What You'd Read is Linamar Was a 'Growth Stock'

What You'd Read is Linamar Was a Growth Stock

I frequently say, "Price drives narrative." Recently I had a thought arise out of some rough calculation I was doing about Linamar. I wanted to briefly share the calculation and thoughts surrounding, 'what the narrative would be if the stock was rising.'

I was curious what the net debt to EBITDA was, live, on a run rate, post Bourgault basis. After all, between the Dura-Shiloh, Mobex and Bourgault acquisitions, they seem like they should be capped out on the balance sheet side.

Depending on how I calculate it, I could see sales in the $11.1B-$11.3B range (excluding additional acquisitions which seem likely at some point in the year).

Assuming less margin expansion than I believe we eventually get, let's round down slightly to $1.5B in EBITDA (~13.5% Margin)

At a target of 1.5x net debt to EBITDA, that would be a balance sheet capacity of $2.25B

Net Debt at the end of the year was $1.118B

The Bourgault acquisition adds $640M

Net: $1.758B

Quick math shows they would have $492M in balance sheet capacity remaining. However, once we add in the retained earnings, that number increases significantly by the end of the year. This was a higher number than I expected given where I thought they were. I'll get back to why that is.

As I was running through the accounting;

Approximately half of EBITDA goes to CapEx (mostly offset by amortization), which, at a level of 6-8% of sales or half of around EBITDA margins, "Supports the double digit sales growth." The rest is split between Tax, Interest and Dividends with some remaining. I won't call the remainder, "free cash flow" because of what comes next. The remainder can be used to pay down debt, make acquisitions or buy back shares. The following is a rough approximation as all components fluctuate.

What started 'bugging' me was that Linamar had spent much more than the remainder and still had more than the remainder to go in the following year... Despite discussing balance sheet capacity near the target after the Bourgault acquisition.

If the capital expenditures supported double digit growth and the acquisitions were at a similar level of returns, then assuming steady margins, you get ~14.5% EBITDA growth. Except, 14.5% EBITDA growth isn't 14.5% balance sheet capacity growth. The balance sheet capacity is 1.5x EBITDA. 14% is actually 21%. Rerunning the numbers, we can see how the growth flows through to balance sheet capacity... Which enables further growth by acquisitions, which enables...

Blue: Before

Red: After adjusting for Balance Sheet

The main difference is the ~20% of EBITDA which shows up in balance sheet capacity which is neither earnings, nor free cash flow. That adds $300M to the available capital, increasing it from ~$350M to ~$650M. If the $750M in CapEx brings 10%, an additional $650M in capital deployment would mean closer to 18.5%. The interesting part is that if you look at what Linamar has achieved in the past when it comes to revenue growth in un-disrupted times, it fluctuates more than math but has been in that range. It moves below as they digest more acquisitions in a given year and above as they deploy the balance sheet capacity. Through this lens, Linamar generates about $50m in balance sheet capacity per month. The obvious intrinsic assumption is that leverage effectively remains at the target. In reality, it fluctuates... And recently has been below their target.

If I wanted to estimate the full picture of how much they should have to spend by the end of the year (or live for that matter) I still need to deduct the retained earnings from the net debt. Using a range of assumption I can come to roughly $1B to spend on acquisitions over the next 9 months (*Excluding the EBITDA that comes with incoming acquisitions). In historical terms that another MacDon (which is 1/3 of their industrial business) or roughly the three acquisitions from the last year which added ~$850M in mobility sales & ~$500M in industrial sales.

Going through the numbers I couldn't help but reflect on how this compared to some other stories out there. Companies whose stock price seems to gradually, perpetually creep higher. "Compounders." The things where 12x EBITDA looks cheap because 3 years out you have a great company trading at a 15% EBITDA yield and people aren't as concerned about a company being immediately overvalued. This is neither my prediction, nor my value assessment, however, if you were to ask me why it traded at +3x book in 2015 (like Danaher does today... By the way, over the last decade, DHR took book value from $34 to $72.5 while Linamar took book value from  $23.5 to $86) or +2x book in 2007 or +5x book in the late 90s, I'd say, "Well, if you want be optimistic about growth runway & not running into economic hardship, the math doesn't have a problem with paying 2-3x book." Overall, this wasn't a piece advocating for multiple expansion. I prefer holding cheap stocks to fully priced ones. I also have grown to be deeply skeptical of the multiple expansion thesis. This was intended to look at a mechanic of how they should be able to hopefully piece together solid increases in fundamental value such that I won't care if the multiple is 8x trailing earnings or 16x forward. It sometimes seems like the deciding factor between 'Compounder' & 'Conglomerate Discount' becomes: is the stock at all time highs?

