Tuesday, January 31, 2006

Barton Biggs-Hedgehogging

Many of us, at least of a certain age, remember Barton Biggs as the Director of Research and later the Global Portfolio strategist for Morgan Stanley, back in the days when Morgan was a partnership. Whenever anybody said "Barton" all of us in the business knew exactly who was meant by this first name. Barton is a great observer of capital markets, amazingly shy, very understated and unassuming. He was always a great reviewer of important books as well as the first person I know to write of the Soros record. Barton left Morgan some years ago to work on a fund of funds hedge fund. He has written a terrific book on the phenomenon of hedge funds.

One of the areas that he seems skeptical of is private equity. As he writes:

"What the private equity guys are forcing their portfolio companies to do now is finance by issuing bonds in the high yield market in which there is plenty of demand for paper. They then use the proceeds to pay big special dividends. Of couse this loads more debt onto companies that are already highly leveraged."

"...in 2004, 77 dividends worth $13.5 billion were financed by junk-bond deals, and highly leveraged loans from banks paid another $9.4 billion in dividends."

Needless to say, this is no way to do corporate finance. Piling leverage on top of leverage to forc a dividend payout is obviously a highly risky and dangerous practice.

Another practice to look out for is the rapid turnover of portfolio companies among private equity funds. The selling of portfolio companies between private equity funds in order to book a gain and charge a 20% "performance" fee is outrageous. These "secondary buyouts" achieve little for the limited partner except increasing his leverage, reducing his participation, and pillaging him with egregious fees.

Though mutual funds have been soundly criticized for lackof performance and high fees, the current private equity arena seems to be the focus, in my opinion of worst practices. The fund of funds area is another sore point for me, but more about that at a later point.

Monday, January 30, 2006

A Little Time Off

I readily admit, and most of us should admit, that one's career has been blessed by having a number of outstanding mentors. On of the great influences in my life was the chairman and ultimately, my partner in an investment counselling business who reminded me of the importance of having some time on my hands. Never burden yourself with the daily administrative tasks of life when one thinks about investment. You need time to think.

Most investors, at least in my opinion, fail to take sufficient time to really think about their investments chosing to look for brokerage advice, investment newsletters, Yahoo message boards, bartenders, or even blogs (I shudder) as a substitute for thinking on their own. Ignore the experts...conventional wisdom will often fail. Fear, ignorance, and status quo tend to predominate much conventional thinking. Extrapolating current trends into the hereafter fails to recognize competitive threats to once successful businesses.

The importance of reading, the importance of thinking about competitive landscapes, the importance of looking at the downside first and the potential reward later; all of these should be part of the mental models that one builds as one considers an investment.

As Shai points out in his review of his Greenblatt interview, independent thinking, in-depth research, and the ability to persevere near term underperformance are critical attributes to successful investing.

Do your own work! If reading something on my blog, or anyone elses for that matter triggers an idea, think it through. Don't accept it as some sort of gospel. My methodologies and risk tolerance levels may be entirely inappropriate for you. Perhaps there is some key factor that I am missing or my biases blank out obvious keys to understanding.

Time on your hands is an important aspect of thinking. Rapid ready-fire-aim trading will enrich your broker but rarely will do much for your wealth. Take some time to cogitate. Much like a stew that sits on a backburner developing a flavor over many hours of blending and heating and stirring, great stock ideas take time.

I am on vacation this week, and as I sit on the Barbados shore, gin and tonic in hand, I do have a lot of investment ideas stewing, on the backburner if not at the front of my mind.

Saturday, January 28, 2006

Abelson, Sentiment, and What's the Symbol for NMT?

Alan Abelson comments in Barrons this week on the speculative tone of trading this week. He highlights the froth that surrounds the Chipotle (CMG) IPO and its doubling on the first day of trading.

Nothing characterizes the frothiness better in my view than the reaction to Cramer's Mad Money recommendation of NMT Medical (NMTI) on Friday. Readers bid a muni-bond closed end fund NMT to silly heights in their zeal to be first on the block with Cramer's pick. Wrong stock home gamers!

Mad Money Trading After Hours

The research basis for NMTI's success is based on a theory that some migraine headaches start in the heart, in a defect referred to as the PFO. Sealing of this heart defect, which can appear in 25% of the population, may rid patients of their migraine issues. There has also been some suspected connection between PFO and stroke.

The stock has risen over 200% in the last 52 weeks, and another 34% in the post Cramer rally.

The company flows red ink, has never made a dime, and has negative retained earnings (accumulated deficit) of about $14 million. Cash (courtesy of several rounds of financing) is about $33 million. Total EV is only $180 million.

Competitors exist with similar technologies namely AGA Medical, St. Jude Medical (STJ) and Cierra Inc, and Cardia Inc. Competitive rivalry is intense, needless to say. Only two analysts provide current estimates but I see interest from a number of others who are sniffing investment banking opportunity as this company continues to spend well in excess of its modest revenues (YTD losses of $5.1 million versus last year's $1.9 million.)

Speaking of needing money, it appears that insiders also have had their sell tickets out. In the last three months, insiders have sold a total of $1.4 million of stock.

Shame they hadn't listened to Cramer, or is it a shame that Cramer's not listening to them?

In any event, there does appear to be some pretty strong evidence of investors going into heat once again.

Base Metal Commodities versus Insiders...Why the Conflict? (corrected)

I came across a terrific article in The Stalwart on backwardation and the base metals. In backwardation, the further out you go in time in futures contracts, the lower the price.

People attribute this to the current low state of inventories, a corollary of high demand. Backwardation suggests that there are supply insufficiencies in the corresponding (physical) spot market.

The Stalwart suggest that though commodity markets remain in backwardation, the shift upward in longer dated commodity deliveries’ prices suggests perhaps some permanency in higher prices.

Here's another example of the bravado in the copper market currently. This fellow had forecast a range of $1.60-$2.00 with a weakening economy, but guess what... he is letting the market's euphoria dictate his price.

Yet, when I look at the base metal producers, almost no insider seems to believe in his stock.

For example, in Freeport-McMoran Copper (FCX) return on capital now exceeds 50% versus a 5 year average of about 6%. Enterpirse Value to EBIT is merely 6.3 times. Yet management seems to be selling stock hand over fist, with sales of over $47 million in the last three months.

Phelps Dodge (PD) has a recent ROIC of 21% versus a 5 year average of about 2% and an EV/EBIT of about 11.7 times. Management here also seems to be eager to sell stock with sales of $1.7 million in the last 3 months.

A particular article that The Stalwart has highlighted comes from the Australasian Investment Review. In it, it suggests that “base metal prices are now so far above traditional methods of valuation that commodity analysts have thrown away the rule book, continuingly upgrading forecasts in simple acts of exasperation.”

Backwardation has been de rigeur thinking for some time. As the AIR points out the frustration of the exercise : “The western world spent 2005 actively de-stocking its inventories. This is a standard response to high spot prices, provided you believe high spot prices have a limited shelf life. Relief has not been forthcoming, however - prices are only higher.”

The article also highlights the emergence of commodity hedge funds as important new actors on the scene. “Now there is a new breed of hedge funds (probably as a direct response to higher prices) establishing large long positions across the metal spectrum. There is also an explosion of interest in commodity index funds, such as the GSCI (Goldman Sachs Commodity Index), which is now estimated to be holding some US$65-80 billion in funds. The second largest, The Dow Jones AIG Index, is holding $15-20 billion.”
“The Australian broker, Macquarie reports current expectations are that investment in commodity index funds could rise by up to US$40 billion to around US$120 billion by the end of this year.”

Commodity markets offer easy and rapid trading, low margin requirements, no need to deal with physical inventory, etc. However, as any of us who have observed the commodity scene recognize, there are very large risks when one deals with very large contracts with small amounts of margin.

“But we also believe it would be extremely dangerous to presume that flows into commodities index investments will always be positive; indeed, our strong inclination is that they will not be" says broker Weres. “Depending on scale, such a reversal could result in a price correction either in line with, or below, the levels justified by supply/demand fundamentals.”

If, as, and when the tide turns, the premium of current metals prices versus fundamental levels will quickly be lost, and it’s a long way back to traditional, fundamental price levels. It seems a little bit like measuring eyeballs back in the Internet heights.

Are we witnessing new era thinking in metals prices? Is the emergence of hedge funds as a significant force in the commodity trading arena leading to imbalances? Why are insiders in the metal producers actively dumping their holdings?

Though the companies seem to fit the value lovers bill as to valuation, free cash flow, and high returns, where is the sustainability? A few questions to ponder.

Friday, January 27, 2006

Pfizer (PFE) versus Novo-Nordisk (NVO)

Pfizer (PFE) received European approval for Exubera, the first inhalable non-injectable form of insulin. This action bodes well for PFE's FDA approval shortly.

One should keep in mind that several other drug companies are in the process of developing inhalable insulin, notably Novo (NVO), Lilly (LLY) and Alkermes (ALKS) in a joint venture, Mannkind (MNKD) and Kos Pharmaceutical (KOSP.)

