The Battleground: Update on future posts

Previous thread on $FERG from 10/04/22

Yes, for better or for worse, I am back to writing. As you’ll notice, I’ve changed the name of the blog to “The Battleground”. This name symbolizes the tension that’s often experienced between longs & shorts (bulls and bears) in public markets. While I built some early momentum writing on here, I constantly felt pressure to post something just for the sake of it or put out a stale idea that’s up 50% with little upside left. So the route I’ve decided to take is one where I publish ideas where I can cleanly layout the bull/bear case in such a way that allows followers to track the subsequent event path and make logical buy, hold, and sell decisions with a measured risk/reward framework. If XYZ event materializes, what’s the upside/downside? When competitor ABC adds 50% more capacity, how does that effect incremental margins? When Gary Friedman buys 10% of shares and attains LVMH margins, will I be rich then? I will attempt to answer those questions, and many more…

While there’s fantastic research out there around all things investing, including, the “here’s a thread”, S-1 deep-dives, or the historical context of a 102yr old compounder, I believe there’s a lack of publicly available research that actually captures the “why now?”

However, what this blog won’t provide is the deepest research, overly-sophisticated models, or the most variant views. What it will attempt to provide is a holistic view of how a stock got to where it at a point in time, the context around that, including management decisions, product-market fit, competitive forces, and the trading dynamics (flows, mandates) that influence the shares momentum, and the event path that will shape it’s forward risk/reward.

Here’s what I hope to accomplish:

1. To stay true to the name “The Battleground”, I will spend time leveraging those involved on both sides of the debate. This includes management, buy-side, sell-side, bloggers, competitors, suppliers, and customers.

2. Provide ideas based on their merits, and not based on an agenda. I see these ideas evolving as they become more or less debated, and therefore, providing asymetric opportunities with varying risk-reward skew along the way. To accomplish this, I have to act more like a moderator than an investor. Thereby, taking a truly unbiased, fact-based view.

3. Give context as to how we got here, the Key Debate, value drivers, consumer psychology, positioning, mandates & incentives, and trading dynamics.

4. Find insights- Sounds cliche, but this isn’t to be confused with an informational edge. They are often subtle, knowable observations that de-risk a bull case, and add risk to a bear case. For the obvious example, Costco, low-cost + high-value products= psychological inevitability→ more customers → memberships build loyalty → more scale→ lower prices. For a non-obvious example, a lesser-known name, OneSpaWorld, is a publicly listed spa operator for both on-shore and cruise lines. At face value, the business should be highly cyclical due to its large exposure to cruise lines. However, the nature of cruise operators, historically, due to there being no additional cost per incremental passenger, aim to fill each voyage to maximum capacity. That means, while cruise operators may have to entice customers with more promotions in tough years, the medspas onboard keep their volume profile with no need to discount services in the same way to attract customers. This is what can be considered a gross profit royalty, where the ships foot the bill to drive passengers, while the medspas collect fees for their services. Combined with a mostly variable cost structure, OSW is able to flex down costs, and therefore maintain positive cash flow during challenging times. This is an over simplification of course, but this model is key to derisking the future cash flows in a way that a generalist may not entirely understand initially.

To reel it all in, I likely will never be writing up the absolute cheapest, fastest-growing, or highest terminal value stocks. What I’m really looking for is a high percentile in each (a lot of boxes checked). Ie, If there’s a stock with a hard catalyst that’s binary, but has 100% upside, that’s typically not for me. But if there’s something trading at a 6% FCF yield, growing HSD, good terminal value, a CEO making an explicit bet on the company’s future, and a notable active manager involved was recently liquidated, that’s something I’m probably into.

I hope to provide as much value as I can here. Please feel free to pass along anything you read here that you think others may enjoy. Below is a brief Twitter post on Ferguson: FERG 0.00%↑. It’s a short-form version of what you can expect moving forward. As always, nothing you read here is investment advice. Thanks for joining!

Ferguson: $FERG writeup

Since everything will eventually trade for 12x earnings, here's one that is. $FERG Full disclosure: I suffer from premature accumulation. Scaled distributor of HVAC, plumbing, fire, and fabrication products that sits between 34k distributors and mm's of end users across North America. Most products are sold through DIFM contractors, where the application, HVAC, and plumbing are non-discretionary.