I must point out that, while I believe this type of growth is possible most years, Linamar operates in industries which can have significant setbacks (Covid and GFC for instance). That's why the multiple, at ~3.6x EV/EBITDA, seems reasonable to some today... And 3.1x EV/EBITDA seemed reasonable months ago. I can't speak to how low the multiple can go. I can say that they're one year of executing away from it being back to roughly the cheapest it's ever been.

Messy Margin

I think the reason why Linamar has been in virtually no 'compounder' discussion that I've seen is due to the variability of the margin.

When the operating margin (EBIT) goes from 6% to 12% (as it did from 2012 to 2016), you're compounding earnings growth... Even if you're not growing revenue.

If your margin goes from 12% to 8% you could be growing the top line nicely and still barely have any earnings growth to show for it.

One looks like a fantastic company... Growing top line nearly 20% and getting much more dropping down to earnings. That's the type of thing that moves your stock from $20 to $85 in 3 years.

The other is a valid reason for your stock to go nowhere for a decade as the multiple declines by half. Put it together and the stock looks far more inconsistent than it has been.

Math

If you wanted to calculate the value of a company looking forward at EBITDA growth, it's truthfully not too difficult to calculate for yourself despite this seemingly scary equation.

(Sales) X (EBITDA Margin) X ((EBITDA growth rate) ^ (Number of years)) X (EBITDA multiple for equity*) ÷ (share count)

On a calculator it would look something like

11300×0.16×1.18^3×2.5÷61.6 = 120.56

You could also replace the first two numbers with your predicted EBITDA

1500×1.185^4×3÷61.6 = 144.05

You can play around with margins depending on what you view as normal, length, and multiple. Note: the multiple I used was 2.5 & 3 times on the equity... This excludes the additional 1-1.5 times  on the debt. Maybe you feel like Linamar is worth 'splurging' on 4 times EBITDA on the equity portion. Maybe you think growth will be slower or more margin will recover or won't. I used small numbers for both years and multiple because if I wanted to assume that rate of growth, I didn't want to assume it would continue indefinitely without issue. That said, that calculation neglected the dividend which adds 1-1.5% per year.

Free Cash Flow

I've had the discussion about free cash flow in this industry surprisingly often. I know many people like to live and die by it. I don't love it in general & in this case exemplifies why. Every dollar they earn (excluding tax) can either be 'free cash flow' or capex. If they see a must have acquisition then can simply allocate to that and spend less on growth capex. Alternatively if there are organic growth opportunities that offer better returns at a given time, they can easily spend on that. Them simply doing what offers the best returns makes the "free cash flow" picture volatile. They could have $1B in FCF one year and $0 the next while adding far more value the second ($0) year. 

This may explain why the measurement of this company could get out of whack. People like FCF, others like earnings. If FCF is out and earnings are facing temporary margin issues, how should it be measured. EV/EBITDA is an option although also volatile and there's a lot of depreciation & amortization. Book is probably best (be it 0.5x book, 2x book or whatever) except, I can make the argument that as brands on old and partially amortized cost basis's become a larger portion of the earnings, book would progress towards being less relevant. 

Results Thoughts

While I'm here spewing random thoughts about Linamar, I suppose I can make a few comments about results and fundamentals.

The responses I saw around last quarter's results were quite positive. I appreciated the step in the right direction however didn't feel like we saw enough to expect a margin normalization in 2024. That absence was enough to keep me from getting excited or overly optimistic. I hope we can progress in that direction as the year plays out. With that in mind, I recognize there may still be some areas with room for improvement. I had in mind the possibility of +$12 in EPS being a normal number. Moving up above $10 as a guestimate is the right direction but not a cure for the general lack of care about the company by the market.

Peers have continued to lament the soft industry outlook predicted by industry analysts. A reduced volume environment isn't one where you'd expect the best margins... Or... Obviously, volumes. Running with strong growth in a depressed environment isn't terrible. 

Peers have also been quick to point out the weakness in EV demand and how that's causing OEMs to shift plans. I'm cautiously optimistic about how that impacts Linamar. Firstly, they're quite effective at pivoting capacity and operating flexibly. Secondly, they have plenty of ICE and propulsion agnostic products. Thirdly, customers reaching out with a change of requests seems like an opportunity to revisit discussions around proper margins. 

Despite the general industry gloom, US auto sales have been creeping higher when compared to last year. They remain around 10% lower than where they were in the 5 year stretch pre-COVID. For a thin margin, volume business, that's a big deal.

For industrials, the Bourgault acquisition plus capacity expansion within Skyjack are likely the two most significant positive growth factors. There's some concern about the Agricultural side. I don't know if it's justified. I believe there's room for market share improvement from MacDon and Salford, however the industry may not be the most supportive. My assumption is that ag will be flattish excluding the acquisition... However it sounded like they were hopeful that their segments would outperform that.

