Sunday, February 26, 2006

NL Industries and Insider Buying at SHW

Theo Wong has some comments regarding Sherwin-Williams and lead paint liability in general. NL, the old National Lead also shares contingent liability exposure. Note Theo's comments regarding the insider purchase of $400,000 of Sherwin-Williams. In fact, 3 insiders, including the CEO and two directors have stepped up to purchase the stock.

Insider Purchases of Sherwin-Williams

Saturday, February 25, 2006

SHW- Further Thoughts and Thanks!

A few more thoughts on SHW from others and finally some additional thoughts personally:

Thanks Geoff for linking your many followers to our work and your frequent citations of our efforts in gannononinvesting

As well, thanks go to Ashish Kelkar for mentioning our work in his blog "Show Me the Money."

AK finds the SHW situation intriguing with the irrational rush of capital out the door since the jury's verdict was announced.

David Jackson of Seeking Alpha has been kind enough to ask me to become a contributor to his "dashboard" of stock market blogs. I have agreed and here is our first post on his fine compendium of blogs.

Some analysts have attempted to quantify the lead paint exposure. The CSFB chemicals team reviewed lead paint exposure as it pertains to ICI, the UK domiciled paint manufacturer that owns Glidden. As well, Fitch the bond rating agency concurs: "The financial impact on SHW cannot be determined at this time as the size and extent of the clean-up activity and costs and punitive damages (if any) have not been established."

Lead paint was not barred from production nationwide until 1978, BUT Sherwin-Williams had stopped manufacturing such paint in 1947.

The company withdrew production a full generation before being required to do so...clearly, no good deed goes unpunished.

The liability presumably could only include housing units constructed prior to 1947, roughly about one-quarter of all housing units. Still, nationwide if this case becomes a template, this could be a huge number.

On the positive side, there have been over 100 paint liability trials in 17 states since they commenced in 1987. Over 85% were either dismissed or stuck in appeal following rulings in favor of the defendants. The Rhode Island case is the ONLY one ever to come to trial. For those legally inclined, here is an excellent link to paint litigation.

We do not know the extent of insurance coverage that SHW could access. If the court ruling is appealed to the RI Supreme Court, SHW could be required to post a bond to stay judgment. The company appears to have ample short-term liquidity to meet any reasonable demand: about $1.4 billion in revolving and letters of credit plus access to accounts receivable securitization borrowing of another half a billion.

Enough with the numbers and the litigation history. How washed out is this stock? According to the most recent institutional holdings lists, about 68% of the stock is held institutionally. There are 136.9 million shares outstanding, and since the announcement,about 51 million shares have traded! About 38% of the stock has changed hands, a huge change in ownership. Of course, this does not allow for double counting where day traders may have relished in the volatility. Volume on Friday started to dry up, with only 6 million shares having traded, or as I like to say, changed their minds. Remember, that for every share sold, somebody is buying!

Bottom-line...the legal system in this country permits all sorts of frivolity...pitchers hit by line drives to sue the manufacturers of baseball bats, manufacturers of a plastic cup that somehow was linked to a child's autism, etc,etc. Please check out to really feel ashamed about this tort system. I do not belittle the consequences for children from lead poisoning. But, an industry that voluntarily stops manufacturing a product 30 years before it is required to do so does not seem like a bad corporate citizen somehow. The landlord or more likely, slumlord who failed to paint a wall with safe paint for 30 years seems more culpable to me.

None of us can predict the outcome, the damage, or the ultimate path for SHW. But almost 40% of the sharebase has changed hands, presumably to cooler hands. Clearly, there is huge uncertainty and consequently great risk. I am willing to accept the risk/reward proposition at these prices.

Thursday, February 23, 2006

SHW- One Brief Additional Comment

I have neglected to mention that in the midst of the sturm and drang of dealing with lead paint liabilities, SHW cranked up the quarterly dividend from $0.205 to $0.25 a 22% increase. The dividend has a five year growth rate of 11.5%.


