Valuing Return on Capital – Smith & Wesson (NASDAQ:SWHC)

Lately I have been reading through Berkshire Hathaway’s annual reports. While sometimes repetitive, there are gems within Warren Buffett’s prose. I consider myself both a value and a growth investor. In a perfect world, every investment would cheap compared to both the current shareholder returns and the future growth prospects of the business. Buffett has some great perspective to offer on how to measure the quality of management in terms of both quality and growth.

“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor….. Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return” – Warren Buffett

Return on Capital is one of Buffett’s favorite tools to measure management with. A well-managed company should have Return on Capital that is both strong and growing. If a company can yield returns on capital far above cost of capital for many years, it probably has a good business model and a good management team in place. Put another way, if you loan a kid $1 to start a lemonade stand, you would hope that they give you back at least $1. If the kid comes back and hands you a ten, consider firing your current financial adviser.

If the kid returns less than $1 to you, then they have destroyed a part of your equity. Basically we want ROC > WACC for many years. The higher the better. It is incredibly simple, yet many of the fad stocks of the day fail to meet this basic requirement (looking at you NYSE:TWTR and NASDAQ:ANGI).

The conundrum I have encountered is how to value ROC. How much is it worth? This is where some Buffett comments really helped out. Berkshire purchases companies when it can buy the cash flow stream for less than half of the return on capital. Price to Cash Flow and Enterprise Value to EBIT are both decent proxies for this. It is important for the investor to ensure that Operating Cash Flow represents the bulk of the Cash Flow or EBIT being applied.

Let’s look at Smith & Wesson (NASDAQ:SWHC). Paul Howanitz, a classmate, pitched this stock in September. I liked it so much I bought it for my portfolio, and intend to buy more soon. Paul can be thanked for finding this diamond-in-the-rough at: Paul_Howanitz@kenan-flagler.unc.eduSWHC Price

SWHC is up 17% since Paul pitched it, and I fully expect it to go higher. In 2009 a new CEO – James Debney stepped in to turn the company around. Mr. Debney was so confident that he could improve the situation that he bought shares of the company in the open market on several occasions. According to Return on Capital metrics, he was certainly not overconfident. Price to Cash Flow and Enterprise Value/EBIT indicate that the company is still undervalued despite the stock tripling within 2 years.

Note the significant ROC growth
Note the significant ROC growth since 2009

From April to October, Price to Cash Flow went up 23%. EV/EBIT has gone up 17%. Return on Capital has gone up a mind-boggling 43% thanks to strong top and bottom line growth and share repurchases. Debney has had only one year where both P/CF and EV/EBIT were not less than half of Return on Capital and has averaged significantly higher ROC than his predecessor. The trend can not continue forever, but it certainly indicates two things:

  1. The company is being very well-managed according to the returns on incremental cash flow
  2. At present, the stock is cheap relative to those same cash flows

Again, Paul Howanitz can be reached at: Thank Paul for this amazing find. He has a nice slide deck with many more salient points about the company and industry which he might let you see. Also, buy SWHC while it is cheap.



Care Service Company – A Japanese Demographics Play (TYO:2425)


This impish sign belies the fascinating success story of a micro-cap company, founded in 1970 as a minuscule futon-cleaning service, which has grown to a market cap of approximately $16M in US dollars. I would imagine that Toshio Fukuhara (Founder and CEO) ran a very tight ship then, and he certainly runs a tight ship now.

Current 5 Yr Avg
P/E LTM 9.5 10.6
P/Bk 1.4 1.5
P/CF 9.1 6.4
P/Sales 0.2 0.2
EV/EBITDA 3.2 3.7
EV/Sales 0.2 0.2
No idea what it says but they sure look happy don’t they?