I wonder how far along they are in the medical device progression and if we could eventually see a relevant acquisition in that area or if there's a new manufacturing market which they could enter.

Hurdle 

I don't know if it would make a difference but with management's push to convince the market about synergies between the mobility and industrial I had a thought. What I could see the market being concerned about is the lowest common denominator. By that I mean, let's say you have 2 business, one you can spend unlimited capital for 1% returns... Let's call this Fauxbility and a second business what earns very high returns 100% or something and cashflows on investment with limited capital needed and less reinvestment opportunity... Call it Windustrial. The high return business is worth a lot more because it can return plenty of capital to shareholders and grow... However, if it's dumping all its profits into the low return business, all those benefits are nullified as those profits are wasted on things less valuable than paying shareholders.

As I've stated in the rest of this article, I don't believe that to be the case with Linamar. Still, I think it's worth thinking about whether they should be talking about their hurdle rates for returns on invested capital in the business that's seen as the drag. Having innumerable investment opportunities only helps if the returns are good.

On the acquisition front, it's tough to measure IRRs in the same way. Some businesses are bought for value, others for longevity. My opinions about their past acquisitions vary. I think Mobex was likely much better than Dura. I like Bourgault from a long term perspective but think in the short to medium term they'll get no recognition for the value. 

I would hope that if they're going to go the acquisition route and target 1.5x net debt to EBITDA, that they TARGET 1.5x, especially with multiples where they are for possible acquisitions. (There are some companies out there that I wouldn't mind them throwing a premium at to buy out with the current pricing environment.) By that I mean try to have debt at that level as opposed to that level being a soft cap. This might not be the case if we were at the point in the cycle where they were already firing on all cylinders and auto volumes had peaked.

Costs

I think costs and inflation are normalizing. It's a mixed bag of factors that are probably helping and hurting. As old business is replaced with new, improvement is likely. When it reaches normal and how high margins go remains to be seen. Small margin improvements can mean significantly more dropping to the bottom line when talking about slim margin operations.

Summary 

Linamar grew their topline revenue 23% in 2023 & 21% in 2022. Numbers which still don't fully reflect the $1B in acquisitions and $750M of capital expenditures they made in 2023. I expect high teens growth in 2024 with upside potential from acquisitions or auto recovery. Why the equity portion of such a company is worth below 3x EBITDA isn't a question to which I have a good answer. My big failing so far has been a failure of imagination when thinking about multiple contraction. Based on how the stock seems to act, my guess would be that we don't see any relevant multiple normalization at least until the share price hits a technical breakout (aka All time highs). It's too quick to forget about good results and meander to a lower multiple only for subsequent good results to regain less. This assessment would probably mean they'd need clear vision on north of $15B in sales & $2B in EBITDA in order to reach all time highs. Does that make sense when comparing the company with what it looked like the first time they hit those $80-$90 prices? No. It's my gut feeling. Granted, ATHs are a significant distance from where we are. The good news is I think that distance isn't astronomically difficult to bridge. Launch business, Auto volumes recover, make acquisitions to get up to the leverage target & it's closer than it sounds. The stock looks inexpensive however I believe there are many scenarios where it's both insanely cheap and being measured incorrectly. 

While the market isn't caring, I do. I watch the value being added and reflect on how much value is added every month. That $30-$50M of capacity that can go towards the next acquisition. The +$50M going towards organic growth. The fact that the decision to buy the brands gets better by the day as they simultaneously amortize and grow. That temporary margins & arbitrary multiples can change are far more variable than intrinsic value. This takes me to a place where I see a lot of reasons for Linamar to do quite well in the coming years.

Disclosure: 

At the time of this article I own $LNR.TO Linamar 

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

Interest Rates: Because We've Always Done It That Way

Interest Rates: Because We've Always Done It That Way

Introduction

There are a great many people who seem to want to believe in higher interest rates. That they're "Better," perhaps "Normal," or "Ideal."

There's this thought about what a normal rate should be. A normal that dates back to a time of kings and queens. A time of colonization. Times of sustained poverty & class systems. I want to deconstruct some traditional thinking about interest rates. Feel free to disagree with my opinions but hopefully some of the ideas prove useful. Bare in mind that what I'm going to be saying is the opposite from what many will want to hear.

Many people would say that the normal rate (when I say rate read risk free interest rate such as that set by the federal reserve) should be something like 4%. The argument will normally read something like, "because that's roughly where it is most of the time" or, "there needs to be a cost of capital to not misallocate capital to wasteful spending."