Last night NVO reported earnings pretty much in line with expectations. There was some disappointment regarding its Novo Seven clinical trials relating to intra cranial hemorrhage.

But let's keep in mind how well this business has done and what management's expectations are.

The goals for this company are a 30% ROIC and a 25% EBIT margin. Currently, the business operates at about a 23% ROIC and an EBIT margin of around 26%. The company is clearly reducing its capital employed by its announcement of a an acceleration in its share buyback. The company has completed its 5 billion Danish kroner buyback and just stepped up to a new 6 billion Danish kroner buyback for 2006 and 2007.

Pfizer's ROIC has been drifting down from historical levels that exceeded 40% in 2001 and 2002 to its most recent 12%. On an EBIT margin basis, Pfizer's margins are similar.

Both companies spend about the same on R&D at about 15% of revenues.

Yet NVO has grown earnings in the last five years at 21% compared to PFE at 14.5%.

NVO also announced a 25% increase in its dividend for March of 2006. This should bring NVO's yield closer to about 1.85% versus PFE's much more substantial 3.9%.

On a valuation basis , NVO selss at less than 15 times EV/EBIT compard to PFE at 16 times. I believe that NVO, much more of a biopharmaceutical company, and with a more interesting drug pipeline, and substantially better return on capital characteristics deserves a higher valuation.

Thursday, January 26, 2006

Cracker Barrel (CBRL)

About a month ago, I highlighted Cracker Barrel as an interesting restaurant chain, an industry that I instinctively avoid. After all, can you think of an easier entry business? However, in this case, I made an exception.

Link-Too Many Seats

The stock was priced at that time at around $35. This is a decent business with a history of free cash flow as well as high ROIC for this industry (currently running just under 12% versus a 5 yr norm of about 10% and having reached 15% levels at times) As I pointed out in December, there is some uniqueness to the franchise, not just the Southern chatchke (I loved putting those two words together :) ) but the fact that the restaurant has performed so well in various consumer surveys.

Yesterday's announcement of a potential restructuring came as quite a pleasant surprise, needless to say.

CBRL Seeks Strategic Advice

Using rough back of the envelope calculations, the potential spin-off or sale of Logan's Roadhouse would be worth around $400-$450 million. This represents about 20% of CBRL's current market cap, but represents only about 15% of revenues.

There is real estate potential in CBRL (akin to the MCD's activism) as they own 384 locations. I have no independent way of assessing the value here, but Wall Street estimates (which of course came alive yesterday after ignoring the stock previously) seem to suggest about $400 million for the properties.

Once again, Wall Street's focus on short term earnings problems and the subsequent downgrades created a great opportunity for those of us who focus on long term cash flow generation and franchise value. Naturally, yesterday's news caused many analysts to jump on the buy bandwagon.

The strong cash flow generation history has allowed the company to return capital to shareholders in plentiful amounts ($750 million in share buybacks over 7 years and terrific growth in dividends.)

Though, at current prices the stock is fairly valued given its capital structure, there remains considerable potential in my opinion for a leveraged buyout or some type of capital restructuring which would result, in my estimation, in a value above $50.

Tuesday, January 24, 2006

Valuation, Technical Analysis, and Expertise

Geoff has written an excellent post on the relative merits of fundamental versus technical analysis.His reasoning follows this logic:
  1. Quoting Ben Graham, market prices are a function of both reason and emotion, in the long run governed by intrinsic value, and in the short term, somewhat random, governed by emotion.

  2. He uses a metaphor that compares the market to a circus fun house mirror, where the ensuing reflection may not be an appropriate representation of the input data. I think this is a brilliant analogy!

  3. Since all things are subject to cause and effect (like Newtonian physics,) and since stock price movements are not "uncaused," therefore measuring the effect through methods like technical analysis must have some logical validity if not merit.

  4. However, because technical analysis is so interpretive, and because fundamental analysis is empirically more powerful and direct, therefore why dedicate too much time to TA?
I think this is a balanced viewpoint. Many investors seem to use technical analysis well over the short term. Taking advantage of sentiment shifts and over-reaction to news is the realm of behavioral finance and some forms of TA. Relative strength and momentum methodologies have proven themselves from my academic as well as my own research, but as an addendum, an asterisk to my primary fundamental work. Bill R. of NoDooDahs is a very bright blend of valuation guy and technician who seems to be skilled at reading the charts with his predictive models. So where does investment expertise lie?Here is another Michael Mauboussin link that addresses this issue:

Michael Mauboussin

The approach to investing really is best defined by people like Munger, Lou Simpson, Bill Miller, or George Soros. What are the characteristics of expertise?

As MM points out:

When tested, experts appear to have recall capacity that exceeds the limits of short-term memory. While they do not have larger short-term memories than the average person, experts have internalized, and hence made automatic, many basic skills. Deliberate practice assures experts have more patterns stored in long-term memory that they are facile in retrieving.

As well: Experts represent problems at a deeper level than novices.

Applying this to the investment area, MM writes:

Successful investors put in plenty of deliberate practice. In investing, this generally means lots of time reading, often across diverse fields. For example, the highly-regarded head of GEICO’s investments, Lou Simpson, says, “I’d say I try to read at least five to eight hours per day. I read a lot of different things . . .” Berkshire Hathaway’s Charlie Munger makes the point more emphatically, “In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time—none, zero. You'd be amazed at how much Warren reads—at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

Great investors conceptualize problems differently than other investors. As a group, these experts go beyond the near-term obvious issues, can identify relevant principles because of their experience, and see meaningful trends. These investors don’t succeed by accessing better information; they succeed by using the information differently than others.

Long-term investment success requires mental flexibility. Just as markets constantly evolve, so too must investors. Further, expert investors possess the second type of flexibility—an ability to recognize when their easily-accessible mental models no longer apply.

Not pattern recognition but process recognition. As scientist Norman Johnson notes, in complex systems an expert can create a mental simulation, fueled by diverse information.

My conclusion: Discipline works. Ultimately it becomes second nature and one becomes facile at retrieving. Being an investment “expert” is a long and deliberate process. In my view, becoming a professional investor is the longest apprenticeship in the world. The ability to think deeply based on the application of a variety of mental models, based on the ability to conceptualize problems differently than others, and having the mental flexibility to evolve your process is what ultimately determines the level of achievement one can attain in this vocation.

As Buffett says, there are a lot of ways to get to heaven. Use whatever works for you if you can define it as a discipline!

Monday, January 23, 2006

Value Investors as Market Timers

A very interesting debate is taking place among fellow value bloggers, Geoff Gannon of Gannon on Investing and Bill R. of Absolutely No Doodahs. Involved as well are Shai Dardashti and Arpit Ranka. The debate centers on one primary issue, the usefulness (or otherwise) of technical analysis and whether value investors can be both.

Here are the relevant links:

Geoff Gannon: On Value Investors as Market Timers

Bill R The Problem(s) with Value Investing
Technical Analysis and Value Investing

Shai Dardashti Is there Value in Technical Analysis?

Arpit Ranka Is There Time for Timing?
Lessons Taught by a Coin

I will share a little of my own perspective, but I am afraid, little incremental value to this debate. If what I suspect is true, I may well be the ancient amongst this group of bloggers, having been a portfolio manager since 1980 and an analyst and investor for five years prior thereto!. Consequently, I may have the dubious distinction of having made more investment mistakes than anyone else here and have tried many approaches to finding an investment nirvana. As Buffett says, there are many ways to get to heaven, and I believe that a blending of disciplines is conceivable and in fact beneficial.

Efficient Markets Hypothesis, as Bill points out, tends to dismiss technical analysis out of hand. Historically, so did I. When EMH died, largely due to what academic finance refers to as anomalies, the weak form of EMH which dismisses technical analysis seemed to be the only remaining tenet. I must confess that in my zeal for fundamental analysis I too dismissed technical analysis. After all, how many chartists do you see on the Forbes 400 list?

My fundamental approach to valuation is similar to that of Geoff, I do attempt to seek intrinsic value primarily through DCF analysis. Such valuation models produce a theoretical value of a company based on your own set of assumptions, in my case, using estimated operating margins, working capital and fixed investment needs, tax rates, and growth rates. The result is calculated for my estimate of a competitive advantage period, the toughest estimate of all. After all, competitive strategies and the competitive landscape will change. I adjust my discount rate according to the variability of the cash flow stream. This is the art in fundamental analysis…a DCF is nothing more than a calculator…it will produce a value based solely on your inputs, garbage in, garbage out. It is the underlying analysis and judgment that brings value to a calculation of a DCF. Bear in mind that there are other sources of value beyond what you see in the cash flow stream. Patents and other intellectual property, licenses, ownership rights, investments in minority held subsidiaries, real estate, etc…the value of these in a DCF is zero! I frequently need to remind myself of the value of these non DCF inputs.

Arpit’s coin toss experiment has been used to ridicule technical analysis and is available on several websites. Arpit’s use of behavioral finance axioms develops some excellent arguments against technical analysis and for a single-minded approach. His logic is irrefutable. But let me tell you about my own experimentation.