Care Service Co., Ltd. is a Japan-based company principally engaged in the provision of nursing care services in the vicinity of Tokyo. The Company operates in three business segments:

  • The Nursing Care segment is engaged in the provision of daycare services, home visiting and bath services, home visiting and care services, home care support services, nursing care equipment rental services, as well as the sale of certain nursing care equipment mainly in Tokyo Metropolitan area. Nursing Care represents 74% of revenue, but only 53% of operating income.
  • The Angel Care segment is engaged in the provision of washing services, as well as cosmetic, dressing and coffin (CDC) services for the deceased. Angel Care represents 21% of revenues, but 40% of operating income. This segment offers the most promising margin and growth opportunities for the company, and will be a focus in the next few years.
  • The Houses with Services for the Elderly segment is engaged in the provision of houses with home-care services for the elderly.
Company care center locations
Company care center locations

I was floored when I saw the financial performance at Care Service Company. Return on Invested Capital has averaged around 10%. For the past year, a turbulent one for the company, ROIC was over 12%.  Since the installation of a new CFO in 2008, Free Cash Flow Yield has stayed between 5-40% per share, factoring in a stock split in June of last year. Furthermore the demographic trends in Japan are promising from the standpoint of Care Service Company.

Note the bulge around and under 65
Note the bulge around and under 65

Japan has the world’s highest percentage of population over 65 years of age, and the trend is set to grow further. The modern Japanese family has gone nuclear, with a very similar corollary to the American version. Working-age children of the elderly would rather pay someone to care for their parents than sacrifice work-time. This bodes well for industry prospects over the next 10 years or so. Annual elder care costs will more than double by 2026, to 19.8 trillion yen ($212 billion), from March 2013, the Japanese health ministry estimates.

Recent changes to health insurance law in Japan have changed the industry dynamic. Currently over 70% of Care Service Company’s Nursing Care business comes from Japanese health insurers. The health law changes will force them to trim payments for daycare and home visiting services by 1-3%. Management has determined that the best way forward is to go high-end, to target wealthier patrons who are willing to pay outside of the health insurance system.

Interestingly, here in the U.S. managed care providers have essentially made the same cost-cutting choice, forcing companies like LHCG and NHC to adjust accordingly. Comps were hard to come by. There really aren’t any big Japanese players in the space, but here are some international comparisons.

Management has drastically improved operating cash flows
Management has drastically improved operating cash flows

Now for the DCF.

Base Case
Base Case

I estimate historical WACC to have been approximately 5%. The Discounted Cash Flow analysis uses 6%, enough to factor in some rate rising on Japanese bonds. At current prices, the base case would yield a 33% upside.

Discount and Terminal Rates



Insiders control 73% of the company, leaving only 27% for the float. The founder alone controls 52.28%. He has no record of stock sales. Some investors might be wary of hitching their cash to someone else’s wagon. The float has continuously shrunk from 38% in 2006 down to the current 27%.

Japan’s Economy

The public debt level in Japan remains unsuitably high, additionally investing in a foreign company naturally entails some foreign exchange risk. Though investing in a single well-chosen company is arguably far safer than macro bets on currency movements. A prolonged economic downturn in Japan could completely change the current family dynamic, and increase cross-generational living situations.

The Founder is 70

Losing Toshio Fukuhara could damage the company prospects. No clear family succession in place, though the Senior Manager (CEO) has been in place for over a decade and is only 43 years old.

Cost of Labor Continues to Rise

A big factor on the company’s bottom line lately has been cost of labor. New regulations foisted new training and education programs on the firm. Rising wages have raised salary costs as well. Robots have been touted by news agencies as a possible solution. I personally doubt this would be practical. The real solution is immigration reform, but it could be a long, long time before a country as insular as Japan starts raining visas on immigrants.

Competition Increasing

Management has a strategy in place and will continue to execute. By shifting towards the Angel Care segment, the firm can grow both the top and bottom line. Additionally, the firm has a strong foothold in the Tokyo area and is continuing to emphasize it’s  regional focus.


At only a $16M market cap, Care Service Company stock is almost impossible for institutional investors to acquire at the meaningful sizes of shares they would need. This leaves small investors who can access the Japanese markets with a distinct advantage.

