Caesarstone Sdot-Yam Ltd (A case study of bulls and bears)

Recently I have been watching some videos about Mohnish Pabrai. I have heard that Mohnish Pabrai plans to go public with the Dhando Holding Company (click here). He is one of the few value investors who like to give talks.

I find him both entertaining and unashamedly blatant about some of his beliefs such as cloning (copying the buy & sell moves of other great investors notably Warren Buffett), marketing tactics used by Hare Krishna disciples and his afternoon naps. To him investors should be seen as Gentlemen of Leisure – who should not be in any hurry to buy or sell, and to study deep into the companies.

Consequently, using Mohnish’s idea of Cloning, I did spend some time reading up on the buy moves of some of the great investors. Some are harder to decipher than others. For instance, Seth Klarman picks seem to be more geared towards Pharmaceutical Companies like Orexigen Therapeutics Inc (which are beyond my circle of competence), while Bruce Berkowitz bought Sears (which I deem as having a weak moat) etc. Often than not the companies are not the typical fundamentally strong companies with good balance sheet or consistent ROE or EPS growth. Among these I noticed 2 companies: Michael Kors Holdings Limited (bought by Joel Greenblatt two months ago) and Caesarstone Sdot-Yam Ltd (bought by Ron Baron one week ago). My initial study of their financial fundamentals show them to be relatively good.

Caesarstone-Blizzard-2141

In the case of Caesarstone Sdot-Yam Ltd, the situation is interesting, because if you read the news, you would have known that the share prices of this company has plunge dramatically since early August 2015. To quote this article, there is literally blood on the streets for this stock.

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The drop in the share price could be attributed to a 54 page research report that was issued in August 2015 by investment firm Spruce Point Capital Management -a short seller (read here). Consequently on 9 Sept 2015,  the law firm of Kessler Topaz Meltzer & Check, LLP announced that a shareholder class action lawsuit has been filed against CaesarStone Sdot-Yam Ltd on behalf of purchasers of the Company’s securities between March 25, 2013 and August 18, 2015. (read here)

As any die hard value investor would attest to, when there are blood on the street, they would be out hungry for a piece of action. Being the vulture at heart, I am intrigued. In addition, unlike the other cases of companies attacked by short sellers / bloggers (eg. Sino Grandness, Olam, Noble or Silverlake Axis) – I am familiar with the Caesarstone brand of engineered quartz surfaces. which are used for kitchen countertops, vanity tops and tiles. You can read about the company here. If you go to any ID outlets in Singapore, it is not hard to find a catalogue of Caesarstone quartz stones (although the designer would probably counter propose a cheaper brand). The company CaesarStone Sdot-Yam Ltd has a long history, and from 1999–2010, the use of these engineered quartz stone has expanded rapidly. As of 2012 Caesarstone estimated that it controls 13% of the global market for engineered quartz surfaces. Caesarstone generates more than half of its revenues from North America, of which a substantial majority is contributed by direct sales.

Indeed, in this article, it states that ” There are currently six analysts that cover CaesarstoneSdot-Yam Ltd stock. Of those six, five have a Buy rating, one has a Hold rating. On a consensus basis this yields to a Buy rating. The consensus target price stands at $63.67.”

For many it would seem risky to buy the shares of this company now.

Risk comes from not knowing what you’re doing.” Warren Buffett

To maybe use another quote from Mohnish Pabrai:  “Dhandho. Heads I win; Tails I don’t lose much”. Given such a situation, if one is to invest in this company, one must have insights into the issues involved.

Ok, so for one we can basically trace the source of the share price plunge to the article by Spruce Point Capital Management – which makes it easy for one to zero in on the cause (and difficult when you actually read the article). Now let’s break down the items stated in the report:

  1. that the cost of quartz rose by approximately 20% in 2014 while the company claimed in SEC filings the impact of the price increase was just 4%;
  2. independent lab tests demonstrate that CaesarStone’s samples contained less quartz than advertised;
  3. CaesarStone’s reported consolidated margins, gross margins, and EBITDA were overstated;
  4. the extent of and risk posed by a growing number of lawsuits for approximately 60 silicosis-related injuries or deaths suffered by workers and fabricators of its product in Israel was understated;
  5. the impact recent OSHA warnings regarding silicosis would have on the opening of a new U.S. facility and associated costs;
  6. recent inspection reports revealed audit deficiencies related to revenue and inventory controls; and
  7. as a result of the foregoing,  the defendants’ statements about CaesarStone’s business, operations, and prospects were false and misleading and/or lacked a reasonable basis at all relevant times.

