Interesting links this week

Sanjay Bakshi - Bayesian thinking piece - Must Read

The most recent Howard Marks memo

Recent podcast of Julia Gatlef on Phil Tetlock's Superforecasting book - great site and Julia has some very good videos on youtube for understanding cognitive functions and scientific stuff.

After Amazon's recent earnings result I found re-reading this great post on their business model

And of course, Andrew Left of Citron Research on Valeant - this is a good introduction for anyone who, like me, has zero knowledge of the biotech world

Pebbles of perception: Book review

Pebbles of Perception by Laurence Endersen is a little big of wisdom and, not surprisingly, stemmed from the author's reading of Poor Charlie's Almanack and his resonation with Mungers thinking. It is a very easy read and gets you to stop and think about all aspects of choice within life and steps to take to ensure you do the best to make the best choice.

Life is about decisions and this book gets you to think more about perception, incentives and emotion in order to go through life making good decisions. I have highlighted a few main points from the book that really made me think:

1. Incentives - 'the rabbit runs faster than the fox, because the rabbit is running for his life while the fox is only running for his dinner'. The chapter on incentives is great and immediately made me think of a bit of advice I got from a former colleague that 'every decision and problem in the real world stems down to incentives and expectations of the parties involved'. The author links incentives to the 'eat what you kill' culture in finance and how there is nothing more dangerous tan underestimating incentives.
2. Perspective - ' too far east is west and too far west is east'. Understanding perspective and contextual differences in decisions will help understand outcomes.
3. Fear and uncertainty - The future is uncertain. The author uses a great analogy of fear of the future in life. 'We are the captain of our own ship. Fear of the future is the anchor that holds us in the harbour. Fear-ruled ships stay in safe harbours, but what use is a ship that won't set sail?' Uncertainty is forever present in all decisions. But without risk there is no return. Understanding the forever presence of uncertainty can not only help us calculate or imagine probable scenarios but also help us strive to eliminate as much uncertainty as possible. This point also resonates with Seth Klarman's comments on uncertainty which can be found in the link in my previous blog post here. 

Munger, MITMCo and Klarman: Interesting links from this week

First link is from Munger on Coca Cola and one of the best examples of 'inverted thinking'. No explicit mentions of basic valuation metrics we would see in most analysts' work and is a must read for anyone attempting to think differently:

Charlie Munger: Coca Cola Analysis

The following link is an interview by Manuel of ideas with MIT's Investment Company MITMCo. Great insight into what they look for in managers and how they analyse the thinking process and characteristics of managers. Great read for money managers and aspiring investors.

MITMCo: Perspectives of Aspiring Superinvestors

The third link is an article by Seth Klarman on uncertainty written in Feb 2009, the midst of the crisis. I think this piece resonates well with recent spouts of high volatility and uncertainty in markets today. Understanding uncertainty and the limits to your analysis helps understand the risk of the investment and also spurs you on to eliminate as much uncertainty as possible.

Seth Klarman: The value of not being sure

Lectra - earnings power of a quality business

Lectra – Free growth in a quality business.  

Lectra is the world leader in integrated technology solutions dedicated to industries using soft materials. The firm designs, produces and markets full-line technological solutions – compromising software, CAD/CAM (computer aided design and manufacturing) equipment and software and associated services such as PLM. This mainly covers automakers, fashion and apparel and furniture amongst other industries. Two founding brothers have a combined 30% ownership of the business own the company.

They have been heavily spending on R&D recently, planning to benefit from the longer term trend of brands modernising their manufacturing processes, using seamless data and technological solutions to improve cost efficiency and product quality. Lectra estimate they have around 25-30% market share in CAD/CAM (computer aided design and manufacturing) software and equipment business. This company is not statistically cheap on basic valuation metrics, although the quality and earnings power of the company provide value.

Business

In 2011 they decided to invest for the long term and transform the company. They have committed €50m to spend on innovation, research and marketing in the years 2012-15. This is a company that is investing for the long-term future of the business and is noticing the rapidly changing requirements of the sector. They have actually spent around €20m per year since 2012 on R&D, although French taxation and research credits mean the net spend is actually around half this value. The company sells machinery with software, which is then contracted annually, providing Lectra with recurring revenues. Revenues from deploying new systems for new clients is the growth revenue of the business.

How much of a margin of safety does the recurring revenue give and what are reasonable growth rates of the growth revenue?

As always, lets think safety first. The recurring revenues are from contracts of existing systems, spare parts and consumables. In 2014, Lectra earned €122m in recurring revenues, which just about covers the fixed overhead costs of running the business entirely. This fixed cost, which is mainly salaries for the engineers and brains behind the solutions, amounts to around 75% of gross profit for the last 10 years. This recurring revenue has also been around 55-60% of total revenues consistently and provides some safety, although obviously subject to some risk.

How reliable are these revenues? How replaceable are they for consumers, i.e. what is the replacement cost of the service and product Lectra provides?

Lectra has around 23,000 customers from all industries, and although they do not equally contribute to revenue, it would take many small or a few large customers to literally shut down operations for Lectra to lose a huge chunk of revenue. FY2014 – no single customer represented more than 7% of revenue, the 10 largest customers account for less than 20% and the 20 largest less than 25%. The sales are fairly evenly spread geographically with 46%, 24% and 23% coming from Europe, Americas and Asia respectively and are evenly spread between both automotive and apparel sectors, with a small portion in aeronautical and furniture. This provides some sustainability in revenues and predictability in the underlying business.