Back in the early 1990’s, I spent a great deal of time back-testing Berkshire’s portfolios to see if I could decipher what it was that WEB was doing. I felt, and continue to believe that one can replicate or at least approach his results. (This is an experiment that Shai is currently undertaking.) The advantage that Buffett has on me, beyond wisdom, brilliance, and all-around intelligence, is a negative cost of capital created by insurance float. His ability to assess long term returns on capital and appropriate discount rates in assessing them is the key to understanding value investing. I believe that WEB’s rate of return, without the benefit of negative cost of capital, is about 14%...still outstanding, EMH defying returns.

I believe that through discipline, any of us can achieve such returns but with one proviso…I learned that using some relative strength or momentum measures as an adjunct to determination of return on capital would add about 1.5% to 2% to the back-tested results. As a fundamentalist down to my toenails, I was shocked by this finding. Yet backtest after backtest, it came through.

Even some academic studies have endorsed the “serial correlation” or sustainability of momentum. (Hope this appeals to your superb statistical understanding, Bill!)

Grundy & Martin

I do NOT suggest that WEB in any way uses such a method. Negative cost of capital provides a far better performance than relative strength will. I will accept any help from any methodology that I can get!

My advice:

  1. Find a discipline in which you can excel. If fundamental analysis seems too rigorous, find a technical approach and learn it well. Though most academic research refutes it, some people, especially using cyclical stocks, have been terrific investors.

  2. Use and appreciate a DCF model. Understand what it captures in your assumptions, and what it misses and dismisses.

  3. Add to your core fundamental performance incrementally using relative strength approaches.

  4. Understand behavioral biases. Identify and understand the biases of managements as well as those of the masses. Control your own.
So where do I stand? I believe that a successful approach to investment can incorporate several methodologies. My primary approach is entirely fundamental and is the basis for any investment I make. I am a great believer in behavioral finance and having an understanding of where opportunities can arise or where short-circuited thinking can fail me. This is always a subsequent test of my fundamental modelling. Finally, I have learned to incorporate some momentum measures into my thinking and entry points. I did it reluctantly, but the backtests demonstrated incremental return.

What Makes Buybacks Effective Part II

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.
Warren Buffett
BerkshireHathaway 1984 Annual Report

I recently explored the notion of the stock buybacks:

What Makes Buybacks Effective?

This post essentially reviewed a Business Week article on buybacks that appeared in the January 23rd edition. My belief is that share buybacks need analysis as far as their “value-added” strategy. The questions that buybacks pose are: Is the company buying back stock below intrinsic value, is it reducing its cost of capital by restructuring its balance sheet, or is it merely sopping up stock that it issues through the exercise of (primarily) executive stock options?

This morning, I found that Michael Mauboussin, now of Legg Mason (working with Bill Miller, portfolio manager estraordinaire) and formerly of CSFB where he was one of very few Wall Street portfolio strategists that I read regularly, has put together a lengthy treatise on share buybacks.

He provides much historical content on the use of dividends versus share buybacks as ways to return capital to shareholders.

He utilizes one over-riding principle that echoes Buffett’s 1984 quotation:

“We can define a principle to serve as a universal yardstick for judging the rationale and attractiveness of a buyback program:
A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
The first part of this principle—“a company should repurchase its shares only when its stock is trading below its expected value”—suggests management should act as a good investor by buying the stock when the price is below the value. Objective, analytical managers likely understand the business and its prospects better than outsiders, positioning them well to make this value-versus-price judgment. If price is truly below value, a buyback transfers wealth from selling shareholders to continuing shareholders. The resulting increase in expected value per share holds with management’s objective to maximize shareholder value for its continuing shareholders.
The principle’s second part, “no better investment opportunities are available,” addresses a company’s priorities. Buybacks may appear attractive, but reinvesting in the business may provide a better opportunity. Value-maximizing companies fund the highest return opportunities first.”

I hope you will find this rather lengthy discussion worthwhile!

Michael Mauboussin

Sunday, January 22, 2006

Tyco International

James B. Stewart, of Smartmoney.com, in a recent article entitled “Breaking Up is Hard to do” outlines what has become a consensus view that de-merging companies into spin-off components is a value-subtracting exercise. Recent data suggests that investors greet such de-mergers with less than complete enthusiasm. I tend to view such spin-offs positively; such action represents an unwinding of a holding company or a conglomerate discount into leaner, meaner components that can control their own destiny rather than fund the nefarious or dubious needs of other parts of the organization.
As Stewart points out:
“That said, there are good reasons the market casts a skeptical eye on these deals. Mergers at least hold out the possibility of operating efficiencies. So-called horizontal mergers may reduce competition and result in higher margins and profits. This is why the Guidant deal is being viewed so warmly, since it's likely to consolidate the growing market for heart defibrillators. "Vertical" mergers promise — though rarely deliver — in-house customers and suppliers. But the very nature of a breakup offers neither reduced competition nor vertical advantages. Generally they're touted for the inverse advantages of bigness. Cost-saving efficiencies like a single management, headquarters, legal, accounting and personnel staffs, are arguably more than offset by the advantages of a management that isn't stretched too thin and a company that is more nimble and opportunistic.”
I view the Tyco International (TYC) de-merger quite favorably. The break-up of the business into its component parts should reveal some otherwise buried levels of profitability.
For example, Tyco Healthcare sports operating margins of close to 27%. Almost as high as JNJ’s 29% but well above Baxter (BAX) at 16.3% or Abbott (ABT) at 17% or CR Bard’s (BCR) 24.5%. Using an average 16.5 times EBIT for enterprise value for the comparable (but less profitable) group would value Tyco Healthcare at about $42 billion. Apportioning debt according to segment sales would leave Tyco Healthcare with about $2 billion in debt. This values the equity of Tyco Healthcare at roughly $20 per share.
The Electronics segment of Tyco sports operating margins of about 15%. Let’s compare that to Motorola (MOT) at 9.6%, American Power Conversion (APCC) at 11.5% and Amphenol (APH) at 19.1%. Using a group average 14 times EBIT for enterprise value would correlate to Tyco Electronics being valued at about $26 billion. Again apportioning debt according to segment sales leaves Tyco Electronics with $2.5 billion in debt. This values the equity of Tyco Electronics at roughly $12 per share.
The fire and security, Sensormatic business of Tyco has about 10% operating margins. Compare this to Parker Hannifin’s (PH) 8.1% operating margin or Cooper Industries’ (CBE)12% operating margins. Checkpoint Systems, one of the competitors to the Sensormatic business has had recent operating losses, so provides little relevant comparison. Using a EV/EBIT multiple of only 10 times, well below the group average, provides a valuation for Tyco Fire and Security of about $6.50 per share.
As you can see, even attributing zero value to the smallest component, the Engineered Products division, still nets a valuation of the sum of the parts of $38.50 per share compared to the current market valuation of $26.00.
What follows is Oscar Shafer’s views of Tyco as espoused in this week’s Barron’s. There is a serious disconnect between the market price and valuation of Tyco.
Schafer: My next pick is Tyco International. The stock is about $29. The company has 2.1 billion shares and $40 billion of sales. It will earn close to $1.90 in the fiscal year ending Sept. 30. Investors are missing two things. First is the enormous cash-generating power of the company, which results in free cash flow of 15 to 25 cents more than reported earnings per share. Second is the value of the company's $10 billion health-care business, which earns close to a dollar a share and would be valued near $20 as a stand-alone company. You're paying only 10 times earnings for the remaining businesses.
When Tyco stock was at $36 last January, there was little incentive to split up the company. But, at 29, there is a serious disconnect between the price and intrinsic value. In November, CEO Ed Breen said that if "the valuation disconnect persists," he was prepared to take additional action besides repurchasing shares. When asked, he said "the full range of options" was being considered. One would be a spinoff or IPO or sale of the health-care division.
Meanwhile, Tyco has reduced net debt from $9.3 billion at the end of September to $6.3 billion now. With $4.5 billion of free cash flow, the company can simultaneously reduce debt, buy back stock and make acquisitions. [Subsequent to the Roundtable, Tyco announced it would split into three separate publicly traded companies specializing in its various business lines. Oscar, who applauded the split, said in a follow-up conversation, "This split aligns three shareholder constituencies in a tax-efficient manner, and allows each company more flexibility to pursue strategies unique to that business."]
I, my family, and my clients are all shareholders of Tyco.

Rejoice! Corrections bring Opportunity

Rejoice! We appear to be having a correction.

I have absolutely no idea where the market may go over the next few days, weeks, or months. I know that if I pay too much for a stock, no matter what the market does, I inevitably receive another lesson in value discipline. Overpaying for a business is always folly. Similarly, regardless of the market’s movement, when I buy stocks with a margin of safety, the performance of the portfolio moves ahead. Buying a business for less than its intrinsic value always makes sense.

Last week’s undoing of the YTD rally in stocks will no doubt cause many investors to pause in their tracks, and to perhaps re-think their strategy for the year. I expect to see somewhat more somber outlooks from Wall Street strategists in the coming weeks if the weakness persists.

