<THE BORING PORTFOLIO>
Another Blip on the Bore Radar
PGI Group Enters Universe
By Dale Wettlaufer ([email protected])
ALEXANDRIA, VA (March 10, 1999) -- Rumors have been floating around the Internet that a prominent business newspaper named after a street in lower Manhattan is working on a story about how the Boring Portfolio is contemplating getting into the textiles business. While we don't normally entertain such rumors, we don't want to provide this particular newspaper with the scoop, so I will say that we are indeed looking at a textiles company named Polymer Group Inc. (NYSE: PGI).
Before we give it a full-scale rundown, here's the main attraction. We're interested in its intellectual property in the nonwoven textiles business, primarily its APEX manufacturing technology. That's where a lot of the potential value comes from. The company is also a large manufacturer of traditional nonwovens, which are used in diapers, feminine hygiene products, and medical products. Disposables such as these account for 85% of worldwide consumer sales of nonwovens, according to trade publisher Miller Freeman.
APEX, however, may revolutionize the manufacture and design of consumer durables because of its ability to "replicate any traditional textile product through a proprietary process involving laser imaging and high-pressure water systems," according to Chemical Market Reporter in an article detailing an address given to the NYSSA Chemical Industry Conference by Polymer Group chairman and CEO Jerry Zucker.
"For a value investor, what's the attraction there?" one could legitimately ask. First, Polymer Group is a working nonwoven textiles company with 1998 revenues of $803 million and operating earnings of $105.6 million. Without a Q4 balance sheet, I can't say what the full year's cash flow was, but EBITDA was $165 million on an average base of tangible assets in the neighborhood of $1 billion. Being Miller & Modigliani adherents, we're not wrapped up in the way the company is financed, so long as the interest coverage is good. Of course, when "EBITDA" enters the conversation, one should remember that there are costs to maintaining a business and costs to financing a business. These we would not ignore for the purposes of valuing the company, but I will ignore those for the purposes of the conversation at hand.
What I am looking at here as a value investor is the ability to buy the core business at a reasonable price and capture the option on this highly valuable set of intellectual property at no premium or at a very low premium.
The Value in Creative Destruction
The labor content in the cost of traditional woven fibers is 30% and the labor cost in Miratec fibers (using the APEX technology) is 2%, according to the company. If you've paid attention to the steel industry, another Industrial Revolution sort of industry like the textiles industry, you know who Nucor Steel (NYSE: NUE) is and the value that it has created. That's a company that I've always admired but was born a little late to take advantage of. When I drive by the rusting shells of the Bethlehem Steel plants around my hometown of Buffalo, New York, it's hard not to think of the value that is generated or redistributed through the process of creative destruction.
As value investors, Alex and I aren't into the whole "paleo-value*" (a term coined by our friend Randy Befumo, a Legg Mason Fund Advisor) approach practiced by some value people that spend all their time in magazine columns ranting about internet companies and bubbles. A dollar of earnings, $20 of book value, and $10 of excess cash all priced at $10 don't interest us in the least if a company refuses to do something with that excess cash and reinvests earnings at suboptimal rates of return. The compounding of value when a company invests in value-creating opportunities also works in reverse. The destruction of value is compounded when earnings are continually reinvested in poor businesses.
Taking excess value from poor producers is abundantly evident at our second-largest holding, Berkshire Hathaway (NYSE: BRK.A). The company generates cash from doing things better than the competition. Auto insurance, for instance, is pretty near to being a commodity. GEICO just does it better. Nebraska Furniture Mart is a retailer of home furnishings and consumer electronics. That's a commodity business with a service element to it, but it generates value for Berkshire by being better at that business than anyone.
Many forms of reinsurance are commodity-like. Many companies can step up to the plate and offer up their capital for the transfer of risk. National Indemnity and GenRe are in that business but they don't offer up capital where others make pricing irrational. Berkshire allocates the capital to its highest potential. If that potential is in a commodity business, it'll go there. When the auto insurance offers no more excess value, as it eventually will if GEICO keeps doing what it does, or the opportunity for returns in Coca-Cola at 15 times earnings is more attractive, then the capital will be allocated elsewhere.
