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Prati Management is run by Richard J. Prati, a seasoned business executive, investor, entrepreneur, philanthropist, and hands-on turnaround specialist, serves as CEO of Prati Management and sits on several boards. Richard spent 20 years on Wall Street and has proven financial leadership and operational execution in investment banking, institutional equity sales, and professional investment management. We discussed why homebuilders are not a buy, why Ferrari’s cars are nicer than the stock and why the rotation to value may finally be here.
Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?
Prati Management: For longs, we focus on value, deep value, contrarian, GARP, and special situations. For our short ideas, we seek promotional, hyped, over-valued, and preferably structurally flawed companies in a competitive space with unrealistic valuations. From a ratio perspective, we typically have 4 or 5 long ideas for each short idea. We tend to focus on small to mid-cap, as there are incredible inefficiencies in that segment of the market. With large to mega-cap, there are more analysts, the companies are more thoroughly analyzed typically, and the handful of quality sell-side analysts tend to gravitate there. (Although there are always exceptions.) Thus, it is more challenging to find excellent value in the larger cap arena. However, today we have opportunities that we view as “best in a lifetime” as the valuations are more compelling than they were in 1987, 2002, and 2009. We seek companies where there is a disconnect between expectations and reality. In the end, we are looking for companies in which normalized free cash flow places the valuation of the companies at compelling levels. We also look for product cycles that have not been factored into expectations. Currently, we see enormous value in basic materials, chemical companies, and some random other sectors.
SA: What type of reader should follow your work?
PM: Traders, investors, and anyone who is focused on quality analysis – not quantity. We won’t publish as often, but when we do, we have high conviction. We are stock pickers. We may have a thematic basis or sector call behind some of the stocks, but basically, anyone who is seeking very thorough differentiated analysis and a desire to make outsized returns. Nobody is perfect, but we have a strong batting average. And when we connect, we usually hit with a huge return. And when we miss, we typically miss small, admit we missed something, and move on. Thus, we tend to make very outsized returns in a smaller number of names, and in the stocks in which we were wrong, we tend to get out flat to down 10%. It is rare for us to have a complete blow-up.
SA: There are a lot of stocks trading at distressed valuations – can you discuss whether value itself is a catalyst (and enough of a reason to buy) or whether catalysts are required? Can you give an example of typical catalysts you look for?
PM: Valuation helps, but we seek to avoid “value traps.” Thus, valuation alone is insufficient to justify investment (again with few exceptions). A great example is the homebuilder space. We have liked the homebuilder space multiple times in the past and for past cycles. We were asked recently if we liked them now that they have been crushed and with very low interest rates. We have done very well in the past with names like LEN, PHM, KBH, and others having sold these names late last year and early this year. With the pullback, one of our collaborators inquired if we would revisit the sector now that they have been crushed again. Although the answer today is an unequivocal “NO.”
Why would anyone want to buy something that is heavily US centric today? The consumer will be hit much harder than industry. Industrial demand has already been in a recession for the past 2 years due to our tariff trade war. China is recovering. Europe will recover more than the US as consumption is a much smaller portion of GDP. Europe gets helped by lower crude, while the US gets hurt. If Biden is elected, corporate tax rates in the US will go back up – so the more US income you have the harder your EPS will get hit. Why would you want to own a US centric consumer play? And if Trump wins a second term, the weaker consumer and low oil pricing still make homebuilders a challenging bet, despite the apparent value.
Value with catalysts or product cycles is optimal. Our favorite names right now are TSE and OLN by far. We also like HUN and DOW. DOW is a large-cap, and the exception for us, but its valuation became extreme (and still is ridiculously cheap). TSE and OLN are both ridiculously priced and misunderstood. TSE and OLN are both at trough valuation and both would still be very compelling if they were suddenly 50-100% higher. This is a combination of horrible sell-side coverage and a lack of active investors who can do the analysis necessary to recognize the absurdity of these two companies. I expect both of these stocks to substantially more than double by year-end, and both to be up 4-5x from current levels by the end of next year.
SA: You recently highlighted a number of ideas for a Bullet-Proof Portfolio – do you see any of these being potential takeover targets by financial or strategic acquirers if the market refuses to re-rate them higher?
