📍 TLDR

• Caesarstone Limited is a manufacturer of engineered quartz, commonly used in kitchen countertops.

• The business is not in good shape and there appears no shortage of reasons to stay away.

• But positive cash flow and a decent balance sheet make this an intriguing value stock.

• Plus, inventory line items suggest the business is even cheaper than it looks.

Before the pandemic, there was a common refrain: “value investing is dead”. It’s not terribly difficult to see why:

source: Lehner Investments. [Positive figure means value outperforms growth].

For 25 years or so, growth investing was far and away the more successful strategy.

This was particularly true during the 2010s. It led to a hypothesis that changes in the economy had permanently altered the investing landscape.

In August 2020, Sparkline Capital summarized this thesis in an article titled “Value Investing Is Short Tech Disruption”. As the firm pointed out, that short trade had been a disaster:

source: Sparkline Capital

Even value investors started to believe the same. As the Financial Times noted five months later, “celebrated value investor” Ted Aronson had given up the ghost in October, closing his hedge fund.

The FT compared Aronson’s departure to that of Tony Dye two decades earlier. Dye had warned consistently and confidently of the excesses of the dot-com bubble, only to quit fighting the tide. He left the industry literally weeks before the bubble peaked in early 2020.

But here in 2022, value investing has made a comeback:

Just since Oct. 1, the Russell 1000 Value ETF has gained 16% while the Russell 1000 Growth has gained less than half that.

However, one potential value play has been left out. Countertop manufacturer Caesarstone Limited CSTE 0.00. If the trend towards value continues, and if Caesarstone can do something — anything — to improve confidence, there’s the potential for huge gains here.

Introducing Caesarstone

Founded in 1987, Israel-based Caesarstone is a manufacturer of engineered quartz countertops. The company essentially invented the category at the time, and as with Kleenex or Xerox, the term ‘Caesarstone’ is often used as a colloquialism for the entire category.

One big advantage of engineered quartz is that it comes in a multitude of colors. At the end of 2021, Caesarstone offered more than 70. Another is that unlike granite, Caesarstone is non-porous. However, the product is more expensive than granite as well as being heavier and less heat-resistant.

source: Caesarstone

Caesarstone has grown to an expected ~$700 million in sales this year. The U.S. is the largest market, driving almost exactly half of year-to-date revenue. Australia is the second-most important country, at 16% of YTD sales, with Canada at 14%. Direct sales channels exist in most major markets, with third-party distributors complementing those channels. In more than 45 countries, the company relies on indirect sales for the entirety of its revenue.

Value Play or Value Trap?

At the moment, CSTE is a pure value play, and a contrarian one at that. On Wednesday, the stock hit an all-time low, more than a decade after it went public.

In context, the lows make some sense. Caesarstone is a play on housing worldwide, with particular exposure to the U.S. Housing markets in the States and elsewhere have seized up amid higher interest rates, inflation and recessionary environments.

The latter two issues are particularly important for CSTE. Given the price premium of Caesarstone to granite, the stock is a play not just on housing, but on discretionary spend in the higher end market. The stronger dollar adds even more pressure on the ~50% of sales denominated in other currencies.

Meanwhile, financial performance has been disappointing. Over the past few years, Caesarstone’s margins have collapsed. The company has taken three price increases already this year, yet the stock sold off following the Q3 report earlier this month amid concerns of even more margin erosion. This simply does not seem like an attractive business at this point.

All that said, CSTE stock is getting ridiculously cheap, even accounting for recent struggles and external pressures. At Friday’s close, the fully diluted market cap sits at $225.2 million. Net cash at the end of Q3 was $31.7 million, though the company also has a legal settlement reserve of $36.4 million (more on this later). Adjusted for that reserve, Caesarstone’s enterprise value comes in right at $230 million.

Full-year Adjusted EBITDA, as implied by the midpoint of the company’s guidance, should come in at $57.3 million. Adding back a modest amount ($1.7 million run rate) of stock-based comp, EV/EBITDA here is about 4.1x.

But even that doesn’t capture how low the valuation is, for one key reason. Caesarstone’s inventories have skyrocketed over the past few years: the line item in fact doubled between Q3 2019 and Q3 2022. Capital expenditures rose sharply as well.

The increases in both categories are going to reverse in 2023 and likely beyond. When accounting for those reversals, the value assigned to the operating business looks lower still. The key question is whether it’s low enough.