Dutch Boy takes a Beating in Rhode Island (SHW)

As Geoff Gannon pointed out so well in his blog yesterday, Sherwin-Williams (SHW) decline yesterday is well worth noting. The beating continues today.

Sherwin-Williams is a marvelous collection of brand names: Dutch Boy, Sherwin-Williams, Krylon, and Kem-Tone among others.

The company received an adverse ruling in Rhode Island yesterday due to lead paint liability. In the first trial, a hung jury was 4-2 in favor of defendants. DuPont avoided the second trial by paying off the lawyers $12 million. Not sure how much of this found its way to the injured or wronged! In the second trial, the jury also became deadlocked, however, the judge ordered the jury to deliberate further.

Lead paint can easily be made safe…paint over it. Landlords or homeowners should be the ones held liable for old lead paint. But put reason aside, this is tort law in America! Go for the dough!

Next Tuesday, RI and defendant attorneys will make recommendations to the jury on punitive damages to be assessed. The jury will make its recommendation to the judge who may or may not agree. Expect appeals from SHW at the state level and beyond if necessary.

Back to fundamental comments about the company. In the period from year end 2001 to September 2005 (the last reported quarter) SHW has generated CFFO of $2.5 billion. Capex over this period was $635 million, roughly equal to depreciation of $600 million. The company has made $720 million in acquisitions over this period.

How were the shareholders treated? Free cash flow for the period totaled $1.9 billion of which $540 million was returned to shareholders by way of dividends. An additional $1.08 billion was returned through share buybacks!

Return on invested capital for the most recent twelve months has been 21%, well above recent history of around 11%.

The total decline in market value since the “news” broke has been $1.6 billion or over 22%. EV/EBIT is down to about 8 times!

As I recall, Mr. Buffett viewed the paint industry quite favorably with his purchase of Benjamin Moore back in December 2000.

What about other competitors. PPG has a ROIC of 14.1 times and trades at EV/EBIT of 10.5 times…it tends to be viewed as being more cyclical than SHW due to its automotive supplier role. RPM International (RPM) has a ROIC of only 5.6% and trades at 13.9 times. Finally, Valspar (VAL) with a ROIC of 9% trades at EV/EBIT of 11.6 times.

What to do? Deep value players will be very interested, grave dancers who party every time that Altria (MO) loses a tobacco liability case. Many institutional investors will bail because they can’t or won’t face the uncertainty of contingent liability. Technicians see a falling knife.

The plaintiff bar will no doubt view this as a clear signal to pursue similar cases in every jurisdiction it can.

Wall Street analysts as of yet have been non-committal, talking of great uncertainty. To his credit, the analyst at Buckingham Research continues to have an accumulate and has written a decent overview of the subject. Good man!

I can’t stand the value opportunity. I will be buying a partial position 24 hours after this post.

How to Beat the Quarter-Playing Mouse Olympics

A terrific link from Jeff Matthews reminds us of the dangers in following too closely the spectacle of earnings surprise.

Jeff Matthews

Though thankfully few companies suffer the corruption of Enron's management, all of us should remember that generally accepted accounting principles (GAAP) offer considerable flexibility to a management.

Analysts love to receive guidance and companies love to set the hurdles and expectations, to establish a game which a friend of mine describes it Mouse Olympics, a game where the hurdles are really low. Whispers from seemingly connected buyside clients, especially hedgies confirm or deny a company's ability to beat those expectations. IR types, or CFOs with whom one has a "great relationship" also contributes to establishing the expectations framework. Of course, analysts and managements would never violate Sarbanes-Oxley guidelines...consequently analysts become experts at reading facial expressions or body language or "how he sounds on the phone."

CNBC contributes to the charade by over-emphasizing whether or not the company beat the Street. Beating estimates by a penny requires only slight adjustments in certain estimates that a management must guess at every quarter. If you need a penny, you simply use a lighter pencil in your slightly breach briefly some principles of conservatism. Things will clarify over time and management can hone in on the real number toward year end.