Wasn’t it just a week ago that the greatest parlor game in town was guessing how high the price targets on GOOG might get? The highest target price is $600 and the highest estimate of growth for 5 years is 70%. The highest target price estimate belongs to Piper Jaffray and was issued on Thursday, Jan 19th. His (or her) estimate for long term growth was 35%, only slightly higher than the 34% consensus. The highest estimate for growth for GOOG belongs to ThinkEquity at 70%, which apparently was a downgrade in the estimated growth rate from prior “thinking.” Glad to see that some conservatism has come back to the fore!

I did a screen of companies that have gone down 10% or more YTD but are trading at free cash flow multiples below their respective industry or had superior returns on capital relative to their industry. Please note that I need to do considerably more work on them and their accounting. If you have any ideas or thoughts, please comment. Here’s a few of the names that I found at least superficially interesting:

Almost Family (AFAM)
Down 11.88% ytd
CFFO consistently greater than net income
Free cash flow generated in 3 of last 5 years
ROIC around 7.5%

Children’s Place (PLCE)
Down 15.07% ytd
EV/EBIT (TTM) 16.39X
CFFO consistently greater than net income
Free cash flow generated in 3 of last 5 years
ROIC 24% in most recent quarter, well above more normalized 11%

InfoSpace (INSP)
Down 10.81% ytd
CFFO consistently greater than net income
Free cash flow generated in 3 of last 5 years
ROIC around 7.0% substantially below recent history of 20% plus.
Can the wireless business offset the weakness in search?

Kendle International (KNDL)
Down 16.86% ytd
CFFO consistently greater than net income
Free cash flow generated in 5 of last 5 years
ROIC around 12.0% most recent quarter, above the TTM of 8.1%
Have the rule changes destroyed the economics?

Kronos (KRON)
Down 11.28% ytd
EV/EBIT (TTM) 13.53X
CFFO consistently greater than net income
Free cash flow generated in 5of last 5 years
ROIC 22% versus TTM of 16.4%

Lifecore Biomedical (LCBM)
Down 19.17% ytd
CFFO consistently greater than net income
Free cash flow generated in 4 of last 5 years
ROIC around 26% in last 12 months versus recent 6%.

LSI Industries (LYTS)
Down 15.58% ytd
EV/EBIT (TTM) 10.95X
CFFO consistently greater than net income
Free cash flow generated in 5 of last 5 years
ROIC around 10.4% consistent with TTM

Modine Manufacturing (MOD)
Down 20.37% ytd
EV/EBIT (TTM) 10.26X
CFFO consistently greater than net income
Free cash flow generated in 5 of last 5 years
ROIC around 7% versus 7.8% TTM.
National Beverage (FIZ)
Down 16.07% ytd
CFFO consistently greater than net income
Free cash flow generated in 5 of last 5 years
ROIC of 10.2% recently versus 10.7% TTM

Syneron Medical (ELOS)
Down 17.86% ytd
EV/EBIT (TTM) 15.85X
CFFO generally but not consistently greater than net income
Free cash flow generated in 4of last 5 years
ROIC of 48% compared to TTM of 34%

When screening for below market price performance, I often come across below market companies. For various and sundry fundamental rationale, and some superficial familiarity, I bring these companies to your attention. As always, not a recommendation to buy, sell, or do anything, these are merely what I believe to be interesting names that merit further attention. I have yet to complete a DCF on any of these names but intend to work on these shortly.

Consequently, at this point, neither I nor my clients own a position in any of these companies.

Thursday, January 19, 2006

Put Writing and the Value Investor

I found an interesting post on put writing earlier today and thought I shuld bring it to your attention.

Link to Mr Market

I agree with "Mr. Market," who incidently has put together a very worthwhile blog. The ability to buy stocks at below current market prices should not be ignored.

In some ways I view this as an insurance writing business. As a put writer, I collect a premium from the buyer who fears the risk of the stock dropping in price. When markets or individual stocks become more volatile, the premium that I collect obviously expands. As time marches on, the time value decays and ultimately, the put either fades into nothingness, or I am forced to exercise, and I own the stock at a much more attractive price than the market would have provided me initially.

Admittedly, with low volatility as evidenced by the VIX, premia have shrunk and the strategy is not as rewarding as it has been in the past.

Nevertheless, capturing a premium to allay someone elses fear is a worthwhile pursuit.

Remember, there is nothing to stop the stock in either direction. If the stock moves up from initial levels, you have simply collected a premium, you have no equity position. If the stock drops below the exercise price, you will be exercised and own the stock, but it the exercise price could well be above where the current market for the stock lies.

This is a strategy that is only suited to those with sufficent capital to absorb the necessity to purchase the underlying stock. It should not be thought of as an income strategy because ultimately, you will be put the stock.

One of the comments is that with low volatility and relatively cheap time premia, one should consider buying calls instead. I view this as a riskier strategy: you do pay a time premium rather than simply pay the current market price. This does not give you a below market entry price for the stock., and consequently, I view this as contrary to a value strategy.

A client of mine once said it best,"The only advantage in buying calls is that I know not only how much I will lose, but also when!"

Put the declining value of time premium in your wallet, sell the nervous investors insurance...write puts!

Wednesday, January 18, 2006

Finding Value in Growth

Think large cap not small. Value can be found in growth!

The only way anyone can see this requires belief that value and growth are joined at the hip. I believe and my portfolios show my faith in this premise.

This excellent post shows the relatively low valuation of large cap growth compared to the other "boxes." As someone who generally has espoused small cap value picks, I have to admit how difficult it is to find value in this part of the universe. A few exceptions naturally do apply, but overall, the pickings are slim.

My only problem with this point of view is it seems to be turning into a consensus viewpoint. Yet the valuations speak for themselves.

Don't think that the recent value destruction of a few high tech names represents the demise of growth. In my view, this is strictly a case of expectations having run ahead of themselves and ahead of the fundamentals.

Tuesday, January 17, 2006

Intel (INTC) Q4 Summary

Looks like a lot of disappointment in results, in outlook both for upcoming quarter and year. Slight market share losses and slight inventory build. Heavy spending!
  • E.P.S. disappointment at 40 cents vs consensus 43 cents vs. yr. ago 33 cents

  • This was despite a very low Q4 effective tax rate of 29.1%.

  • Revenues up 6% at $10.2 billion vs consensus of $10.56 billion
  • Forecast for first quarter revenues is between $9.1 billion and $9.7 billion vs consensus forecast of $10 billion.

  • Forecast gross margins at 59% plus or minus a couple of points which is below fourth quarter level of 61.8%.

  • Inventories built by over $300 million compared to the third quarter.

  • Full year forecast has revenue growth of 6-9% and gross margins of only 57%.

  • Full year spending growth will be +11% not including share based compensation. All in, with R&D, G&A, marketing, and share based compensation, spending will be at $13.1 billion versus $10.8 billion for 2005. Revenue growth of 6-9% versus spending growth of 11% is well outside their plan to keep spending growth in line with revenue growth. R&D spending itself will be at $6.5 billion versus 2005’s $5.1 billion.

More bad news…capital spending will be up too, by about 19%. Capex will be around $6.5 billion. The spending will relate to ramping up their 65 nm technology and investing in even smaller geometries. With tech, it never really ends.

The good news of last year was the return of capital to shareholders. Stock repurchases and cash dividends returned over $12 billion to stockholders. Quarterly average shares outstanding were down nearly 5% from a year ago and 11% from the peak in 1998. The board has approved a 25 percent increase in the quarterly cash dividend to 10 cents per share beginning with a dividend expected to be declared in the first quarter of 2006 and authorized the repurchase of up to $25 billion in shares of common stock under the company’s ongoing stock repurchase program.

My conclusion…the company is fighting a revitalized AMD for market share. Is there a fundamental disadvantage in terms of INTC design architecture? INTC customers had built up inventories of chips in the previous quarter resulting in less demand for the fourth quarter. Heavy R&D spending and heavy capex are the weapons in fighting this market share game. The impact of heavy start up costs will have a negative effect on gross margins.

Looks like increasing capital intensity for the industry overall...not good news for multiples or for free cash flow. This should represent good news for the semiconductor capital equipment industry.

Given the 9 or 10% correction in the stock price after the close, the company is now trading at an EV/EBIT of 10.67 times. The business has recently returned about 20% on invested capital. It appears that we could be returning to numbers a little closer to the 16 to 17% level. Far from a disaster, but there’s enough disappointment relative to analysts expectations that we’ll see a lot of gnashing of teeth at the open.

Keystone Automotive

Keystone Automotive Industries (KEYS) has been upgraded by several brokers in the last few weeks, including an upgrade to a Buy last night.

The company is a leading distributor of aftermarket collision replacement parts which are produced by independent manufacturers (mostly in Asia) for automobiles and light trucks. The company essentially sells auto body parts i.e. fenders and bumpers made in Taiwan as a replacement for parts damaged in a collision. The company is primarily a distributor; though it does do some wheel remanufacturing (repairing damaged wheels) as well as steel bumper recycling. The distribution system consists of many small locations numbering currently 129 distribution centers (22 of which serve as regional hubs) 38 states throughout the United States and Canada. The company acquired a competitor in New England recently.

