Fructivore Investments

Insnurance companies

According to some guy from Columbia…

In my final article on this series of whether companies in certain sectors can be bought based on price to book ratio, I examine insurance companies. Recall that my original thesis is that, according to some well known financier whose name I forget, banks have assets that are impossible to value, and insurance companies have both assets and liabilities that are impossible to value. Even so, it is conceivable that any errors in valuation could be in the owner’s favor as easily as to their detriment. More to the point, the assets of these companies tend to consist largely of financial investments rather than, say, industrial equipment, so their book value tends to be a more reliable guide to their actual value and often times may be quoted regularly in the market. And so the naive strategy of evaluating these companies solely on their book value might be effective.

As we have seen, the correlation coefficient between a bank’s price/book ratio and its performance in 2024 was practically nonexistent, but when using tangible book value there was slight evidence of low price to book ratios producing outperformance when outliers are eliminated but at least in 2024 higher than average price to book ratios were not punished and even showed a tendency to be rewarded, which came as a surprise.

Turning now to insurance companies, the first complication is which book value to use. Insurance companies, particularly life insurance companies, make actuarial assumptions about life expectancy, interest rates, expected return on investments, and so forth. These assumptions are subject to change, of course, and as they change the value of the company’s liabilities change with them, sometimes dramatically, even though the company’s assets and near term cash flows are unchanged and a future shift in actuarial assumptions could erase the effect of the current ones instantly. The effects of these changes in actuarial assumptions are subsumed in “Accumulated Other Comprehensive Income” on the balance sheet, as these changes are not considered operating, since an insurance company is in the business of selling insurance and investing assets, not actuarial services.

However, insurance companies are in the habit of reporting their book value under GAAP and their book value not counting this accumulated other comprehensive income. By an extraordinary coincidence, of the fifty or so insurance companies that formed my sample, every single one of them reported a higher book value with this adjustment. Apparently, not a single insurance company has ever had its actuarial assumptions move in its favor in the history of the American insurance business. (Or, more likely, if they have the company sneakily counted it as operating income to make themselves look better). At any rate, in my opinion accumulated other comprehensive income, or more accurately, accumulated other comprehensive losses, should be included in book value, as it represents an economic loss, even if unrealized as yet, and a constraint on the insurance company’s business activities. This is also the view of a noted professor at Columbia School of Business.

Also, some insurance companies have goodwill, and eliminating that to arrive at tangible book value is another possible adjustment .

That said, what are our results? The Value Line, from which I draw my samples, divides insurers into life insurers and property and casualty insurers, the latter being much more numerous. There are also reinsurers, but not many of them so it is difficult to draw conclusions from such a small set.

Among life insurers I was pleased to discover that in 2024 the naive strategy actually showed some signs of success, with a correlation coefficient of about 0.2 for both raw and tangible book value. Unsurprisingly, book value modified for accumulated other comprehensive income showed a weaker correlation. As I’ve said, given the numerous possible determinants of investment performance, one can hardly expect price to book ratio to be the sole factor in returns, but a correlation coefficient this high at least suggests that something is going on.

Among property and casualty insurers, I was disappointed to find a correlation coefficient of about 0.015, essentially consistent with no correlation. However, by dividing the outcomes into quadrants as before, I find that a higher than average price to book ratio was almost twice as likely to produce a lower than average return as a higher one, while a lower than average price to book ratio was more likely to produce a low return. Also, apparently 2024 was a difficult year for the average insurer, as returns were skewed to the downside.

So, to conclude, at least for 2024 the naive strategy of buying banks or insurance companies based on price/book ratio did not show reliable correlations apart from among life insurers. However, when purely considering if the price/book ratio was above average there were some minor indications of the validity of the strategy; with property and casualty insurers high price/book ratios were more likely to underperform, while with Midwestern banks, high price/book ratio banks showed above average returns but curiously that advantage disappeared when looking at tangible book values, to be replaced by a slight advantage for low price/book ratios, a sign that goodwill writeoffs are not overdue at least. And for non-Midwestern banks low price/book ratios had a slight advantage once outliers are removed, but curiously the high price/book outliers were more likely to outperform, which is counterintuitive and requiring further investigation. And of course this study should be extended to prior years.

As a followup to my previous article where we discovered that at least in 2024 the naive strategy of buying banks based solely on price to book ratio did not perform as advertised. However, the Value Line from which I drew my sample also treats Midwestern banks as a separate category of bank, for reasons knowable only to them. True, Midwestern banks are more likely to be small or medium sized and regional, but in my previous article I focused on similar non-Midwestern banks, as large investment or money center banks likely have a distinct competitive niche that makes them less susceptible to being examined purely on their balance sheets. Also, I found some repeat entries from last week in this set of banks, meaning that depending on when one looks a bank can simultaneously be Midwestern and not Midwestern.