The Message

I'll address both of those but first I want to look at what a 4% interest rate says. Saying a higher interest rate is good is somewhere between the money equivalent of "Yes I know where electricity comes from, there's a plug right over there," &, "Wouldn't the world be perfect if I was the emperor." Where does the money come from that pays those high interest rates? And... Good for who? Suggesting that an ideal interest rate is 2% above an ideal inflation rate is to suggest that having capital gives people the right to tax society. 

Maybe you believe that, maybe you don't. Maybe you think, well, in order to get this capital I had to pay taxes so I deserve it. I don't know what you think. I don't think my one line was a deep enough summary. It's a tax for two reasons. Firstly; in the current setup of the US for example, the $35 trillion in government debt is the biggest payer of interest in the economy. That is literally (un)-funded by the taxpayer. All else equal, higher rates should mean higher taxes.

Secondly; moving interest rates higher raises the cost of money to every company. The companies who do things like... Build homes, make food, etc. This increased cost of capital either reduces their investment or causes them to push their costs on consumers. Consumers then have to pay more to buy food, cars to get to work, and a house to have a family etc. Everyone must pay their added fees... Because for some people's 'ideal' people with money DESERVE to be given more money. Is that capitalist or feudal?

Higher investment hurdles & more money spent on servicing the borrowed capital... Wouldn't it be funny if the Bank of Canada hiked rates up 500 basis points in a few years then 'sounded the alarm on productivity?' How is it possible that the the productive paying more interest to the unproductive hurts productivity? We probably need more academic papers on the nuisance of what constitutes productivity for us common folk to understand.

Does it surprise you that people with money and influence would prefer a world where having money means you have a societal right to have more for free? Before I inspire some socialist, I want to point out a distinction here. Capital, invested in a business or asset creates jobs, increases productivity, lowers costs for consumers, generates taxes and overall benefits society. Business investment makes everyone's lives better... But it also carries risk. The business could be replaced by another better business. It could lose money. Paying more money to a credit risk free, overnight lending is the reverse. It's a drain on capitalism... So when you see one of those loons who's calling for +10% real rates because that's capitalism, you're seeing someone who believes they should be treated like a king because they, or their family have money. It's not a functional system, it's an individualistic ideal.

The misconception around interest rates is an entrenched problem. It's a generational issue. Older people are perfectly happy clipping their 5% coupon easing into retirement. Quick to tell the younger generation how much they paid back in their day.

Younger people then are stuck paying the tab from the higher government debt and now having to fund their parents retirement & pay more than necessary for their house... While ironically having to deal with "where are my /why not more grandchildren?"

I started this by talking about kings, queens, and classes for a reason. "Because we have always done it that way," doesn't make it inherently right. People love saying that low interest rates cause wealth division. That's not logical nor is it a full story. If you look at the very wealthy, many are those who created businesses that millions use and benefit from. Amazon, Microsoft and so on. If low rates allowed businesses and people to thrive, that would also cause capital to pool up in the hands of good businesses and their owners. Saying that's bad is in interesting superficial argument that amounts to, "Wouldn't it be better if less people could buy Iphones and shop on Amazon." I don't know about better, but there'd be less wealth inequality and if that's the only measure of better then maybe we should revert to Stalin's USSR. Thinking logically about the rich-poor dynamic, it SHOULD becomes more difficult to argue that those without money giving more money to those with money, is good for those without money... Incredibly, the most common arguments amount to, the poor need to be poorer to help the poor. It's a hidden way of enforcing a neo-class system.

Wasteful Spending 

I can understand not wanting money to be thrown around too liberally when there's an inflation problem. (Now, how the Government throwing around an extra 2% of GDP in deficit spending on interest payments is helpful to cool inflation has yet to be adequately explained to me)… Wasteful spending is a judgement call. Controlling how others waste their money is an interesting question. Should we let people buy products that will slowly kill them and be a tax on the medical infrastructure but not burn their money on a business that sells snowmen online? In the end, if the spending is wasteful, it will be replaced by something else. Maybe it's a stupid idea... It probably is (whatever you're currently imagining).

I should also point out that there have been many times where people threw money at wasteful, stupid ideas outside of a low rate environment. If you can't find any right now with rates at 5%, perhaps you might in Y2K? 2007? Stupid things will happen in every environment. It's what unites us as humans.

My Opinion

My belief would be that right would be either 2% or 0%.

2% because I could argue that it would be good for people to have a way of safely maintaining their purchasing power. I recognize there are plenty of other ways to almost do this and perhaps those should be good enough but as a baseline lowest possible risk, not losing to inflation seems reasonable.

If I was more of a capitalist, I'd say ideal is 0%. If you want returns, put it somewhere helpful to society... Or pay your tax (inflation) for the safety. If money is "too cheap" borrow it and put it to a good use... (You'd quickly find out that 0% interest on government bonds doesn't mean free money). Most of the "0% rates caused problems" arguments aren't as logically sound as they purport to be. They're often significantly based in nostalgia & bias. If it pushed prices too high, why didn't more supply come... For instance.