Why CSTE Is A Terrible Idea

From the perspective of individual stocks, the performance of growth versus value from 2016 to 2021 boiled down to one key factor: the quality of the business won out over the attractiveness of the valuation.

A low interest rate environment gave some ballast to that perspective. But whatever the cause, fast-growing and dearly-valued businesses outperformed, while “cheap” but lower-growth plays headed south.

In that kind of market, a stock like CSTE was a poor choice. And broadly speaking, that’s a key risk in this market too. Essentially, this is the same kind of value trap that snared investors for most of the 2010s.

The business itself has performed poorly and margins have absolutely collapsed:

source: Caesarstone Q3 investor presentation

There’s been a variety of factors at play and Caesarstone has certainly suffered some self-inflicted wounds. Most notably, a new facility in Richmond Hill, Georgia was troubled from the time it opened in 2015. Legacy plants in Israel then had their own problems. The company still hasn’t returned capacity utilization anywhere close to past levels, which in turn has been a major driver of the stunning compression in gross profit margin.

More recently, higher costs (for quartz itself, shipping and other expenses) have been a factor, and there’s been no sign of a bottom. Despite this year’s price increases, Caesarstone hasn’t been able to keep margins intact. Updated guidance post-Q3 suggests EBITDA margins this year of just 8.0% to 8.5%, which at the midpoint implies a stunning ~1600 basis points in compression in just six years (including ~240 bps against 2021 performance).

Competition is a factor as well. Chinese rivals entered the market years ago, but began to improve their quality noticeably last decade. Strong tariffs have protected the U.S. market, but in Australia and elsewhere in Asia that competition has pressured revenue and pricing. 2022 sales in Australia, even on a constant-currency basis should come in below those achieved five years earlier.

And, as mentioned earlier, the company faces significant legal liabilities. The company is facing some 200 claims regarding silicosis, a long-term lung disease, mostly in Israel. Insurance should cover some of the potential liability. But as noted the company has booked a material reserve. (Caesarstone excludes those costs from Adjusted EBITDA, so they are not a factor in the substantial margin compression over the past few years.)

All of these complications of course arose in the context of a strong economy. It’s little surprise investors are worried about what occurs in a more negative environment. Caesarstone did manage nicely through the financial crisis though. Revenue declined just 4% in 2009 and net income (excluding a non-cash charge) grew sharply. But at that time, engineered quartz was more quickly taking industry share, and Caesarstone itself was executing at a much better level.

4x 2022 EBITDA does sound cheap, certainly. But cut revenue next year by even 15% and assume another 200 bps in margin compression and the stock, based on current enterprise value, is at 6x-plus EBITDA and likely more than 20x free cash flow. Neither seems all that attractive in the context of multi-year performance; both will prove to be too high if the company cannot find a way to pull out of its tailspin.

But The Stock Is Cheap!

There’s an important qualification in the last paragraph, however. “Based on current enterprise value.” That EV has a path to come down over the next few quarters irrespective of the CSTE stock price.

As noted, inventory has skied in recent quarters. Some of that has come from unit pricing, of course. But inflation alone does not explain a roughly 100% jump. In dollar terms, the increase has been $123 million. Again, the company right now has an enterprise value of $230 million.

On the Q3 call, Caesarstone chief executive officer Yuval Dagim said the company would align inventory levels with macro conditions going forward, which suggests a substantial reduction over the next few quarters. Presumably, there will be a modest offset from trade payables, which ballooned $44 million over the same period, but presumably there’s still at least a $30 million-plus net tailwind to free cash flow on the horizon. Get EV under the $200 million mark and even modeling in a difficult 2023, valuation here still looks fairly reasonable (mid-5s EBITDA if not lower).

And that imprecise model presumes 2023 will be materially worse than 2022 — which in turn requires two key assumptions. First, that the currency environment will get even worse. In Q3 at least, per the call, a good chunk of margin compression came from the strengthening dollar. Higher pricing contributes as well. Margins on a percentage basis will compress even if margins on a unit basis are relatively stable.

More importantly, it presumes that Caesarstone doesn’t respond to lower volume. The company said after Q3 that it was already taking costs out. Pricing actions taken this year should boost margins next year. Richmond Hill appears finally in shape. Should the US market outperform in 2023, production can shift to that facility. In turn, that would reduce shipping costs and provide some margin relief.

