Advanced Drainage, Discover, and Under Armour

Advanced Drainage Systems (WMS)

As I wrote about before, I think WMS represents an excellent short. Jeremy Raper on SA and utah1009 on VIC wrote some great, detailed write ups on it, and I’d recommend you read those. Basically, it is fundamentally overvalued, has significant accounting issues, and a large amount of convertible bonds that can add 38% to the market cap that many analysts miss. Analysts are projecting huge margin gains on the back of drops to the material cost.
In addition, the CEO Joe Chlapaty owns a significant amount of stock (13%) and probably drew some margin to get that much, so it is one of those stocks that could run into a CEO-margin-call issue if it starts falling very fast.
If you take out some of the more absurd add-backs to EBITDA, add in the extra convertible shares, and value the company based on its comparables, you get a price ~ $12.
The drop in material costs has been boosting the gross margin significantly, and macro tailwinds in construction have been holding up revenues enough to keep the stock moving higher the last several months, putting me well underwater on my short position. However, after negative earnings announcements by U.S. Concrete, Martin Marietta, and others in the construction industry, all the stocks have taken a bath. I added a bit to my short in the mid-20’s after reading USCR’s conference call.
U.S. Concrete is particularly relevant to WMS because WMS makes plastic pipes used to replaced concrete ones. The price of concrete has been soaring, which boosts demand for WMS’s plastic pipes. This is coming at the same time that the price of polyethylene has been dropping, which boosts WMS gross margin.
The construction industry in general was pretty hot Q4 2015 – Q1 2016. The BEA data from Q1 showed that the biggest gains in GDP came from the construction industry. I think its slowing down as the latest housing starts from Q2 2016 show. USCR and Martin Marietta maintain that the slowdown in construction is a temporary blip related to weather. Maybe it is, maybe it isn’t. Either way, WMS ought to announce pretty crumby earnings tomorrow, which should be a nice time to take some profits.
Discover Financial Services (DFS)

Discover is an interesting idea. It trades at a discount to AXP, 2.25X Book vs AXP’s 2.91 X Book, despite being essentially the same business model*. AXP has an E/A ratio of 12.9% and DFS has an E/A of 13.1%.
It originates the credit card loans and holds them, unlike V and MA, which originate and sell off the loans. But the great thing about Discover’s business is they generally go after very credit-worthy customers.
The stock has taken a hit, in my opinion, over two issues – the recent loss of exclusivity with Sam’s Club, and an expectation that the lower than average loan losses will reverse in the next credit cycle. Both are reasonable concerns, but the even if the company takes a pretty big hit on these, say 20-30% of earnings wiped out, it is still going to be trading at a PE in the low teens, and a cash flow yield in the 8-10% range. I am perfectly happy to take the possibility of a drawdown of 20% over the next year for the chance to own a security that is essentially yielding 10+% a year for the foreseeable future, and with a substantial possibility of a re-rating to a 7-8% yield.
I think the business is good enough to trade at a higher multiple, a P/E something like 15X and a cash flow yield around 7-8%, or a 12-13X P/FCF, compared to its current P/E of 11 and its current P/FCF of 8.65. It could probably rise to AXP’s price to book, though I think even AXP could go a little higher on that ratio.
On top of that, technically, the chart looks great. It’s made a nearly perfect inverted head and shoulders over the past year, with a neckline around $56. It just broke through the neck line over the past couple of weeks. This is generally a pretty positive sign, and it gives you a natural stop, so it is an easy stock to set up a large size in – you know exactly at what point the thesis is invalidated and you need to get out.
Let’s say you couldn’t get out, or you hate using technicals. In a downside scenario, an upcoming recession, if you take it for granted we don’t have a 2008-09 style recession in our near future, I don’t think DFS would trade for less than 1.5X book, even if earnings collapse and loan losses go up a lot, which gives you $40 a share. In an upside scenario, 3X book, you get exactly $80 a share. This upside target at 3X book also roughly corresponds to a 15X earnings multiple.
3X book may seem high for a company that is essentially a bank. But consider this: banks with 10% ROEs and a high E/A ratio routinely trade for 1.5X book. Discover has a 20% ROE and a very high E/A so a 3X book doesn’t seem unreasonable.
The odds then appear roughly 50/50. Then look at the macro. The BEA released real consumer spending numbers that were surprisingly positive for the second quarter, and I think consumer spending was a key driver of the latest rise in the stock market. This actually bodes well for another upturn in the cycle, despite narrowly missing a recession earlier this year.

