Value Investment: AZZ Incorporated

AZZ Incorporated offers products through two primary business segments: Galvanizing Services and Electrical and Industrial Products.  According to the AZZ 10K for the fiscal year ended February 28th, 2011, the Galvanizing Services segment accounted for $218 million in revenue while Electrical and Industrial Products accounted for approximately $162 million, a split of 57% and 43% respectively.  Recent acquisition activity indicates that AZZ is aggressively expanding the Galvanizing Services business, which I would assume is related to favorable valuation conditions and the geographic monopolies that are created by galvanizing operations.  Materials are somewhat heavy and expensive to move, so it is assumed that facilities are located close to manufacturing operations who consume galvanized materials.  Electrical and Industrial Products appears to be much more volatile, particularly considering that overall revenues have declined nearly 25% from February 28, 2010 to 2011.  My expectations moving forward in terms of the overall business are somewhat in line with Management.  I do not anticipate a continued stabilization in Electrical and Industrial Product segments until infrastructure stimulus hits the real economy, whereby additional expansion of electrical and industrial infrastructure spending should increase AZZ backlog and product delivery.

According to analyst estimates as of May 2011, AZZ is expected to generate approximately $434 million in revenue in 2012 and $471 million in revenue in 2013.  Recently, management re-affirmed their guidance for fiscal year end February 2012 with revenues of $450 million to $475 million and earnings between $2.90 to $3.10 per share.  I generally prefer to maintain conservative revenue estimations within my model, so I projected that 2012 revenues would amount to approximately $405.8 million and 2013 revenues amount to approximately $436.7 million, well below management and analyst expectations.  Below is an example of my DCF projections which exclude the net effect of debt on operations (i.e. interest).



In the above model, revenue trends upward at a high single digit pace until 2015, whereby I project that revenues will grow at approximately 13% representing stimulus spending in infrastructure (utility upgrades / electrical infrastructure), which then scales downward to a long-term growth rate of 3% by the terminal period beyond 2021. I projected that Cost of Goods Sold (COGS) will remain flat at the 3 year historical rate of approximately 71% during the projection period and beyond.  Overtime COGS may fluctuate significantly due to variations in raw material costs and volatility in commodities markets, particularly markets for Zinc, a critical input for steel galvanizing.  Sales, General, and Administrative Expenses (SG&A) were projected at their 3 year historical average of 11.6%.  It is anticipated that SG&A expenses will converge at historical values once synergies are realized from the acquisition of North American Galvanizing.  The historical low for SG&A expenses was 10.5% in 2009, which lends itself to the additional value creation that can be generated by effective cost controls within the organization.  The remaining operating income was then burdened with a US effective tax rate of 39.3%, which is in line with the firm specific tax rate of 38.5% as of August 31, 2011.  After calculating the After-tax Operating Income, additional adjustments were made for Depreciation & Amortization (D&A), Changes in Working Capital, and Capital Expenditures.  D&A expenses were projected at the 3 year historical rate 3.8% during the discrete projection period.  CAPEX was projected at the 3 year historical rate of 4.2% and then reduced to a 3.8% by the terminal period to alleviate any long term value depletion that is associated with the variations in the CAPEX to D&A relationship.  Given the unpredictability of historical Working Capital (excluding cash), 3.0% was applied through the entire projection period, thus creating an additional burden to conservative cash flows.  Overall, FCF to the business as a percentage of sales was 7.1% for the projection years, 2012 to 2018.  From 2019 to the terminal period, FCF increased to 7.4% of sales.  For the most part, I believe that my estimations are relatively conservative and do not represent any potential windfall profits that be achieved through conservative management of the business.  Additional research is need to gain a better understanding of potential commodity volatility, reasonable CAPEX spend and associated D&A, and Working Capital.

After completing the cash flow calculations, I modeled out a reasonable discount rate using the CAPM for Cost of Equity.  My estimation included the following variables: Cost of Debt, Risk Free Rate, Market Risk Premium, Size Premium, Beta, and Debt to Capital Ratios.  Below is the build up of my WACC.



