NACCO (NC, Financial) is spinning off its Hamilton Beach small appliance business this week. NACCO’s remaining business will be a lignite coal miner (NACoal) that operates mostly unconsolidated mines under mostly long-term cost-plus supply contracts. In an earlier article, I explained why this lignite (“brown”) coal-producing business would be inside my “circle of competence” and the Hamilton Beach small appliance business would be outside my “circle of competence.” This led some people to ask: But what if Hamilton Brands trades at a deeper discount to your appraisal value than the post-spinoff NACCO? What if the value is in Hamilton Beach, not NACCO? You’re a value investor. So you’d have to buy Hamilton Beach, right?
That’s a good question. And, in this case, it’s likely that Hamilton Beach will trade at an especially low valuation compared to peers. Unlike some value investors, I do a detailed – like to the exact dollar – appraisal of a company before I invest in it. I have a share price in mind that I designate as intrinsic value. It’s not that I believe I can precisely value a company. The two reasons for always doing an explicit intrinsic value calculation are: 1) It forces me to make my assumptions explicit, and 2) it forces me to be honest about how big my “margin of safety” is.
I try never to pay more than 65 cents on the intrinsic value dollar for a stock I like – no matter how much I like it. So, for instance, I appraised Frost (CFR, Financial) at about $141 per share a couple years ago and then I bought that stock at about $49 per share. That’s a discount of about 66%. It’s very unusual for me to find any stock trading at a discount of more than 50% to my appraisal of intrinsic value. I have probably averaged one such find per year in each of the last few years. This approach helps explain why I get questions like: if you like Cheesecake Factory (CAKE, Financial) so much, why don’t you just buy it now? And, if you like Omnicom (OMC, Financial) so much, why don’t you just buy it now? Omnicom trades at $75 per share right now. So you can guess – based on the fact I want a 35% discount to my appraisal value – that I appraise Omnicom at not much more than $115 per share. It might be less. I might appraise it at about $100 per share. In fact, while I don’t normally talk in too great detail about the appraisal value I’d personally put on a stock, $100 per share isn’t a bad guess for how I’d appraise Omnicom. So, yes, I may like Omnicom as a business and be willing to hold it long term. But I don’t want to pay $75 for something I think is only worth $100.
Cheesecake Factory trades at $42 per share. I haven’t bought it. So you can probably guess that I don’t think the business is worth much more than $65 per share. This is because $42 / $65 is about 65%. I want to pay less than 65% of my appraisal value for a stock. You can think of this as meaning I want a little more than a one-third margin of safety or that I want a little over 50% upside potential (65 * 1.54 = 100). I just think of it as meaning that when a stock enters my portfolio I want it to be 65% or less of what I think the business is worth. This is where I expect a good portion of my returns to come from. Over time, you’d expect something that trades at 65% of what it’s worth to eventually find its way up to 100% of what it’s worth (or even go a bit beyond that).
Say you hold that stock for 10 years while this process takes place. That adds 4% a year to your return.
Say you hold the stock for five years while this process takes place. That adds 9% a year to your return.
Say you hold the stock for three years while this process takes place. That adds 15% a year to your returns.
I’ve included this last figure – of how big the gain in a multiple expansion can be if the expansion takes just three years to be completed – to make the case for why something like Hamilton Beach can sometimes be a better stock to buy than something like the coal half of NACCO. I’m personally more interested in – and more comfortable owning – the coal half. However, NACCO is keeping the coal half. The spinoff will be Hamilton Beach.
NACCO as a whole already trades at a reasonable price-earnings (P/E) ratio. You can trust me on this and skip this next paragraph or you can slog through some simple math with me that proves it.
The EV/EBITDA on the combined NACCO stock is maybe nine or 10 times. An EV/EBITDA of nine to 10 often translates into something like a debt-free P/E of 18. However, half of NACCO is a coal miner. U.S. companies pay federal taxes of up to 35%. However, you’d expect a company with NACoal’s business model to never pay more than 25% a year in taxes and probably to pay closer to 20% a year in taxes. This is because NACoal has a reduction in taxes related to “depletion” of its coal deposits. This tax break isn’t related to the corporate structure. It’s a result of the basic business activity NACoal is involved in (the surface mining of coal). The depletion tax break has significant value. Right now, I’d estimate it saves NACCO about $7 million a year in taxes. The company only has 6.8 million shares outstanding. So the tax code adds about $1 a share to EPS. I just said an EV/EBITDA of nine to 10 often translates into a debt-free P/E of about 18. So an extra $1 of EPS can be worth as much as $18 per share to the company’s valuation. A normal P/E is more like 15. So let’s call it $15 per share in value added from lower taxes. The EV/EBITDA ratio does not capture this tax break. And investors are not used to seeing businesses that have high depletion for tax purposes yet have low capex needs for cash flow purposes.