Some Specifics on PGI
So being involved with a textiles company isn't the most worrisome thing in the world, as long as this proprietary technology works. A rough sketch: First Union Capital Markets estimates Miratec (just one unit at PGI that uses APEX technology) can achieve $70 million in revenues by next year and $170 million in revenues by 2002. Off that, gross margin next year would be 40% and 45% in 2002. On revenues of $170 million, analysts Bryan Hunt and Mark Doehla estimate that can bring $62.9 million to the operating income line. They also estimate that each Miratec production line can generate $75 million in revenue and that a line costs $30 million to $45 million.
Departing from their conclusions (I don't want any logical mistake of mine to be blamed on them), we're looking at unleveraged net margin of 23.3% (using a 37% tax rate) and annual asset turns of around 1.25 to 1.5 times (I've built in some other assets there and assumed a faster cash conversion cycle than is typical with textiles manufacturers, due to these being higher-speed production lines that can work through raw materials and don't have a long work-in-process cycle).
Using the lower asset turns number, that's a return on assets of about 30%. This prospective return is in-line with what specialty manufacturers operating at volume and using proprietary processes can expect to earn, so I'm comfortable that my conclusions about the potential are realistic.
The investment question here centers around a business that already does a fine job in nonwovens. It's not anything to write home about, but it generates cash and can fund this other business that has an addressable market of $800 million or more in the U.S. textiles market, which is itself an $80 billion market. According to management, the only difference in texture is seen solely through a microscope. Therefore, the applications range from oxford shirts to khaki pants to upholstery, and so on. Virtually every textile product can be replicated using the computer imagery and Web-forming technology.
Depending upon growth, the financing and timetable of the growth, and marginal return on capital characteristics, this has the potential to add a good deal of value to Polymer Group's equity. This is totally a work in progress, however, and we're walking into this thing cold. As Boring readers know, we think out loud. We could just as well short the thing tomorrow if our conclusions pointed in that direction, so I will reiterate a long-standing admonishment to "do your own research." In another report, we'll break down and value the ongoing business and the APEX assets, but right now it appears to be a fairly valued asset with a nearly free option on a process technology that could totally change the textiles business.
Other Research Projects
Philip Morris (NYSE: MO) is on our list. I'm still in the middle of working on this, but I'll attach below a simple breakout of the business lines. I'm still very much in the early stages of modeling the company.
You might be interested in 1998 ROA results by business line:
Tobacco...42.51%
Food...9.18%
Beer...21.41%
Financial services...1.95%
I've made some adjustments on the income statement, such as for last year's settlement charges. The above are returns on total assets by business unit. Returns on tangible assets would of course be higher. These are also unleveraged returns, before financing costs. In looking at these, we want to see the raw economics of these business lines without the financing methods selected coloring these. Also, I have done a very simple allocation of corporate overhead, but allocating to each business line the same proportion of corporate expenses as the proportion of business line revenues to corporate revenues.
I've taken the settlement charges out of the business line decomposition, by the way. These will just look a little different on the income statement in future years rather than just being a straight deduction to operations. I'll explain that later, but the way I see it, the consumer pays more and the cigarette company acts as the transfer agent of those funds. Did you know, by the way, that Philip Morris passed through $16.6 billion in excise taxes last year?
Bore Port Holdings
Berkshire Hathaway released a bare-bones income statement yesterday. At this point, I haven't spent much time on it. Berkshire is way too complicated for this statement to mean that much at the moment. This Saturday the company will release its annual Chairman's letter to shareholders within its annual report. I'm tempted to tell you that it will be posted in the afternoon, so people won't crowd the server, but I believe it will be posted by 8 a.m. eastern time. Even if you don't own or entertain any thoughts of ever owning Berkshire, I think your business and investing education could be advanced by reading these letters. And if you have a kid that's thinking of going to business school, stop them. Give him or her a bound copy of these letters, the $100,000 or more in cash that the degree would have cost, and a swift kick out the door. They'll thank you for it later.
Gateway (NYSE: GTW) dropped to $65 5/8 in composite trading today, dropping a couple more dollars after-hours from the close around $67. I am keeping a cyanide pill on the back of my tongue if I get the temptation to read any stories talking about "PC growth slowing" or falling prices in the PC market. If reporters can't figure out that PC prices drop by design and by the natural laws of the economics of the industries feeding PC growth, then they're braindead.
Wondering how many Internet users there are and how much has been spent on e-commerce since 1998? Go to Cisco Systems (Nasdaq: CSCO) Web page and click on http://www.cisco.com/public/Corp_root.shtml. Refresh the page to toggle between the two.
I'm done for today. Have a good Wednesday and we hope to see you on the Boring message board soon.
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