Barron’s 2018 Roundtable Notes: Meryl Witmer’s Stock Picks

Meryl Witmer

Eagle Capital Partners

For all the Barron’s 2018 Roundtable articles and notes click here.

Notes:

CarMax (KMX) $70.74 ($71.04 when published). Target $82 to $93.

    • It trades for around $70 a share, and there are 184 million shares, for an equity capitalization of about $13 billion.
    • It also has about $1 billion of corporate debt outstanding.
    • The company has several income streams that emanate from the sale of used cars. It sells cars to consumers, providing financing on some. It sells extended warranties, which get extremely high marks from buyers, and it also has an amazing wholesale auction business that sold about 400,000 cars in the past year to used-car dealers.
    • The source of the auction cars is the company’s direct purchase of cars. CarMax will buy a car from any seller—not just people who come in to buy a car—and sell the older ones wholesale at the auctions. The younger ones tend to go to the CarMax retail customers. The average age of cars sold to retail is four years. At the auctions, it is about 10 years.
    • CarMax’s proprietary data analytics give it a competitive advantage in both buying and pricing cars.
    • Its average annual gross profit on a used car has stayed within a $25 range annually over the past seven years. In the wholesale-auction business, it has stayed within a $75 range.
    • CarMax makes a couple thousand dollars on the cars
    • No-haggle policy; you don’t have to wonder if you could have gotten a better deal.
    • It does best when used-car prices are going down, since it passes through the savings to the consumer and does so faster than competitors.
    • Catalysts: Near-term, there is a big increase in cars coming off lease, and that will enable CarMax to buy them at lower prices.
    • The company also has room to expand: The current store base is about 190, growing by about 15 stores a year.
    • CarMax also could be a beneficiary of the new tax bill. First, its corporate tax rate will go down. We use 26% in our estimates, but it could be lower. In addition, many of its potential customers should have bigger paychecks from lower federal taxes and the bonuses and pay increases companies have announced.
    • Job creation from economic growth should also benefit CarMax.
    • CarMax reported $3.26 a share in earnings for the year ended in February 2017, which would have been more than $4 with the lower tax rate. For the year ending in February 2018, earnings should be about $4.50 a share pro forma, accounting for the lower tax rate.
    • We assume CarMax continues its stock-buyback program and buys about $1 billion of stock over the next six quarters. CarMax has repurchased about 20% of its outstanding shares, net, in the past four years.
    • With minimal same-store sales growth, it will earn about $5 a share next fiscal year and $5.50 in the year ending February 2020. With a few percentage points of same-store sales growth, earnings could reach $6.25 a share for the year ending in February 2020.
    • CarMax had a great after-tax return on capital of 15% at its prior 38% tax rate. It has a long runway of growth with about 3% national market share and 10% share in the markets where it has stores.
    • It deserves at least a 15 multiple on forward earnings, which gives us a one-year target price of $82 a share on the low side. But things should play out much better, and the stock could be $93 in a year.
    • CarMax faces some tough same-store sales comparisons in the next couple of quarters, as it is going up against 8% same-store sales growth in the prior period. Then comps get easier. By year end, we should see a good return.
    • CarMax has great data, and it will continue to benefit from all of that information.

Orion Engineered Carbons (OEC) $28.98 ($27.05 when published). Target $40

  • Makes differentiated high-value specialty carbon black and commodity carbon black. In the specialty area, it is used as a pigment in printing inks and paints.
  • It is also used to absorb ultraviolet light and impart color into adhesives, sealants, plastic pipe, and the like. And it is used in batteries. The commodity product is essential for making tires and other rubber products strong because it ensures a high resistance to abrasion and aging.
  • The company is based in Luxembourg, trades on the New York Stock Exchange in dollars, and reports earnings in euros. It is complicated to analyze.
  • It came public in 2014 out of private equity, which in turn had purchased it from Evonik Industries [EVK.Germany]. Private equity recently sold the last of its stake at around $23 a share, increasing the float.
  • Orion is slowly getting some attention from institutions. Its equity capitalization is $1.6 billion.
  • The specialty grades are about 25% of volume and about 60% of earnings before EBITDA. The commodity grades are 75% of volume and 40% of EBITDA.
  • The carbon black industry outlook is very bright. A lot of tire capacity is coming on in North America in the next few years with no incremental supply in carbon black.
  • Pricing outside of North America is at good levels and improving, and pricing in the U.S. is finally starting to move up to acceptable levels.
  • The trend toward hybrid and electric vehicles is great for carbon black since tires require more carbon black to withstand the heavier weight.
  • Orion has committed to convert its financials from IFRS to GAAP accounting and thereby change its reporting currency to dollars, which should be a catalyst for the share price.
  • Orion has excess amortization charges to its earnings above its maintenance capital-spending needs.
  • See after-tax free cash flow per share growing from about $2.15 last year to $2.50 in 2018 to $2.80-$3 in 2019. The company has done a great job paying down debt and has superb corporate leadership. We see it trading at about a 14 multiple and have a target price of about $40 in a year, up from $27 today.
  • Debt coverage is about 2.3 times adjusted Ebitda, and the company is going to generate a lot of cash.
  • The price increase in carbon black in the commodity market is a game changer because Orion is going to start earning an appropriate return.

Dart Group (DTG.UK) 676.50p (699.00p when published)

  • The parent of Jet2.com and Jet2holidays, grew its revenue 41% in the half-year ended on Sept. 30, as it successfully opened new bases at Birmingham and Stansted airports and continued to expand the brand.
  • It sells high-quality, affordable vacation packages, along with flights. Its Jet2holidays, the vacation-package business, was ranked fourth in the U.K. among 250 companies for highest customer satisfaction.
  • Vacations are Jet2’s profitable niche. Britain is a cold, rainy, cloudy island, and people have to get away.
  • We view management as exceptional, and they’re owner-operators [the founder owns 38% of the company].
  • The stock is 700 pence ($9.62), and we estimate the company will earn at least 75p a share in the year ending March 2019.
  • There will be about 300p per share of extra cash on hand at the end of the year if it isn’t used for growth. Using an 11 multiple on forward earnings, plus that extra cash, yields a target price of over 1,000p.

Howden Joinery Group (HWDN.UK) 451.50p (467.10p when published). Target: 620p

  • Market cap of £2.9 billion [$4 billion], and no debt.
  • Howden is the leading British kitchen wholesaler and distributor, with a dominant market share of more than 50%. It sells kitchen cabinets, countertops, and private-label appliances. It sells only to contractors, so the retail customer can’t price-shop the product.
  • It can deliver the cabinetry within two days of an order being placed, so it delivers almost instant gratification.
  • The business performed well in the first 10 months of 2017, with total sales growth of 6.3% and same-store sales growth of 4.4%. Sales are accelerating, with total sales up 8% from June to October and same-store sales up an estimated 6%.
  • Howden is vertically integrated and can adapt to customer preferences quickly. It introduced 25 new products and ranges last year, which helped drive demand. The average kitchen remodel through Howden is £5,000, so the cost is very reasonable.
  • The company gives autonomy to its location managers. It has 680 locations, and all employees are incentivized by profits at their respective location.
  • Had 29.2p in earnings per share in 2016 and should report a similar number in 2017 because it opened a new distribution center while keeping the older one running to avoid delivery issues. We see earnings growth resuming, with earnings per share of 33p in 2018 and 38p in 2019. We value the company at 15 times forward earnings per share.
  • It has no debt and should have about 50p of extra cash by year end. It has a history of returning cash to shareholders with dividends and buybacks. Our target price is 620p in a year, up from 467p recently.
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