Insurance companies love using alternative parts supplied by companies like KEYS. They are much cheaper than what replacement auto parts purchased directly from the auto manufacturers cost. In many cases, they are made in exactly the same plants. But consumers have protested the substitution of alternative parts for the “real thing.” In fact, a lawsuit that embattled State Farm for 6 years was decided by the IL Supreme Court in August of 2005 which found in State Farm’s favor, and consequently should benefit KEYS. However, this decision is still pending appeal.

The company has generally been a free cash flow generator, but recent trends suggest some changes here. CFFO for the YTD has been less than net earnings, reporting CFFO of only $2.3 million versus the $4.7 million in reported net income. The comparable figures for last year were only $3.5 million in net income but $9 million in CFFO. Free cash flow YTD is only $1.1 million versus $5.9 million in last year’s comparable period.

The stock is currently trading around $34, up over 60% versus a year ago when the stock was $21.

Wall Street analysts expect earnings growth of 19.5% versus what I calculate as a sustainable growth rate of about 8.5%. EV/EBIT is about 23.5 times and ROIC is only about 8% for the last twelve months stats. The company pays no dividend and has not bought back any stock since 2001, in fact issuing about $16 million in stock in the last five years.

Free cash flow in the last five years has totaled about $37 million but none of it seemed to find its way back to shareholders as dividend or buyback. Returns on capital have not been that spectacular recently either …back in the late 90’s the company used to be a 12-15% ROIC company, post 2000, it has averaged 8.7%. By way of contrast, Cardinal Health (CAH) a drug distributor has averaged 14% ROIC in the last five years, 75% higher than KEYS and sells at an EV/EBIT of about 17 times, or about 30% less.

The FCF margin for the last twelve months is less than 1%. The FCF yield at current prices is also less than 1%.

I was somewhat encouraged when I looked at insider sales and their relative inactivity. The CEO has actually accumulated some stock, having made open market purchases, and holding about 62,000 shares. However, just about all other officers aren’t shareholders:

John Palumbo, the CFO, doesn’t own a share.
James Lockwood, vice-president…no stock
George Seebart, director………..nada
Jesus Arriaga, CIO…..no stock

I can’t expect to see insider sales, when most of them have already sold!

This is a distribution company with a fairly neat niche holding over 20% of its market. Litigation against the auto insurance companies may have cooled but still could be appealed. The free cash flow characteristics of this business do not appear to be what they had been. Returns on capital are okay but not spectacular and certainly not where they were. Returns of capital to shareholders are non-existent…no dividend, no buybacks since 2001. Wall Street growth estimates seem very high relative to what the company has historically achieved.

In my view, the price seems to have incorporated a lot of these robust expectations.

Boston Scientific (BSX)-Desperate Strategic Bid?

The battle for Guidant (GDT) is starting to reek. Boston Scientific (BSX) is becoming more creative in its financing, obtaining more support from Abbott (ABT) by selling it equity at $25 and raising $200 million more in debt financing, again from ABT.

The valuation of Guidant is becoming astronomical, at least from a conventional investment standpoint. GDT's EV has climbed to over $24.1 billion representing EV/Revenue of 6.55 times and EV/EBIT of 35.77 times based on trailing twelve months revenues and EBIT respectively. Compare this with Boston Scientifics' own valuation which is likely to get diminished by at least 5% this morning, EV/Revenue of 3.5 times and EV/EBIT of about 22 times.

The GDT board will have a tough time defending its approval of the JNJ deal. BSX offers higher growth, better valuation, more leverage to medical devices, and no exposure to patent expiration. BSX is competing with a company that generates $1.5 billion in FCF per quarter and has $7 billion in cash after paying down all debt.

BSX is very reliant on a single product line being the TAXUS stent which represents over 40% of sales and about half of earnings. If BSX succeeds in its pursuit of GDT, the revenue contribution of TAXUS would drop to 27% of revenues. Its exposure to the cardiac rhythm market of pacemakers and defibrillators would provide instant exposure to a rapidly growing field.

This grudge match between JNJ and BSX could ultimately lead to a direct offer to GDT shareholders with a hostile tender if the GDT board remains oblivious to BSX.

The ultimate winner in this battle may well be ABT which would gain exposure to GDT's vascular and endovascular businesses as well as equity exposure to BSX at a very reasonable valuation.

Monday, January 16, 2006

Stock Options Expensing

"When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don’t belong in the earnings statement, where in the world do they belong?"

Here is a terrific series of links regarding the expensing of options and an assessment of its impact on earnings.

I Have a Dream

One of the most stirring speeches ever delivered. We remember and honor his memory.

Text of Speech

Audio of Speech

Sunday, January 15, 2006

Barrons Round Table-Thomson (TMS)

Barron’s Round Table features a number of interesting picks, some of which I intend to explore in greater depth.

Link-Barron’s subscription required

Though not discussed per se this week, Thomson (TMS) was one of Oscar Shafer’s selections in July of 2005, and in fact is down about 20% since that time. This is the French company that most of us think is still an also-ran European television manufacturer rather than the former Canadian, but now Stamford, CT based information database company. Two totally different and unrelated businesses!

Thomson trades on the NYSE as an American Depository Share (ADS.) The company is essentially a supplier to the movie-making, television and entertainment industry. The business has completely transformed itself over the last several years, really, since its 1999 listing. It now consists of three divisions:

Services, Systems & Equipment, and Technology

Services- The best known part of Thomson’s biz is a sub called Technicolor, which was acquired in 2001 and has grown through a series of acquisitions. The company provides outsourcing solutions to the movie production and TV distribution industries such as film services, DVD and VHS duplication (tiny and getting tinier), post-production services. Disney, Dreamworks, Universal, as well as Electronic Arts have signed long term contracts with Technicolor. This appears to be essentially a duopoly between themselves and Cinram ( a Canadian company, each with about 40% share. Balance is Sony which supplies its own entertainment division’s needs. The movie business tends to get more revenues from the post-release after life of films rather than the initial release. This business does not seem to have the risks of the movie business itself but is reliant on the continuing demand of consumers (and the Netflix and the Block Busters of the world) to resell content in this format. The post-production and editing biz are a function of Hollywood’s continuing production of movies.

The company has also made inroads into electronic, digital media and I suspect that more and more content will require modification for an HD world as well as the video on demand world.

The businesses within this division appear to have operating margins that range from 7-8% up to the mid-to high teens. I like the contractual nature of the business and the limited number of companies that compete in this arena with the breadth of services.

Systems & Equipment- This is broadcast equipment, cameras and production equipment, as well as video compression and networking equipment. The move to HD should support ongoing demand for their products, though they compete with a large number of competitors here (Sony, Tandberg, Avid, etc.) The company also provides set-top boxes, like Scientific Atlanta or General Instrument, but has achieved success with satellite TV set-top boxes. There is a long term contract with DISH.DISH related revenues represent about one-third of the biz...there is a relationship with France Telecom and BSKYB. This looks like about a 5% margin business.

The entrails of the former consumer TV biz are here too. VCRs, DVD players, MP3 players are sold under the Thomson, and yes the RCA brand in the U.S. They may well exit this business, if they can. They are very much a secondary also-ran in this segment of the biz.

Technology- Revenues here are mostly licensing revenues and hence very high (80% plus) kinds of operating margins. The company’s ongoing R&D efforts continue to build more and more intellectual property that has been licensed. The image that most analysts seem to have of Thomson’s IP is that it is old “his master’s voice” kind of property. Much of it appears to be digital rather than analog.

The result of all of these changes is that Thomson has become a significant free cash flow generator. At current prices, it appears that the company could have a greater than 10% FCF yield for next year, versus a current 4%. Massive restructuring expenses over the last two years have clouded the inherent FCF generation characteristics of what remains. The best evidence is the following: The company has completed over 60% of a €400 million buyback instituted in September of 2004. Returns on capital have trended up from barely 2% to approach 7%. In my view, with a little more restructuring, a 10% return on capital could be attained. The decisions to exit from TV and picture tube manufacturing in 2004 and 2005 establish management’s willingness to drop historical businesses and focus on returns and growth. EV to EBIT is about 12 X.

It should also be mentioned that Silver Lake Partners, a private equity group, made a €500 convertible investment in Thomson in 2004 and can convert its interest into equity in March of 2006.

The free cash flow characteristics, the improving operating margins, and the willingness to restructure and accept short-term pain to achieve long term goals are admirable. The risks that I see relate to the potential decline in DVD’s and the technological risk in the shift to Video on Demand. Institutional ownership in the States is only about 10%, insiders, employees, and the French state own about 9%.

Friday, January 13, 2006

What Makes Buybacks Effective?

The January 23rd edition of Business week has an interesting article about “The Dirty Little Secret About Buybacks.”

Buybacks are often viewed as some sort of a panacea by investors. The return of capital to shareholders can take two forms, dividends or share buybacks. But there are problems with following share buyback announcements too closely or blindly.

First of all, a share buyback announcement is just that…there is little demonstration of management’s desire to actually execute anything. I know of one company that having announced its intent to buy back stock, proceeded in the next seven years to pick up less than 10,000 shares!