The new CFO, Mitsuru Iwahara, has had a hugely positive impact on finances, the founder still has his hand firmly on the company till, and has not sold any shares. Additionally, the demographic trends in Japan promise top-line growth within the industry. Mr. Fukuhara has been through booms and busts aplenty, and will find ways to stay profitable. Any firm which can shift from cleaning futons, to nursing the elderly, to funeral services is at no risk of failing to evolve at the pace of business. For those willing to take the risks, Care Service Company offers a compelling value proposition.

Buying to Close ANGI short

I have decided to end my ANGI short for the following reasons:

  1. This is my first short
  2. Stocks tend to go up
  3. I have made over 10% within less than 2 months

I learned quite a bit via the exercise, and am still extremely confident that Angie’s List will fail in the long term. Unfortunately, I cannot predict the short-term and believe the stock may have hit a floor. I will post again when I believe the stock is primed for another sell-off.

Angie’s List – Pump and Dump Probability Rises

Do you use Angie’s List? Do you know anyone who has? I certainly do not. When an internal stock pitch competition called for a short pitch on a technology stock and I stumbled across ANGI, I knew I had something.

Recently, I wrote a post about Angie’s List (NASDAQ:ANGI) promising to dig more. Well I dug, and this company is far worse than I suspected.

Some serious questions are starting to pop up around Bill Oesterle. Google was not kind. Probably the most damning allegations stem from his purchase of $2M worth of property with another Angie’s List board member. Who did they lease the property to? Angie’s List, for over $6M. One wonders where the additional $4M dollars went, since reviews complain about the poor quality of the buildings in which employees work. Most of the positive reviews on Glassdoor are by the commissions-based sales force which emphasize that you can make a lot of money at ANGI. It is nice to know the sales force is being well-taken care of by a company which has never turned a profit in 18 years.

Additional shady details on the building deal can be found here. Now there could be perfectly legitimate reasons to do this sort of thing, but combined with the massive insider stock selling, we should be very skeptical. ANGI has also been rated as having aggressive accounting practices by GMI. Specifically, prepaid expenses got ticked as dangerously large, this would increase Operating Cash Flows, which management has been emphasizing as the best performance metric by which to gauge the company.

Additionally, despite having a much smaller user base, ANGI actually has more negative reviews than all of Yelp. Reviews of Angie’s List, written by both service providers and members, can be found here, here, here, here, and here.

The CFO and CTO have both been changed out this year. I’m not sure how much more I really need to dig into this. All the factors we’ve mentioned in our first post and this one, by themselves would be concerns. Combined, these are klaxons blaring “Abandon Ship”.

Consensus estimates paint a rosy picture. I will not. I finally had some time this weekend to work out a DCF. The primary assumptions are listed below:

  1. ANGI stays in business and is able to pay off coming loans in the next two years
  2. Membership revenues decline and ANGI focuses on service provider (contractor) revenues
  3. Margins remain at their historically awful levels, improving only slightly
  4. Revenue growth continues to be high

Bear and Bull Cases

Base Case

Being a little generous on the WACC (10% and Terminal Rates)
Being a little generous on the WACC (10% and Terminal Rates)

DCF Results Fair Value

It is possible that Yelp or another firm could purchase ANGI, but I have to wonder why. Management has been trying to sell the company for years, and has not been able to find a willing buyer. The firm is neither large nor profitable, so the competitive threat is minimal to a firm like Yelp or Ebay. To be safe, I would estimate ANGI is worth $5-6 as a takeover target.

The more I dig the more disgusted I have become with the practices behind this business. Good products sell themselves. Yelp does not need a call center, staffed with hundreds of sales specialists to obtain site visits. The reality is that management could pull a lot of levers to keep the company going for at least another year. I really feel bad for the shareholders who have invested in this firm. This story will probably not end well for them.

