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Mar 30 15

Further Thoughts on the Merits of Buybacks

by Cove Street Capital

by Rohan Rangaraj | Research Analyst

One of the official Favorite Books in the Cove Street Capital Library is The Outsiders by William Thorndike, an in-depth study of eight of the last half-century’s greatest CEOs in terms of value creation. One trait they all shared was the propensity to go against conventional wisdom and buy back their company’s own stock when it was cheap.

The key here is cheap. We’ve noted on this blog before that many Boards and management teams don’t understand effective share repurchase, and with events of late we can’t help but revisit the topic. By now you’ve surely heard that everyone is buying back stock. Some say it’s great; others are worried because these buybacks coincide with a market near all-time highs. We would argue that both are correct, and point out that it depends entirely on the situation. For some reason, the discussion often seems to neglect the simple task of framing it properly: intelligent share repurchases can add tremendous value in the long run, while mindless, unintelligent repurchases with no regard for value can do just the opposite.

Recently, General Motors reached an agreement with a set of activist shareholders to spend $5 billion on share buybacks over the next two years. On the one hand, no shareholder is complaining about the near-term effect it had on GM’s stock. On the other hand, one can’t fault investors who express concern at the prospect of a company in an intensely cyclical industry having less cash to serve as a cushion when an inevitable downturn hits. From our standpoint, we think GM is cheap, that it will be purchasing its shares below intrinsic value, and it has plenty of cash to weather even something a little bit stronger than a garden variety recession.

On that note, we were irked to come across this drivel vomited out by no less than the Harvard Business Review. The money quote: “Taxpayers and workers should demand that open-market repurchases by all companies be banned.” Ugh. We didn’t know they were letting high school seniors write for HBR.

While we won’t dispute that a majority of repurchases are likely done for misguided reasons without any eye towards intrinsic value—like, say, buying back exactly enough to offset dilution every single year regardless of price—it’s sheer nonsense to discount the enormous advantage prudent buybacks can create for a company whose management uses them as an effective capital allocation lever over the long-term. Arguments suggesting that buybacks ignore the common worker are extraordinarily short-sighted—for instance, they ignore the glaring likelihood that a company trading under its intrinsic value for too long will more often than not be gobbled up by a larger competitor (or private equity buyer) who invariably proceeds to lay off half the company. So not only does intelligent share repurchase add tremendous value in the long run, it can also add tremendous stability for companies as well. We are optimistic that GM’s should do the same.

On that point, we would be remiss not to mention one buyback program of recent years that was at least somewhat off the mark—that of IBM. Warren Buffett, in his 2011 letter to shareholders, extolled IBM’s leverage-to-buyback strategy of the prior several years. He further expressed his hope that over the next five years, as the company plowed perhaps $50 billion into buybacks, the stock would languish so IBM could buy in more shares more cheaply, and as a result he’d own a greater proportional share of a wonderful business.

Hindsight is 20/20 of course, but unfortunately that letter top-ticked the stock. 3 years and $40 billion of buybacks later, it’s fair to question whether IBM would have been better served had they allocated some portion of those buybacks towards more aggressively building out the weaker areas of the business. Despite using massive buybacks to show continued increases in EPS in dogged pursuit of the prior CEO’s stated 2015 $20 EPS target, the stock indeed languished up until last fall, at which point it tumbled off a cliff as its relative underinvestment in cloud and data analytics finally caught up to it and IBM abandoned its pie-in-the-sky $20 goal.

This is not to knock Mr. Buffett for failing to forecast this (though several have argued it violated his “circle of competence” standard), but it brings up an important caveat when thinking about buybacks: is it better to be a larger shareholder of a declining business, or a smaller shareholder of a business which actually has solid prospects for the foreseeable future? Instead of buying back $40 billion of stock at an average price of $191—nearly 20% above today’s price—as IBM did over the past 3 years, it easily could have used its cash along with a slight amount of leverage and, as some analysts have suggested, purchased companies such as Salesforce.com or Workday. Just taking those as an example, the two would not have come cheaply—they’d have cost around $25-30 billion for $2.5 billion in sales (versus combined market caps today of $60 billion and sales of $6 billion, growing 36%)—but they would have immediately established IBM as an early-mover in precisely the area which it finds itself so far behind today: cloud services. Meanwhile, in part due to the company’s efforts coming so late, IBM is seeing such an acceleration of declines that one analyst notes they are “dwarfing IBM’s ability to capture new revenue opportunities as the market shifts.”

Now, investors (yours truly included) almost certainly would have slammed IBM for the lofty multiples it would’ve needed to pay to snap up those businesses. However—and here’s the rub—it’s not likely that it has been overwhelmingly cheap to attract the talent necessary to build out those systems internally. Additionally, it has taken much more time for them to attempt to build these capabilities internally, while the resulting organizational dysfunction has led to considerable reputational damage for IBM with its longstanding clients. Being an early mover can mean a lot more in this business than it does in, say, widget manufacturing. Further, given the near-existential threat these competitors have posed to IBM—something the company almost certainly must have suspected at the time—IBM may have been better off paying a fair premium to save the company.