I don't think it makes sense to subsidize the unproductive by taxing the productive. Nor does it make sense to put added financial strain on people in their 20s-40s only to come back with... Gee... why is the birth rate declining? Remember, the risk free overnight rate isn't the price for all money. It's the basis upon which the rest of the money is priced. Most items are set by the market. Fed funds isn't whether too high or too low, that's one number that is completely manipulated. It gets chosen and the rest of the prices follow. Let's not conflate private entities mispricing credit risk with something that's caused by one overnight rate or another.

Nobody forces anyone to lend money to anyone else*. 2% for the government might mean 5% for an enterprising business and 10% for someone with poor credit who needs a used car to commute to work. The idea of "Easy Money," is relative. To the rich, +5% interest rates is precisely "Easy money," in a different way of course.

Does any of this matter?

Ideal doesn't matter at all IF interest rates were merely set as a scientific policy to control inflation. That's mostly a separate discussion. A discussion which I think conventional thinking is equally misguided about, once again ignoring half the equation.

There are also a bunch of people who think they read a textbook that says something along the lines of 'high interest rates are good because they mean there's a lot of demand for money to invest.' A theory akin to, "With interest rates high there's nobody why wants to fund the US government because it can't afford the higher interest rates." Aka, a story that people tell because it sounds like it makes sense despite it being evidence-less, reflexive and an arbitrary price driven narrative. It's overly simplistic so people take it as fact instead of delve into an evidence driven debate around multiple factors and theoreticals.

That's enough prognostication for one day. Thanks for reading.

Linamar: More Distractions Please

More Distractions Please

I've been thinking about Linamar a lot recently and collected a few short thoughts here.

1: Cheapness

 I think Linamar currently is in the 'obviously cheap but who cares' category. Single digit multiple, somewhat ok metrics in tough, slow moving, low margin industries. If you told me a company with low margins ok ROIC & ROE and almost no capital returns deserves to trade at 7 or 8 times earnings, I'd say 'meh, ok, I wouldn't fight you on that.' if that were my thesis (that the multiple should get to 9 instead of 7 so I could flip to something else) I wouldn't find it particularly interesting.

What I've been focused on because I believe it's eventually likely is a return of the old Linamar. While a 10% company is somewhat average and justifiably uninteresting... A mid to high teen ROE company isn't. I think as they prove they can once again be that company, not only does the value grow faster than average but the prospects also become much more interesting from an investment perspective. Ie: multiple expansion. You can get better decade returns from a 15% ROE company starting at 1.5x book (10x earnings) than a 10% ROE company at 0.8x Book (8x earnings). Of course both depend heavily on starting and ending multiples.

That said

A 15% ROE company turns $100 into $404 in a decade. Or if the 100 is valued at a premium... $150 to $606.

A 10% ROE company turns $100 into $259 in a decade. Or if the 100 is valued at a discount... $80 to $207.

Without a change in multiple (read, someone willing to pay more when you sell to them) everything reverts back to ROE.

Point being, you get multiple expansions when you deserve it... If you deserve it. My thinking is that Linamar will normalize to a place where if proves it deserves it.

2: Agriculture Division

 The recent Bourgault acquisition opened up some operating details of Linamar's agricultural division. I don't know that people would have called the transformational 2018 acquisition of MacDon a "distraction" but it was a step away from the auto business that they had plenty of success with for decades. Since the stock has essentially done nothing since the acquisition, I was wondering if;

 A: the market didn't like the move because it made the company less appealing in some way... Like a distraction.

B: if the market would be right in that assumption.

The conclusion I came to is essentially no. They spent $1.2 Billion on MacDon (financed entirely by reasonably low cost debt). I don't have all the refinance terms, exactly amortization, capex or year by year details so I smoothed a few things out.

Effectively in the decade following the purchase of MacDon (2028), they're on track to have that $1.2B completely pay itself off, plus fully pay for the Salford & Bourgault acquisitions (another $880M)... And generate +400M per year in EBIT.

That assumes essentially 225M from MacDon (192 today... Assumes 4% CAGR vs 15% CAGR since acquisition). $45M from Salford (35? today... They didn't really comment on that aside from saying they paid a higher multiple than the other two... So naturally I assume less growth) and $130+ from Bourgault ($76M today and a suggestion that they plan to double that in 5 years). That end point, with everything paid off and cash-flowing would likely be worth multiples of the initial capital used to expand their presence in the space. In fact, the earnings alone would probably support the debt capacity to purchase 'another MacDon eq.'