The fact of the matter is that there is no REAL number when it comes to earnings! Accounting with its matching principles necessitates guesswork and estimates of accruals. Increasing complexity and a determination to establish everything at "fair market value" where no markets exist only adds to the confusion. Non-recurring charges appear regularly as estimates change and divisions are bought and sold.

What do we do as individual investors? Use Buffett principles rather than what CNBC, most managements, and much of Wall Street would like you to use.

Ask yourself about the competitive advantage that a business has. How durable is it? Will this business throw off cash flow or is it essentially a sinkhole for cash and management ambitions? What does the competitive landscape reveal? Is this a commodity business where you are as good as your worst competitor (once again, TY Warren!) Does this management treat you like a partner? In other words, does it return capital to you in the form of dividends and buybacks or is the business so good that the company can continue to reinvest its cash flows. How does the company treat its invested capital? Is the return respectable, well above the company's cost of capital, or would all of us be better off if someone merely rolled T-bills quarterly?

Put simply, it is difficult for us to get increasing value from our stock if management is not creating shareholder value. Shareholder value is, in my opinion, not created by earnings surprises, except for an evanescent moment where the hallelujah chorus of Wall Street ballyhoos the spasmodic "success." Shareholder value only comes from building a business that can generate cash in excess of its needs, and earn a return on its capital in excess of its cost.

FASB means flexibility and complexity. Cash pays payrolls, capex, and ultimately dividends. Which would you rather follow in measuring success?

Wednesday, February 22, 2006

Heinz and Peltz

I apologize for a dearth of activity in this blog for the last few days. I have been busy with the business, and had a lot of demands on my time. But finally, an opportunity to come up for air!

There was some speculation on CNBC yesterday, that Nelson Peltz was undertaking an activist role with H.J. Heinz Company (HNZ). As of today, no 13-D or proxy statement opposing management has appeared.


This follows a few days of considerable activity in HNZ options. Let’s look at the Heinz business.

No question that this is a collection of brand “icons.” Whether ubiquitous ketchup where HNZ controls 60% of the US ketchup market, OreIda, or Weight-Watchers Food, Heinz has many thousands of products versus the famous 57. The company has many products that seem to have been commoditized. The international efforts of HNZ seem to have been focused on traditional slow-growth economies such as the UK or Italy rather than Asian economies. There is a food service business that represents about 20% of relatively low-margin sales. On December 20, 2002, HNZ completed the spin-off of its underperforming U.S. and Canadian pet food and pet snacks, U.S. tuna, U.S. retail private label soup and private label gravy, College Inn ® broths, and its US infant feeding businesses to a subsidiary of Del Monte Foods Company. The company had a 16% stake in Hain Celestial which it recently sold. In my view, the worst of the businesses have been sold…what remains is a un undermanaged business that lacks focus.

From a governance standpoint, the company has an 80% super-majority vote requirement to make certain governance changes. Given its Pennsylvania incorporation and the PA legislative propensity to quash minority shareholder rights as demonstrated to Relational Investors recently in its lawsuit against Sovereign Bank (SOV), this could be a very nasty battle of pyrrhic proportions.

Pennsylvania Bill aids Sovereign

What has management done for you lately? Regrettably, from what I can ascertain, I am sad to report not much. All numbers are as of April 2005, the last complete fiscal.The company has generated CFFO over the last five years of $5.26 billion from continuing operations. They have spent about $1.7 billion in capex leaving free cash flow of $3.5 billion. Dividends over this period of time have totaled $2.4 billion and share buybacks (net of issuance) are $928 million. On a TTM basis, the ROIC is a fairly modest 10% but ROE is 34.4% due to debt leverage. Long term debt to equity is 240%! Long term debt to assets is 46%. Interestingly, the FCF for the TTM is negative. On an EV/EBIT basis for the TTM, the company is valued at 14.6 times.