For my WACC build up I applied the following variables: Bloomberg average investment grade Cost of Debt (Kd) of 6%, 4.5% 20 year treasury rate, 5.5% market risk premium, beta of 1.2 (AZZ beta), effective tax rate of 39.3% for the US, and a conservative capital estimation of 70% equity to 30% debt.  After compiling my variables I calculated the Cost of Equity (Ke) using the Capital Asset Pricing Model (CAPM).  According to the CAPM, the following Ke should be applied to AZZ Incorporated:

Ke= Rf + B * MRP + Sp + a
11.1% = 4.5% + 1.2 * 5.5%

Using a 11.1% Ke, 6.0% Kd, and 30 / 70 debt to equity ratio, I derived a discount rate for AZZ of 10%.  Additional analysis is required to develop an actual market capitalization ratio, market cost of debt, market beta, and size premium.

Upon calculating my discount rate I calculated the residual value of the firm using a 3.0% long term growth rate.  For the most part, this value is somewhat subjective; however, 3.0% should be in line with long term inflationary expectations.  It is assumed that over an infinite time period, the performance of all firms converges at the expected long term growth rate for the economy as a whole.  Depending on the nature of the business, this may be slightly higher or lower than the total output of the US economy.  I have yet to see an empirical evidence to support unmanageable inflationary levels above 3.0% so I will continue to use 3.0% as a proxy until I believe otherwise.  In general, my long term growth expectations range between 2.5% and 3.5%.  Below I have included my calculation for the residual value of AZZ.




Additionally, I have calculated present value of my projected cash flows to derive a total value of Equity for AZZ.



Based on the assumptions listed above and the calculated diluted shares outstanding for AZZ I derived an intrinsic value per share of $47.65.  This estimation is below the analyst consensus estimation of $52; however, I have already adjusted my expectations for the future to better align with what I believe are reasonable expectations for the business.  Additionally, I have created a sensitivity model, whereby variations in the WACC is plotted against variations in the long term growth rate to gain a better understanding of the potential implications that may occur to an investment in AZZ.  Below I have provided an example of my sensitivity model.

 

The overall valuation of AZZ, given conservative estimations, falls somewhere between $42 and $52 a share, barring any significant changes to the business, management expectations, or major value depletion.  Given the current market price of $38.04 (10/03/2011), AZZ offers a fairly substantial value at its current price level, implied MOS of between 12.8% and 37.9%.  Management has indicated that they currently do not foresee any major obstacles in their business and they continue to establish and build upon their backlog of business.  I intend in future entries to provide additional measures of value including the details to my Cost Method analysis, in addition to providing additional details pertaining to the strength and weaknesses of management and the future value accretive opportunities for the business.  For now however, I will provide the current details pertaining to my valuation summary for those who are interested.



Please feel free to provide any commentary or feedback that may assist in my analytical methods for valuing companies.  I am always open to new ideas or considerations.  Additionally, this entry is in no way a recommendation to buy or sell a stock.

Disclosure: I currently hold a position in AZZ.

Additional Resources:
AZZ Homepage
Stock Ideas
Lifts Guidance
Dividend Stock

Application of the Prisoners Dilemma: 3rd Party Contracts

Today I brainstormed a method to apply Prisoner's Dilemma to 3rd Party Contracts.  For those who are not familiar with the Prisoner's Dilemma, I recommend reading the book entitled "Prisoner's Dilemma" by William Poundstone.  The Prisoner's Dilemma is defined as follows:

A paradox in decision analysis in which two individuals acting in their own best interest pursue a course of action that does not result in the ideal outcome. The typical prisoner’s dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant. As a result of following a purely logical thought process to help oneself, both participants find themselves in a worse state than if they had cooperated with each other in the decision-making process. - Investopedia

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated the prisoners, visit each of them to offer the same deal. If one testifies for the prosecution against the other (defects) and the other remains silent (cooperates), the defector goes free and the silent accomplice receives the full one-year sentence. If both remain silent, both prisoners are sentenced to only one month in jail for a minor charge. If each betrays the other, each receives a three-month sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act?  -Wikipedia

Similar to the Prisoner's Dilemma, within 3rd party contracts, the optimal outcome for both parties is to mutually cooperate.  This outcome when applied ensures a healthy business relationship through operating efficiency, mutual profitability, effective communication, and shared outcome.  Unfortunately, much like the Prisoners Dilemma, mutual cooperation is least like to occur naturally, specifically when evaluated over many iterations.  In the context of contracting, defection amongst each party is probably the most natural outcome, and will result in conflicts, disputes, service reductions, scope changes, employee turnover, errors, etc.