Even at ~$30 million in Adjusted EBITDA or so (down almost half from 2022 guidance), the company still should be free cash flow positive. This isn’t a leveraged business facing solvency risk. There is thus some evidence that Caesarstone, as poorly as it has performed of late, can muddle through a housing bust, and that the stock is priced for the worst-case scenario, or something close.

The Big Move

To be sure, this is not quite a “tails I win, heads I don’t lose much” type of case. But particularly with CSTE falling off the table after Q3 earnings earlier this month, the stock is modeling in a recession and further declines in both profits and margins.

What it’s not modeling in — at all — is a rather material change to strategy. And there is some reason to see that kind of response coming. A little over 40% of the company remains in the hands of two major shareholders. Mifalei Sdot-Yam, an Israeli kibbutz (or communal society) founded the company and still owns about 30% of outstanding shares. Tene Investment Funds, an Israeli private equity firm, has another 10%-plus. And the two shareholders have an agreement to vote their shares together, giving them substantial power over the direction of this company from this point forward.

There’s already a sign that they are exercising that power. In October, Caesarstone disclosed proposals to be voted on at this month’s annual meeting. Notably, the company amended Dagim’s bonus to focus heavily on growth in revenue, Adjusted EBITDA and operating cash flow (and with any acquired growth excluded from the calculation). Another proposal sought to award the CEO 6,000 restricted stock units and another 45,000 options.

But last week the company said the proposal regarding the equity award had been withdrawn “after receiving input from shareholders”. There are only two shareholders that can cause that kind of response — and, again, they are legally obligated to work in concert.

Any kind of change beyond that adjustment to CEO compensation would have to be seen as a positive. Even though the margin compression began before Dagim arrived in 2018, his tenure appears to have been a disappointment, to put it mildly. It’s not just a financial problem, either. Employee reviews of the U.S. operations on Glassdoor suggest a disorganized, poorly-led business, with particular problems on the sales side.

But it’s the potential for a bigger move that makes CSTE intriguing here. After the annual meeting change, there is some reason to see that move coming. And despite the ugly performance over the past few years, there are reasons to see some potential success on that front as well.

After all, at the end of the day, the pillars of the bull case that led Caesarstone to a $2.5 billion market cap in 2015 still remain. Engineered quartz is still taking share from other materials:

source: Caesarstone 20-F

Competition clearly has made a dent, but improved execution can help on that front. Trends toward higher spending on kitchens appear largely intact.

Yes, cyclical pressures are on the way. But the key word is “cyclical”, and we’d point to commentary from Home Depot HD 0.00 chief financial officer Richard McPhail on his company's Q3 call this month:

And so, the question has always been, number one, is there a lag to spending? Are you going to spend in that specific period when you know your home price is appreciated or is there a halo effect that lags over multiple periods? And our hypothesis is yes [there is a lag once homeowners realize their home is more valuable]…

If you’re a homeowner, you’ve done quite well from a balance sheet perspective. You likely have a job, you likely have cash in the bank. And then, we’re seeing another just interesting dynamic where with mortgage rates increasing, our customer is becoming more and more likely to stay in place and begin a project, so improved in place…

Of owner-occupied households, 40% are owned outright, no mortgage. Of the 60% that do have a mortgage, 90% of those mortgages are fixed rate, 73% of those mortgages are fixed rate below 4%.

So, we are now seeing a dynamic of stay in place and improve your home. And that’s what our customers are telling us, and that’s what the Pros are telling us their customers are telling them.

Even in this environment, there’s an underlying business here that has value. The company just needs to realize that value.

Long-awaited execution improvements under Dagim could do the trick, even if it seems unlikely at this point. A bigger change in the C-suite, or in strategy, offer another potential catalyst. Given the balance sheet and remaining brand strength, there’s room for a double-digit jump in CSTE simply on the news of a change in the top spot.

If Tene and Mifalei Sdot-yam want to go bigger in capturing what value remains, there’s another move to make. G&A is running at a $50 million-plus run rate; slash that in half and pro forma EBITDA gets toward $80 million. The leading brand in an industry should have some value, particularly to a larger business that could fold Caesarstone into its existing distribution network.

Either way, the status quo seems unlikely to hold. The market is pricing CSTE as if that’s a bad thing. That’s not necessarily the case.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a position in CSTE this week.

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