How do these numbers compare with other packaged food companies? Kellogg (K) generates ROIC of 16.8% and a comparable ROE of about 36%. Campbell’s Soup (CPB) generates ROIC of 21.3% and an ROE of 52%. Even Hormel (HRL) with its heavy orientation to the tough meat processing business has a ROIC of 13.2%. Kraft (KFT) has managed to underperform HNZ with an ROIC of a modest 6.3%.

I would not care to speculate on the possibilities of takeover. The Commonwealth of Pennsylvania is not a shareholder friendly jurisdiction as I have already expressed. The low-hanging under-performing assets have already been plucked. Shareholder proposals to sell the company have been presented in prior proxies and to no avail. Returns on capital seem low relative to most other companies in this business. The company has a history of generating free cash flow, but hasn’t done so in the last twelve months. Finally, returns to shareholders in terms of dividends and share buybacks have pretty much equaled the FCF generated in the last five years. Short of recapitalizing the business, one cannot expect much more.

However, the real issue remains…can this business generate greater free cash flow if it is managed properly and more aggressively?

I suspect the answer is yes.

Saturday, February 18, 2006

Olympics Broadcasting Economics

I love watching Olympic events, though for this Olympics, I certainly appear to be in the minority. Apparently, prime time viewership is down 36% from Salt Lake City, 17% from Nagano, and 44% from Lillehammer. So much for the thrill of victory, and the agony of defeat when broadcast some eight hours following the event. Apparently, counter-programming by other networks has been successful, even including Fox's "Idol," what I view as a pageant of discordance.

If NBC fails to deliver the promised audiences to its sponsors, it owes "make-good" or free ads to these companies. Given NBC's investment of greater than $700 million in production rights, fees and incremental production costs, the network apparently still expects to see some $50 million in profits. To an outsider, this level of profitability, given the relatively poor audience seems unlikely. This level of profits is in line with what the network earned from the Athens and the Sydney Olympics but less than the $75 million it apparently earned from Salt Lake City.

However, put in context with other broadcasting rights, i.e. Howard Stern's contract, perhaps the Olympics is a relative bargain. After all, getting the rights to broadcast what to a North American seems like an obscure sport like cricket, is getting very expensive. Not knocking the sport, I have had the privilege of meeting Dickie Bird, the cricket umpire and fabulous raconteur, though I have yet to be persuaded to actually observe the game.

As this link points out, four years of broadcasting rights to Indian cricket has just been sold for $612 million versus the previous contract for $77 million. How do you possibly recoup the investment? From what I have read, the current TV penetration in India is some 110 million homes with cable reaching about 60 million homes. Far from an insignificant market.

The developing world may be catching up on what we started here...paying almost anything for content. Time to grab a Kingfisher beer and find the Mumbai sports channel!

Carl Icahn and Time Warner-Defeat or Victory?

I believe that Icahn and shareholders in general won a victory in the Time Warner (TWX) battle that has been fought over the last six months.

As you know, the two sides came to agreement last night with Icahn agreeing to back away from a proxy fight for representation on the board. The company agreed to the following:

  1. The company will increase its existing share repurchase program and extend the program’s ending date. Under the expanded program, management will be authorized to repurchase up to an aggregate of $20 billion of the corporation’s common stock during the period from July 29, 2005 through December 31, 2007. At existing price levels, the company intends to continue the current pace of purchases under its share repurchase program within its stated objective of maintaining a net debt-to-OIBDA ratio of around 3-to-1, and expects it will purchase approximately $15 billion of its common stock by the end of 2006, and the remainder in 2007.

  2. The Nominating and Governance Committee will recommend the election or appointment of two new independent directors to the board. The company will seek the advice and recommendations of its major shareholders, including Icahn Partners, in this process. This will be accomplished by no later than July 31, 2006.