Below I have outlined the Prisoners Dilemma assumptions and scenarios in the context of 3rd party contracting and recommended several considerations that firms can apply to optimize iterative outcomes.

Assumptions:

• Contractors and customers want to maximize their own benefits
• Singular defection between the contractor and costumer produces the most severe penalty for the cooperative party
• Mutual defection between the contractor and customer produces the most severe outcome for both parties
• Cooperation produces mutual benefit

Scenarios:

Cooperate / Cooperate: 3rd party relationships are often most effective when both parties cooperate.  Cooperation can be defined by the contractor and customers mutual collaboration in service delivery, planning, and conflict resolution.  Each party has a mutual understanding for the needs of the other, including their demands for profitability, quality of service, knowledge development, and talent retention.  This outcome is often difficult to accomplish with 3rd party contracts because it requires a level of transparency which most firms are likely to be wary of, particularly in the context of divulging too much information critical to the livelihood and long term strategy of each firm.  A contractor who cooperates, adapts to the client needs, is proactive about identifying areas of improvement, yields a healthy profit to achieve the objectives of the firm, and still satisfies the expansive needs of the client.  A client who cooperates, proactively works to resolve issues internally to alleviate conflicts, yields the appropriate value for the services delivered, and continuously works to build a longstanding and healthy relationship.  The contracts in a cooperative vehicle are the guidelines for engagement and not the rules.  This scenario is also the least likely to occur because self interest and changing business needs may require one party to temporary sabotage the cooperative benefits.  On an iterative basis, once defection has been implemented by one party, it is difficult to return to mutual cooperation.  Well structured 3rd party contracts can help to alleviate the probability of defection; however, cooperation is never guaranteed.

Defect / Cooperate:  This scenario represents the most likely scenario to occur amongst 3rd party contractors and customers.  Within complex business relationships, each party from time to time will exercise their right to pursue their own self interest, resulting in a scenario that is not necessarily favorable for their counterpart.  In 3rd party contracting, defection / cooperation may be marked by reductions in service, commitment, resources and an increase in escalation, exception, and dispute.  Unlike the defect / defect scenario, which produces a disruptive stalemate, the defect / cooperate scenario generally represents a give and take relationship that occurs between 3rd parties and their customers.  When a self interest becomes a critical issue, either the customer or 3rd party will exert their defection position to satisfy that need.  In general, 3rd party contracts should be structured to provide a framework for managing defection.  Well written contracts and documented processes by nature produce relationships in equilibrium.  Equilibrium scenarios produce an outcome, whereby, the customer defects in one iteration and contractors defect in the following iteration.  Defection / cooperation does not have to occur on a sequential process; however, over time the defection / cooperation procedures should converge at a natural balance point (ideal would be 50/50).

Defect / Defect: Mutual defection outcomes are the most destructive to the customer and 3rd party contractor on an iterative business.  This scenario can be identified by legal ramifications, constant disputes, high employee turn over, irreparable relationships, unacceptable service quality, financial penalties, or breach of contract.  Mutual defection is the least desired outcome and is most likely the result of a contract that either provides way to much rigidity that the 3rd party cannot deliver on their expectations or the customer cannot accommodate expansion in their business portfolio.  Defection can also be defined by limited capabilities, capacity, or poor financial performance, which results in each party sabotaging the performance of the other.  Mutual defection would most likely result in contract termination or renegotiation and is often a direct result of poor or ineffective contracting procedure.

