Dear valued investors,

We are now more than three quarters of the way through the year and I want to wish all of you happiness and profitability in the fast-approaching holiday season. In this letter, I will be marking a notable gainer and decliner in most of your portfolios and sharing my thoughts on them. Then, I will be touching on the current interest rate environment. Please note that we do not perform macroeconomic analysis when making investment decisions and this is meant to be more speculative than actionable. To wrap it up, I will be analyzing PVH Corp. Let’s begin.

Many of you hold World Fuel Services (WFS) in your portfolio and it has been one of the best performers for a substantial number of our clients. To recap, WFS is a leading global fuel services company principally engaged in fuel distribution to airports, airlines, retail fuel stations, seaborne shipping companies, NATO, and U.S. and foreign governments. Our analysis had indicated that we believed the price we paid for World Fuel was fair. We also found that while it is likely that the marine transportation industry is suffering structural change, we believe that any value for WFS’ marine segment was not being considered in the company’s stock price.

Since our analysis, the marine segment has been undergoing a recovery with income from operations increasing 44% YOY for the 6 months ended June 30th, 2019. We were also optimistic about the potential of the aviation segment and it continues to deliver with income from operations up 15% YOY. The land segment’s results have improved somewhat with income from operations increasing 10% YOY. WFS also increased its dividend by 50% which was a pleasant surprise. We continue to monitor WFS and will sell it if the price gets too high relative to our expectations for the business.

Now for the decliner. Many of you have The Andersons in your portfolio and you might have noticed that it has not been performing too well recently. To recap, The Andersons conduct business across North America in the grain, ethanol, plant nutrient, and rail sectors. In our Q4 2018 analysis, we concluded that the stock should be trading at around 1.3 to 1.5 times book value. At the time, it was trading at just that – 1.35 times book value. So, what has changed to cause the perception of The Andersons’ valuation to drop so drastically?

There are two main events which have taken place since our last analysis: The Andersons’ acquisition of The Lansing Trading Group (LTG) and the Trump administration’s granting of biofuel waivers to a number of small refineries. These waivers free refineries from their obligation under the Renewable Fuel Standard (RFS) to blend biofuels like ethanol into their gasoline or purchase credits from others that do, lowering the demand for ethanol.

We believe that the price paid for LTG was a good price, but we do have concerns about the issuing of equity to do so and would have preferred it be an all cash deal. The ethanol waiver situation, however, is more complicated because the ethanol and farming lobby are powerful and have been pushing back against these waivers. In response to vocal and harsh criticism from corn farmers, Trump has made a promise to boost ethanol consumption in the RFS but it remains to be seen whether there will be follow through on that.

Another significant development is the easing of restrictions on the sale of E15 fuel (15% ethanol) in the summer months where it is usually banned. The effect in the short term is unlikely to be significant, but the long-term effect will likely be a boost to ethanol consumption as long as it is cost competitive with gasoline. In short, we still believe that The Andersons offers a good risk-reward scenario.

Negative interest rates and inflation

There are many rationalizations made for negative interest rates, but none of them hold up. The most prominent one of these is that people’s preference for money has changed and they now value the future more than the present. If this were true, then why would they invest in a bond that is guaranteed to lose money if held to maturity – why not just hold cash?

No, the only rational conclusion to be drawn is that there is a bubble in the bond market. You either invest in a bond and receive more cash over the lifetime of the bond than your purchase price, or you hold cash. Negative interest rates even have negative effects on banks as they are required by law to hold a certain number of government bonds. When these bonds yield negative returns, that capital ends up shrinking over time.

Furthermore, if the benchmark rate offered by the central bank is negative, then private banks are paying central banks for storing their excess reserves. This erodes private banks’ capital and leaves them more vulnerable than they would be with positive interest rates. The theory for negative interest rates explains that because the banks would be losing money on those excess reserves, they would rather lend it out than be guaranteed to lose money storing it.

This is a sound policy when money is tight and lending is not flowing through the real economy, but that is just not the case today. Financial conditions are quite loose; consumers and businesses have little to no trouble accessing capital on reasonable or generous terms.

Now that we have addressed the irrationality of negative interest rates, let’s talk about inflation. Most observers have noted that inflation seems to have disappeared over the last decade and ponder how there can be all this excess money sloshing around with no inflation to speak of. What these observers are missing is that inflation can be either consumer price inflation or asset price inflation and the latter is alive and well. Loose money has done a marvelous job of inflating asset prices; especially bond prices. Whether consumer price inflation will increase significantly in the short term is unknown. In the long term however, this decade’s episode of low inflation is unlikely to be repeated over the next 30 years. Note that this is just my opinion, I am no better at predicting the direction of the economy than an economist.