  3. Time Warner has begun a comprehensive review of costs at each of its operating divisions and at its corporate parent with the objective of better aligning its costs with the long term needs of the business. This resulted in at least $500 million of cost reductions that are reflected in its current operating plan for 2006. The company will intensify these efforts with the objective of achieving commensurate reductions against planned expenses in 2007, for a total reduction of $1 billion over the period. These initiatives should improve the company’s operating margins and increase both free cash flow and earnings per share.

  4. The company will continue to review the Lazard Report and will continue its dialogue with Icahn Partners regarding the recommendations in the report. Management’s view continues to be that a different capital and corporate structure may be appropriate for Time Warner Cable in the future so long as it provides strategic flexibility with the company’s content businesses.

I think it is noteworthy to see how much has been accomplished by a corporate activist with merely a 3% position in the stock. Icahn et al filed their preliminary proxy in September of 2005. One of the major tenets that they cited was:

We believe that Time Warner’s most attractive acquisition opportunity right now is its own stock. The IRR generated by purchasing TWX stock at what we believe to be a 40% discount to its inherent value is superior to any other investment opportunity the company has today. The typical cash flow yield for acquisitions in the content/media space is in the sub 3% range, while the implied after−tax Free Cash Flow Yield on TWX stock is well in excess of this. Using low cost debt financing to repurchase TWX’s undervalued stock will reduce the share base and leverage Free Cash Flow per Share growth. With the steady growth profile of TWX’s remaining asset base, this action should garner a premium multiple.

In the last 5 years, TWX has generated operating cash flow of $24 billion, or which approximately $13.5 billion was free cash flow. Despite the huge dissipation of shareholder wealth in the purchase of AOL in 2000 (having spent $106.2 billion only to write off $54 billion two years later) since that time, the company has thrown off considerable free cash flow but little of it saw its way back to shareholders.

In fact, prior to the August 29th issuance of a 5 cent dividend, the company had never paid a dividend in this time period. Roughly $1.1 billion had been spent on share buybacks in early 2003 and through 2002. The buybacks hardly meet the test of effectiveness…the share count on a fully diluted basis has gone from 4.4 billion shares to 4.71 billion shares.

On August 3rd, the company announced its intent to buy back $5 billion in stock. By November 2nd, the company relenting to the pressure and influence of dissident shareholders increased its authorized buyback to $12.5 billion. Now, finally we have a $20 billion program with a $15 billion initial cut at it for 2006.

TWX will not only look to reducing its operating costs but will likely look for changes in capital structure to improve its capital efficiency. The company has a pathetic 3% return on invested capital. Buying back stock at a price below intrinsic value can only improve the financial performance.

By way of disclosure, I, my family, and my clients have a position in TWX. On behalf of all minority shareholders, we thank you Mr. Icahn for your influence on the management and board of TWX.

To Dick Parsons and the Board, I am glad that you could come to agreement. But,it is a shame that the obvious actions that were required of you could only be cajoled through outside shareholders. I note with considerable interest, that directors have sold $3.5 million in stock in the last six months, not to mention officers who have sold about $2.7 million. There are some terrific businesses in this conglomerate, HBO, TNT, TBS, Warner Brothers, cable businesses, Warner Brothers, etc, etc, etc. But surely, the return on capital is dismal for a business that contains so many leading franchises. For comparables, I suggest you look to the some of the peer group that you identify in your proxy and their returns on capital:

McGraw Hill 23%
Yahoo 20%
Disney 7%

I think all minority shareholders should carefully watch the progress that this company will make. Though activists are often portrayed in a very negative fashion, seeking publicity and short term gains, I believe that Mr. Icahn's influence has resulted in a return to shareholders of some $20 billion before any additional capital appreciation.

Thursday, February 16, 2006

Foot Locker (FL)

There is something about the shoe business that seems to intrigue value players. The steadiness of the cash flow, perhaps the relatively low fashion risk compared to the apparel business, maybe just the understandability and the tangible nature of the business gives it appeal.

