So what does Carl Icahn see in Masco?
We’re going to start with the same 10 numbers I used to analyze McGraw-Hill (MHP) yesterday. Those 10 numbers measure 5 different aspects of a stock:
1. Safety (Z-Score, F-Score)
2. Quality (FCF Margin, Return on Capital)
3. Reliability (FCF Margin Variation, Return on Capital Variation)
4. Earning Power (Price/10-Year Real FCF, EV/10-Year Real EBIT)
5. Asset Value (Price/NCAV, Price/Tangible Book)
This standard test works a lot like a patient’s vital signs. It alerts us to any dangers. And it clues us in on what aspect of the stock is a problem.
Like with McGraw-Hill, we aren’t going to spend any time on asset value, because Masco is also a company with no tangible equity. Masco runs on intangibles. Its earnings come from brands and acquisitions. The salvage value of Masco’s assets won’t protect us.
Masco’s Vital Signs
1. Z-Score: 2.04
2. F-Score: 4
3. FCF Margin: 8.09%
4. Return on Capital: 16.65%
5. FCF Margin Variation: 0.22
6. Return on Capital Variation: 0.50
7. Price/10-Year Real FCF: 4.39
8. EV/10-Year Real EBIT: 5.38
9. Price/NCAV: NMF
10. Price/Tangible Book: NMF
These numbers tell us a lot. If we put them into words it would go something like this. Masco’s safety is bad. Its quality is good. Its reliability and earning power are both very good. And it’ asset value – since it has none – is obviously very bad.
That means any buyer of Masco stock is betting on Masco’s earning power.
The problem with this approach is not unreliability. Although Masco – a home improvement company with 80% of sales in North America – is having a hard time right now, there’s nothing in the past record to suggest it’s results are especially choppy. Sales rise and fall. But even during the extreme economic events of the last 10 years – first a huge housing boom and then a bust – Masco is more reliable than your average business. In fact, it’s a lot more reliable.
Why is that?
It has to be the competitive landscape. We see this in some other businesses – like advertising – which are perceived to be very cyclical businesses with intense competition but are in fact remarkably calm and steady cash generators.
Masco’s free cash flow variation – at 0.22 – is incredibly low. It’s the same as McGraw-Hill. If we just picked a public company at random – it would almost certainly have much bigger fluctuations in its free cash flow margin. In fact, most companies fail to consistently produce free cash flow over 10 straight years.
In this case, the better gauge of Masco’s reliability is the variation in its return on capital. Remember: return on capital is operating earnings (EBIT) divided by tangible assets employed in the business.
Good cash management can smooth out some of the bumps in free cash flow generation. Basically, you can convert inventory and receivables into cash faster during bad times. If you’re disciplined. As a rule: better than expected free cash flow generation during bad times is usually a sign of good management. Cash conversion is one of the few things managers can control during downturns.
However, good cash conversion can’t go on forever. So, a more realistic estimate of variation in earnings is return on capital variation. Obviously, the ideal solution would be to look at both numbers. And that’s what we’ll do.
|Free Cash Flow Margin||Return On Capital|
A lot of readers have emailed me wondering about my obsession with free cash flow.
Some – actually quite a lot – of you would rather I used EBITDA and some sort of maintenance capital spending assumption. I’d love to. I don’t know how. If you have a good way to estimate needed capital spending that works just as well for a bookstore chain, a railroad, and an advertising agency – I’d be happy to use it.
Instead, I prefer to keep assumptions on the sidelines during the descriptive part of our stock analysis. First, we get a standard set of numbers together. We don’t analyze at this point. That comes later. Analysis requires assumptions. But the collecting and recording of these 10 standard numbers just requires a little drudge work.
So, we’ve dealt with what Carl Icahn sees in Masco. Its has strong, reliable earning power. Masco’s actually more reliable – not less – than companies in supposedly less cyclical businesses. That’s not because sales aren’t volatile – they are. It’s because Masco manages to eke out positive free cash flow and operating income in bad times and good. Even companies with more reliable sales usually have less reliable profits.
Now no one is interested in a stock with reliable earnings unless the price is low compared to those earnings.
Price is probably what attracted Carl Icahn to Masco. It’s certainly what attracted Richard Pzena.