So you get a mildly positive macro tailwind, a positive technical indicator, and good fundamentals, with a worst-case downside about equal to the best-case upside. DFS makes for a good bet.

* So okay, AXP might be a little better business. The ROE at AXP is 25%, so maybe it deserves a higher P/Book than DFS. But AXP probably has upside too – it is trading at a discount to its own historical multiples on P/Book and P/E.


UA is starting to stress me out. The latest quarterly earnigns really bore out core points of my short thesis – the accounts receivable continue to rise, and inventories continue to climb, with management making a mountain of excuses. But I was troubled by one comment they made on the call. Management compared the amount of distribution outlets UA has to the amount that Nike has, with the argument they still had substantial room to expand distribution.
A big chunk of my thesis was that UA had benefitted for years from growth in distribution channels. But I figured that it was running out of new channels to grow into, and would start to suffer lower growth. I also postulated that the recent Sports Authority’s bankruptcy and weak same-store sales from the department stores were contributing to the bigger charge-offs and inventory build-up, and I thought that management was trying to obfuscate this by announcing they were changing their inventory management system.
The problem with this thesis is that if UA can still expand distribution – like they just announced with Kohl’s – there may be a while left before the negative fundamentals start to catch up.

I also made a cardinal mistake when I thought about UA earlier this year. I made the assertion that industry growth in athleisure was about 10%, and UA had been growing for 25-30% for years because of its market share growth and distribution channel expansion. Eventually, if the latter was coming to an end, and the former was being challenged by new entrants, then UA revenue growth would ultimately slow to 10%. As such, it did not deserve a premium P/E multiple to NKE and definitely did not deserve a premium multiple to LULU. Moreover, as LULU took back market share after its latest turnaround strategies set in, UA would suffer. This was the basis of my short position, and where I was figuring my profit targets for the trade.
The fault was that I didn’t consider that instead of UA’s P/E multiple falling, the P/E multiple of LULU and NKE could RISE to match that of UA. And that is essentially what happened, the returns of LULU and NKE have been exceptional, while UA just stayed flat. In retrospect, the smarter play would have been a pair trade, short UA and long LULU. I just have difficulty paying 40X earnings for any company, even fast growing ones with positive underlying market dynamics.
One last thing that’s making me nervous is David Einhorn’s Q2 letter. I noticed he just wrote that Greenlight closed out their UA short. I don’t think he has a crystal ball any more than the rest of us, but Greenlight is a bunch of incredibly smart people who have a long history of shorting successfully, and if they think the risk/reward is gone from the trade in the high 30’s, who am I to say that there is more potential for this thing to fall? The last time I held on to a trade after Einhorn closed out his short was Mobileye, and I got crushed by the subsequent rally.
Here are the parts of the thesis that are still intact. Lululemon is still taking back market share. I don’t think the Stephen Curry line will be as profitable as the Jordan line, despite expectations of analysts to the contrary.
But the most important component is this: 5-6 years ago, Under Armour had a unique proprietary product that no one had ever seen before and that everyone wanted. Now that sweat-wicking material is being copied everywhere for dirt cheap prices, and UA has to compete by making incremental improvements that really won’t move the needle on consumer preference. Even it’s biggest customer, Dick’s Sporting Goods, is moving aggressively with their own athleisure line. This is a substantial change in the business model – it’s never good for business to compete with your customers.
It’s the classic problem of an innovator – eventually, everyone catches on to the basic innovation, and the company is now left spending tons on R+D for small gains while competitors take market share. UA is betting hard on “connected fitness”, taking on debt to buy MyFitnessPal, but it will be a long time before these initiatives are a contributor to revenues, and in the meantime it’s a drag on the bottom line, while the top-line is under attack.
The technicals on this one are interesting. The stock is stuck in a wedge. Being at the bottom of the wedge, its prudent to at least take some off the table – it’s more likely to bounce back up into the wedge than it is to break lower.  But as the wedge narrows, there is an increasing probability of a large price move in either direction.


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