PM: Absolutely YES. I think TSE and OLN are both likely to be taken out by strategic or financial acquirers. There has been a lot of M&A in the sector. Moreover, both TSE and OLN have activist shareholders who own a ton of stock (both at much higher levels). Warren Buffett already owns a stake in Lanxess AG, which is an excellent German company and very cheap. Buffett paid about 50% higher for his stake in Lanxess than where the stock is now. It would make total sense for him to buy the entire company or to at least increase his stake.
I think CPRI is an excellent takeout candidate. I think we could see either a big industry player such as LVMH or Kering or even a PVH or private equity takeout CPRI at these levels of valuation, which are silly. Both LVMH and Kering were interested in both of the acquisitions that CPRI made (Versace and Jimmy Choo) over the last two years. Now they can buy these brands much cheaper. These two brands were acquired for a total Enterprise Value of $3.5 billion. Today, CPRI’s enterprise value is $5.8 billion and the acquisitions are not even contributing to earnings as CPRI is investing to structurally improve the margins further. If you back out the value of the acquisitions you are left with $2.3 billion of EV for the Michael Kors business, which is 2x EBITDA on a normalized basis.
CPRI got beaten harder than many retailers because of their debt. But they restructured their debt covenants, so either the business recovers and the stock soars, or they get acquired while the stock is still silly-cheap.
SA: In your excellent coverage on Ferrari (see here and here) you take a different angle than most investors – previously even the bears generally agreed that the fundamentals were solid (they just disagreed on the valuation) whereas you make a compelling case that in addition to the extreme valuation, the fundamentals are not so solid – can you discuss this a bit more in-depth?
PM: Ferrari is one of the best three structural shorts I have seen in my career. There have been plenty of “bubble” stocks that were great shorts back in 1999-2000, but for a large-cap well-known company such as Ferrari to be so grossly overpriced, and the investor base to be so oblivious to the rapidly approaching problems, I am astounded. The only thing that stopped Ferrari from further free-fall was the Italian government prohibition on shorting the stock. Nevertheless, the shareholders will abandon the stock in the coming quarters as they come to recognize that the Ferrari exclusivity is gone, and the valuation is absurd.
Some Investors who read the pieces argued that Ferrari is more like Hermes, and exclusive like a “Birkin Bag.” The analogy is completely ridiculous. It seems silly to use Hermes’s valuation as a proxy for Ferrari. There are many more people that can afford a Hermes bag for $10k than a Ferrari for $500K, and more importantly, people will likely want bags in the future, while Ferrari is on borrowed time as longer term, self-driving cars will make sports cars obsolete. The fact that the bulls argue the multiple of EBITDA is the right comparison is also laughable given the capital intensity of an auto company compared to a global fashion brand. $500,000 allocated for the purchase of an internal combustion engine car will increasingly come under scrutiny both within family and social circles and within communities.
Aside from the enormous financial distress brought about by the coronavirus and the recent market crash, the over-production by Ferrari, and the enormous production by competition is rapidly bringing this game to an end. The other bull argument “China will save the day with huge growth of wealth” is proving to be completely flawed. First, China Ferrari sales (and sales in general) fell off of a cliff so far in 2020. And I suspect this will likely be the case with luxury and ultra-high performance ICE automobile manufacturers globally. With all of the new and almost new supercars for sale, either this year (2020) or possibly last year, we likely have already seen peak sales. Consequently, we expect Ferrari to lose at least another 60-70% of its value in the next year. Analysts have Ferrari earning $4.50 per share this year up from $4.13 last year. I would be surprised if they ever earn $4.00 per share again, but let’s say for the sake of argument that they completely drain their backlog and place cars with everyone on their list (who would still take one), and they earned $5.00 per share, what would a cyclical company be worth on peak earnings? 5x? 10x? 15x? I think $5.00 is a fantasy number, and 15x for peak fantasy numbers would be absurd, but that gets us to $75 per share. The stock is still at $156 per share! It traded at $181 per share. For shareholders, they have a gift from Italy – no shorting, and a bid that is much too generous. And for short-sellers, hopefully, the restriction will be lifted soon, and in the meantime, investors can sell calls or buy puts.
SA: A correction or bear market presents greater risks and opportunities – are there any specific steps investors should take during these times to maximize returns and/or minimize risk?