I have always preferred companies such as NIKE (NKE) or Reebok (mistakenly) or K-Swiss (KSWS.) Wolverine Worldwide (WWW) has also been an interesting stock at times and if I was particularly venturesome, Genesco (GCO.)

Shoe retailers have been less interesting to me, but I am developing some interest in this area. The consolidation of the athletic footwear retailers has been quite thorough, and essentially the only players left at this point are Foot Locker (FL) and Finish Line (FINL.)

Foot Locker was downgraded by one of the analysts this morning, and this has prompted my interest. The downgrade was based on four observations/conclusions:
  • Margins have peaked…low-hanging fruit has been plucked…turnaround is over.

  • Competition is increasing from sporting goods retailers as well as vendors’ owned retail networks.

  • The European market has become more competitive for what had been a high margin part of FL’s biz.

  • Foot Locker’s offering is not significantly differentiated from competitor offerings and relies heavily on product from Nike.

I suspect that there is some truth to the competitive landscape margin pressure issue, but as the analyst surmises, there may still be another 100 additional basis points left in operating margins due to some recycling of unfavorable leases and improved utilization. The rapid growth of brand-owned stores has been a trend for some time and is hardly new. Nike has 240 stores compared to Foot Lockers’ 4000. I recognize that Reebok, New Balance, and Adidas also have a presence, but it is clear that FL is quite dominant.

What was ignored or at least not highlighted by the analyst in this report?

  • FCF yield of about 6.5%

  • A $150 million share buyback program which replaces the $50 million authorization.

  • The buyback is effective with some $35 million purchased in 2005.

  • ROIC has been very steady at around 10-11%

  • The dividend was cranked up by 20% in November and still represents a low payout ratio.

The stock is down about 25% from its highs reached a year ago. EV/EBIT is only about 9 times. Long term debt is less than 10% of assets. The company has only recently instituted its share buyback program, certainly a step in the right direction. The consensus growth estimate of 13.4% seems high, but even with an 8 or 9% growth assumption and some erosion of operating margins, I still come up with values in the high $30’s and low $40’s versus the current $22-23.

There may be an opportunity for long term investors in this downgrade.

Monday, February 13, 2006

Master Limited Partnerships

Just found a wonderful blog that highlights MLP's in particular and energy prices in general. One of the errors in judgment that I have made in portfolios last year was a relative underweighting in energy. There is nothing magical about the capital structure of MLP's versus energy stocks in general...clearly, a view of the underlying commodity is what predicates value. Hope you find this useful!

Sunday, February 12, 2006

Seven Sins of Fund Management

This is an excellent discussion of behavioral finance and the follies to be avoided in investment.


Barry, at "The Big Picture" has provided this link to James Montier's compendium of behavioral financial advice.

The first "sin" as he describes it is listening to strategists, economists, and analysts. Ignoring others and utilizing your own common sense is a very valuable attribute in investing.

I have a great deal of empathy for analysts (especially being guilty by association...I am a CFA myself) and recognize the enormous pressure that exists to provide useful comment with every bit of incremental "news." There is tremendous pressure to come up with insightful and timely comment and to be the first on the "Street." Instant analysis tends to undermine thoughtful, quality analysis.

There are tremendous pressures from corporate managements, from investment bankers (at least fewer than pre-Sarbanes-Oxley) and from institutional holders of stocks that one follows. Maintaining an optimistic or bullish viewpoint is pretty general, rocking the boat is frowned upon or at least is difficult to accomplish, and non-consensus viewpoints can make one look pretty aggressive, if not stupid. The Buffetism about no individual lemming ever getting a bad rap is apropos here.

The pressure to conform is huge.

Unfortunately, conformity and consensus does not win as far as stock market performance. Consequently, all the biases that analysts tend to bring if not suffer, also tend to reduce a client's ability to excel.

