As part of our process for preparing Singular Diligence, Quan and I keep a list of 10 possible stocks to research next which we rank against each other. I shared this list with a subscriber to Singular Diligence who picked out the #7 stock on that list, CBIZ (CBZ), and wanted to know whether the stock is cheap enough to ever make it into an issue of Singular Diligence and why – if we think the stock is cheap enough – it isn’t ranked higher than #7 on our stocks to research next list.
Here is his question:
I have pretty much read through the 10K of CBIZ. I find the company very interesting…After reading through the reports, I tried to use the similar valuation method you guys use, and came up with a range of like $500 - $650 million. I then compare it with the current EV of around $600 million I think. The price is such not very very appealing. The business looks appealing, but the price is not as much so. Is this why it's only number 7 on the list?
And here’s my answer:
Yes. CBIZ is not cheap on an EV/EBIT basis. When Quan collected scores for CBIZ they looked like this:
Short Interest: 16% (of float)
EV/(Sales * Normal Operating Margin): 9.2x
Net Debt/EBITDA: 2.6x
Net Capitalized Debt/EBITDAR: 4.5x
Net Debt/EBIT: 2.8x
Net Capitalized Debt/EBITR: 4.7x
Consecutive Years of Profitability: More than 13 years
Gross Margin Stability: 0.19 (coefficient of variation)
EBIT Margin Stability: 0.38 (ditto)
Industry: Business Services (which is like maybe 8oth percentile in terms of ROC persistency versus other industries - business services has below average reversion to the mean relative to the U.S. economy generally)
We gather these scores and data on everything we consider for the top 10. Let’s look at the red flags here. Warren Buffett says life tends to break you at your weakest link. The same is true for business and investments. So, let’s focus on the weak links here.
Z-Score: 1.85 (below 3 - huge red flag)
Short Interest: 16% (above average - red flag; although very high short interest may have a “paradoxical reaction” - it can actually mean the stock is overhated)
Net Capitalized Debt/EBITDAR: 4.5x (this is very high)
Okay. So, as far as debt goes - let’s say banks will freely lend to any company that is generally profitable in all years and maintains Debt/EBITDA < 3. In that case, you would want a margin of safety to ensure the company could have access to additional capital in bad times. Using a 1/3 margin of safety, we’d want to see a company keep Debt/EBITDA around 2 times or so. So, any net debt above 2 times EBITDA will make us dig into the question of how solvent the company will be under stressful business conditions hitting at the same time as tight credit.
The Z-Score under 3 is a huge concern. Now, to be fair, the Z-Score is a very poor measure for a company that is service oriented and especially for a company that has any sort of float. The Z-Score punishes companies for float and rewards high working capital. So, companies with minimal current assets and very high retention rates - multi-year supply agreements, etc. - always score badly on the Z-Score. For example, if you look at the beverage can makers: Rexam, Crown, and Ball - only Ball has a Z-Score better than 3. They are manufacturers but they don't engage in speculative manufacturing of anything. Working capital is essentially speculative in nature. Business that retain nearly all their customers from year to year or only build plants and produce product once they have a supply agreement in place for their output have different solvency risks than businesses that create inventory on the speculation they can sell it. We have picked companies with Z-Scores below 3. John Wiley had a Z-Score below 3. We didn’t believe it had a solvency risk. And so we essentially overrode the Z-Score veto. John Wiley collects money up front, retains nearly all of its customers from year to year, and never reduces prices. None of these things are true of manufacturers. Customers pay after the sale is made, many customers are not retained, and manufactured products sometimes decline in price per unit.
But we have checklists for a reason. And I think that sacrificing the potential reward of picking companies with a Z-Score below 3 does not outweigh the gain you get from eliminating the risk of truly catastrophic losses from picking some companies with a Z-Score below 3 where you misjudge their solvency.
Going forward, it would be incredibly rare for me to allow Singular Diligence to pick a company with a Z-Score below 3. There is a chance I will block CBIZ in discussion with Quan specifically because of the Z-Score.
Short interest is easy to look at. As you know, Quan and I go looking for short thesis posts on companies we are interested in. So, we would go to places like Value Investors Club and search online for blogs and find whatever short posts we can.
I’m not sure why CBIZ has a high short interest except for its past. But that past is very distant. The company was run very differently in the 1990s than it was in the 2000s. As you can see from the stock chart, the stock has never returned to the price it had 15-20 years ago.
They do a lot of acquisitions. And so we would look closely at the accounting and the prices paid. The easiest company to analyze is one that never makes acquisitions. The second easiest company to analyze is a serial acquirer of small businesses in its own industry. Horizontal mergers of troubled or private competitors are usually the best acquisitions a company can make. They have a high success rate. There are cost synergies. And the market for private control of small businesses generally undervalues those companies relative to the market for control of a public company (where the premium for control is so high that cost synergies are often cancelled out by the premium the buyer has to pay).