Strategy:

1. Understand your contractors likelihood to defect (retaliatory or instinctive)
2. Understand your own likelihood to defect (retaliatory or instinctive)
3. Establish minimum requirements to align with desired outcome
4. Identify and define cooperative processes and benefits with 3rd parties
5. Create 3rd party contracts that reward cooperation and penalize defection

Follow-up Questions:

• What are a few examples of cooperation amongst customers and 3rd party contractors?
• What are a few examples of defection amongst customers and 3rd party contractors?
• How do I evaluate the likelihood of defection or cooperation amongst contracting parties?
• How do I create cooperation amongst defect / defect iterative loops?
• Can defect / defect relationships be managed back to a more manageable scenario?

Returns on Capital

The cost of capital and related returns on capital produce results that can be either accretive or depletive for investors.  Given the complexity of the issue I will stick to a relatively simple definition of capital, and then provide a few additional calculations for much more complex and detail oriented analysts to decide which to use for their formula of returns on capital.  In general, returns on capital in excess of firm specific capital costs, result in excess returns for shareholders.  These returns are used to either grow the business or distribute to shareholders through cash dividends or stock dividends. 

Capital - Financial Assets or financial resources available for use

The following calculations are general formulas for calculating return on capital:

Return on Capital:
EBIT (1- Effective Tax) / Capital

Capital 1:
Book Value Debt + Book Value Equity - Cash
also referred to as Enterprise Value

Capital 2 (Operating Approach):
Net Working Capital + Net Property Plant Equipment + Capitalized Operating Leases + Other Operating Assets + Operating Intangibles - Other Operating Liabilities - Cumulative Adjustment for R&D

Capital 3 (Financing Approach):
Total Debt + Total Leases + Equity and Equivalents - Non-Cash Investments

When attempting to assess the value creation of a firm, take the return on capital, which represents the amount of after-tax operating income that the firm generates, and compare that figure to the firms weighted average cost of capital.  Any returns on excess of the cost of capital is creating value for shareholders.  In order to identify whether any investment opportunity is cheap or not, compare that figure to the price multiples in order to gauge whether or not the additional value accretion is cheap or not.

Part 3: Are Newspapers Buggy Whips?

As a continuation of my previous posts on the newspaper industry, I aim to provide additional insight into the business fundamentals at the firm level.  Thus far I have provided a brief over view of industry trends via circulation and advertising, in addition, to providing a broad overview of the publishing industry in aggregate.

Gannett Corporation (GCI)

Business Summary:
Gannett Co., Inc. operates as a media and marketing solutions company in the United States and internationally.  It operates in three segments: Publishing, Digital, and Broadcasting.  the Publishing segment publishes 83 U.S. daily newspapers with affiliated online sites, including USA TODAY, a general-interest daily newspaper; USATODAY.com; USA WEEKEND, a magazine supplement for newspapers; Clipper magazine, a direct mail advertising magazine, bi-weekly Nursing Spectrum and NurseWeek periodicals; and military and defense newspapers.  the Publishing segment also includes 17 paid-for daily newspapers; approximately 200 weekly newspaper, magazines, and trade publications; and approximately 650 non-daily publications, as well as involves in commercial printing, newswire, marketing, and data services operations.  The Digital segment owns and operates CareerBuilder, an employment Web site, which offers job postings and related products to employers; provides multi channel shopping and advertising services; digital marketing services and technology; hosted search and advertising services; scheduling solution for high school athletic departments; and social media technology and services; scheduling solution for high school athletic departments; and social media technology and services. The Broadcasting segment operates 23 television stations and affiliated Web sites, which produce local programming, such as news, sports, and entertainment programming.  This segment also includes Captivate Network, a news and entertainment network that delivers programming and full-motion video advertising on video screens located in elevators of office towers and select hotel lobbies.  The company has strategic business relationships with online affiliates, including Classified Ventures; Topix, and Metromix LLC. Gannett Co., Inc. was founding in 1906 and is headquartered in McLean, Virginia.