For the non-Midwestern banks, recall, neither regression analysis nor the simple sorting into quadrants of above and below average indicated that this strategy showed any chances of outperforming. Nor were results noticeably different when using tangible book value, which at least implies that most banks are not sitting on overdue writeoffs of goodwill, which I suppose is promising.

But now focusing on Midwestern banks, using raw book value the naive strategy fared no better in 2024, with an r-squared value of 1.72%, which is entirely consistent with the relationship between price/book value and returns being nonexistent. And removing outliers resulted in no improvement, as three of the banks with a price/book ratio above 1.8 performed better than the average for all banks under consideration and two such banks underperformed.

Looking at the quadrant approach, we see that in fact twice as many banks with an above average price to book ratio earned an above average return. So much for price/book ratio mattering! Low price to book was divided evenly.

However, when we switch to tangible book values, we see that the low price to book ratio strategy has some stirrings of validity. The r squared value was 2.75%, which is still quite small but considering how many factors actually go into bank returns, ferreting out the effect of a single causative factor is not easy and 2.75% is certainly further from zero than we’ve seen earlier.

And looking at the quadrant we see dramatic results indeed. The apparent “advantage” in high price to book banks more or less disappears, and is replaced by an apparent advantage in low price to book banks. So this suggests, at least subtly, that for Midwestern banks some goodwill writeoffs are indeed overdue and that the effort banks go through to report tangible as well as raw book value is not wasted, at least in the Midwest.

Obviously, more years and more potential for confounding variables should be examined, but it is encouraging to see that our naive price to book strategy is not entirely off base. And we haven’t even started on insurance companies yet.

A wise financier whose name escapes me once wrote that the trouble with banks is that they have assets that are impossible to value, and the trouble with insurance companies is that they have assets and liabilities that are impossible to value. Given the current situation with insurance companies and natural disasters, this is a difficult statement to gainsay, and likewise valuing mortgages and derivatives is difficult even during non-financial crisis times.

However, the possibility did occur to me that even if valuation of such companies is error prone, the error might in fact be nonbiased, which is to say that one has the same odds of guessing too high as too low. And so, as most valuation techniques of banks and insurance companies center on the balance sheet, could the naive strategy of assembling a portfolio based solely on buying companies with a low price/book ratio and avoiding the companies with a high price to book ratio be a valid strategy?

In order to investigate this, I computed the price/book ratio of all the banks in the Value Line investment survey (which hopefully is a representative sample) as of roughly February 2, 2024 and examined their one year performance. I decided to focus on the smaller community or regional banks, ignoring the massive money center or investment banks. And then, because banks are complicated by goodwill and other intangible assets, I did the same with tangible book value, which most but not all banks are kind enough to report in their earnings announcements. I then ran a linear regression analysis, as data mining analysts are known to do.

Before I reveal the results, I should try to discuss why banks and insurance companies are more transparent to balance sheet analysis than other companies. The reason is the assets of, say, an industrial company, are custom-designed to produce a particular product, and the value of those assets on the balance sheet may have nothing to do with their actual value in the economic sense, which is determined mainly by the demand for the company’s product and its competitive position. However, banks’ assets are generally marketable and fungible, as a bank’s “product” is simply the use of money, and the size of its portfolio of assets is generally a reasonable measure of its ability to do so. Insurance companies operate in an analogous way; they profit by taking in premiums and investing them, thus pocketing any investment income produced between when the premium is collected and when claims are paid.

So, how did my regression turn out? I have to confess, not at all convincingly. Using pure book ratio, the r squared turned out to be less than 1%, and eliminating outliers it actually went down. Tangible price to book ratio, outliers or not, fared no better. The r squared, recall, measures how much of the variation in the dependent variable (investment returns) is determined by the independent variable (price/book ratio). A value of 1% implies that hardly any relationship between the two exists.

However, the r squared is not the end-all of analysis, and much like the Spanish Inquisition, when you have data you want to torture it until it says something. So, I divided my 161 banks into four quadrants based on whether the price to book ratio was below the mean or above and whether the one year return was below the mean or above. Using the raw price to book ratio, 38 banks had a low price/book ratio and below average returns, 40 banks had a low price/book ratio and above average returns, 38 banks had a high price/book ratio and below average returns, and 45 banks had a high price/book ratio and above average returns, which more or less confirms what the regression told us, that at least in 2024 price/book ratio had essentially nothing to do with performance, and indeed the number of banks that broke the rule outnumbered the ones that followed it.

However, I did mention outliers before; there are times when the reported price/book ratio is so unrealistic as to be “obviously” wrong. I decided that any bank with a price/book ratio below 0.5 or above 1.8 was so far beyond the pale that it was unlikely that investors were seriously using it as a criterion. This eliminated three of the low price/book, low return banks, three of the high price/book, low return banks, fully 7 of the high price/book, high return banks, and none at all of the low price/book, high return banks. Curiously this has the salutary effect of making the proposed strategy look slightly better, but at the cost of eliminating a disproportionate number of high return banks, which obviously is exactly the opposite of what we want.

