swing even while not being stopped out. Given a choice, however, I have ordered current positions in order of conviction to sell (VOYA/IBTX are near the top, so won't be sold unless a severe disruption occurs). I don't anticipate current weakness to last past the Fed meeting next week.
Wednesday, December 11, 2013
Rage against the EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is often used by sophisticated investors to price companies. A sample valuation statement can be "XYZ company is trading at 5x mid-cycle EBITDA and presents a compelling opportunity." 5 times means its enterprise value (equity + net debt) divided by EBITDA is 5 (a 20% yield).
The traditional explanation is that EBITDA is a proxy for cash flow that is capitalization (debt) agnostic and allows for a less noisy picture of the earnings power. In more practical terms, a buyer of a company often changes the capital structure (by paying off/adding additional debt). The current debt structure is merely the financial decision by management and often has little to do with the underlying business.
The cynical explanation is that EBITDA, by ignoring capital expenditures, is often a misleading metric. Combined with metrics such as "adjusted EBITDA," these metrics are often used to justify high prices for transactions. 10mm EBITDA is really 5 mm if there is 5mm of maintenance capex expected.
More specifically:
1) Interest and Taxes are paid by the company and do not belong to shareholders. Sure, companies may choose a capital structure with less debt and pay less in interest. But that by definition means companies have less cash to deploy to make money. More fundamentally, companies profit from what is, not what could be. If a company is under/over-levered, is that not just a reflection of the company's management and should be evaluated? Other than in LBO situations, debt is part of what one buys. Such buyout perspectives should not be the main source of valuation, unless you are selling to a LBO sponsor!
2) Depreciation and Amortization (D&A from capital expenditures/goodwill from acquisitions) is actually a benefit to company financials. It allows the smoothing out of large expenses to buy equipment, etc. when the benefits of the expense is over the long term. Backing out D&A should also mean a car company doesn't need a factory to make cars. Now, if there is a one-time capital expenditure that will not repeat for many years (longer than the depreciation period), then maybe it is work considering. The workaround of EBITDA minus average (maintenance) capex is in fact D&A anyways. A similar analogy applies to amortization of goodwill.
Bottom line, using EBITDA can easily lead to overestimation of earnings power, which conveniently allows higher selling prices! EBITDA used and adjusted correctly usually results in roughly the same as averaging 10-year GAAP financials in most cases. As a result, I have little faith in EBITDA..
The traditional explanation is that EBITDA is a proxy for cash flow that is capitalization (debt) agnostic and allows for a less noisy picture of the earnings power. In more practical terms, a buyer of a company often changes the capital structure (by paying off/adding additional debt). The current debt structure is merely the financial decision by management and often has little to do with the underlying business.
The cynical explanation is that EBITDA, by ignoring capital expenditures, is often a misleading metric. Combined with metrics such as "adjusted EBITDA," these metrics are often used to justify high prices for transactions. 10mm EBITDA is really 5 mm if there is 5mm of maintenance capex expected.
More specifically:
1) Interest and Taxes are paid by the company and do not belong to shareholders. Sure, companies may choose a capital structure with less debt and pay less in interest. But that by definition means companies have less cash to deploy to make money. More fundamentally, companies profit from what is, not what could be. If a company is under/over-levered, is that not just a reflection of the company's management and should be evaluated? Other than in LBO situations, debt is part of what one buys. Such buyout perspectives should not be the main source of valuation, unless you are selling to a LBO sponsor!
2) Depreciation and Amortization (D&A from capital expenditures/goodwill from acquisitions) is actually a benefit to company financials. It allows the smoothing out of large expenses to buy equipment, etc. when the benefits of the expense is over the long term. Backing out D&A should also mean a car company doesn't need a factory to make cars. Now, if there is a one-time capital expenditure that will not repeat for many years (longer than the depreciation period), then maybe it is work considering. The workaround of EBITDA minus average (maintenance) capex is in fact D&A anyways. A similar analogy applies to amortization of goodwill.
Bottom line, using EBITDA can easily lead to overestimation of earnings power, which conveniently allows higher selling prices! EBITDA used and adjusted correctly usually results in roughly the same as averaging 10-year GAAP financials in most cases. As a result, I have little faith in EBITDA..
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