In any event, the result of all this is that IBM has scaled back its buyback program to a decade-plus low after it finally abandoned its 2015 goal of $20 EPS. While the stock reacted swiftly and negatively to this retreat, we can’t help but think that the resulting freedom from the tether of using buybacks to hit that arbitrary-and-no-longer-relevant earnings target just might enable IBM to act more aggressively and someday regain its prior heights (opportunistic buybacks included, of course!).

In the meantime, there is no question IBM is facing a very real threat, one that may at least have been partially staved off by a different capital allocation strategy over the past several years. The larger point here is this: blind devotion to buybacks is not much better than blind disregard for them. Buyback decisions ought to be intelligent and opportunistic (i.e. based on intrinsic value), but should also remain in balance with the other capital needs of the business as an important part of generating outsized returns over the long-term.

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The opinions expressed herein are those of Cove Street Capital, LLC and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. The information in this presentation should not be considered as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that the security discussed in this report is or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the security discussed in this presentation. The report is based on data obtained from sources believed to be reliable but is not guaranteed as being accurate and does not purport to be a complete summary of the available data.Recommendations for the past twelve months are available upon request. In addition to clients, partners and employees or their family members may have a position in security mentioned herein. Cove Street Capital, LLC is a registered investment advisor. More information about us is located in our ADV Part 2, which is available upon request.

Mar 30 15

Send Your Kids to Bowdoin?

by Cove Street Capital

CLICK HERE to download a recent speech by noted Soros “sidekick” Stanley Druckenmiller.

Mar 25 15

Pondering Things Way Out of Our Control

by Cove Street Capital

by Eugene Robin | Research Analyst

The magnitude of the recent price decline caught many of “us” off guard and caused many (including Cove Street) to re-think our notion of what constitutes a sustainable oil price. Here, we analyze the somewhat complex question of “is $40 oil sustainable?”

Currently, with storage in the US looking like it’s about to hit escape velocity (see below), short term price pressures will continue as long as the supply overhang exists. While refiners will feast on the lower cost oil, nothing will change this dynamic until either one (or both) of two things happen: supply is decreased through less drilling, meaning we see actual production declines, or demand increases to absorb excess supply.

In the medium term (1-2 years), oil can stay in the current $40-50 range due to both supply not correcting and to demand stalling around the world. An interesting fact to mention is that while rig counts and capital budgets have been slashed by 50% and 20-60%, respectively, the overall year over year change in oil production for the US and the world is still forecasted to be positive. This is due to the fact that not all rigs are created equally, with many of the dropped rigs performing what is known in the oil patch as delineation drilling (where exploration companies drill wells to hold acreage or to discover how far a certain oil formation extends). The remaining rigs are drilling more efficiently, producing more wells per rig, and thus companies can produce more oil with less invested capital. Many small operators, who are the marginal producers in the US business, have slashed budgets but will still grow oil output. Our very own bloody warrior Approach Resources is cutting its capital outlay from $400 million to $160 million, yet production is expected to increase 10-14% this coming year. Approach is not alone. Only the majors are going to experience anything close to flat or declining production with many other smaller independents growing in the face of these very low oil prices. Given this, we find it difficult to argue against those that believe that a v-shaped recovery of oil prices is impractical.

However, if you look out longer term, thinking in five year increments, it is inconceivable that $40 oil stays around for much longer than a few years, barring a massive global depression. Several reasons exist to still be optimistic about higher oil prices over a longer time horizon. First, because oil is nothing more than a commodity, its price should approximate the marginal cost of extraction for the marginal barrel. With the US shale plays acting as the swing producer over the past year, we look to the fundamental economics of shale drilling to understand the marginal cost issue. If you were to look by basin (thanks to our friends at RBN Energy), you would see that current energy prices are having a hugely negative impact on returns on capital:

No one is profitable anywhere besides a few places in Texas or Oklahoma that can eke out returns far lower than the cost of capital of the operators. Of course one of the issues in this analysis is that just as the oil and gas prices are dynamic, so are the input costs. Again, our friends at RBN provide us with a rough approximation of what happens with a 25% reduction in well costs (producers have the range of reductions as 15-30% for 2015):

All of a sudden, it appears that 4 of the major oil basins in the country (Permian, Bakken, Eagle Ford, and Anadarko) are now exceptionally profitable and can generate high IRRs. However, we caution that these are averages that exclude company specific metrics such as operating cost structure or debt burden. In reality, there will be many marginal producers who are over-leveraged or who do not have the proper operating infrastructure in place to attain this average return. Another issue with this analysis is that it uses pre-tax calculations and thus avoids IRR calculations on an after-tax basis. The good news for oil prices is that, even with these potential returns, the overall growth of production will flatten out and might even decline in 2017 due to curtailment on the part of marginal producers in the best basins as well as curtailment by “liquids rich” or “combo” plays that have oil percentages less than 40%.