Applying the same method to the tangible book value, we find as follows:

Notice that there are more below average tangible price/book ratios. This is not surprising as a bank’s tangible assets can always be less than its raw book value but can never be greater. However, we still see that whether the price to book ratio is low or high, the odds of outperforming the average is the same as underperforming.

But, applying our search for outliers again we see that low price/tangible book value stocks are made to look slightly better.

Perhaps 2024 was an unusual year for banks, but it may be that investors who assign a high price to book ratio are actually seeing something in those banks that, if the year bears out their expectations, will justify a price advance and presumably an even higher multiple. Or it may be that a naive and cheap to execute strategy like low price to book is naturally too simple and exploitable to reliably produce outperformance. I may have to repeat this experiment with insurance companies or other years of historical data.

BlueLinx (BXC) is a wholesaler of construction materials, mostly wood products such as lumber, siding, and plywood. What interests me, though, is the company’s enormous cash reserves. Of its $800 million market cap, nearly $500 million consists of cash, the fruit of a very profitable 2021 and 2022, which the company seems to have no idea what to do with. Obviously my suggestion would be either a massive special dividend or repurchasing of shares (the company has repurchased $120 million so far, but it could handle plenty more), but the point is that for a cash-flow-positive business with a credit facility available to cover liquidity needs, most of that cash may be considered “excess,” and can essentially be deducted from the company’s market cap when analyzing it.

In terms of financial theory, a company is basically worth the money it has plus the present value of the money it will have. Obviously a company needs to keep some cash on hand for liquidity needs or other conveniences, but the issue is one of return on assets. Ordinarily every asset inside a company is contributing to that company’s return on assets, and the attractiveness of the company depends on whether its assets exceed, equal, or fall below the investor’s required return, and since that return is invariably higher than the short term interest rate for cash, a company should try to operate with as little cash tied up as possible. However, if there is “excess” cash not needed for the company’s operations, that cash is not required to meet any return on assets hurdle, because it can (and usually should) be distributed to the shareholders. I should point out that at the beginning of 2021, the company operated with the princely sum of $82,000 in cash on its balance sheet.

So, if we reduce the company’s market cap to $310 million, are the company’s earnings adequate? I did point out that 2021 and 2022 were remarkably profitable years. In fact, the company’s net income was $300 million in each of those years, and if those results were repeated the company would have a P/E ratio of…one. However, the market recognized those results as largely exceptional, with the share price actually declining in 2022, and as the company is essentially tied to the home construction market, which is apparently in a bit of a slump right now, this is understandable.

At any rate, in 2023 sales were $3136 million, gross profit was $527 million, operating income was $138 million, net interest expense (the company only started reporting interest income and expense separately in 2024–again, not used to having lots of cash lying around) was $24 million, leaving $114 million, or $92 million after taxes.

In 2022, sales were $4450 million, gross profit was $833 million, operating income was $439 million, interest was $42 million, leaving $394 million, or $311 million after a provision for taxes.

In 2021, sales were $4277 million, gross profit was $778 million, operating income was $438 million, interest was $46 million, leaving $392 million, or $311 million again.

It is unfortunate that BlueLinx’s gross profit margins tend to decline alongside sales, but that is the nature of operating as a warehouser and distributor. However, the company has been able to reduce inventory levels by nearly 30% between the end of 2022 and 2023, freeing up an additional $140 million in cash which, although not a suitable measure of long term free cash flow generation, as I have written before does suggest that management is not unaware or unresponsive to the slow housing construction market, even though selling, general & administrative expenses haven’t declined significantly since 2022.

At any rate, for 2024 to date sales were $1494 million versus $1613 million for the first half of 2023, gross profit was $250 million versus $269 million, operating income was $52 million vs $72 million, interest expense was $24 million versus $23 million, leaving $28 million versus $39 million, or $22 million estimated net income after taxes versus $31 million for the same period last year. Furthermore, depreciation exceeded capital expenditures by $7.6 million when historically they have tracked each other more closely, which is a source of additional free cash flow, not to mention a small further reduction in inventory.

So, if in a slump in the housing construction market the company is still able to produce, say, $50 million in free cash flow, that looks like a fairly anemic return against a market cap of $800 million but really quite impressive for a market cap of $310 million. And if the company is agile enough to take advantage of a resurgence in the market, as they were in 2021 and 2022, there may be other significant earnings windfalls in the future. However, I am not sure whether the housing industry in the United States has really reached its nadir, or whether the company enjoys a substantial competitive advantage against any competitors, so I would conclude it to be an attractive candidate for investment but not an unqualified buy.