Secondly, buybacks might not be done at prices that create value for shareholders. For example, Hewlett Packard in the period between October 1998 and October 2000 spent over $10.5 billion in share repurchase activity at prices that ranged anywhere between the mid-$20’s to the low $60’s with much of it coming during 1999-2000 at prices between $40 and $60. The stock at a current $31 with a market cap of only about $90 million shows very little value creation benefit from this activity.

Third, buybacks frequently are a camouflage for share issuance. One of the best examples of this has been Merrill Lynch. The company has spent almost $14 billion on share repurchases since December of 2003, yet the fully diluted share count has only recently dropped below its December 2003 level. The share base was just about 975 million shares outstanding, despite all of the buyback activity has dropped to only 968.5 million. The buyback was merely sopping up the issuance of stock through generous stock options that were executed and generally sold. The treasury appeared to be merely providing a ready market for executive stock sales, at least in my opinion. Just think about spending $14 billion to effectively buy back 7 million shares…effectively over $2000 per share. Obviously, the company was buying back stock in the open market, but issuing stock “on the other side of the trading desk!”

The Business Week article highlights the fact that the S&P 500 companies spent about $315 billion in buybacks last year but the share counts rarely are reduced significantly. According to the article, only 108 companies in the S&P have reduced their share counts by 2% or more.

Share buybacks can also signal other messages…the company may be finding fewer profitable capital projects in which to invest. There is nothing wrong with that admission, but managements should return capital in this manner without paying too much for the remaining intrinsic value.

Too often, share buybacks have been used to inflate a stock price above a certain threshold to award managements with bonuses. We should examine all management compensation packages carefully to ensure that such reward systems are not in place.

Buy backs will only create value if the stock is purchased at prices below intrinsic value. If a company is buying back stock at prices above intrinsic value, we remaining shareholders are “stuck” with misappropriated capital allocation decision.

Thursday, January 12, 2006

Sanderson Farms Announces New Capital Project

Sanderson (SAFM) announced today that it is building a large new Texas facility for big bird de-boning. The capacity is quite large, 1.2 million birds per week.

The end markets for big bird deboning (makes Sesame Street fans shudder!) is retail and food service. The dark meat is sold as frozen leg quarters for the export markets. White meat is sold as higher margin deboned breast meat and whole or cut chicken wings.

At this point, the firm has 2.35 million head per week of big bird deboning capacity, consequently a 50% capacity addition.

Obviously, the firm is less concerned about the chicken cycle than the Wall Street consensus.

POSCO (PKX) and Chinese Steel

Overnight, there was an interesting news item on Reuters regarding steel stocks and POSCO (PKX) in particular.

“POSCO, the world's fifth-largest steel maker, posted a worse-than-expected 68 percent slump in its quarterly profits on Thursday, hit by sinking steel prices and high raw materials costs”. ”The South Korean steel maker forecast its 2006 sales would fall between 8-12 percent from a year ago alongside reduced output, as steel prices crumbled on a supply glut from China. Steel stocks have been running at high levels in Asia with prices dipping, although Beijing has been trying to slim down its over-crowded steel industry, which has cranked up output to feed China's hot economic growth and booming steel demand since 2004.” "I am worried about a slump in the steel market condition," POSCO Chairman Lee Ku-taek said at a news conference. "Steel market condition deteriorated sharply starting from the second half (of 2005) because of the impact from China's supply glut... and that impact has been realized faster than our expectations." ”Analysts said POSCO might have to slash prices again this year, even after several cuts in key product prices in 2005.” "POSCO is facing deep problems. The steel industry is facing a serious oversupply situation, with China's steel capacity continuing to grow," said Kim Hyun-tae, fund manager at Landmark Investment Management. "It's hard to think of POSCO as any kind of long-term growth stock." ”POSCO earned a net profit of 382 billion won ($388 million) in the three months to December, missing a consensus forecast of 575.5 billion won, according to seven analysts surveyed by Reuters. The result compared with 1.18 trillion won a year ago.”

Operating profits were actually somewhat better than most analyst expectations but net was hurt by several one-time charges. The accelerated development of China’s steel industry has already created a steel surplus.

This has been one of the most profitable steel companies in the world, great technology, modern plant, high returns as it is a very low cost producer. Though there has been some attempt at product differentiation in the steel industry in terms of quality, this is still primarily a commodity business. Remember, in a commodity business you are as good as your worst competitor. The key is to find the low cost competitor at the right price. This could well be the right competitor, my guess is the right price is the low $40's.

See also Shai's link on Korean stocks

Wednesday, January 11, 2006

Masco (MAS)...The Obvious Should not be an Impediment!

How much time do we as value investors waste looking for tiny companies as potential un-discovered jewels when companies with well-established franchises and brand names continue to earn superior returns on their capital, but also treat shareholders like partners. Most of us have a real weakness for trying to find a cheap version of a great company in the hopes that it may turn into something. Yet such tiny companies often face a perilous future. High current returns invite competition and over time, excess returns over the cost of capital diminish.

Masco (MAS) is a mature business that most of us should recognize. In an announcement this morning, they are once again completing two divestitures to maintain their record of solid returns on capital. As well, the company announced that as a result of this action, they were lowering earnings guidance.

This prompted me to have another look at their cash flow and returns history over the last several years. It truly is impeccable.

Free cash flow generation over the last five years (incorporating TTM results from Q3 2005) has been about $4.8 billion. Compare this with CFFO which has totalled about $6.3 billion. Non nonsense here in terms of quality of earnings...free cash flow approximates about 75% of CFFO.

Share buybacks have also been an important part of Masco's partnership with its shareholders. These have been effective share buybacks, not merely the sopping up of executive stock options. The fully diluted sharecount as of Sept 2005 was 427 million shares compared to December of 2003 at 491 million shares, a full 13% reduction in share count.

At current prices, the shares are yielding 2.63%, well above the S&P's 2.08%. Dividends have grown at about 8.6%, slightly behind the S&P's 9.1%. However, share buybacks have represented a significant return of capital to shareholders.

The FCF yield is about 4.6%, well above that of the S&P which has a 3.3% FCF yield but still a little expensive for what I would like to pay. On an EV/EBIT basis, the company is trading for 11.2 times, again not quite a bargain in my opinion.

Returns on capital have been solid recently at 12%, improved from 2004's 11.40%, 2003's 8.70%, 2002's 8.50%, and 2001's 9.40%.

Much like a good portfolio manager, MAS management continuously oversees its portfolio of businesses with an eye to pruning the weeds and letting the flowers thrive.

Keeping an eye on this for a better entry point. Hopefully, we get it.

Tuesday, January 10, 2006

Mortgage Hiring Slowdown

All of your friends become mortgage brokers? Certainly, a lot of my friends who were in the stock brokerage business who suffered through the post 9-11 cutbacks by many firms went into mortgage banking and brokerage. Apparently, in the last 20 months, 53,000 jobs were created in this business.

As the housing markets slowed recently and refi opportunities diminished, business has started to dry up.

Here is some evidence as to the beginnings of a slowdown in employment in this sector. Look out below!


Alcoa (AA) sets Hurdles Low

Alcoa (AA) is the first large company to report in every earnings season, and as a Dow component, it tends to be viewed with some importance.

It’s not that many years ago that aluminum was considered a growth industry with high potential for broad applications for the light metal. The substitution possibilities seemed endless, and the use of aluminum in aerospace as well as potential automotive applications seemed to only increase. As time went by, aluminum became just another cyclical metal where international demand, particularly from places like China, recently indicated higher prices.

Aluminum stocks have responded recently to strength in basic materials in general and AA which had flat-lined for most of last year had moved up smartly since last October.

The earnings, which are just out disappointed the street, and deserve some comment.

I see this morning that “Random Stock Market Thoughts” expresses his/her frustration with the management. Who can argue?

Having listened to the conference call, management continues to blame its shortfall on one-time items. Three non-one time problems:

  1. Upstream cost pressures- Higher energy and raw materials costs

  2. Downstream margin pressures- Inability to pass through costs

  3. Disingenuous treatment of shareholders-More on this later.

Operating margins have declined in 4 of 6 segments YOY with primary metals the only positive exception courtesy of improving aluminum prices. In other words, management succeeded only through extraneous factors, and NOTHING of their own doing. The wind happened to be a tailwind, thereby propelling them!

In an aerospace environment that seems to be strong, with revenues up 16% and shipments up 10% margins fell to 3.5% versus 3.9% a year ago and 4.7% last quarter. Engineered solutions, which provides a lot of fasteners and castings for the aerospace industry, showed similar trends: revenues were up 10% YOY but margins were unch at 3.5%, though improved from last quarter’s 2.6%. I don’t get it, and apparently, neither do they.

My view of management perhaps being disingenuous with us comes from a comment in the conference call ballyhooing the improvement in return on capital for the fourth consecutive year. Absolutely true statement with return on capital in the last four years as follows:
8.3% (2005), 7.4% (2004), 5.4% (2003), 5.2% (2002).