What all of this implies is that oil drilling will continue in the US until the funding runs dry and returns dip below 10% on a pre-tax basis. This augers for $40 oil as a long-term floor (since adjusting the above map for $40 would show no one above a 10% IRR), even taking into account the large service cost reductions already in the works. So if $40 is unsustainable, then where are prices “normalized?” That is the billion dollar question and while we have no way of knowing the right answer we can only surmise that the previous concept of $80 oil as the “normal marginal cost” of production has, thanks to cost reductions and efficiencies, given way to $60 oil as the new “normal marginal cost” going forward. We caution anyone that believes in “New Normals” or some version thereof, since normality is just a function of time and with small service providers in the oil field space is likely to disappear over the next year. We would like to point to the inevitable price inflation in the oil field service space after the reckoning is over.

In the short term, over-capacity will drive prices lower than the current WTI price until the stored oil overhang disappears. In the medium term, a combination of over-leveraged small independents running into financial problems, larger independents choosing to grow moderately or to drill within their cash flows, and majors curtailing some of their bigger ambitions all point to an eventual flattening of US production growth. In the long-term, barring a disintermediation of oil by some new energy source within the next three years, we see no reason to believe that these prices are sustainable with longer-term marginal economics winning out eventually and pushing oil back towards $80.

We continue to hold a small handful of producers that don’t have a survivability issue, and we are leaning into what we affectionately call “widget” companies that happen to have some energy exposure.

“To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.” — Sir John Templeton

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The opinions expressed herein are those of Cove Street Capital, LLC and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. The information in this presentation should not be considered as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that the security discussed in this report is or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the security discussed in this presentation. The report is based on data obtained from sources believed to be reliable but is not guaranteed as being accurate and does not purport to be a complete summary of the available data.Recommendations for the past twelve months are available upon request. In addition to clients, partners and employees or their family members may have a position in security mentioned herein. Cove Street Capital, LLC is a registered investment advisor. More information about us is located in our ADV Part 2, which is available upon request.

 

Feb 18 15

50 Shades of Grey, the G-rated Version

by Cove Street Capital

From time to time I have embarrassing moments, like admitting I have read L.J. Rittenhouse’s book, “Investing Between the Lines: How to Make Smarter Decisions by Decoding CEO Communications.” This was a fairly simplistic read on a 2 hour flight that essentially says: a CEO should write like Carol Loomis (or Warren Buffett)—be clear, be honest, and admit when you have made a mistake.

This press release could be its polar opposite. When viewed in the context of a CEO that made an absolutely miserably timed and expensive acquisition, you quickly realize you are being cheated. There is no owning up to the mistake, the writing is complete PR feel-good gobbledygook, and the “fact” does not make its appearance until the last paragraph.

There is no wonder why OM group is an activist’s dream. We own it lower as our work suggests that prior bad news and capital allocation issues have been priced in.

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The opinions expressed herein are those of Cove Street Capital, LLC and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. The information in this presentation should not be considered as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that the security discussed in this report is or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the security discussed in this presentation. The report is based on data obtained from sources believed to be reliable but is not guaranteed as being accurate and does not purport to be a complete summary of the available data.Recommendations for the past twelve months are available upon request. In addition to clients, partners and employees or their family members may have a position in security mentioned herein. Cove Street Capital, LLC is a registered investment advisor. More information about us is located in our ADV Part 2, which is available upon request.

Feb 10 15

Forestar

by Cove Street Capital

CLICK HERE to download a press release from Forestar Group Inc.

Feb 9 15

Are You Better at Currency or Oil Price Forecasting?

by Cove Street Capital

by Dean Pagonis | Research Analyst

We think you might have noticed the dollar has been appreciating versus most currencies. (Have you heard the one about the Canadian Peso?)

Source: New York Times, 2015

So yes, there is a negative translation effect for large multi-national companies and yes, a product gets more expensive vis-à-vis foreign competitors and yes, there will be problems for some foreign companies whose dollar denominated debt is getting larger by the moment. The overall effect is equity investors don’t like a strong dollar, but the correlation is mixed depending upon the environment. read more…

Feb 9 15

Coherent and Consistent

by Cove Street Capital

This report remains the single most coherent and consistently negative argument against…a lot of things we do.

Feb 9 15

Well Said.

by Cove Street Capital

Mr. Gideon King’s parting notes on his decision to close down his hedge fund business:

“Controlling capital and engaging intellectually is good work if one can get it. The business, on the other hand, has changed dramatically. As the endless quest for becoming institutional continues on, the soul of investing might get lost, as the unmitigated compliance processes become cumbersome and interfere with the purity of speculative contemplation.”

Feb 9 15

The Blame Game

by Cove Street Capital

From time to time we must look in the investment mirror and conclude that we are stinking and we have no one to blame but ourselves. This is an interesting piece that academically exposes a lot of the other times.

Jan 29 15

CSC Strategy Letter | Number 19 | The Great Complacency…Continued

by Cove Street Capital

CLICK HERE to download Cove Street Capital’s January 2015 Strategy Letter Number 19, “The Great Complacency…Continued”