PM: There are variables we cannot yet see, but with the fastest sell-off in history, we believe the panic has largely come and gone. The coronavirus will ultimately be contained, and society will adjust (somewhat) its behavior and social interaction. We have already seen the virus contained at its origin in China. We are past the curve in Italy and Spain and seen the virus very well contained in S. Korea. We will see the curve decline in the USA within two weeks. Containment with the encouraging news on therapeutic treatments for COVID-19, such as Chloroquine and Hydroxychloroquine are promising and already approved as they have treated several forms of malaria safely for decades.
So, while we will see volatility, we think the bottom has been put in, and we are likely to see a rotation to value as investors begin to realize that value is overdone to the weakest levels in history, while growth has corrected, but is still not cheap. We have loved technology in the past. Coming out of the tech bubble in October 2002, my former firm, American Technology Research called the bottom in semiconductors at the absolute bottom. We anticipated camera phones driving chip consumption. Likewise, we aggressively pushed names like CREE (when it was very cheap) in anticipation of the LED lighting revolution. And we relished opportunities in companies like Micron (NASDAQ:MU) when the stock was around $2 or $3 per share in late 2008. In markets like we have now, it is important to look at the end markets, the drivers, and who are the likely beneficiaries and who is likely to feel more pain.
Thus, companies that are going to see growth drivers, and pricing strength are well-positioned for a big cyclical move. We will avoid large-cap growth in general, while making short bets on some specific names (e.g. Ferrari), while the bulk of our longs are trading at historic lows, paying huge dividend yields, and in zero danger (or close to it) of going out of business.
SA: How should investors consume financial news and incorporate it into their investment decision making process? What news sources do you rely on and trust the most?
PM: Casual investors are challenged because of the enormous information flow, and the need to consume and digest it to see what the implications are. Now there are bots and algorithms reading the news and reacting immediately (sometimes the opposite of how they should), so investors need to be extra careful. I find Bloomberg is my best general source, and then I have a bunch of off-the-beaten-track websites that I like to review. I think websites like Seeking Alpha can be very helpful. And then, I listen to countless company presentations, as it is good to listen first-hand to suppliers, customers, and companies of interest in general. I think it is critical to know what competitors are saying, and companies throughout the supply chain. I also scan insider buying and selling. Insider selling does not always reveal a lot. There are many reasons people sell stock. But there is only one reason people buy stock in the open market – to make money. I like to check the frequency, quantity, as well as how management allocates capital, etc. I like seeing insider buying at the chemical companies I mentioned (TSE, OLN, HUN, and DOW) – each of these companies has seen substantial insider buying in the open market.
SA: What is, and is not, valuable from sell-side research and how do you use it (if at all) in your investing? Are there any firms/analysts you think add value?
PM: In general, the sell-side is abysmal. Most of the analysts are hiding and hoping to not lose their jobs. They gravitate towards the consensus, and rarely make a bold call. There are isolated analysts who do great work, and who make solid stock calls. But in general, the sell-side is largely embarrassing with many of their calls. Their calls are often random – much like a coin-toss, offering no insight. There are some analysts who make very good contra-indicators, and they should be utilized for that. A great example would be the chemical analysts at both SunTrust and Royal Bank of Canada. Both downgraded Olin (NYSE:OLN) at $12 per share. This is clearly the bottom of the cycle for chlor-alkali. Where were these guys at $50? Where were they at $30? Downgrading the stock at $12? This to me signals analysts who truly do not understand the industry and made a reactionary call. This was capitulation. After having missed the entire downturn for the past ~18 months, they could not sit by any longer, so they downgraded. I suspect they will upgrade in the $20s or $30s.
SA: What’s one of your highest conviction ideas right now?
PM: My highest conviction idea here and now is Trinseo (NYSE:TSE). Olin (OLN) is close behind. TSE is so ridiculously priced that I am trying to find additional liquidity to put towards TSE as I simply believe there is no way this remains below $30 over the next month or two. (I recognize it is below $20 today and $30 would represent a 50% move.) I believe TSE could easily be at $30 within a single trading day or two, as soon as investors realize what is happening here and how inefficient the news is on the company. Trinseo is a well-run company with a new 20% activist investor who bought his stake much higher (suggesting that he already thought the stock was really cheap at $30). With over an 8% dividend yield, people have abandoned the company not recognizing that Trinseo’s exposure is Europe and China, not so much the USA. China is already recovering with many citizens returning to work, and the country controlling the COVID-19 outbreak, and things beginning to get back to “normal.” TSE has been hit more than the other players, despite having no gas business in the USA. Trinseo’s business is predominantly European, so lower oil not only does not hurt them; it helps them as companies using crude oil, vs. Chinese companies using thermal coal. I cannot ever remember being able to buy a stock at a normalized 46% FCF yield and 2.2x normalized FCF per share. Given their exposure to engineering plastic, latex, synthetic rubber, polystyrene and styrenics, Trinseo is at the beginning of a multi-year run and investors are catching this at unheard of levels. I understand we are in a day and age, in which analysts and pundits are encouraged to be conservative. I am not embellishing or trying to hype these names. I am simply enthusiastic when I see such a rare opportunity to make 5x on my money.