Garrett Motion Inc. is a maker of turbochargers, compressors, and related technologies for vehicles, primarily for internal combustion engines but the company adds, almost defiantly, that they are devoting considerable research into adapting their product lines to electric vehicles in the form of compressors for fuel cells or circulating coolant. Sales have improved over the last few years, although somewhat offset by the strong dollar (the company does most of its work in Europe and China) and it offers an earnings yield of upwards of 13% that looks sustainable for the foreseeable future.

The company has an interesting corporate history; it emerged from Chapter 11 a few years ago, but this was not in order to avoid a default on its debts. Rather, it was because the company, which was spun off of its parent company Honeywell, was forced to indemnify Honeywell for asbestos liability, and this was an undeserved millstone around its neck as we have seen in other companies like OI Glass. Last year Garrett redeemed the preferred stock that was created by the sponsors of the bankruptcy, giving it a normal capital structure and improving clarity for the analyst.

Turning to the figures, Garrett has a market cap of roughly $1.8 billion. In 2023, net sales were $3.886 billion, gross profit was $756 million, operating profit was $509 billion, interest expense was $159 million and taxes were $86 billion, producing $261 in net profit. The company’s capital expenditures are in line with its depreciation charges, and I should note that the company also engages in significant research and development, which some analysts do not recommend writing off entirely as they may translate into improved income down the line, although this is uncertain.

In 2022 net sales were $3.603 billion, gross profit $683 million, operating profit $467 million, no interest at all (unfortunately the company had to take on some debt to redeem the preferred shares), taxation was $106 leaving $361 million.

In 2021 net sales were $3.633 billion, gross profit $707 million, operating profit $491 million, interest expense $83 million, taxes $43 million, producing net income of $345.

Year to date, sales were $1.805 billion for the first two quarters as compared to $1.981 billion last year. The company cites weakness in automotive demand slightly offset by aftermarket parts. Gross income was $357 million versus $391 million and operating income was $232 million versus $272 million. Interest expense, net of a writeoff of debt issuance costs, was $66 million compared to $56 million last year, leaving $166 million, or $127 million after actual taxes, as compared to $159 million for the first two quarters of 2023.

Although it is unclear how long, if at all, transition away from internal combustion or hybrids into full electric vehicles will take, for the present and foreseeable future GTX offers an attractive earnings yield well in excess of 10%, although the exposure to the auto industry suggests that volumes can be expected to be variable. Furthermore, the Federal Reserve finally cutting interest rates may be of some assistance, and there I can recommend Garrett Motion as an intriguing candidate for portfolio inclusion.

Warren Buffett famously said that investment opportunities arise when a business faces a large but solvable problem. However, how can an investor be sure that a problem is solvable until it’s been solved? And once the market consensus is that it has been solved, the stock price can be expected to reflect the fact that it has been solved, making the stock no longer a bargain.

This brings us to Ingevity, a chemical company that has been confronting a steep rise in a key input material that has resulted in substantial and expensive restructurings. The company is projecting that these changes will return the company to profitability and stability, and if their views are correct the company offers an attractive prospect at the current price. However, the company’s sales are under pressure even if the restructuring is effective, and if that is the case, it is possible that management’s projections can be disappointed.

Ingevity produces various carbon products from plant sources. It operates in three divisions: performance materials, which makes activated carbon products for internal combustion engines designed to capture gasoline vapor and return it to the engine, thus simultaneously improving fuel efficiency and pollution. Performance materials also comprises various carbon filters. Their second line of business, and the problematic one, is performance chemicals, which produces road surfacing and also a hodgepodge of chemicals for glue, ink, paper finishing, and emulsifiers for oil drilling. The problem is that prior to this year, the company’s main input for these products has included crude tall oil (CTO), which is a byproduct of making paper out of pine wood, which represented 26% of total cost of sales and 51% of its raw materials. Until very recently, Ingevity was locked into a long term supply contract while the price of CTO has risen dramatically, partly as a result of a decline in paper manufacturing, and was unable to pass this increased cost on to their customers. The company has since made considerable efforts to switch over to soy, canola, and palm oil, and to negotiate a way out of the supply contract at considerable expense. However, this restructuring will reduce the company’s exposure to the its miscellaneous chemical products, allowing it to focus on paving, charcoal filters, and its third division. The company claims that these miscellaneous product lines are low margin (negative margin, actually, because of the CTO problem), but still, profits are profits. Their third division, advanced polymers, produces caprolactone-based specialty polymers for use in coatings, resins, elastomers, adhesives, bioplastics, and medical devices (obviously I’m not an organic chemist).

As of this writing, the company’s market cap is $1.4 billion. The figures we have to work with are:

In fiscal year 2023, sales were $1692 million, operating income was $256 million before restructuring charges, interest expense of $99 million, leaving $157 million, or $124 million after estimated taxes. There is also $13 million in excess depreciation, resulting in $137 million in free cash flow, adjusted for restructuring charges.