The McClatchy Company (MNI)

Business Summary:

The McClatchy Company operates as a newspaper publisher in the United States. The companys newspapers include the Miami Herald, The Sacramento Bee, the Fort Worth Star-Telegram, The Kansas City Star, The Charlotte Observer, and The (Raleigh) News & Observer.  As of December 27, 2009, it owned 30 daily newspapers and approximately43 non-dailies in 29 markets.  The company also operates local Websites that offer users information, comprehensive news, advertising, e-commerce, and other services, as well as engages in direct marketing and direct mail operations.  In addition, it owns a portfolio of digital assets, including 14.4% of CareerBuilder LLC, an online job site; and 33.3% of HomeFinder, LLC, which operates the online real estate Website HomeFinder.com, as well as 25.6% of Classified Ventures LLC, a newspaper industry partnership that offers classified Websites, such as the auto Website, cars.com and the rental site, Apartments.com.  The McClatchy Company was founded in 1860 and is headquartered in Sacramento, California.

The Washington Post (WPO)

Business Summary:

The Washington Post Company, together with its subsidiaries, operates as a diversified education and media company in the United States and internationally. It provides a range of educational services, including postsecondary and career programs, English-language programs, and tutoring offerings, as well as operates fixed-facility colleges.  In addition, it provides cable television services consisting of video, Internet, phone, cable modem, digital and basic cable, and other services to subscribers in the midwestern, western, and southern states.  Further, the company publishes and distributes The Washington Post, a morning daily and Sunday newspaper in the Washington, D.C. metropolitan area, including portions of Maryland and northern Virginia.  Additionally, it produces washingtonpost.com, which features news and information products.  The company also conducts television broadcasting operations through its six VHF television stations serving the Detroit, Houston, Miami, San Antonio, Orlando, and Jacksonville television markets; and engages in commercial printing business.  The Washington Post Company was founded in 1877 and is based in Washington, the District of Columbia.

Part 4: Are Newspapers Buggy Whips?

While I do not believe that in their current form that newspaper companies will exist in the future, I believe that many of the "newspaper" organizations are well positioned to profit from what I would consider to be a major trend on the internet that I prefer to identify as 'localization of content'. By this, I mean that customers require news content, advertisements, job postings, classifieds, coupons, obituaries, and periodicals pertaining to issues and events that are occurring within their particular community.  The medium and form is with which individuals choose to receive their content is clearly shifting. Without credible  and localized content developers there is no credible source for information at the community, city, or state levels.  All businesses require a feedback loop with in their operating areas so that they can ensure that the customers in the primary markets that they serve have access to the appropriate products and services.  A world absence of localization could become very expensive for businesses advertising on the web and extremely inefficient.

With that said, it is important to acknowledge that many of the large newspaper firms have struggled to take their nationalized news brands to the internet.  Niche newspaper providers like the Financial Times and Wall Street Journal have been a lot more successful implementing an online pay model.  This success can be atributable to the specialized nature of their content and ability to charge for this based on consumer demand.  The demographic for specialized newspapers varies from national papers like the Washington Post, USA Today, or New York Times.  Generally audiences appear to be younger and much more technology saavy, which lends itself to the implementation of a pull content model.

It should be noted that over the last several years, the larger traditional newspaper providers have been diversifying their businesses through the acquisition of internet based information services platforms.  Gannett specifically has increased its position in Careerbuilder several times, in addition, to making additional investmetns in websites like Shop Local.  It has yet to be seen whether the traditional newspapers can integrate these web services into their news content delivery and advertising model.  Fully integrated sites like Google and Bing pose serious competition to advertising revenues; however the decoupling of advertising and content, makes it difficult for those sites to provide the kind of value that newspapers can potentially deliver.

Overall, like everyone else I continue to remain skeptical about the ability of the newspaper industry to transform itself into a modern day goliath.  The lack of responsiveness to a changing market, which could have been predicted nearly a decade ago, aging and legacy management, and a lack of direction, indicate that news paper firms are not a viable option in a long term investment portfolio.  All of the firms previously listed are trading at discounts to both book value and earnings, which tend to make them somewhat attractive; I however, view these opportunities as value traps.  Continual erosion of market share, lack of barriers in an online environment, poor management, and major business strategy flaws make me extremely concerned.  News papers are not going to go away in my life time; however, they will certainly operate in an entirely different fashion than they are currently.  Technology and content production and dispersion methods have changed entirely from the good old days .  I am thankful that I no longer have to get my hands dirty with running ink nor trip on the brick of a newspaper in the driveway on my way to leave for work.