Sincerely,

Eddy Elba

Lead Security Analyst & Associate Portfolio Manager


Analysis of PVH Corp

PVH Corp is one of the largest branded apparel companies in the world with revenue of $9.7 billion. PVH’s major brands are Tommy Hilfiger and Calvin Klein with some other less significant brands including Van Heusen, IZOD, and Arrow. PVH’s two major brands were acquired rather than started organically.

Calvin Klein’s heritage is older than Tommy Hilfiger being founded in 1968. Its focus is less on shirts and visible apparel and more on underwear, accessories, and fragrances. PVH acquired CK in 2003 for roughly $850 million and incurred restricting charges of approximately $50 million for a total capital investment of $900 million. CK produced revenues of $3.7 billion and earnings before interest and taxes (EBIT) of $378 million in 2018.

PVH also bought out Warnaco which controls CK’s jeans and underwear licenses for $2.9 billion in 2013. Therefore, the total acquisition cost is close to $4 billion dollars. With an EBIT of $378 million, this equates to an after-tax return on invested capital of roughly 7%. Frankly this is not that great1. It is important to note that the original CK acquisition took place under a different CEO than the current CEO who has served in the role since 2006.

Tommy Hilfiger was founded in 1985 and rose quickly in popularity, becoming one of the most popular brands of the 1990s. However, popularity isn’t enough as the key to a successful fashion business is three-fold: always keep evolving but stay true to your roots, price appropriately, and do not try to supply more goods than your market wants as this ends up cheapening the brand2.

Unfortunately, Tommy Hilfiger could not stop itself from overreaching3 and oversupplied the market which significantly weakened the brand and its pricing power. It was bought by Apax partners for $1.6 billion in 2006 and a new CEO was installed with a focus on decreasing supply along with rejuvenating the brand’s style.

The efforts were a success and PVH bought the brand in 2010 for $3 billion and the assumption of $100 million in debt. It also incurred restructuring costs totaling almost $400 million and paid $263 million for 55% equity in the Chinese joint venture for Tommy Hilfiger. The total acquisition cost is close to $3.8 billion.

Tommy Hilfiger had revenues of $2.25 billion and EBIT of $280 million. I would like to note that this was a steep price to pay in March 2010 when valuations were much lower than today. However, this acquisition turned out favorably as Tommy Hilfiger’s revenue in 2018 was around $3.35 billion with EBIT of $611 million. The after-tax return on invested capital is roughly 12% which is a much better allocation of capital than the acquisition of Warnaco in the CK situation.

PVH’s legacy brands include Van Heusen, IZOD, and Arrow. These brands combined represent roughly 16% of PVH’s revenue and roughly 10% of its income before interest and taxes. Therefore, performance of PVH as an investment will depend on the price paid for the shares and the performance of the Tommy Hilfiger and Calvin Klein brands rather than on the other brands PVH owns.

Evaluating fashion brands is tricky and, in some circumstances, represents an exercise in futility. With that in mind, why do we expect that Tommy Hilfiger and Calvin Klein will continue to do as well as they have done in the past? 

Tommy Hilfiger and Calvin Klein are not luxury fashion brands when compared to the likes of Louis Vuitton or Moncler. They are not low-end brands either for the most part but rather represent middle of the road brands. Such brands are needed as most consumers do not want to signal to others that they are poor but cannot justify the price they would have to pay to buy luxury fashion. This represents most of the population and this population is Tommy Hilfiger’s and CK’s target market.

Now that we have established a need for their products which is unlikely to go away, we need to ask why Tommy Hilfiger and CK specifically will continue to do well as opposed to some other middle of the market brand. Lasting fashion brands are few and far in between while many fad brands have their time of day and then shrink into a shadow of their former selves. Most of these shadow brands are characterized by a lack of heritage and a temporary mania for the goods supplied by that brand.

CK has been around since 1968 and has kept up with the times having a very strong brand image in the mind of consumers. This is especially true for consumers outside of the United States who tend to be more status conscious. Tommy Hilfiger while newer, has still been around since 1985, and has enjoyed strong sales growth since being acquired by PVH. It is our belief that given the brands’ established positions and history that they are likely to continue to do well in the future. But will they grow?

We believe that the growth prospects for these brands are modest as they are already established meaning future growth will equal population growth plus inflation. This growth will not require much additional capital investment by PVH which means that PVH can return that cash to shareholders or invest it in other opportunities while growing at around 3%.

An expected return on this investment of 7 to 8% seems reasonable. Given this expected return, PVH should have a value for the equity of around $10 billion to $13 billion4. This equates to a share price between $135 and $175.


1 Assumed tax rate of 25% on EBIT, ROIC = after tax profits/invested capital.

2 For those interested there is a great New York Times article on Tommy Hilfiger: nytimes.com/2010/05/16/fashion/16TOMMY.html 

3 Trying to satisfy Wall Street’s endless thirst for growth. Tommy Hilfiger had an IPO in 1992.

4 Roughly $500 million in free cash flow which can be distributed to shareholders plus 3% growth without much reinvestment of capital.

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.