In 2022, sales were $1668 million, operating income $341 million, interest expense $62 million, leaving $279 million in income, or $220 million after estimated taxes, before $32 million in capital expenditures in excess of depreciation, leaving $188 million. The company would like to chalk much of the difference up to the spike in CTO costs, and indeed cost of goods sold for the specialty chemicals did increase by $157 million between 2022 and 2023, while sales in every division except their miscellaneous industrial chemicals improved in 2023.

In 2021, sales were $1391, operating income was $307 million, interest expense was $51 million leaving $256 in pretax income or $202 million after taxes, and depreciation closely tracked capital expenditures.

Sorting out the projected effects of Ingevity’s restructuring involves going through a lot of SEC filings. The company has projected $250 million in writeoffs and restructuring charges, of which $70 million will be in cash. Of this amount, $25 million has already been recognized, and $25-$35 million more will be recognized in the remainder of 2024. But on the upside, the restructuring is expected to contribute a projected $30-35 million annually to the bottom line. As a result of this restructuring, the company also was forced by its supply contract to purchase vast amounts of CTO that it no longer required and had to sell into the open market, which resulted in a $50 million loss in 2023, which the company very kindly included in non-operating activities so it would not affect the free cash flow estimates above.

Furthermore, in July of 2024, conveniently just after the second quarter financials were filed, the company reported that they spent $100 million to finally get out of the CTO supply contract. Also, Ingevity is consolidating two manufacturing plants, which will cost a further $135 million in restructuring, of which $35 million is in cash, but which will, according to their projections save them $95-110 million in expenses, but 70-80% of that represents cost of sales and is therefore not accretive to earnings. At any rate, if we keep a price/sales ratio of 1 and a required return on investment of 10%, the costs of the restructuring and the savings produced by it seem to be roughly in line, if Ingevity’s management projections can be trusted. But at any rate, it is refreshing to see management being capable of such bold moves affecting such a large portion of their operations

So, in this difficult transitional year, for the first half of 2024 net sales were $731 million vs $874 last year, operating income was $120 vs $166, interest was 45 vs 41, leaving 75 vs 125 or 59 vs 99, and excess depreciation of $18 vs $15, resulting in estimated free cash flow from operations of $77 vs $114.

I should point out that based on the second quarter earnings call, the company was projecting $75 million in free cash flow for the entire year before the contract termination fee, although this figure did include $45 million in cash from CTO sales that are not expected to recur. Even so, I note that the $114 million for 2023 is already the bulk of the company’s free cash flow for the entire year. This is not surprising, as road surfacing is a seasonal business and most of the purchases take place between April and September apparently. I should also point out that excess depreciation may be unreliable, as many of what would under normal circumstances be new capital expenditures on the non-CTO-using product lines have been filed under the heading of restructuring charges and therefore deemed nonrecurring.

That same earnings call suggested that management was projecting free cash flow of $150 million for 2025, which seems to be achievable if the restructuring proceeds according to plan. However, although automotive products and carbon filters showed growth in 2024, road surfacing showed slight declines and so did industrial polymers, and of course the miscellaneous chemicals showed significant declines as the company has already stated it is transitioning away from these areas. So, even if the CTO-related problems have been solved, Ingevity may have some difficulty in controlling its pricing and margins, which can derange projections. Moreover, whenever I compare a company’s estimate of its free cash flow to my own calculations, theirs always comes in a little higher for some reason.

So, is the market consensus that the problem has been solved? Well, as of this writing the share price is near a multi-year low at $38.60, having fallen there from a peak of $90 at the beginning of 2023 when this CTO problem emerged. However, the share price fell to $38 in October of 2023, drifted back up to $54 last May, and then fell back to the $35s with the latest earnings announcement. Interpreting investor sentiment from price movements is a speculative business at best, but the decline from the latest earnings suggests that market believes that nothing has been solved yet, or that the cost of getting out of the CTO contract was disappointingly high. However, if the market does buy the figure of $150 million as a reasonable estimate of Ingevity’s free cash flow generation in the future, and sticks with a 10% return on investment as a reasonable figure given the company’s somewhat weak pricing power and ability to pass costs of input on to its customers as offsetting potential growth in investments, then the company seems reasonably priced as of now, and any shift in a positive direction might result in price increases.

Wherefore, I cannot recommend this as a pure value investment as it seems to be not in a strong competitive position and much of its value proposition depends on the management’s projection of the effectiveness of its restructuring. However, as a speculation, there are certainly worse opportunities out there.

You may recall from my previous article that I saw opportunities in the packaging company, Greif. But I see now an intriguing opportunity in the packaging-adjacent. Clearwater is a company that makes paper products including bleached paperboard and also tissues for retail consumers, and it offers an attractive free cash flow yield upwards of 15%.