More links are listed below:

Again I would like to thank my fellow student for conducting much of the research, especially the per-member analysis. He can be reached on Twitter as @adammcash

I intend to short the stock until December, in case a major institution decides to cut losses. This is my first short, and I do not want to be greedy. I have already made ~17% since initiating a position in late October.

Angie’s List – Say Goodbye to 90s Internet (NASDAQ:ANGI)


I need to thank my fellow b-school student for doing a LOT of the digging which went into this:

I have never shorted a stock before. Even when I have had a compelling case, timing has been a huge problem for me. I am now shorting Angie’s List. I feel so confident in an impending collapse at this point that I have put a small portion of my portfolio into the short.

For those of you who have not seen the terrible commercials, Angie’s List is a premium-membership review site.

NASDAQ:ANGI targets households worth $100,000 or more and provides premium services. The company plan is to grow memberships as big and fast as possible, and sell advertising to service providers. Angie’s is attempting to develop a Facebook-like ecosystem. Angie’s List promises its members better quality reviews of local contractors. Angie’s then turns around and promises its contractors/service providers access to higher net-worth customers. Angie’s also offers search ranking boosts and other positioning perks to its contractors as well for a fee. Membership fees cover SG&A while advertising is supposed to benefit profits.

Anyone under 30 can see that the business model is flawed. You can’t claim to offer unbiased reviews of contractors to members, charge them money, and then turn around and promise those same contractors better search placement and reviews, also for money. It’s one or the other. Competitors recognize this, and there are many.

Competitor Logos

There have been rumblings out of management that they might tweak the model. Doing so at this point would put a significant drain on their cash reserves, and, as you will see, those reserves are already extremely weak.

Angie’s List 2013
Market Cap $784,000,000
Total Assets $109,735,000
Total Liabilities $132,766,000  < Yikes!
Total Members 2,378,867
Average member value $280
Total Shares 58,420,000

Negative book value is never a good sign. For a tech company we might shrug it off and say, “well maybe it will grow”. So let’s look at the growth.

Service Provider Revenue 69% (increasing)
Membership Revenue 31% (decreasing)
New Members Added y/y 933,556 (flattening trend)
Average Lifetime Membership 4.5 years (decreasing)
Avg Yearly Membership Fee $30 (decreasing)
Avg Yearly Service Revenue/user $40 (decreasing)
Avg Cost of Acquisition $80 (steady)
Avg Maintenance Cost/user $55 (steady)

Average costs need to decline in order for the business model to succeed. Membership growth is slower than anticipated. Membership fees have been slashed as of October 2nd. Angie’s List is alienating it’s customer base, experiencing membership churn of 5-7% per quarter. There are only so many +$100,000 households out there. As the company grows advertising, the ads get less targeted and less valuable.

Adam crunched some NPV membership numbers for Angie’s List:

Membership Lifetime
5 yrs 4 yrs 3 yrs 2 yrs
Membership Fee $40 $67.91 $49.83 $28.13 $2.08
$30 $38.00 $23.94 $7.06 ($13.19)
$20 $8.10 ($1.95) ($14.00) ($28.47)
$10 ($21.81) ($27.84) ($35.07) ($43.75)
Current Value  
Value per User $5.00 – $6.00
Market Cap $784,000,000
Share Price $13.32

Adam assumed an advertisement revenue per member of $50 and a 20% discount rate. Those are heady numbers for a company which may abruptly change its model to something more like Yelp! What happens to all the members who paid for a 5-year membership if Angie’s List were to change to a free member model? One giant refund.

I estimate it to be around $40M, which would represent all of the cash that Angie’s List has on hand! $42M!

Well OK what about a loan? That gets pretty dicey for a company such as Angie’s List which has negative book value already (more liabilities than assets).

Management is in dire straits and they know it, but really they’ve known it all along. Having cashed out over 10M shares (20% of the shares outstanding), and made no substantial purchases since the IPO in 2011, they must clearly understand that they are riding a sinking ship. There has not even been any rhyme or reason to insider stock sales, which would probably help them claim innocence during the inevitable lawsuits and bankruptcy proceedings to come.