Until the last year or two, CBIZ's share count had declined every year. That's a huge deal for us. If they were using a constantly rising share count to finance these deals - we’d never consider this stock. Quan and I are both focused on the trend in share count. I’m probably even more of a hardliner on this one than Quan is. Even if a company adds value when issuing shares, I definitely investigating a rising share count with skepticism it will benefit shareholders long-term. Capital markets tend to benefit sellers at the expense of buyers. I really don't care how good an IPO looks or what it's priced at - I’m not going to buy it. Likewise, the first thing I will look at is a spin-off because it often means the company couldn't sell the business unit at a fair price. Probably the two biggest rules I have for my first glance at a company are: 1) Never lose money 2) Never issue shares. A lot of investors overthink these issues. If you want to avoid big losses, you can eliminate most of the possible problem stocks simply by making sure the stock you buy will never post an annual loss or dilute your ownership. A huge amount of harm done to shareholders come from just those two sources: 1) Losing money 2) Issuing shares.
My next biggest concern about CBIZ - behind the Z-Score - is that the CEO (Steven Gerard) will retire in 2016. He is staying on as Chairman. And the transition will be a long one (they announced his 2016 retirement in 2014). But, this is a big deal.
He ran the company for 15 years. And management - at the very top - is more important at CBIZ than at most companies. Free cash flow is very discretionary here. They can't reinvest cash earnings in their offices. They have to acquire other things, paying down debt, buy back stock, or pay dividends with that money. They just don't have sufficient need to retain earnings (organically) to soak up their free cash flow. So the capital allocation philosophy of the CEO and the board is what matters here.
Now, I should point out the next CEO is simply the Chief Operating Office since 2000. So, basically you had a new management team filling both the CEO and COO roles in 2000. And 15 years later, the COO is simply replacing the CEO. It’s the least amount of change you can have when changing your CEO. But it's definitely a subject Quan and I would look at and talk about quite a lot if we ever dig into CBIZ in depth.
You mentioned the price not being that good. For me, the number I'd use would probably be the long-term average operating margin times today's sales. It’s a little north of 9 times normal EBIT using that measure. That's not cheap. Quan and I never pick stocks above 10x pre-tax owner earnings. That's a hard ceiling for us.
With CBIZ, the price is more of a margin of safety concern than a future return concern. With the right capital allocation, the stock could go up quite a lot without any multiple expansion in terms of EV/EBIT because you can increase EPS very, very fast relative to organic sales growth (which is minimal in this industry).
For example, from 2004 to 2012, the company grew earnings per share by about 20% a year. And the way the company grows EPS wouldn't really require putting more assets into competitive service. There's no reason for results to get progressively poorer unless the acquisition targets and price terms get poorer. Because you are buying out companies that already exist not adding anything new to the industry. The best companies are usually those that can grow EPS as fast as possible while growing assets in their company and in the industry as slowly as possible. Fast asset growth is the last thing you want to see in a business or an industry. It's the harbinger of doom. With doom here being low returns on sales and assets in the future.
I think CBIZ could be a little difficult to analyze and very difficult to write about. Those are concerns when you are writing a newsletter. Can I explain this business - how it actually works day-to-day - to subscribers? It's easier to describe a consumer facing business than a business that serves other businesses. And it's easier to describe a product than a service. It's also much easier to describe a business with a few very big customers than a business with a lot of very small custom.
CBIZ has 50,000 business clients (90,000 clients total). Most are between 100 and 2,500 employees with sales between $5 million and $200 million. Most of those kinds of companies are invisible to the general public. Many are local or regional. And many are not high profile consumer businesses. Their biggest customer- Edward Jones - was only billed a little over $20 million. And only a very small part of their business is "national practices". So, CBIZ is essentially invisible to the general public. That can make it hard to write about. And that's another reason why CBIZ is not near the top of the list.
So, my concerns about CBIZ are:
- Does it have too much debt?
- Do we know why people short it?
- Will the new CEO continue the policies of the old CEO?
- Is there a margin of safety at 9x EBIT?
- How hard will it be to research and explain CBIZ to subscribers?
Those aren't uncommon concerns for us to have. But they are very real questions. If the stock market wasn't so incredibly expensive right now, CBIZ wouldn't be on our top 10 at all. The bottom half of our top 10 is weak right now. CBIZ is now at #7 on our research pipeline. The stocks at #8, #9, and #10 all get close to half their sales from one industry or one customer we have concerns about. CBIZ doesn't have that problem at all. It's very diversified by customer.
Our approach is to pit our best ideas against each other. Do I love the price of CBIZ? No. Not all. But there are only 6 cheaper stocks I like better right now that Quan hasn't yet written notes on. That's why CBIZ is at #7 in our research pipeline. There just aren't a lot of cheap stocks out there