Clearwater recently reported earnings that Wall Street cheered, resulting in its share price going up by 25% (sorry), but even after this advance the company’s earnings power could justify an even greater advance.

Sales in 2023 were $2.083 billion, and operating income was $108 million, and excess depreciation over cash flow produced a free cash flow of $149 million. Set against the current market cap of just under $800 million once excess cash is taken into account, that is a free cash flow yield of nearly 19%. In 2022 sales were $2.080 billion and free cash flow was $124 million, and in 2021, sales were $1.773 billion and free cash flow was $77 million. From 2021 to 2023, paperboard shipments have declined at a single digit percentage while prices increased by over 25%. In the consumer product division, which is roughly of equal size, sales volume increased by 10% and pricing by 15%. This is an encouraging sign that Clearwater is capable of passing on inflation to its customers.

For the first quarter of 2024, sales were $496 million versus $525 million in 2023, operating income was $17 million versus $24 million, and free cash flow was $22 million versus $29 million. Paperboard volumes were unchanged while sale prices declined by 10% as compared to the previous year, and consumer tissues showed a 5% increase in volume while sales prices remained flat. However, the company reported that an extreme weather event affected one of their plants to the effect of $15 million, so that $22 million is a low estimate of earning power. But on the downside, Clearwater also announced that capital expenditures for 2024 would be on the order of $100 million, as opposed to $70 million in 2023.

Now, in terms of free cash flow it is conceptually helpful to distinguish between maintenance capital and growth capital–that is, the amount of capital expenditures necessary to maintain the company’s earnings power as opposed to expenditures designed to increase the company’s productive capacity. The former must definitely be counted as a deduction against free cash flow; the latter does not (subject to the customary skepticism about growth projections, the concept of diminishing marginal return, concerns about management empire-building, etc. etc.). Unfortunately, corporate reporting does not seem to be aware of this distinction, as most managers, including Clearwater’s, do not disclose whether incremental capital spending is maintenance or growth, and analysts seem to be reticent to press them on the matter. Therefore, it is not clear whether the $30 million increase in capital investment in 2024 will be maintenance or growth.

One clue, however, is what the company is doing with the free cash flow it already generates. A company that sees plenty of growth opportunities will deploy free cash flow back into capital assets, while a company that sees fewer growth opportunities will find another use for that money, either returning it to shareholders in the form of dividends or share repurchases, or, in the case of Clearwater, repurchasing debt. Now, Clearwater has only $420 million in long term debt against $840 million in equity, and its interest is covered five and a half times, so I do not see its debt position as particularly worrisome at present, or at least, that lowering its debt further is unlikely to result in a significant multiple expansion. But as the company has chosen the low-return strategy of debt reduction, the implication is that it does not see the possibility of higher returns from investing in additional capacity, and therefore the extra $30 million should at least for the moment be considered maintenance rather than growth capital, unfortunately.

Nonetheless, taking the 2023 free cash flow figure of $149 million as representative of Clearwater’s earnings power, and deducting $30 million for additional capital expenditures still produces a free cash flow yield of 15%, and the company is a reasonable candidate for portfolio inclusion.

DXC Technology Company is a provider of IT outsourcing services to other corporations, and it has been going through a rough patch over the last few years as shown by a dramatically declining share price. Investors have been holding out for a turnaround from the introduction of new management over this period, and perhaps at the moment they are seeing early signs of it. And in the meantime, the company’s free cash flow yield of 28% has brought it a lot of attention.

DXC offers a suite of offerings including IT outsourcing and consulting, data analysis, etc. The company was formed by the merger of Computer Sciences Corporation with HP Enterprise, and has spent the last few years whittling away at its noncore assets, which has made analyzing its year over year performance trends difficult, as has the fact that the company operates all over the world and apparently doesn’t bother to hedge the bulk of its currency exposure. However, the company has been kind enough to disclose “organic growth” of sales (or to be precise, “organic shrinkage”), and the trends on that appear to be leveling off. Moreover, as a result of this shrinkage, depreciation substantially exceeds new capital investments, making free cash flow significantly higher than earnings.

DXC operates in two sectors: Global Business Services and Global Infrastructure Services. GBS offers analytics and engineering to automate operations and analyze data, writing applications, and run insurance software and business process services in the form of bank cards, payment processing, etc. . GIS offers security, cloud infrastructure and IT outsourcing, and a modern workplace service.

For fiscal year 2023, Global Business services showed organic revenue growth of 2.4%, while Global Infrastructure Services showed organic revenue shrinkage of 7.2%, making a total revenue decline of 5.3% on a comparable basis. As stated before, divestitures and the strong dollar produces a larger overall revenue decline. At any rate, free cash flow from operations for the year came to $1.088 billion (the calculation is somewhat complicated by substantial swings in pension funded status, currency translation effects, and the inclusion of gains on divestments in “other income,” but I think I’ve sorted most of it out). This is an improvement on fiscal year 2022, where sales declined by 9.1% on a comparable basis, affecting both Global Business and Global Infrastructure, while free cash flows came to $490 million. I would also note that restructuring costs declined from $551 million in fiscal year 2021 to “only” $216 million in 2023 and are on course to be about $120 million in fiscal year 2024.

