Price: C$10.70 (2/15/2012)
Recently a reader sent me an email asking for my opinion on a stock they were looking at. The company is Danier Leather a Canadian retailer. The company has retail locations located in malls and power centers which are large outdoor malls. Danier is a vertically integrated leather company meaning they don't just sell leather apparel they also design and manufacture it. They source their leather from China and then manufacture their designs domestically.
Before I dive into the weeds I want to make a small investment case for Danier Leather:
-Trading slightly above NCAV
-55% of market cap in cash
-EV/EBIT of 2.16
-EV/FCF of 11.02
-ROE of 12%
Asset value examined
I recently overhauled my net-net template to something that I think will be easier to read and contain more information. Danier is a perfect company to trial the template on:
There are two columns, the first shows the balance sheet values for different assets. The second column shows a discounted value of that asset. Both columns have a per share breakdown as well.
So as you can see with Danier they have an NCAV of $9.06 a share, and a discounted NCAV of $6.08 per share. Most of the company's assets are in cash and inventory which isn't surprising given they are a retailer. It might seem strange that they don't have a large account receivable balance but this makes sense. When a customer comes into a store they pay on the spot, the company shouldn't be waiting for a payment from customers at all.
The item that stuck out to me when reviewing the balance sheet was that there was a relatively small balance of fixed assets. Knowing that most locations are in malls I figured Danier doesn't own any retails space. So I searched the annual report for operating leases and voila an off balance sheet contingency.
Adding back the operating leases discounted to the present squarely knocks Danier out of the net-net category. If they were to liquidate they could still contractually be on the hook for those leases, and the minimum lease amount is more than cash on hand eliminating that buffer.
Fortunately for the reader who asked about Danier all is not lost. Even though Danier isn't a solid net-net it's not really a problem, the company has no plans to liquidate and in fact they have something most net-net's don't have, a decent business.
The operating business
The company has had a nice run of profitability outside of a small loss in 2009 which is a bit surprising because Canada only had a mild recession as a result of missing the housing bubble. Some people argue that Canada is in a housing bubble now, but based on Danier's earnings it doesn't appear like too many people are borrowing on their homes to purchase leather goods.
The company has a nice summary in their annual report of the past few years results:
The key takeaway for me is that results aren't consistent but they've been profitable four out of the last five years. The second key point is that shares outstanding has been declining at a pretty rapid pace, almost 30% fewer shares in 2011 than in 2007.
The next thing I did was to steal an idea from Richard Beddard at Interactive Investor Blog (a must read if you don't already). He likes to show the growth in book value by breaking out tangible assets, intangible assets and cumulative dividends. Danier doesn't pay a dividend so I decided to do two charts, one showing assets on a gross basis, and the second showing assets on a per share basis. The second chart is what shareholders get as a result of buybacks, a steadily increasing book value per share.
Gross Assets
Assets per Share
The last thing I looked at was the return on invested capital. I get questions about this all the time so I want to explain my calculation. I take free cash flow divided by equity minus cash plus debt and operating leases. So let me explain a bit, I use free cash flow because this is a realized return above what the company needs to operate. This eliminates companies that eat up a dollar generating a dollar even if on a net income or EBIT basis returns look great there's nothing left over for shareholders. Secondly I add in operating leases because this is an intangible asset the company needs for their business. If Danier didn't have their leases they wouldn't have a place to sell their apparel.
In computing this for Danier I ended up with a 3.56% ROIC. Here is the calculation:
So what we have is a retailer that has a solid balance sheet operating leases not withstanding. They have a stable sales history and a pretty good track record of profitability recently. The company's free cash flow has fluctuated over the years with inventory build ups and draw downs. When free cash is flush the company's used it to buy back shares which have increased the book value for shareholders.
I like to invest in businesses that have an absolute margin of safety which is something I'm not seeing with Danier. The balance sheet at first appears to provide it but once all liabilities are considered the margin disappears. The company is undeniably cheap trading below book, with a low P/E and EV/EBIT multiple.