Investors tend to price businesses off EV/EBITDA or EV/EBIT multiples versus peers. So there’s a belief that a small appliance maker should trade at a certain EV/EBITDA and a coal miner should trade at another, different EV/EBITDA. However, the reason companies in the same industry should trade at the same EV/EBITDA is because their business models are the same. In industries where different companies have different business models – multiples are not similar. So, for example, banks like Frost (which I own), Bank of Hawaii (BOH, Financial)Â and Wells Fargo (WFC, Financial) have very high prices relative to book value because they generate very high earnings relative to book value. If a business converts more EBITDA into after-tax free cash flow than its peers, it should be worth a higher multiple of EBITDA than its peers. I would expect NACoal to have low taxes (as other miners do) but also low capex (which is the opposite of what most miners have). Inflation would also work differently for NACoal than other miners because the combination of depletion, low capex and cost-plus contracts that re-price with inflation is much more beneficial during inflation to a company that generates revenue from coal mines without sinking capital into coal mines (NACoal has one mine that works differently – it does cost a lot of capital). So NACoal should have less ITDA (interest, taxes, depreciation and amortization) than other mining companies. That makes what it earns before ITDA more valuable.
Some of this may be recognized in the current stock price. We won’t really know till Hamilton Beach is trading normally on its own. We know how the market appraises NACCO as a whole. But we don’t yet know how much of that overall appraisal pie goes to NACoal and how much to Hamilton Beach. As I said, you have a price of like nine or 10 times EBITDA or maybe something like 13 times EBIT for a business that is just coal mining and small appliances. We’re talking about a P/E of close to 20 for a combination of coal mining and small appliances. That doesn’t seem especially cheap.
My hope – since I am interested in the coal business rather than the small appliance business – is that investors would put a higher value on the spinoff (to trade as HBB) and a lower value on the remaining business (to continue trading as NC). This would make my decision easy. I like NACoal. So if NACoal is cheap and I like it, I should buy it.
But what if investors don’t put a high value on Hamilton Beach and instead many investors are eager to sell the spun off shares they receive? This would make Hamilton Beach the clearly cheap stock. Should I buy it?
Joel Greenblatt (Trades, Portfolio) would say “yes.” He wrote a great book called “You Can Be a Stock Market Genius.” That’s not the only book he’s written. But that’s the only book of his you need to read. In that book, he talks about investing in spinoffs. And he talks about valuing these spinoffs against comparable companies. Basically, you do a peer valuation.
I did this with every issue of the newsletter I wrote from 2013-2016. I would gather five peers of the company I was interested in and I’d calculate their prices in terms of EV/Sales, EV/Gross Profit, EV/EBITDA and EV/Owner Earnings (often an adjusted form of EBIT). The best stocks to buy were often those that were cheaper than their peers. For example, I used “Price/Deposits” for banks instead of Price/Revenues. By that measure, Frost was a cheaper bank than most peers I could find.
The best situation is when you can find a business you think is higher quality than all its peers selling at a price you think is lower than all its peers. So the combination of NACoal and Hamilton Beach was trading close to 10 times EBITDA. What if the Hamilton Beach spinoff is valued in the weeks ahead at just five times EBITDA? Shouldn’t I forget about NACoal and invest in Hamilton Beach instead?
That would be a tough decision. I like Hamilton Beach less than NACoal. But I know that the average small appliance maker is definitely not going to be valued at less than eight times EBITDA. If Hamilton Beach spun off at something as low as five times EBITDA, it would be selling at a greater than 35% discount to a peer-based appraisal value (5/8 = 63%). In fact, in today’s expensive stock market, you’d expect a business like Hamilton Beach to be valued more at something like 8 to 10 times EBITDA. So if it was spun off at something like five to seven times EBITDA, it would hit my magic number of a 35% discount to appraisal value.
That would make Hamilton Beach a value stock. But would it make Hamilton Beach a stock I should buy? Surely there are other stocks that trade at a 35% discount to their peers. They’re just lower quality than their peers. Or they are riskier than their peers. Or their peers are pretty expensive in the first place. Does that mean we – as value investors – should always buy any stock that trades at a 35% discount to a group of its peers?
I actually think that’s a pretty good strategy. If you can find a group of five peers and you can find a stock in that group that is trading for less than all the rest of them – then you know you are building a portfolio only out of those stocks in the bottom quintile of expensiveness. You’d be diversified by industry, business model, etc. And you’d be using capitalization adjusted measures like EV/EBITDA that take debt into account. This approach seems much better than either a low P/B or low P/E approach – which is what some people think value investing is.