A couple of days ago, TSE issued a release, and like most companies, suspended the guidance for the year. I was amazed to read a few message boards, and even news summaries that both got the facts incorrect and missed the key points of the release. As I have said before, there is a lack of good coverage and understanding of this company, and therein lies the opportunity. The sell-side is truly asleep at the wheel here. There were a number of positives in this release that I highlight below.
a) The company mentioned that most of Q1 was very strong, with weakness starting to show up only in the second half of March, mainly in automotive applications. They did highlight however, that two of the divisions, polystyrene and latex binders have still been relatively strong. This means that not only did the weakness come late in the quarter, but it mainly applied to the two divisions that sell into autos (synthetic rubber and engineering plastics), with the rest of the portfolio holding up relatively well.
b) The company highlighted the very strong balance sheet, with leverage only at 2.1x with no maintenance covenants and no significant debt maturities until 2024.
c) Importantly, the company highlighted that it is in the process of selling some German styrene and polybutadiene assets that are currently EBITDA negative to the tune of 18 million. While we don’t know what the value for these assets will be, we have a few comps to give us an idea. For the styrene assets (300 kt), we can look at INEOS’ styrene capacity expansion in 2018, which implies a value for the styrene asset of $282 million. For the polybutadiene asset (small, only 30kt), we can look at Lanxess capacity expansion, which implies a value of $12 million. Obviously, these are new capacity economics, so we assume that the TSE being sold will trade at a discount to these numbers. Assuming they trade for a 25% discount, we arrive at 220 million (which is an incremental 34% upside to the stock). In addition, EBITDA for TSE will go up by 18 million as the losses go away. At the current depressed 5.3x multiple of TSE, this is worth another $95 million (incremental 15% upside to the stock). This means that at a 25% discount to the comps, we get incremental upside of 49% to the stock. I have already walked-through in detail how we arrive at a valuation in about 12 months in which TSE is worth more than 500% more than today. The TSE press release adds an additional 49% today. Hence, I believe this is one of the best if not the single best investment long idea I have seen in my lifetime, and believe investors will be rewarded for buying aggressively at current levels.
Olin (OLN), on the other hand, is so well-positioned also. Their ammo business (“Winchester”) has gone from lagging to being on allocation. They have a new government contract kicking-in this year and already, just the retail ammo business has been characterized as “on fire” across the country. Another division not usually highlighted is their sanitizer business. In light of COVID-19, and with the huge stock performance of Clorox (NYSE:CLX), it is worth noting that OLN is a big supplier of disinfectant to Clorox. Regardless, for some reason, the analyst community is clueless on OLN and misses the point that it is counter-cyclical. OLN saw peak earnings in the last downturn. Since Chlorine can neither be stored nor shipped long-term, when demand slows, caustic-soda sees price increases, as slowing chlorine production also slows down caustic soda production. So, pricing goes up. Olin is the largest player in the world and the lowest cost producer. No other players will bring on new capacity for years. Another interesting point? It would cost $15 billion to replace all of Olin’s manufacturing assets. Olin is trading at around $1.8 billion market cap. It has been around for a century. Trinseo is around $700mm market cap. With both TSE and OLN seeing substantial insider buying, and both having large activist investors, I anticipate shareholders of both companies are going to have a phenomenal next couple of years, with huge moves starting this year.
Thanks to Prati Management for the interview.
Disclosure: I am/we are long TSE, OLN, CPRI, WRK, HUN, DOW, PVH, LANXESS, HEIDELBERG CEMENT, COVESTRO AND SHORT FERRARI (RACE), CTAS, APD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.