Because the actual parts necessary are typically a small % of the overall cost of an RMI job, ie. labor cost greatest component of the total, service-geared distributors at scale have a tendency to pass pricing through "friendly middlemen" to end users

Local density * large # of SKUs creates significant op leverage by spreading sales over fixed-cost blended branches. Generating stellar ROICs and driving break-even costs lower per box. Ferg uses this scale advantage & local footprint to outcompete & roll-up Mom and Pops.

Ferg has handily outgrown their end markets by acquiring disadvantaged peers, adding 200-300bps topline. However, mgmt's conservative stance on cap allocation has them underleveraged at 1x (could run at 2x) and continuing with opportunistic buybacks, expecting +$1.b over NTM

Why now? Ferg recently divested their UK business and filed for a direct US listing. This created mandate-driven selling pressure due to a boot from FTSE, in turn lowering total volume and analyst coverage= mispricing potential

FY23 consensus sales are $28.8b with group op income at $2.75b, implying 9.5% margins-inline with management’s guide. The street is at $8.80 in FY EPS- or 11.7x vs 10.7x trailing. -8.2% and +21.4% on a 1yr and 2yr stack.

60% of business is RMI and 40% is new construction. Since 2012 the business has divested lower margin regions including France, Nordics, EU, and most recently UK. Structurally, these initiatives have boosted op margins between 150-250bps= "shrink to grow"

Over the same time, residential exposure grew from 42% to 54% of sales, and importantly RMI grew from just 31% of sales to 60% currently. For nearly a doubling of exposure to repair & maintenance vs new build discretionary spend.

I'm variant on both the business & the stock. Ferg is underappreciated vs top-tier distributor $WSO (20x eps), yet priced below trough multiples of home improvement retailers $HD $LOW (12x eps), who are 50% and 75% exposed to DIY vs DIFM

Key debate 1) Industrial distributors over earning as commodity inflation largely +ve to GM dollars. ie. Lt op margins normalize btw 6-8% 2) Resi & industrial equity/demand cracks, thereby reducing demand/volumes

Rebuttal 1) I believe margin improvement is secular vs cyclical- contractor labor costs are likely to remain robust allowing distributors to hang on to a large % of margin expansion 2) RMI business remains sticky + EPA's increasing standards create demand for new unit demand

Mgmt has traditionally been conservative but I see there is a 16% risk to their FY23 guide, which is LSD topline into v tough comps & approx 9.5% midpoint op margins, for $8.97 in EPS

Assuming resi & commercial demand normalize, discretionary spending falls off, and commodity GM benefit reverts to historic norms my bear case EPS into FY23 is $7.50 on 209mm FDSO for 15x EPS

Catalyst path 1) Inflation reduction act will set aside $21b in rebates & tax reducts for energy saving initiatives which bode well for demand. But exact implications TBD @rsandler21969 may know magnitude here?

2) EPA phasing out R-410a refrigerant starting in Jan 2023, which will create new demand for eco-sensitive units & parts with higher ASPs- leading to what could be a softer landing for demand and margin improvement when combined with strong rebates https://acshvac.com/hvac-refrigerant-and-seer-changes-in-2023/

3) Technical buying from passives due to greater coverage ->index inclusion- Should have enough demand for +20% of shares when viewed on total ownership vs. peers

JPM has total units + replacement down vs 2021 through 2025. Barring a clear catalyst path, and extrapolating the current resi/commercial demand, this should be down to dead money for the next 12-18mo until we start seeing a clear path to FY25 #s

Conclusion However, I believe there's a path to soft-landing #s due to both margin & volume uplift from higher ASPs post-R-410a phase-out and additional tax incentives tied to eco-sensitive units

You're paying 15x worst for MSD growth and a modest catalyst path through 2023. In a base case, where Ferg sustains margins at 9% vs 7-8% historically for peers, on $1b in repos @ $113 px NTM, gets you $8.07 in EPS or 14x. @ 20x it's a $160 stock in <2yrs.