Let’s have a look at the years prior to this:
8.7% (2001), 9.1% (2000), 11.7% (1999), 9.5% (1998)

Further evidence of management’s “head in sand “ attitude, at least in my humble opinion was another comment about this year’s ROIC of 8.3%. They commented that return on capital would have been 9.5% “when growth projects such as Iceland and Russia are excluded.” This is a little like an insurance company telling you that other than the hurricane or the earthquake, we’re doing fine. I can empathize with certain non-recurring events affecting a business…for an insurance business, hurricanes happen…that’s what you are in business for. The fact that management chose to develop projects to grow the business that will reduce ROIC initially is their choice, but should not be viewed as an excuse for where we measure the returns on capital.

It seems to me that for a business which is enjoying the highest aluminum prices in 17 years and with their views that “inflation is under control” that returns on this cyclical business should be higher.

If management is happy with their returns, they are playing what a friend of mine calls Mouse Olympics…the hurdles are really low.

Monday, January 09, 2006

Stern goes to outer space- back on earth...Arbitron (ARB)

Howard Stern launched his Sirius Satellite (SIRI) program this morning, apparently to not the greatest of reviews (Chicago Trib registration may be required.)

Whatever your views of Howard, whatever your views of Sirius ( though I haven’t commented publicly, I suspect that you know mine,) there has been a profound effect on terrestrial radio, and its Wall Street valuations.

I intend to review a number of the broadcasting companies to search for value over the next few weeks.

Today, however, I would like to look at Arbitron (ARB.) Arbitron is the sole source of radio measurement data in the U.S., a spectacular monopoly position. The company is absolutely critical to radio broadcasters who use the data in order to sell their air time to advertisers to demonstrate their effectiveness and penetration. On the other side of the table, Arbitron also sells its data to advertisers and agencies to help them make decisions as far as the selection of media. ARB’s relationship to radio stations is not unlike IMS Health (RX)’s relationship to the drug companies, except RX faces more competition in my opinion.

Arbitron provides measurement for 293 radio markets across the U.S. but also provides measurement for 38 national network radio audiences, consequently Clear Channel and Infinity Broadcasting, the largest national radio broadcasters are important clients.

ARB has two major projects which will affect its future, PPM, the Portable People Meter technology, and Project Apollo.

Project PPM is a passive technology to measure a consumer’s exposure to radio, TV, and cable media. It is also being deployed within Project Apollo for consumer marketing companies so they get a better idea of their return on investment for their advertising dollar, a measure of advertising effectiveness. Essentially, it should provide an answer to the age-old problem of advertisers, “I know that half of my advertising is wasted…I just don’t know which half.” The end result of this effort should be a better understanding of the combination of data to combine media data with consumption data. Both Proctor & Gamble and S.C. Johnson have signed on as sponsors of Project Apollo. VNU, the French data company is part of a joint venture in Apollo and may be accompanied by Nielsen sometime later this quarter.

The economics of this business are nothing short of spectacular. The company had operating margins of about 38% in the most recent quarter and a ROIC of almost 60%. ROE approaches 100% because of debt leverage with LT debt/ equity at 63%. Interest coverage is over twenty times.

In the TTM period, we have had $54 million in free cash flow…in fact, the last five years have shown $335 million in free cash flow. CFFO has always exceeded net income.

From a valuation standpoint, the company is trading at 12.7 times EV/EBIT.
Howard contends that radio is dead. I suspect that considerable effort will be made by radio stations and networks to prove otherwise. I also suspect that consumer products companies will be avidly following the progress of all of this as consumers of ARB product.

If the pilot projects of PPM and Apollo are adopted, this should open up international opportunities for this business as well. PPM, in fact, has already come into being in the Canadian and Singapore radio markets.

The company has been de-leveraging its balance sheet and buying back stock as well.

Sunday, January 08, 2006

Some great work on SAFM that you should know about!

This morning on Geoff Gannon's blog, Gannononinvesting.com, he once again is kind enough to mention this blog. Geoff is quite correct in pointing out that PPC did run into difficulties in its history because of its leverage. I very much appreciate your comments Geoff! Too much leverage in a cyclical business when the cycle is going against you is a sure-fire way to create agita at a minimum. I much prefer SAFM.

Free Morningstar Research

Fat Pitch Financials has brought this free deal to my attention. Certainly, a number of interesting wide-moat companies are part of this offer. Just thought you might want to know about it!

Fund Managers Hope for a Bit of the Buffett Effect

The NY Times has an article today about a number of mutual funds holding significant positions in Berkshire Hathaway.

As the article points out: “Morningstar data shows that of the 15 domestic stock funds with the greatest percentage of their assets in Berkshire, most were classified as blend funds, which straddle the line between growth and value.”

I enjoyed the reference to straddling the line. This observation is in keeping with WEB’s view that "Many investment professionals see any mixing (of value and growth) as a form of intellectual cross-dressing. We view this as fuzzy thinking….In our opinion, the two approaches are joined at the hip."

Consequently, buying great businesses at a fair price is often a far more successful approach than buying an ordinary business just because it is cheap.

Think about Greenblatt’s approach in “The Little Book that Beats the Market,” which endorses a simple summation of ranking of ROIC with ranking of value (EV/EBIT.)

As you can ascertain, I love high return businesses that provide a valuation opportunity because of a short-term issue. I generally avoid commodity businesses (with the notable exception of my recent views of chicken processing.)

I tend to look for a few other criteria as well.

I love businesses that have the ability to generate free cash flow...such businesses have the greatest flexibility to ride our difficult spells in an industry, have the ability to make acquisitions, and have the ability to return capital to us through share buybacks or dividends.

Having a management that treats shareholders as partners in the enterprise is important. Evidence of decent corporate governance is very important. We as shareholders must act like owners; we entitle management to act on our behalf, not the other way around. Imagine if you had your capital invested in an apartment building and your property manager were to dictate all aspects of your capital decision-making and would tell you nothing about why he was making these decisions…how long would you put up with this attitude? Why put up with it in securities markets?

No rocket science here…no new discoveries…just sticking to a simple discipline and developing the ability to say no to at current prices, most ideas. What can I add that Warren and Charlie haven’t already drummed into our heads?

A few noteworthy holders of Berkie were not mentioned in the article and deserve your attention:

Ruane Cuniff & Goldfarb As Munger says, I have nothing to add. Simply the best.

Davis Advisors- We have remained steadfastly dedicated to the same patient, long-term investment discipline for more than 35 years. We seek to invest in durable, well-managed businesses that can be purchased at value prices and held for the long term.

First Manhattan- Who needs a website when smart people come knocking anyway?

Fairholme Capital Management- Our primary strategy is to concentrate investments in attractive businesses run by proven owner-managers. We also employ other strategies designed to profit from a discrepancy between market value and intrinsic value. All of our investments strategies demand a price low enough to provide the right combination of limited risk and high prospective return.

Saturday, January 07, 2006

Oh no..not chicken again!

Not a comment on what is being served for dinner, but a comment on just how cheap these chicken stocks have gotten. As well, a bit of a humble contribution to the Sanderson Farms (SAFM) versus Pilgrim’s Pride (PPC) debate. I apologize for the heavy use of numbers and stats but a fundamental guy talks this way:

I agree with Geoff Gannon that SAFM may be a somewhat better or at least cheaper choice than PPC. And by the way Geoff, thank you for that kind mention on your blog! I do appreciate it a lot! Both companies would be hurt by lower chicken prices (obviously) but there are subtle differences in their fundamental qualities.

SAFM has just completed on time and on budget a new Georgia complex that will add about 23% in production capacity. With conversions to their Collins facility, production will be up about 26% next year.

Capital expenditures for SAFM were a record for 2005, having spent $128 million on various projects, the major ones being $92.3 million for the GA facility and $15.1 million for a new head office. Despite this well above normal expenditure, the company ended up with negative free cash flow of only $7.5 million. In fact, last year’s capex was greater than the company had spent cumulatively in the last five years. Next year’s forecast capex is going to be much lower than 2005 at $73.4 million, but well above current depreciation expense of about $31 million. The company can easily fund this expenditure internally. EBITDA last year was about $140 million, the lowest level of EBITDA in the last five years has been about $75 million. Consequently, despite this still above average spending effort, I believe that the company will be generating free cash.

The ability to generate large amounts of FCF is the difference in my view between SAFM and PPC. Here is a comparison of FCF margins (FCF divided by sales) for these two companies for the last five years:

2005 -0.74% +0.13%
2004 +7.14% +0.14%
2003 +6.01% -0.03%
2002 +3.89% -0.47%
2001 +7.1% -0.03%

When I look at a cyclical business, I like to look at the FCF generation over a five year cycle. The value that the stock market has accorded SAFM on an enterprise value basis (reflecting market cap plus debt less cash) is only 2.65 times the free cash flow generated over the last five years. On the other hand, the EV/5 yr FCF generation for PPC is about 4.2 times, still cheap by just about any standard, but more expensive than SAFM.

SAFM also appears to have superior working capital management. Its cash conversion cycle is only 27 days whereas for PPC it is just over 40 days. SAFM has had faster inventory turns as well.