I conducted a regression analysis, to try to determine whether management was timing sales, or simply dumping as many shares as possible every month. It is rare for management to sell so much stock periodically, when ANGI is not making a single dime of profit. How many start-up entrepreneurs cash out of their firm when it is not making money??

No Pattern to Insider Sales

R2 No Pattern

Note the incredibly low R-Square. These guys aren’t cashing out at a certain price point, or attempting to sell at some internal price goal. They just want out. The CEO has already sold over $16M since the IPO. An astounding total of $133M (1/7th of the float) has been sold by insiders since the IPO! What does that say about management’s honest outlook?

Management has two options:

1. Rework the business model, take a massive hit to current assets, hopefully get more loans from the underwriting banks, and continue to fight for revenues in a crowded space against established competitors. Meanwhile, app-based competitors run the risk of outflanking Web 2.0 models entirely.

2. Sell the business.

Option 2 is really the only viable option, and the company has been for sale for years now. Bankruptcy looms within 2-3 years max. I put it at 1-2 years personally. I don’t think the banks are going to be willing to throw much more sunk cost in. The only banks recommending the stock as a buy are the ones still holding the paper, in loans,bonds, and equity. More numbers to come as I dig deeper at one of the worst public companies I have seen.

On a good day, if the wind is right, this stock is only worth $9-10 dollars as a buyout candidate. In reality, this company is worth maybe $3-5. I intend to short until it hits $10/share.

Salute Your Shorts – NASDAQ:SWKS

Skyworks Logo

Recent Price: $25.93
Target Price: $31.57
Potential Gain: 22%
Market Cap: $4.48B
CEO: David Aldrich (2001-Present)

Skyworks Solutions (NASDAQ:SWKS) is a differentiated, low-cost provider of analog radio-frequency semiconductors. The company sells its products primarily through a direct sales force, as well as through independent manufacturers’ representatives and distribution partners. SWKS manufactures 80% of its wafers and does 90% of its assembly and testing in-house.

Products include amplifiers, attenuators, circulators, demodulators, detectors, diodes, directional couplers, front-end modules, hybrids, infrastructure RF subsystems, isolators, lighting and display solutions, mixers, modulators, optocouplers, optoisolators, phase shifters, phase locked loops/synthesizers/VCOs, power dividers/combiners, power management devices, receivers, switches, and technical ceramics. The company also offers MIS silicon chip capacitors and transceivers.


The global population is still under-connected. Traffic from wireless and mobile devices will exceed traffic from wired devices by 2017. SWKS is uniquely positioned to capitalize on this trend. Product segmentation has moved from an 80/20 to a 60/40 mix of mobile / non-mobile revenues. Management sees a 50/50 mix in the near term. This runs contrary to the theme of many semiconductor producers, who, if anything, have become more closely tied to the big handset manufacturers.

Product Potential

Customers include Cisco, Boston Scientific, GE, Harman, Lenovo, Foxconn, ZTE, Samsung, Google, and Huawei.

SWKS has products which address the mobile-to-mobile, medical, automotive, networking, SmartEnergy, Infrastructure, and mobile devices.

The company also owns a portfolio of approximately 1,000 patents.

Expanding FootprintIf you own an Iphone 4 or 5, or a Samsung Galaxy, you have already bought this company’s products.

Key restrictions in the mobile space revolve around two things:

  1. Power – That little device in your pocket has to be able to reach a cell tower 10-30 miles away. SWKS started out in power amplifiers, and that skill-set has a very direct technical relation to number 2.
  2. Spectrum – Different providers use different radio-wave frequency ranges.  Furthermore, different countries regulate their RF spaces as well. More information can be found here: . Transmitting on a specific frequency requires minute changes in power amplification.

What about the competition?


It is worth noting that Skyworks has lower employee turnover than the industry average. ratings by employees are also very positive. In the tech industry, your most important assets are people. These trends bode well for Skyworks, and are reflected by revenue/employee.