Calling newspaper companies buggy whip manufacturers may be a bit extreme, particularly since the do produce and provide more valuable services.  It may not be more than a few years before a physical newspaper is all but history.

Here is to New Beginnings

As of Saturday, May 14th, I will officially be a resident of the city of Chicago, Illinois.  For the readers that know me, you may very well know, that I have been talking about relocating for quite some time.  It may also not come as any surprise when I say that I will truly miss the Metro Detroit area and the people that reside there.  There is something extremely attractive about Detroit and its residents.  For the most part, the people are resilient, dedicated, and surprisingly not yet hardened by the environment and circumstances with which they are living.  I am certain that in the next few chapters of my life I will not meet the type of people that I have grown fond of for the first third of my life.  I have listed a few things below in memory of Detroit.  For those who live there or ever plan to visit, I highly recommend adding a few of these items to your list.

• Chicken Schwarma at Bucharest
• Random Passings with Professional Athletes and Actors
• Greektown
• Mexican Village
• Air Plane Races at the Rencen
• Target Fireworks at the Rencen
• Hydro Plane Races at Sinbads
• Patio Happy Hours
• Slows BBQ
• Eastern Market and the food at Russell Street Deli
• Redcoat Burgers
• Tower 700
• Bowling League
• Funk Night (Anywhere)
• Random concerts at St. Andrews
• Detroit Economic Club Events
• Not Stopping for Stop Signs or Red Lights
• Greenfield Village
• Heidelberg Project
• The Bronx Bar
• Indian Village
• James aka Eat Em Up Tigers
• Detroit Lions Games
• Detroit Tigers Opening Day
• Detroit Red Wings Games
• St.Pattys Day
• Pure Michigan Spoofs
• Cliff Bells
• The View of the Train Station
• Going to Canada
• River Walk
• The Detroit Zoo
• Driving Down Lakeshore into Detroit
• Lafayette versus American Coney Island
• Colleague Going Away Parties
• Jacoby's
• Bookies
• Brewery Tours
• Detroit Jazz Festival
• The Hoedown
• Detroit Electronic Music Festival
• The Autoshow
• Winterfest
• NCAA Tournament
• Superbowl
• Roma Cafe
• The Detroiter
• The Detroit Institute of Art
• Bravo! Bravo!

I look forward to creating a new list of life experiences in Chicago as well.  Keep it classy Detroit!

NNCV Screen Update

Criteria:
Custom Formula (NNCV): Cash and Short Term Investments - Market Capitalization - Total Debt

Exchanges: Major US Exchanges

Industry Classifications: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Healthcare,  Information Technology, Telecommunication Services, Utilities

Custom Data Point: NNCV / Market Capitalization > .25

Date: 1/31/2011

1. Adolor Corp. (ADLR)
2. Capstone Therapeutics Corp. (CAPS)
3. China Mass Media Corp. (CMM)
4. Daxor Corp. (DXR)
5. Endwave Corp. (ENWV)
6. Global-Tech Advances Innovations Inc. (GAI)
7. Insmed Incorporated (INSM)
8. Linktone Ltd. (LTON)
9. Maxygen, Inc. (MAXY)
10. MGT Capital Investments, Inc. (MGT)
11. Myrexis, Inc. (MYRX)
12. Neurometrix Inc (NURO)
13. Ninetowns Internet Technology Group Company Ltd. (NINE)
14. Peerless Systems Corp. (PRLS)
15. Performance Technologies Inc. (PTIX)
16. Qiao Xing Mobile Communications Co. Ltd. (QXM)
17. Qiao Xing Universal Resources Inc. (XING)
18. Tegal Corp. (TGAL)
19. The9 Limited (NCTY)
20. Thomas Group, Inc. (TGIS)

Added (3): China Mass Media Corp.; Tegal Corp.; Thomas Group Inc.

Removed (1): ARC Wireless Solutions Inc.

"Be greedy when others are fearful and fearful when others are greedy." - Warren Buffett