PPC has enjoyed faster sales and earnings growth as a result of its more intensive capital spending program. But this is the fallacy of looking at sales and earnings growth as important metrics. What really counts to a value investor is how is the capital deployed: what is the return on invested capital? Check out the differences here:

2005 20.1% 15.2%
2004 31.5% 7.7%
2003 24.7% 1.1%
2002 14.0% 1.7%
2001 12.5% 5.0%

Finally, in terms of balance sheets and financial strength, both companies are just fine. PPC has total debt to equity of 43% (long term debt to equity of about 21%.) Interest coverage is ample. SAFM has a much stronger balance sheet with total debt to equity of only 3.2% and long term debt to equity of 1.5%!

In conclusion, SAFM has had higher returns on invested capital every year of the last five and a superior free cash flow generation history as well as a rock solid balance sheet. Its production capacity will be up over 20% this year.

On a valuation basis SAFM is trading at EV/EBIT of 4.66 times. Pilgrim’s Pride is trading slightly higher at 4.99 times EBITDA. Just to put it in perspective versus other cyclical businesses, the five largest homebuilders in the U.S. trade at an average of 7.33 times EBITDA for EV/EBITDA or more than 50% higher than SAFM. Homebuilders generally do not have the FCF characteristics of the chicken processing industry and only in this hyper-cycle have demonstrated returns on capital that were anywhere near that of chickens.

Friday, January 06, 2006

Value-Stock-Plus: Chant the right investment mantras before riding the market

Value-Stock-Plus: Chant the right investment mantras before riding the market

It's all about developing an investment philosophy and sticking with it. I happen to espouse the discipline of value investing. Others, like Soros, espouse reflexivity and deploy this in macroeconomic approaches to the market.

Having a consistent philosophy that is sensible, is not affected by the whims of the Street, and is pursued exclusively, forsaking all others, is what wins. It is important, as this post points out, to understand yourself, to know your strengths and weaknesses, as you develop and deploy your investment philosophy.

Short Sellers versus the Firm

In recent times, the relationship between short-sellers and the firm whose stock they are shorting has become acrimonious, if not caustic. Managements rant and rave at hedgies that have made a profession of selling short.

Shorts do provide a very useful service.

First of all, they do highlight accounting shenanigans and businesses that do not deserve to exist or draw capital. I can remember one company that sold a very high priced product which sold at about 7 or 8 times what a perfectly acceptable substitute product would sell for. The business had a negative gross margin and needless to say, had never made a profit. The ensuing short squeeze as a number of us discovered this "jewel" resulted in a move in the stock from its IPO of $10 to $18. Ultimately, under the weight of bad accounting, bad finance, and bad product, the business collapsed into oblivion.

Consequently, short sellers will provide liquidity to the marketplace...both as sellers when markets are eager to buy, but also as buyers, as markets get squeezed, and ultimately as they cover.

The attached link was brought to my attention by Value Investor Insight, one of the most useful resources I read. I have no financial interest in promoting their service; rather, I merely commend it as a useful and timely resource. Not only do they (Whitney Tilson et al) provide a regular monthly publication, but also intersperse the month with a bonus e-mail.

The article is written by a professor of finance at Yale, Owen Lamont, who has been a keen student of short-sellers. In this lengthy working paper, he examines the techniques that "angry" firms used to attack the short selling community, legal threats, attempts to impede stock lending practices etc. I have seen and experienced both, not only as a short-seller of stock but also as a corporate activist. Such activities by managements may provide near-term Pyrrhic victories, but in the end, tend to be pointless and ill-advised. As Lamont points out,companies taking ant-shorting actions have well-below normal returns in the subsequent year of -2% per month.

Go down fighting

The best way for a firm to act when it is under a short-sellers siege is to get them where it hurts. Provide honest accounting, decent finances, and a respectable return on capital. In short, run the business!

Thursday, January 05, 2006

Chicken stocks...are we about to get plucked?

There is an excellent post this morning on Shai’s blog regarding chicken stocks. He links another insightful blog from Geoffrey Gannon on the chicken processing industry and Sanderson Farms (SAFM) in particular.

I have written up some of the fundamentals regarding SAFM in a previous post.

The cyclicality of the business should come as no surprise. To quote from the Sanderson 10-K:

“Profitability in the poultry industry is materially affected by the commodity prices of feed ingredients, chicken and alternative proteins, particularly beef. These prices are determined by supply and demand factors. As a result, the poultry industry is subject to wide fluctuations that are called cycles. Typically we do well when chicken and beef prices are high and feed prices are low. We do less well and sometimes have losses, when chicken and beef prices are low and feed prices are high. It is very difficult to predict when these cycles will occur. All we can safely predict is that they do and will occur.”

The Pilgrim’s Pride (PPC) recent shortfall was addressed by management. PPC explained that about half of its sales are in the form of prepared foods that are sold on fixed priced contracts. The other half is a function of whole bird prices and by leg quarter prices.

Leg quarter prices have plummeted from 49c per pound in early October to 29c in the last week of December according to Bloomberg. The average price during the December
quarter (according to Bloomberg) of 39c was down 17%.About 80% of chicken exports are leg quarters and according to PPC, export sales had weakened earlier in the quarter, lasting through mid-December. However, I suspect that lower prices became sufficiently enticing that demand picked up again in the last two weeks of the year and in early 2006.

Insiders at SAFM have sold some stock, notably the CEO, Joe Sanderson. However, through options exercise, he now actually has greater exposure to the company than he had a year ago with a total of 1,091,104 shares versus the prior year’s 954,854 shares.

Harkening back to the valuation, on an EV/EBITDA basis, based on TTM which is the last full fiscal year, the company is trading at 4.94 times EBIT. Long term debt to capital is below 2%. In fact cash of $35 million exceeds long-term debt of about $11 million.

ROIC has sunk to about 11% for the most recent quarter compared to about 21% for the full year. ROIC peaked at about 36% for FY 2004, but has been at 0% back in 2000.

In my view, the risk relates to the perception of avian flu. Consumption patterns for chicken have been very strong over the last dozen years, reaching an all-time high of 86.8 pounds per capita! Per capita consumption of beef has been flat recently but falling from levels of a decade ago.

Recognize that this is a highly cyclical industry that is currently being squeezed by higher input costs and weakening product prices. Momentum trends are clearly against us at the moment. However, for a reasonable horizon, the stock appears very cheap.

Wednesday, January 04, 2006

InfoSpace (INSP)

InfoSpace (INSP) suffers from bipolar tendencies. On the one hand, the Search and Directory division is probably the best known segment of the business. This segment offers its services through its branded Web sites, InfoSpace.com, Dogpile.com, Switchboard.com, Webcrawler.com, and MetaCrawler.com, as well as through the Web properties of distribution partners. In many ways, old names that seem destined to oblivion in a Google world. However, consumer use of on-line directories such as Switchboard.com may still prove to be a growth element in this division.

The other segment enjoys higher growth. InfoSpace is also a leading content aggregator and platform provider in the consumer wireless data market. InfoSpace uses a business model that sells directly to large wireless carriers such as Verizon, Congular, T-Mobile, and Virgin USA both in the States and in Europe. Some analysts envision the growth of mobile content to run at 30-40%! Content provided includes ringtones, games, and graphics. There is increasing competition especially in ringtones where deals are being struck by carriers directly with record labels. Consequently, margins have started to compress. In the games area, INSP continues to earn much higher contribution margins, nearing 45-50%.

Revenues in Search and Directory could well fall this year especially with the loss of the AOL directory business. Most analysts have these expectations baked in their projections. As to the wireless business, most analysts seem to be very conservative in their operating margin assumptions, at least in my opinion. The wireless area will represent over half of revenues in 2006.

Further disturbing analysts has been management’s indication that 2006 will be an investment year…expanding mobile content, increased spending on marketing, investing in local and mobile search, etc. In short, doing what is needed to grow the biz.

Financials have been stellar. The enterprise value, EV is merely $400 million versus the market cap of about $750 million due to a large stash of cash and equivalents of some $350 million. EV/EBITDA is only 5.1 times TTM EBITDA. EV/EBIT is also quite low at 7.23 times. The stock is down about 45% in the last 52 weeks. A number of analysts have downgraded the stock, most recently Needham.

ROIC has been falling from last year’s 10% to a current 7%. Sales growth has creaked to a halt versus a 5 year growth rate of 28%.

But listen up…this company YTD has generated $123 million in FCF, that’s free cash flow. Compare that with an Enterprise Value of $400 million. No debt and roughly $12 per share in cash. In addition, there is a tax-loss carry-forward worth probably about $1.50-$2.50 per share, in my estimation.

The company has not bought back stock historically. However, as of the June quarter, the company has spent over $50 million in share buybacks.

No positive momentum in the near term, that’s for sure. There is the possibility of some bad news if it loses additional search business. Is there a long-term sustainable competitive advantage? Not at all clear what is sustainable in this industry, at least not to me.

But the positive aspects include a debt-free capital structure, almost $12.00 per share in cash, more coming in with its history of free cash flow, and I think some potential as a leveraged buyout candidate if the market continues to ignore it.

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