In a microcosm, this is something like 15% compounded in a segment that arguably increases the quality, diversity and sustainability of the business. If that's a distraction, I'll take more distractions please.

3: The auto business...

Linamar's mobility segment has undoubtedly been the problem recently. In the last 12 reported months, they've had sales of almost $6.8B yet operating earnings of only $332M. That's a 4.9% EBIT margin. The segment left $245M on the table via underperformance versus what it should have. Now, that's not all purely failings, there was some launch costs associated with future sales growth... And I'm not sure I'd call all the issues (inflation, automakers strike, supply chain issues etc) "failings" so much as failing to go as hoped.

That leads me to my next point, that $6.8B of TTM sales will probably be significantly higher next year. Linamar acquired both Mobex and Dura-Shiloh's battery enclosure business and should launch the better part of a billion dollars worth of sales in 2024. It wouldn't surprise me to see in the range of $8B in mobility sales in 2024. That should in theory allow for $680M in EBIT if they could achieve a normalized margin. While I expect better than the $392M of a 4.9% margin is possible, I don't know that a full normalization will be achieved immediately. The tiny delta being $4.50/share in EBIT...

4: Leverage

Linamar was running for a few years with leverage below their target of 1.5x EBITDA. Bourgault took them to 1.4x... still below but almost there. I think that utilizing the balance sheet will help them be more effective with their resources. Remember, the MacDon point mentioned above essentially all came from extending the balance sheet and using 100% debt. In this case the 3 acquisitions should theoretically add ~150M of EBIT... Although nearly half of that will be offset by interest. Still after amortization that's 1-2% return on equity that otherwise wouldn't be there. If you can get some growth out of those assets, the value could easily be well beyond the initial earnings accretion... Ie MacDon... And perhaps Bourgault.

I don't know if any acquisition is as value accretive as their own shares at this share price (figure, buying a 15% yield for 0.75 on the dollar) but that's a situation that can change. 

5: Capital Budget

When I started writing about Linamar, I mentioned one positive being that they had a lot of capital to deploy. They did (Dura, Mobex & Bourgault... Plus a lot of capex). The market didn't care. Should it? Remains to be seen.

TTM Capex was $722M +  ~$1.2B in acquisitions. (Crazy to think that's basically half their market cap spent in 1 year) Hopefully it shows up.

NTM capex sounds like it'll be nominally slightly lower... Maybe $650M-$700M. I think that should compare against over $1.5B in EBITDA. If that turns out to be the case, it leaves maybe $800M in capital for acquisitions, deleveraging, or buybacks. As much as I'd love that to mean buying back 20% of the shares, for multiple reasons, it won't. Still, it could be something like another Bourgault side acquisition + 4% of the shares outstanding... Without even getting all the way up to the leverage target.

Conclusion

Maybe I'm wrong about the normalized earnings power... Maybe they can't 'fix' the margin. I don't think that's a disaster based on the trailing 8x earnings. Even if the imbedded growth from the acquisitions and launches doesn't show up or offsets declines elsewhere. The reason I think I'm stuck on this company is firstly that I can see so clearly the path to better results. Secondly, that would mean the company is a good one... Which isn't in the price... But really, doesn't need to be. If it's the company I think it is, the valuation that gets tacked on it is less consequential. If they can regularly generated 15% ROE 5x 10x 15x it's the same thing longer term. A diversified company able to grow teens.

Thirdly, maybe it takes longer, maybe it doesn't happen... Owning an ok company at 8x earnings isn't a disaster.

I think the discussion will remain the same while the share price remains under all time highs...

"Who cares about the low multiple"

"Discount to book value... So what"

Price drives narrative and an 8 year consolidation dictates a big "who cares." I looked back recently at presentations from when Linamar first went to $70, $80, $90. They were over-earning. They literally told people in the presentation. "Margins should be 5-7%... They were 7.7% in 2014 8.5% in 2015, 8.7% in 2016." That's 10-25% above the top of the range. Oddly, the market didn't really listen or care. Last Quarter they said their net margin should be 7-9%... In 2022 it was 5.1% & in 2023 it was roughly 5.7%... which would need to increase by 20-25% to get back to the bottom of the normal range. Again, however, the market doesn't seem to listen or care. Symmetry. They wouldn't over earn forever (I mean probably). They won't underearn forever (I mean probably).

My suspicion is, at some point, the market will change its mind on what it's worth... But that remains to be seen.

The path to 'good' returns from today is pretty simple. Mean revert the margins & mean revert the valuation. There is a logical reason why they should happen at the same time (as the company proves it's a better company it attracts investors willing to value it higher). I can't guarantee any of that but I'm just saying we don't need years of 30% revenue growth to be fairly valued. We don't need to win the AI space race. We don't need commodity prices to hit all time highs. You can, quite simply model for yourself what you think will happen and what that makes the company worth.