The danger – for me – in investing in something like Hamilton Beach (even if it is spun off at a value price) is twofold: 1) I’m bad at judging just how much increased competition can reduce a business’ value, and 2) I’m bad at investing in stocks where analysts, investors, etc., know the business as well or better than I do.
This next part may sound a bit arrogant. But it’s important for you to understand why businesses like Frost and BWX Technologies (BWXT, Financial) seem “simpler” to me than something like Hamilton Beach.
Hamilton Beach makes toasters and BWX Technologies makes nuclear reactors. Surely, I understand a toaster better than a nuclear reactor, right?
I don’t think I understand the economics of a toaster better than most people do. I do think I understand the economics of a nuclear reactor better than most people do.
BWX Technologies builds nuclear reactors for the U.S. Navy, does work for existing nuclear plants in Canada and then provides nuclear-related services to the U.S. government (often having to do with America’s nuclear weapons program). I tend to know more about nuclear reactors, U.S. submarines and aircraft carriers, CANDU reactors, nuclear weapons, etc., than the average analyst, investor, etc., who comes across BWX Technologies. I certainly know more about the history of all those things than most people do.
Having a better sense of history is probably why I was able to get a good price on stocks like Frost and BWX Technologies.
Whenever I talked to someone who had read my reports on Frost and Babcock & Wilcox (BW, Financial) who ended up not buying the stocks, their reason for doing so was usually not that they passed on the stock after researching it but simply that they found the research itself too confusing. One person I talked to said, “You know, I tried reading about BWXT for the second time last night, and my eyes just glazed over. I can’t make myself care about that kind of business enough to read through the filings.” That’s the advantage of NACoal over Hamilton Beach. I really don’t feel like I’m ever going to understand Hamilton Beach better than other people will. I think I’ll be able to understand NACoal better than other people will because a lot of people will just stop reading about a business like that.
I’ll use Frost as an example. In my report on Frost, I went through a lot of detail about how you can calculate the true long-term interest rate sensitivity of a bank by analyzing its funding sources. Frost is funded differently than most banks. It gets more money from customer deposits, and it pays less interest on those deposits than other banks do. This is important because all banks make more money on their asset side when the Fed Funds Rate rises, but depending on its funding sources a bank’s cost of funding can go up either a lot or not very much with higher Fed Funds Rates. History can show you pretty clearly which banks will make a lot more money when interest rates are higher in a few years and which banks will make only a little bit more money when that happens.
This is the part that bored people about Frost. I did a post on my blog just about this topic. And I think people were bored by all the arithmetic in it. The fact I called the post “Frost: Interest Rate Expense and Cyclically Adjusted Earnings” probably didn’t help. But it's posts with titles like that which are usually most valuable to investors.
In the case of Hamilton Beach, its biggest customers are retailers like Walmart (WMT, Financial) and Amazon (AMZN, Financial). I’m just not going to know before other people do whether Amazon decides to introduce private label Amazon Basics type blenders, toasters, slow cookers, coffeemakers, etc. I am an Amazon Prime member. But I don’t shop at Walmart and a lot of America does and Walmart is 30% of Hamilton Beach’s business. There are investors and analysts out there who probably use Walmart as their primary shopping destination, have relatives who work at Walmart, etc. They have a big advantage over me. There are also people out there who actually care about blenders, toasters, slow cookers and coffeemakers. They know which brands are good and which aren’t. They know a lot of things I don’t.
These people would be much more capable of judging any diminishing market power at Hamilton Beach. Are Walmart and Amazon gaining bargaining power over Hamilton Beach? Is it staying the same, or are things moving in Hamilton Beach’s favor? I don’t know that better than millions of other Americans know that.
So I will consider HBB stock if it trades at more than a 35% discount to what I think a control buyer (like a competitor) would pay for the entire Hamilton Beach business. But I’m never going to prefer Hamilton Beach over other stocks I think are equally cheap. I understand Omnicom and Cheesecake Factory and Howden Joinery (LSE:HWDN, Financial) better than I understand Hamilton Beach.
I’ve said before that the most important thing for me when looking at a stock is evaluating the business’ market power. If I understand the business’ market power, I understand the business.
I define market power as:
“Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”
I feel much better able to evaluate NACoal’s market power than Hamilton Beach’s market power. I’m really not sure I can evaluate market power at Hamilton Beach. If the stock is spun off at like five to seven times EBITDA, I guess I will have to spend some time trying to see if there’s a way for me to get a better grasp on this company’s market power. But without some understanding of a company’s market power, I just can’t invest in it regardless of the earnings multiple it trades at.
Disclosure: Long Frost and BWX Technologies.