I believe the replacement cost of the machinery Lectra provides is fairly high. I am assuming here that once Lectra do employ a system (machinery and software) for a client, like Oracle and other back office operating systems, it takes huge cost and efficiency incentives for the client to change. A brand is not going to replace all their systems, plus educate and teach their employees to use a new system, with a new competitor once Lectra have installed their software into the brand’s processes. Therefore, Lectra benefit from great first mover advantages and the innovation and R&D provides high barriers to entry. The main issue is recruiting and educating the clients on the solutions they provide.  

Growth

Selling new systems, the machinery and the software with it, is the growth driver in this business. They have COGS made up of purchase and freight costs which amount to around 25% of revenue giving a 5-year average gross margin of 75%. Operating costs are c55-60%, which involve fixed overheads and fixed and variable wages. This gives operational leverage to the business and if they begin to sell many new systems, a large amount of marginal revenue flows to bottom line. FY2014 the firm had operational leverage of 2.27 (fixed costs / variables) and therefore for every 1% change in revenue, operating income will increase 2.2x. These fixed costs have been around 55% of revenue for the last 10 years consistently. The company has negative working capital requirements as they receive payments for their software and equipment and then shift the goods/service. As long as gross profit from recurring contracts cover personnel costs, a security ratio management refer to, the risk of this investment is reduced. Lectra benefit from 30% R&D tax credit and employment tax credits from French government enabling them to literally spend all cash generated on growth.

Instead of asking the obvious questions around growth; why/how will they sell these new systems and what kind of growth rates can we expect, I am going to invert the question and say how is it possible they will not grow and in what scenario would this happen?

Lectra estimate they have around 25-30% market share in their core business of CAD/CAM equipment and services. I have mentioned before about the replacement cost of their services and that it would need a seriously highly efficient, low cost service provider to take Lectra’s clientele. Another way to not grow is to implode and this would cause a global crisis to halt all manufacturing in the fashion and apparel and automotive industries. 

The company’s cost base is largely in euros in France, which has given Lectra an edge over its US competitor for the last year. Adjusting for Lectras intangible strength, mainly customer relationships and brainpower in this niche field, and the remaining assets shows the reproduction asset cost of business is around 1.5x book value. The value of the assets actually needed to start a competitor in this niche field is around €160m. The earnings power and reproduction cost show the company have a competitive advantage. The majority of the assets are intangibles and therefore the main risk is a large competitor entering the market with greater innovative solutions. This is a risk, although the niche nature of the business makes it highly inefficient for a large player to spend as much time as Lectra to enter a small market. 

I feel there is definitely spare capacity in the demand on the micro level for Lectra’s services as global brands move towards using technology and data in all processes. I am confident in the long-term growth in new systems as it is clear more and more brands will need to adopt systems that enable the full use of seamless data and technology to maintain their brands cost efficiency and quality. The business is sustainable on recurring revenues and operational leverage is going to accelerate earnings once new systems are employed. Also, Lectra have publicised a 10-year plan to speed up China’s product development and add value to their design and manufacturing activities. Their strategy to targeting growth seems to be adequate although valuing this growth is difficult. To attempt an estimate of the value of growth I use the basic Greenwald method:

Lectra have spent c€20m a year on innovation, engineers, marketing and revamping the business. This R&D is fully expensed each year and actually only amounts to 70% of the total value due to tax credits.

Assuming 5% growth rate and 10% WACC:

Future cash flow = (ROC – g) * Capital invested

                                          = (.35 - .05) * 55m = 16.5m

Value of a growing firm = 16.5m * 1 / ( .1 - .05) = 330m or this can be proven by:

(ROC – g ) * Capital / (r –g).

This value of future growth gives 25% upside to the current value of the firm.

Valuation

Greenwald states that ‘when earnings power is above market value, growth comes for free’, and Lectra seems to provide this. The firm has great potential to evolve into a high growth stock. Average operating margins for the last 5 years have been around 11-12% and the operational leverage in the business provides space for expansion as they grow.

Management claim to have around 25-30% market share in the CAD/CAM software and equipment sector, and they have patents running until 2022 that protect this share and therefore margins. The power of these patents were recently proven when Lectra won a battle with a German manufacturer claiming they had infringed on Lectra’s airbag cutting system. I feel there is a high chance Lectra will remain global leader in the CAD/CAM sector and I do not consider any growth in the PLM market as this is a very competitive service. 

The current price of Lectra is not cheap by any means. Trading at around 9.8x EBIT and 16.8x FCF with a PE of 16.8 with all metrics higher than their 5 year averages. However, it’s clear you are paying for quality here. Insider ownership, 35% 5-year average ROIC and consistent cash flow proves the quality of this company. Lectra's main competitor is a private company called Gerber. Vector Capital bought Gerber Scientific, in 2011, for $282m. This price was at around P/S 0.5 of the last 4 years total revenue, and a huge PE of over 40 but no recent data is available on Gerber.

I have calculated the earnings power value of Lectra to be around €12.09, giving an 11.5% margin of safety to the market price. This is using a 10% cost of capital and being conservative with adding back only 10% of SG&A and R&D. This current earning power eases some of the uncertainty against future growth in new systems. I am happy to pay for quality here. Also, looking plainly at the facts of the firm investing over €60m in the last 3 years, with an average ROIC of around 35%, this has a high probability of returning at least €21m in cash in the coming years.