You can model based on book value / ROE

You can model based on revenue & margins

If you want to confuse yourself you can even model based on free cash flow.

You can give any multiple you want. My model includes an ~$86 Book (today vs last Q) and is based around the sales idea i mentioned above (LTM + acquisitions + Capex - business leaving)

6x forward earnings at 10% ROE? ~$51

8.5x forward earnings at 12% ROE? ~$87

10x 2025 earnings at 15% ROE? ~$170

15x 2025 earnings at 15 then 20% ROE?... Best not say.

5% margin on $9B sales at 7x earnings? $51

6% margin on $11B sales at 8x earnings?  $85

8% margin on $11.5B sales at 6x earnings? $89

10.5% margin on $11.25B sales at 4x earnings?$76

Maybe it even deserves a real multiple.

Based on my assumptions, my fair value target is relevantly higher. That said, fair value is somewhat reflexive. Prove it and my assessment could easily be 33% lower than the market's. Fail to and my assessment might need to be trimmed by 33%. I think Linamar is probably a three digit stock. Refinement beyond that really depends.

The other day, I saw a list of 'hidden gems' in Canada. The companies were good and all but the measure of hidden gem was stock performance... I was thinking, are they really hidden when everyone sees the stock go up. In an alternative world where stocks were measured by the value of their assets per share + dividends... Linamar's +15% CAGR over the last decade, despite all the disruptions was roughly as good as most of the 'hidden gems' whose stock went up and is valued at 2-4x as much.

Disclosure: 

At the time of this article I own $LNR.TO Linamar 

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

Ranking 🇨🇦 Banking

Ranking Banking

I was curious. I've been thinking about the banks recently and wondering how the performance of the Canadian banks would rank as well as how big is the difference?

So today, I'll try not to ramble too much (unbelievable I know... don't worry I'll probably fail) and focus on the results I got when trying to figure this out. As always, past performance isn't necessarily indicative of future results.

Best Banks

The first rather important lens to decide on is over what timeframe? I decided to pick 5, 10 and 20 years to get different perspectives.

Over 5 years the rankings go

1: National Bank 15.8

2: Royal Bank 15.16

3: EQB 14.9

4: Toronto Dominion 13.8

5: Bank of Montreal 12.6

6: Canadian Imperial Bank of Commerce 12.4

7: Scotiabank 12.3

8: Canadian Western Bank 9.65

9: Laurentian Bank 5.8

Over 10 years the rankings go

1: Royal Bank 15.7

2: EQB 15.5

3: National Bank 15.2

4: Canadian Imperial Bank of Commerce 15

5: Toronto Dominion 13.7

6: Scotiabank 13.3

7: Bank of Montreal 12.4

8: Canadian Western Bank 10.2

9: Laurentian Bank 7.3

Over 20 years the rankings go

1: Royal Bank 16.1

2: EQB 16

5: Scotiabank 15.5

3: National Bank 15.1

5: Canadian Imperial Bank of Commerce 15.1

6: Toronto Dominion 14.0

7: Bank of Montreal 13.4

8: Canadian Western Bank 12.1

9: Laurentian Bank 8.1

Some in the middle probably surprised people...  I think most would have guessed Royal would be where it is. 

Expected earnings yield

The next problem is that the market has assumptions. So I looked at what I'll call expected earnings yield. Essentially long run return on equity decided by price to book. This will be my basic cheapness factor.

I think this one was more interesting as it questions 'how much better does the market think'

It's still imperfect because of various payout ratios, and rates of growth on retained earnings but it's close.

Normalized Payout Ratios

On the topic of payout ratios... here's my 'normalized payout ratio' (today's payout vs the expected earnings)

Over 10 years the rankings go

1: EQB 14.5%

2: CWB 33.6%

3: LB 41.4%

4: NA 42.5%

5: CIBC 44.1%

6: RY 45.6%

7: TD 47.5%

8: BMO 48%

9: BNS 50.1%

Most are very similar.

Upside to 10X Earnings

On a similar 'judgmental' metric, I looked at what the upside in valuation would have to be to get the company to a 10% earning yield. I picked 10x with the thought that at 10x earnings all companies would have 'the ability' to payout all earnings for a 10% expected return which is in the range of reasonable.

Over 10 years the rankings go

1: LB 64%

2: CIBC 55%

3: CWB 43%

4: EQB 42%

5: BNS 40%

6: BMO 11%

7: NA 8%

8: RY 3%

9: TD 2%

*** as of the time of writing this, this will fluctuate by the day and the quarter***

Keep in mind, retained earnings would ideally increase these numbers over time. The scale of the increase could be 3%-10% per year depending on the results and the case.

