Below is a brief discussion of the three investment ideas I presented at the Cyprus Value Investor Conference.
Office Depot (ODP) is a cost savings story where reductions have resulted in significant improvements in operating margins over the last few years. Sales growth though remains a headache and last quarter same-store sales were -6% (a 3-year low). Management initiatives on sales are the new ‘Store of the future’ concept, theme events (‘Slime day’ resulted in more glue sales in 1 day than an entire year), increased use of social media, and expanding same-day delivery. There is also an introduction and expansion of private/own brands but that probably affects margin more than sales. All sound nice, but stores take time to convert, theme events are once off and I’m not sure how much social media can help. Hence ODP is strict a cost savings plan and any sales stabilization is a bonus. In all the retail carnage there are doubts but you are getting paid for that in the very cheap price. A potential exit by Staples from retail would also make ODP the only game in town. There are some rumours of Staples selling their stores to ODP which is more efficient and if they could secure a good price they could generate significant synergies (as they did with OfficeMax).
In the meantime, ODP came out with an announcement just after my presentation at the event (unfortunate for me). They are buying CompuCom for $1 bn at around 10x EV/EBITDA. This may have to do with the CEO, Gerry Smith, who was VP and COO at Lenovo before joining ODP in February 2017. He took over from Ronald Smith (2013-16) who retired post the regulator-blocked merger with Staples in May 2016. Smith believes that “1,400 locations across the country is ripe for selling tech services”. He believes he can tap a $25 bn market which includes small and medium-sized businesses. CompuCom has $1 bn in sales and adjusted EBITDA of $98m. They expect to achieve $40m in synergies which if included reduces the purchase price to 7.2x. If they can execute and manage to increase sales of the group then it could be a stroke of genius, however it’s difficult to say as it could be desperation or perhaps a CEO bias in favour of tech (speculating). Along with the announcement, the firm reduced its outlook for the next quarter and year. Same-store sales are expected to drop by 5-6% in the next quarter and operating income for the year has been reduced to $400-425m from $500m. This does not include the CompuCom profits. CompuCom is private so we don’t have all the numbers. The deal will close by year-end, and ODP will give us further information in the next quarterly lease. We do know that shares will be diluted by around 45m (~8-9%) and that the group will take on around CompuCom’s $750m in debt so interest costs will increase. The stock remains cheap despite the purchase, however the market will need a catalyst to get the stock back on track.
DXC Technology (DXC) is a stock I like and discussed at the event. It is an IT services company, number 3 behind IBM and Accenture. The company was formed from a combination of Computer Science Corp (CSC) and HP Enterprise Services division. It is also a cost saving story, however there is also an element of growth from a change in the business mix. The company is pushing digital which is growing at 25%+. CEO Mike Lawrie is a 27-year IBM veteran and since his appointment at CSC in 2012, he has materially improved the company operations. The stock is new and not as widely known to investors. It is already trading at a discount to its major competitors and the industry. Furthermore it expects to increase EBIT margins by 300 bps and generate 1-4% of growth by 2020. 2020 EPS is guided at $9.25-10.00 while the stock trades at $87.
Dynam (6889 HK) was the stock which generated all the questions post my presentation. A simple and fun story. The company is the largest operator of pachinko halls in Japan (gaming machines with a local twist). The stock is trading at 4x EBITDA and a 7% dividend yield. The significant discount to other gaming companies around the world is due to:
- Industry decline in revenues (-1.4% annually from ’95),
- Popularity of mobile games,
- Traditional to the older crowd,
- Increase in low cost halls (low cost machines generate 25% of the revenues of high cost machines on a per hour comparison),
- Regulation that reduces the highest payout machines,
- Sales tax increase in 2015 and potential increase in 2019,
- Currency risk (listed in HKD),
- Legalization of gambling with at least 2 potential integrate resort licenses expected.
On the positive side:
- It is the largest operator in an industry with 3600 companies of which 82% have 1-3 halls. M&A is highly likely as the majority do not have the scale to remain profitable.
- The closure of halls will lead to cheaper leases.
- Number of halls has actually been declining at a faster rate than wagering volume. As a result volume per hall is increasing.
- Dynam is already the market leader in low cost halls and has a lower % of high payout machines vs the industry.
- The company is controlled by the Sato family (70%) which makes the dividend very likely. FCF exceeds dividends.
- Pachinko is a homegrown industry and could get some legislative support should the second gaming bill proceed.
- The second gaming bill which contains the details of the integrated resorts (IR) has not yet been passed and so the delay means that an IR won’t be operational before 2024 due to size ($10 bn investment per location) and time to build.
- Dynam is a potential partner and/or a strong candidate for a regional small-scale IR. The bill itself could require a local partner. Dynam is the only local company that has casino experience due to its $85m investment in Macao Legend Development. Furthermore it has a 50-year history with a largest database of information on clients and behavior.
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