The share price has been declining for some time, but the first quarter of fiscal year 2024 (last August) severely disappointed the markets and drove the price down from $28 per share down to $20, where it lies today after drifting back up to $24 in the interim. In that quarter, organic revenue declined on a year over year basis by 3.6% and free cash flow from operations was $130 million as compared to $203 million the year before. However, $25 million of this difference was due to increases in contract onboarding costs and software (both of which DXC capitalizes somewhat aggressively in my opinion, but as I count them against free cash flow anyway it all comes out in the wash).

However, in the second quarter of fiscal year 2024, free cash flow for the quarter was $233 million versus $252 for the previous year, and in the third quarter, $276 million versus $164 million, making for $629 million year to date as compared to $619 for last year. Projecting this out to the entire year produces $838 million, which based on the company’s market cap and taking excess cash into account, comes to a free cash flow yield of 28% against an adjusted market cap of $3 billion. I should also point out that DXC recently won a lawsuit against Tata Consultancy for trade secret violations, with the jury recommending an award of $210 million, but that would have to be approved by a judge and presumably survive an appeal as well.

So, is that free cash flow yield attractive given DXC’s situation? Well, since sales declines seem to be flattening and restructuring costs are declining, we may say tentatively that DXC is approaching the size and configuration that the management has in mind. If we assume a terminal 5% decline in revenues, and that the company adjusts its operating and capital expenses accordingly, that works out to a multiple of 6 2/3, while a 28% free cash flow yield is a multiple of about 3.75, so there is apparently significant upside.

But on the other hand, there is the possibility that DXC could see a major exodus of clients which will make these past figures an unreliable guide to its earnings power, and it seems clear to me that DXC does not have the competitive moat that Warren Buffett looks for. That, combined with the ongoing declines, suggests that DXC could easily turn into a value trap despite its attractive free cash flow yield. In other words, there is not the asymmetry between the upside and the downside that makes for an attractive value play.

Greif is a packaging company that has a global operation to make industrial packaging out of steel and plastic, and a similarly-sized operation to make paper packaging in the United States, and also a line of paper goods. Based on its recent performance it appears to be attractive, but the results of the first quarter of 2024 are concerning.

The packaging industry is pro-cyclical to an extent, meaning that its fortunes rise and fall with the level of GDP, and Greif does cite a weakness in volumes and pricing as the cause of its recent drop in earnings, but this has not stopped the company from making several acquisitions of paper packaging companies in the United States in the last couple of years. If the industry itself is depressed and due for a rebound, this is sound strategy, but if not these acquisitions are highly questionable.

Turning to the figures, Greif has a market cap of approximately $3 billion and $180 million in excess cash on its balance sheet. Sales in 2023 were $5.2 billion as compared to $6.3 billion in 2022 and $5.6 billion in 2021. Gross margin in 2023 improved slightly, but overall operating income was $540 million, fiddling out the gain on disposal of a business. The company was careful to point out that in 2023 Russia represented 4% of its sales, 2% of its assets, and 9% of its operating profits. From the operating income we remove $96 million in interest expense, and applying estimated taxes gives us $355 in operating cash flow. The company also had $37 million in excess depreciation and impairment charges and $20 million in the earnings to noncontrolling interests, producing a final free cash flow of $372 million, representing a hefty yield to equity of 13.3%. The comparable figures in 2022 and 2021 were $519 million and $390 million respectively, again stripping out special or nonrecurring items.

However, in the first quarter of 2024 sales declined by a further 4% compared to the first quarter of 2023, mostly in the American paper packaging sector, but operating profit declined by 30% to $69 million. Interest expense was $24 million, and applying estimated taxes, operating earnings should come to $36 million. (I should point out that the company’s actual tax provision was actually minus $38 million owing to a loss upon repatriation of foreign assets, which I shall speak of later). Taking excess depreciation into account, free cash flow came to $42 million, as compared to $68 million for the same quarter in 2023.

The market seems to have taken this substantial decline in free cash flow in stride, just as it has the annual declines in free cash flow since 2022; the stock has remained roughly at its current level. I suppose it is recognition of the principle that one should not place excessive concern on one quarter’s or even one year’s earnings, particularly as the company and the entire industry, I understand, is already seeing early signs of an improvement. But on the other hand it is questionable whether a business that is subject to such swings is stable or predictable enough to constitute a genuine value investment.