Danier doesn't jump out to me as a fat pitch stock. The stock is cheap, but there are a lot of cheap stocks out there. The question to ask "Is Danier cheap due to it's business or something external?" I don't know the answer. I also recognized I'm biased because leather doesn't seem to be in style in the US, which means nothing for Canada and a Canadian retailer. This is probably the type of stock for someone who likes to build a portfolio of low EV/EBITDA, EV/EBIT or P/CF stocks would own and do well with.
Talk to Nate about Danier Leather
Disclosure: No position
Hey Nate,
ReplyDeleteGreat post. Interesting idea.
One thing I have noticed though is that when you make your ROIC calc's and add back operating lease value is it doesn't seem you adjust earnings by adding rent expense, which makes ROIC seem lower than it likely is.
Check out WMT's annual report (see page 7) for an example -http://www.sec.gov/Archives/edgar/data/104169/000119312511083157/dex13.htm
If I'm wrong and you are making the adjustment, my bad!!!
Either way, keep up the great work.
Correct, I don't add back in rent expense on purpose. The rent is a requirement to run their business, without rent they wouldn't be able to operate. That's the same reason I add in leases to the denominator.
DeleteThe key is I use FCF as the numerator instead of EBIT or net income. FCF gives me the investor return on total invested capital. FCF also accounts for working capital changes as well, a company might have a great net income but then consume all that cash on working capital changes leaving nothing for an investor.
The ROIC calculation tries to screen out and avoid companies that have a solid profit but then are required to plow all that profit back into the business to keep operating.
The criteria is a bit stricter and like you said will give a lower number than say ROE, but I believe it's more accurate and realistic.
Another way to think about my ROIC calculation is that I'm showing the cash return on cash spent.
DeleteVery old post I know but hopefully my reply will help someone going through the old posts (as I have)
DeleteAnyway, I believe that Whopper is correct in this instance. By capitalizing the Operating lease in the denominator of the ROIC figure, you must subsequently think of lease expense as a financing expense rather than an operating expense. Accordingly, it should be added back to the numerator in order to maintain a capital structure agnostic figure. Damodaran writes about this very subject in this essay:
http://people.stern.nyu.edu/adamodar/pdfiles/papers/oplev.pdf
Allow me to partially amend my previous comment--you should not just blindly add back the entire lease expense to the numerator--that would imply that leased capital is the same as capital purchased with debt. Rather you should add back the imputed interest expense on the capitalized lease--so the NPV of future lease payments * the company's cost of debt.
DeleteThe idea is that with a capitalized lease the payment is split between depreciation of the lease which obviously falls into operating expenses and interest payment which falls into financing expenses. Your adjusted operating income should add back just the imputed interest portion (the financing cost) of the capitalized lease.
So in a sense you guys are both right--adjusted EBIT in this case shouldn't add back the entire lease expense that would be too generous, but it also shouldn't have the full lease expense deducted from it as that would be too onerous.
Hopefully that makes sense, it's kind of a weird gray area which makes for an interesting debate. If I am wrong I look forward to being corrected.
Allow me to partially amend my previous comment--you should not just blindly add back the entire lease expense to the numerator--that would imply that leased capital is the same as capital purchased with debt. Rather you should add back the imputed interest expense on the capitalized lease--so the NPV of future lease payments * the company's cost of debt.
DeleteThe idea is that with a capitalized lease the payment is split between depreciation of the lease which obviously falls into operating expenses and interest payment which falls into financing expenses. Your adjusted operating income should add back just the imputed interest portion (the financing cost) of the capitalized lease.
So in a sense you guys are both right--adjusted EBIT in this case shouldn't add back the entire lease expense that would be too generous, but it also shouldn't have the full lease expense deducted from it as that would be too onerous.
Hopefully that makes sense, it's kind of a weird gray area which makes for an interesting debate. If I am wrong I look forward to being corrected.