Now before you think that Caesarstone Sdot-Yam Ltd is just another bad company whose stocks should be selling at $15, let’s consider the bull’s argument.

UBS: What The Bears Are Missing By Selling This Home Remodeling Company (read here)
Caesarstone: We’re Not Buying What Spruce Is Selling – Yet (read here)

I find this article by Jonathan Fishman informative and it seeks to correct some misconceptions stated by Spruce Point Capital Management.

1) With reference to item 2 in Spruce Point’s report on the quality of the engineered stone. While Spruce highlighted CaesarStone’s samples contained less quartz than advertised. Jonathan stated that the test weighed only a small sample of several different brands and models of quartz surface and the disclaimer by Spruce highlighted that there is an element of randomness in the data points. Most importantly in the raw material cost in CaesarStone report, the cost of polyester and polymers is much more expensive than quartz. If the quartz is more finely ground, its particles will have greater total surface area, and more resin will be required to make them adhere to each other. The company’s reported a warranty claim rate of only 0.4% in 2014 (amounted to $1.78M-not enough to shake the company financially).

So given the above fact, it doesn’t make sense for Caesarstone to use less quartz (which is cheaper than polyester & polymers) if they are to create a cheaper and more inferior product. So Spruce example of the price increase of Quartz by Mikroman is contradictory. And Caesarstone Sdot-Yam Ltd do have a very low warranty claim rate.

2) Pertaining to item 5 on the Silicosis Issue, Jonathan argues that although Caesarstone Sdot-Yam Ltd would be required to pay for some damages, these damages nevertheless would not be recurring.

3) Pertaining the CEO’s Supposedly Sordid Past. Spruce reminds us that Caesarstone’s CEO, Yos Shiran, was the head of Tefron, a textile company, during a turbulent period.  Tefron suffered in part because of industry dynamics. Caesarstone prospered in part because of industry dynamics.

I was trying to find information on the web regarding the delisting of Tefron from the New York Exchange after Yos Shiran stepped down as Tefron CEO in 2008. However, I did not find any. What I did find is an extensive study by the Tel Aviv University on the business of Tefron and its struggle and triumph over the years (read here). Apparently the fortunes of Tefron has improved much since the delisting. We can’t really insinuate that Yos Shiran is the main reason for the delisting of Tefron and even if he is, there is still no evidence of any of his wrong doings in Caesarstone Sdot-Yam Ltd.

 

While studying the financials of the company, what strikes me is the increasing ROA, ROE, ROIC and EPS over the years and also the decreasing free cash flow over the years (see below).

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The decreasing free cash flow could be explained by the capital expenditure needed for the new U.S. manufacturing facility in Richmond Hill, Georgia (read here). Although as stated by Spruce, Caesarstone’s U.S. facility is vastly more expensive than peer manufacturing facilities around the world, is over budget by $30m (read here).

Well, although I do agree with Jonathan’s point above, however what strikes me the most on Spruce’s report is the lack of competitive advantages. This can be also read in the VIC report (read here).

The corner piece of VIC argument is stated below:

Extremely limited competitive advantage- no patents, all companies use the same equipment to produce, not a differentiated product, Caesarstone puts shiny chemicals in their slabs to “differentiate themselves”, when they were founded in 1980 the Company was the only one producing quartz, now they’re the third largest (behind Silestone, Cambria)

Caeasarstone product is significantly more costly than Silestone and there is no obvious price advantages. The quartz countertops have been commoditized.

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Moreover the industry is highly cyclical. In the long term, I do not see the company as one with a strong moat. Even given the recent share price plunge I won’t not consider dipping into it (even if it is to profit for the short to medium term).

 

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About apenquotes

Born in 1976. Married with 2 kids (a boy and a girl). A typical Singaporean living in a 4 room HDB flat.
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