Gross Margin Comparison

SWKS has expanded its gross margin at a time when the semiconductor industry, and the company’s main competition, experienced a downturn. Management has been guiding margins up!

The secret sauce here is the manufacturing process and the deep relationships with clients. Skyworks is rolling out products which are manufactured as one total package. This reduces manufacturing costs, and limits opportunities for OEMs to plug and play with competitors. In addition, they have been able to consistently improve chips per wafer.

The semiconductor industry is notoriously cyclical. SWKS manages these risks with a hybrid model. They manufacture in-house in segments where they feel they have a competitive advantage, and partner up with others when they do not. Vertical market discipline is something management talks about quite a bit in their earnings calls.


We should all be thanking the shorts for keeping a lid on the stock. Having painted Skyworks with a broad, industry-wide brush, they have realized their mistake and are now hitting the eject button. Current short interest is around 3%.

DCF Assumptions

I settled on a WACC of 12%, based upon comparisons to competitors, and to company information on cost-of-capital available on the website. No debt certainly made the calculations easier.

WACC and Terminal

The bear case assumes a more tepid sales growth rate than average Wall Street estimates.

The base case is pretty much in line with Wall Street estimates.

The bull case assumes management can grow margins to 30%, which is their stated goal, as well as strong revenue growth as the internet of things picks up speed.

Platform Agnostic – Samsung, Apple, HTC who cares? Any way you slice it Skyworks wins and is pushing out into growing wireless device markets

Tax Advantaged Dividends (Buybacks) – $250M share buybacks announced recently, represents about 5.6% of the common stock

China – movement from 2G to 3G networks is still ongoing. 3G is only ~30% of market in China

Internet of Things – Growing demand for wireless devices of all flavors (NEST home devices, keyless FOB, GPS guidance, UAVs, etc)

Mr. Market is forecasting the typical semiconductor woes on a superior management team, with a superior business model, yielding ROIC well above the cost of capital (5-10% above cost FY10-FY13)

I have put 2% of my portfolio into this company, and may buy more as opportunities present themselves.

Possible Research Paper – Covered Puts on Deep Value Stocks?

I am wondering if a systematic process of writing deep value puts could be done successfully. We define deep value stocks here as stocks which are undervalued to their intrinsic or tangible book values. Consider the case of Blackberry (NASDAQ:BBRY):

Recently the stock has been selling around $8.25, below the Tangible Book Value(TGBV) of $9.38/share. Interest in covered puts extends all the way down to $4/share, or just 43 cents for one dollar of TGBV. I recently wrote 5 covered puts for December at the $4 price for a sum of $38. Obviously, this is not a lot of money, but I think this might be a viable way to earn interest on my cash with almost no risk.

If Blackberry plunges below $4/share it will almost certainly be worth more. The company is sitting on piles of cash with almost no debt. I would love to get into this stock at such a low price. The company may not be a going concern, but the breakup value will be more than $4.

If Blackberry does not drop below $4/share by December then I will have made a 1.9% return on cash which is basically sitting idle anyway. The strategy matters here a bit. I always try to keep between 5-10% of my portfolio in cash. Lately, it’s been hard to find many good places to put it, and I actually plan to take gains on a few other positions. So if my cash is reserved in case of a major plunge, why not write puts to employ it for a plunge now? The theory is probably sounder than the reality. The problem I have with puts/calls is timing. Writing puts, you only get to buy the stock when the put owner is willing to sell. Blackberry might plunge below $4 in a panic, but it will not stay there. Still, perhaps by splitting purchases between covered puts and limit orders, one could eke out a slightly higher return at very little risk.

Half of my initial planned purchase of Smith & Wesson (NASDAQ:SWHC)is employed in a similar manner. I would love to get into the company under $10/share, and hope that my put holder exercises their right to sell me the shares under $10.

This is definitely something I want to research further.