Nate - good on you for capitalizing operating leases as part of Invested Capital. Not many do that and its often a material off-bs use of capital and a sizable obligation. Its especially material for retailers. I also capitalize r&d (obviously not relevant here) and add that to Invested Capital. When I looked at DL, my problem was that as a retail concept there isnt much room for expansion - they are all over canada already. They have already expanded into accessories and made improvements to their fashion appeal (low hanging fruit). If anything, this makes them more susceptible to a seasonal miss. I have noticed they increasingly rely on clearances and sales, so I cant help but think this it makes it tougher to sell stuff at full price going forward. I applaud management focus on prudent capital allocation, but given the lack of expansion opportunities, this maybe all thats left to do to create shareholder value. Another interesting bit that turned me off is management option issuance - over 10% of the float (although i havent looked at the vesting schedule) and at much below current prices. Management total compensation is pretty hefty. Overall I decided to wait for them to miss or the environment in canadian retail (another yellow flag) to provide some downturn in the shares...
ReplyDeleteFrank,
DeleteThanks for the comment. You raise a lot of good points, especially in terms of expansion. If the company has saturated Canada, and they failed to expand to the US what happens next? I think this is the big question a potential investor would need to ask themselves.
I noticed the same thing with options as well. I didn't look at management compensation, but when I saw the shares outstanding vs the diluted shares I knew I didn't need to look much further.
Nate
Thank you for the article.
ReplyDeleteI thought I would add my 2 cents since I am currently long DL. I think you bring up some good points but regarding the FCF, I would personally make some adjustments. Looking at last year's CF statement, it is true that there was an inventory build-up, reducing the CF from operations -- but looking at previous years that is not always the case. It might be a good to add back some of the increase in working capital to the cash flow since on average, the achievable FCF is closer to $8-10M.
Best quote ever: "Danier's earnings it doesn't appear like too many people are borrowing on their homes to purchase leather goods."
ReplyDeleteLOL!
A few small questions/remarks on your ROIC calculation. I don't quite understand why you add debt (obviously not relevant with Danier) to TOTAL assets? This greatly overstates invested capital?
ReplyDeleteAssets 100 Debt 50
Equity 50
Invested Capital = 150 which makes no sense to me at all if the total capital (equity + debt)= 100?
I'm presuming (perhaps incorrectly - I don't use it for instance)FCF also includes interest expense. One problem with this is that you mix operating returns (which is what you want to know in this case) with financing returns (or costs in this case). Furthermore, by including NWC changes you also get some double counting it seems to me: assume inventories rise by X in a year this would lead to more capital (+X) AND lower FCF (-X).
I use a variant of the following, usually:
NOPLAT (EBIT - taxes adjusted for interest +/- any non tax provisions)
divided by
Capital Employed (Total Assets less cash & investments less non-interest bearing current liabilities [the latter essentially being short-term non-interest bearing financing]).
Finally, there is an element of double counting in adding the PV of lease obligations to the denominator whilst also deducting the lease payments from the numerator (included in costs and thus also in FCF).
Curious to hear your thoughts!
Anon,
ReplyDeleteThanks for the comments, I actually get so many questions on ROIC that I created a post to explain why I use what I use.
Here is the post: http://www.oddballstocks.com/2012/02/few-thoughts-on-roic.html
You also caught an error in my post, I use equity not total assets. The formula I have shows equity, but in the text I put total assets. You're right, assets plus debt would be incorrect because the debt is used to purchase the assets.
I'm going to correct this, thanks for the catch.
Thanks for the clarification. I should have known it was a mistake.