Also, I mentioned earlier that the company’s actual provision for income taxes in the first quarter of 2024 was minus $38 million instead of the $9 million one would expect. This is the result of the company’s “onshoring of certain non-U.S. tangible property,” as stated in the 10-Q. I am tempted to call accounting shenanigans on this move, as the timing of this “onshoring” is totally within the company’s discretion and seems to be timed specifically to make a disappointing quarter look better.

There is one point that concerns me as to Greif’s corporate structure. The company has two classes of shares. The class A shares are entitled to two thirds of the dividends of the class B shares, and are not entitled to a vote unless the dividend has been passed for an entire year. And yet, the class A shares as of this writing trade for $61.36, and the class B shares trade for $62.73, which is barely a year and a half of dividends more. On the one hand, this is further evidence that dividend policy is no longer a major influence on valuation and that the company is seen as being run tolerably well to the point where control is a non-issue. But I still think such a narrow spread between the two share classes is surprising, and naturally I would recommend the class B shares.

So, if one has confidence that the earnings of Greif are temporarily depressed and the company’s perception of improving conditions will return the company to historical performance levels, then the current price is attractive. But as such a view is dependent on potentially optimistic assumptions about the future, I cannot say that Greif is an obvious value play.

Tegna, formerly Gannett, is a broadcast TV company (that’s the obvious part), which the market has been incomprehensibly punishing despite its free cash flow yield of 18% or potentially higher. In fact, a recent merger agreement valued the company at $24 (the stock is at $14 as of this writing) failed for regulatory reasons, not for any problems with the deal itself. And of course we have the 2024 election season coming up, which is always a lucrative time for broadcast television.

The reason I say that the stock is hated is that Tegna expended $600 million on share repurchases in the last couple of years (out of a market cap, adjusted for excess cash, of $2.2 billion as of this writing), and yet the stock has not moved. The company’s announcement of $600 million more in buybacks in the next two years have also left it unmoved. It is possible that the post-merger slump has chased away investor interest, but even so, a free cash flow yield this high cannot be ignored forever, as management in its 10-K has committed to returning half its free cash flow at least to the shareholders. The repurchases are a positive sign, as a company that is undervalued should be using its cash flow to repurchase stock, while a company that is fairly valued should be paying dividends, and a company that is overvalued should be focusing on using its stock to acquire other companies.

In fairness, broadcast television is a declining industry, but not necessarily a dying one anytime soon (and don’t forget that cable companies do pay local broadcasters to carry their content). But even a declining company can throw off considerable free cash flow, particularly as depreciation and amortization tends to outweigh new capital expenditures.

Turning to the figures, the election cycle tends to make year over year comparisons difficult, so it would be fairer to compare 2023 to 2021. In 2023, sales of $2.91 billion declined by 3% as compared to 2021 and operating income (not counting the merger termination fee Tegna earned because it is obviously nonrecurring), declined by 25%, which management attributed partially to a more difficult business environment that affected advertising revenue, as well as higher programming costs. Even so, taking excess depreciation into account, free cash flow for 2023 came to $400 million. The comparable figure for 2021 was $634 million, so one can see why there is market pessimism. The non-political advertising situation may improve in 2024 or it may not, but $400 million still represents a yield of 18% on what is essentially an off-year. For the election year of 2022, sales were up 8% compared to 2021, operating income was up by 25%, and free cash flow was $782 million. So even if the decline in free cash flow yields is permanent, political advertising in 2022 added $280 million to Tegna’s sales, and the Olympics also occur in even-numbered years, so 2024 is likely to improve on that $400 million figure to the tune of more than a hundred million easily, particularly as 20% of Tegna’s reachable households live in swing states.

Of course, I wouldn’t be me if I didn’t point out an accounting shenanigan. In the 2023 10-K Tegna reported the free cash flow figures for the two year period ending in December of 2023, and again for 2022. It is fair to present an odd- and even-numbered year together, but a reader who skims might miss the two year figure and conclude that free cash flow was over one billion in a single year, and furthermore might miss the significance of the even-numbered year being counted twice and the smaller, odd-numbered years being counted once each. The company computes that free cash flow in 2023 was $120 million less than in 2021, as their calculation differs somewhat from mine.

And for what it’s worth, the company’s bonds are rated BB+ or just barely sub-investment grade, and according to the St. Louis Fed, the current option-adjusted spread for BB bonds is just under 2% as of this writing, suggesting that new bonds (such as the ones Tegna will have to issue to refinance its existing ones in the next few years), would yield about 6.4% based on the current 10-year Treasury rate, so I do think an 18% cost of capital (or higher given that 2024 is an even year) is unrealistically demanding.

So, even in the absence of the catalyst of a merger I do think Tegna’s substantial free cash flow yield must be recognized by the market eventually, and I recommend it as a candidate for portfolio inclusion.

Disclosure: At the time of this writing I held shares in Tegna.