It should be noted that the higher ROE banks would have increased benefits on retained earnings in the very long term... if they retain them at least. Given the difference between the main banks is so small, I didn't go too far into the attempt to sort out the minutia there as it would take many years to see a noticeable difference. 

Can't really look at banks without some capitalization comparison. On a global scale, Canadian banks are all very well capitalized but here you go:

Best Bank Awards

I'm making this up now... but this is how many of the last 20 years each bank was the best performing (based on my data)

CIBC 9 (I know right... the same guys who have no share appreciation since 2007?)

BNS 2

RY 2

BMO 2

NA 2

EQB 2

TD 1

CWB No

LB Lol

Commentary

To the surprise of no one, Royal is probably the best bank. Unfortunately "Canada's Worst Bank" aka Canadian Western Bank (CWB) isn't the worst bank. That title probably belongs with Laurentian.

I wasn't particularly surprised about LB and CWB being the bottom two by a decent length. I was surprised that the data matched my "eyeball test" for BNS, CM, BMO and TD being almost interchangeable over many timeframes. I also admittedly didn't expect CIBC to have scored so well over 10 years or Scoita over 20.

I also had in my head that there was a bigger gap between the top banks like Royal and the rest. In reality, it's 2-3% over most timeframes. In fairness, that adds up over time. I guess my misconception came from... stock performance. I think a big factor is everyone knows Royal is the best, but fewer think about how good some others were many years ago. Some have seen expectations collapse in slow motion over time. If unjustified, that certainly makes them more interesting.

CIBC

CIBC was the bank with the most chaotic results. They were the best bank 9 times but if you exclude CWB and LB from the worst bank calculations, CIBC was the worst bank 5 time too. That's 14 of the 20 years that they were either 1/7 or 7/7 CIBC: Consistency Isn't Bank's Code.

Scotiabank

Scotia was the best bank over the first 10 years I looked at... which is surprising because over the second decade it was the worst of the big 6. I didn't know this going in.

Bank of Montreal

BMO has lagged the other big 6 members over most timeframes. Only recently did CIBC and BNS catch down as BMO improved.

Toronto Dominion

TD has been very medium among the banks. That's not to say a medium bank as all the Canadian banks have done pretty well globally.

National Bank

National has actually been pretty good for longer than many might think. While most has a hiccup in the GFC, National really had 3 bad years. Recently it has been the best of the banks but it's also been fine over longer periods.

Royal Bank

Nobody sits higher than the king... that's the rule of Canada. Royal has long been one of the greats, stocks, companies and banks. National has been slightly batter in recent years but the consistency of Royal for a long time has been what stuck out. They've only been the best in 2 of the last 20 years but still wind up on top.

EQB

EQB scores pretty well across most perspectives, near the top across many timeframes in operating and cheapness. It really only would stand out to the negative because of the low dividend. Others would look at that same fact as a significant positive due to the significant growth.

Laurentian

There has been a concerning decline in the last few years. Perhaps that's why we're seeing the executive exodus. They're surprisingly cheap on assets that they can't seem to get much out of. Most upside if they can turn recent results around but there's little to suggest they are.

Canadian Western Bank

Not Canada's worst bank... But far from Canada's best. CWB is clearly not on the same level as the rest but it's unclear if their "western" exposure would make them less vulnerable going forward. They certainly are not as proficient as they once were (like many)... So there's certainly potential for upside surprise if they can recover.

Fading Earnings

The last 5 years haven't been straightforward. There was an economic slowdown in 2019, Covid in 2020, a bit of a bounce in 2021 before rapid enough rate hikes to send shockwaves through the banking system in 2022 & 2023. It's always difficult to pin down what's going on in a single year with provisions/provision releases etc. That said, most of the banks have put out lower to noticeably lower numbers in the last 5 years. When that persists, it's hard to tell if they're deteriorating or if it's a temporarily uncooperative market.

I think the idea of 'broken banks' bleeds into the fear of a bursting housing bubble in Canada... Negative amortization of mortgages and so on. I couldn't tell you what next year will look like let alone the next 10. I can say that if you remove the word "bank," and look at the history and the price that today's market is giving the performance data suggests some above average returns even using the lower end of historic results. The risk to that statement is a continued prolonged trend in lower earnings or a severe crisis.

Conclusion

They say past performance isn't indicative of future results... Then they go out and pretend to have a good idea of what's going to happen in the future. We've seen multiple rate hiking cycles and crises over the last 20 years. We've seen periods with strong growth and periods of weak growth. Some banks have stayed strong, others have weakened. We can only wait to see what the next 20 years brings.

Disclosure: At the time of this article I own shares in multiple banks as well as indirect stakes in other entities mentioned in this article.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.