ReplyDeleteReferring to operating leases once more (after having read your earlier post)I still can't shake the idea that including lease payments and the PV of lease obligations is far too onerous. To illustrate, imagine a company owned its property rather than leasing. Capital employed would be higher vs. a company without ownership but leases. However by using FCF (which adds back D, and land is usually not depreciated at all) the costs of owning that property would on a cash basis be 0 (to quibble; you could say at most there would be the interest payments on the debt associated with buying them, if you include interest in FCF). A company with operating leases would need to make substantial cash payments each year. Thus the company with owned buildings would have a higher ROIC than one without - which makes no sense to me. And while owning your own property has advantages it also has disadvantages relative to leases.
If you want to calculate a cash return on cash invested for shareholders why don't you just use FCF/EV?
Operating leases are just a form of off balance sheet debt. Danier needed to acquire the stores somehow, so if they purchased them with debt the ROIC calculation would be the same except we'd see the debt on the balance sheet.
DeleteIf the company acquired the stores outright FCF would be higher due to lack of interest payments but the denominator would be much higher as well. I only add the PV of lease payments whereas if they purchased the stores it'd be a much higher value than those lease payments which would work to shrink ROIC. My suspicion is that if you worked out each of these methods (debt/lease/outright ownership) with realistic values the ROIC would be similar for all of them. That's the beauty of this formula, it isn't skewed by financing decisions, it really tries to get to what the cash return is on cash invested.
I realize Danier can't buy their stores so they have to lease, that's a business model limitation. But they shouldn't be rewarded with juiced up earnings due to that.
I wrote a post about TNT express a while back where I compared them to UPS and Fedex, I put operating leases back in for those. UPS purchases everything with debt, Fedex leases, Fedex claims much better metrics but if you add back in leases they're similar.
Hello,
ReplyDeleteInteresting articles and discussions here. I first wasn't that convinced with adding the leases to the bottom line, but I actually think it is fully correct.
I tried to simulated the situation if Danier would have purchased all the real estate it leases and would have financed it with all the money at hand and rest with debt. This resulted in topline FCF increasing from 2293 to ~10746, mainly due to non-cash depretiation that they would record from now owning the locations. At the same time the bottom line would increase from 64356 to ~217299 due to added debt resulting in a ROIC of slightly below 5% depending on the parameters. Assumptions were that Danier would need to pay 183,000 for the locations 183,000 * 0,06 = ~11 000 (which they seem to pay yearly now in leases and assuming the owners require 6% yield on their malls). 4% depretiation, and 6% interest on debt. Don't know how reasonable these assumptions are but... So the ROIC increases slightly, but so does the risk of bearing a huge amount of added debt.
Concluding question: What is a reasonably price to pay for a business earning ROIC of 3,5%, which is clearly underneath the cost of capital? Doesn't sound like a Buffett type "Wonderful business" and as he has stated earlier, "Time is the friend of the wonderful company, the enemy of the mediocre".
Hello,
ReplyDeleteAren't the operating lease payments already included into sg&a?
Hey Nate,
DeleteI have recently been doing some work on Danier Leather. I have tried to value the business both on an asset basis (NCAC, etc.) as well as on an earning basis (P/E or P/FCF ex cash).
When looking at a business like this, do you have any advice on how to calculate a P/E net of cash? It appears the cash balance fluctuates throughout the year given that their sales are heavily tied to one particular quarter. In the quarters leading up to the holidays, cash is low and inventory is high. After the holidays, cash is high and inventory is low.
When calculating a P/E or EV/FCF, what cash balance do you use? Do you use current period cash (which could be skewed depending upon the time of year)? Or do you take an average cash balance (ex. trailing 4 quarters)?
I'd love to hear your thoughts.
valueguy123,
DeleteFor backing out cash, if it's consistent or roughly consistent I'll just take the latest period cash and back it out for EV or whatever. If it's lumpy you can take the average throughout the year, or take the lowest period with the presumption that at the lowest point anything not used is excess.
I've looked at some companies and roughly estimated what is necessary cash and what is excess cash, then adjusted accordingly. Alternatively you can just call and ask the CFO, he would probably be able to clarify exactly what their cash needs are on an operating basis.