At $12 a share Masco stock is selling for just 4.4 times its 10-year average real free cash flow of $2.73 a share. As always, I’ve adjusted past free cash flow to reflect both economy wide price changes (“inflation”) and share count changes. Masco bought back a lot of stock over the last 10 years. So each share now makes up a bigger slice of the total Masco pie.
Since Masco’s free cash flow doesn’t match up perfectly with its operating earnings, I’ll show them both to you side-by-side and let you decide which you want to use to value the company.
|Real FCF Per Share||Real EBIT Per Share|
What if we count the debt?
If we count the debt – we have to add another $7.15 a share to Masco’s stock price. That’s because Masco is carrying $7.15 a share in net debt. Since the current stock price is $12 – that gives us a stock price with debt attached of $19.15 a share.
Masco’s 10-year average real EBIT is $3.56 a share. And $19.15 divided by $3.56 is 5.38. So – even with debt attached – we’re still looking at an earnings multiple (basically, a P/E) of less than 6.
Either way you choose to measure it – free cash flow or operating income – Masco is trading for less than 6 times what it earned on average over the last decade.
But – as we all know – the last decade was an extraordinary one. Once in a lifetime boom and bust. Never to be repeated, etc., etc.
So how do we adjust Masco’s past earnings to come up with Ben Graham’s idea of “normal” earning power?
Each investor has their own way of doing this. None of them are wrong. Some folks like to get into really detailed macroeconomic forecasts. Maybe layer on some industry analysis.
I don’t do any of that.
I just look ahead 10 years and ask how much worse can the next ten years be compared to the last 10 years before I start losing money in this stock.
In Masco’s case, we know the free cash flow and EBIT multiples are 4.4 and 5.4 respectively. If we assume Masco will trade at your typical market matching multiples of free cash flow and EBIT sometime in the next 10 years – which is my usual assumption – we see there’s about a 50% to 70% earnings decline cushion built into the stock price.
There are lots of ways of looking at this. One way is to just use a 15 times free cash flow multiple as “normal” and then ask how far can Masco’s “normal” free cash flow fall and still justify a $12 price. That’s easy. It’s $12 divided by 15 equals $0.80. And we know Masco averaged real free cash flow of $2.73 per share over the last 10 years. So, there’s a 71% decline built into the stock price.
But is there? Is that really what the market is predicting?
I don’t think so.
If it was – I’d say go right out and buy Masco. Follow Carl Icahn and Richard Pzena into the stock. No problem. At some point – Masco’s cash earnings will stabilize and they’ll be higher than 80 cents a share. So, you’ll make money one day. Plus, the company has a history of paying a dividend and buying back stock.
So what’s not to like?
The balance sheet.
Masco has a poor Z-Score (2.04) and a poor F-Score (4). The amount of debt the company is carrying wouldn’t be problematic in normal times. There are a lot of ways to think about debt loads. My favorite – and I think I’ve mentioned this before – is to compare free cash flow with the amount of debt.
In other words, I like to think in terms of how fast the company could pay off the debt without slowing capital expenditures.
In good times, Masco could pay off its entire debt in under 3 years. The debt is $7.15 a share. And the long-term average free cash flow is $2.73 a share. That’s 2 and a half years of free cash flow. Not bad.
But these aren’t good times.
The real question for anyone buying Masco stock at $12 a share is how safe is it? What does the balance sheet look like? How quickly do we need to see increases in free cash flow?
I find that questions about a stock’s safety – beyond the obvious points like the Z-Score and F-Score – are really very personal decisions. I’ve never been able to convince someone who thought a stock was unsafe that it really was safe. Nor has anyone ever convinced me a stock I thought was safe was really risky.
For whatever reason, I’ve found arguing about bankruptcy risk to be a waste of time.
For Masco, even if the company was faced with a liquidity problem, it’s likely it could get the cash from somebody. Masco is a valuable business trading at a low price. In normal times, the worst that usually happens in those cases is having to sell a large part of yourself to someone at an obscenely low price, because you needed the cash fast.
Anyone interested in Masco should start by looking at its financial risk. Is the stock safe? Will the company survive without making changes to its capital structure? Without selling things off?
If that happens, expect the stock to rise to $20 to $35 a share. I wouldn’t bet on $35 a share. In fact, I’d bet against it. The last 10 years won’t be repeated.
But $20 a share is possible. That’s more than a 60% gain from the current $12 price.
And Masco doesn’t have to return to its earning glory days to justify a $20 price.
It just has to stagger through some tough economic times without diluting its shareholders.