One other issue in defence of analysts...your horizon may differ from theirs. The outlook over the near-term tends to be what analysts are paid for...not a five year outlook. I have always maintained the view that it is far easier for us to have a better perspective of long-term profitability rather than what the next quarter will look like. Yet analysts gravitate to the short-term forecast, much of Wall Street demands it, and most "investors" think that short-term earnings surprise is what matters.

The study of behavioral finance helps one appreciate the biases that one brings to the investment arena, and better yet, the biases that all market players may bring here. Though this article is quite lengthy, it is quite pertinent.

Go with your own thinking but be aware of your psychological biases and those of the marketplace. You can overcome both!

Saturday, February 11, 2006

Top Down versus Bottom-Up

Geoff Gannon has posted two outstanding comments on the issue of top-down versus bottom up investing that I commend to your attention.

Against the Top Down Approach

Against the Top Down Approach (Again)

In particular, he highlights some really terrific performers of the last ten years, which on a macro overview basis would have been unlikely picks. However, based on individual security selection, using a discounted cash flow approach, some of these could have been part of your portfolio.

Let's imagine we were looking at some of these companies ten years ago. Genlyte (GLYT) is one of the example Geoff highlights. Back in 1995, a reasonable guess at the macro picture for lighting fixtures would have seemed to be GDP growth at best. Looking at GLYT's revenue growth back in 1995 and 1996, this would have been quite correct...revenues grew at 3.0% and 2.5% respectively. Nothing that would make your socks roll up and down!

But let's look beneath the surface at the underlying fundamentals, something that a macro view would miss. Back in 1995, that 3% top line growth leveraged its way into 10.5% operating income growth! Quite impressive, if not exciting! Let's dig a little deeper...operating cash flow growth was about 24%, FCF growth in 1995 was 62%! These trends followed in 1996 with operating cash flow growth of 29% and FCF growth of 45%.

Perhaps we would have been discouraged by the stock's valuation at this time...perhaps it reflected these dynamically improving fundamentals. NOT!!! The price/book of GLYT was a miserly 1.2 times; price to cash flow was 3 times, both measures well below the overall market valuation.

Another company that Geoff mentions is Brown and Brown, the insurance broker. Let's imagine that ten years ago,you had developed some macro notion that you would prefer investing in the insurance brokerage part of the property casualty value chain. The well-known "stars" of the industry at that time were Marsh Mac (MMC) and AJ Gallagher (AJG.) MMC, given its "star" qualities traded in 1995 at over 20 times cash flow and about 4 times book. Returns were respectable for all of these companies. AJG traded at 4.9 times book and about 14.7 times cash flow. Little BRO traded at 4 times book but only 10 times cash flow.

Though MMC had its own set of unfortunate issues and has been left behind this pack, the race between AJG and BRO was easily won by Brown.

As Buffett wisely counsels us, there are many ways to get to heaven...there are superb macro investors, and someone like George Soros, immediately comes to mind. There are some superb group rotators, who seem to have the ability to step in and out of industry groups with great timing.

But certainly, from my own experience, a bottoms-up investor with a cool contrarian hand, will often lead the long term performance charts.

In looking at that list of 17 stocks, I have been fortunate to have participated for at least part of the last decade in SCP Pool (Thank you Rusty!,) Brown and Brown, Florida Rock, Franklin Elec, Graco (the ONLY survivor in machine tools.)

I was not bright enough to see Genlyte though I had toyed with at at several times. "Moved too far too fast," is one of the really stupid conclusions that I have reached in the past, and which I continually try to shove aside now. Chicos always looked like too much fashion risk ( my favorite in this area has been Claires, which unfortunately exhibited only 1/3 of the return of CHS over the last ten years but has beaten the pants off the industry and the S&P, small consolation); Harbor always looked like a fully-priced takeout candidate...I was wrong here too!

On the bright side, owning just a few high return on invested capital stocks at reasonable prices will enliven your portfolio and build your wealth. Avoiding too much stupidity and too much trading will maintain it.

The obvious should not be an impediment to your thinking. Great companies are out there at reasonable prices. Throw out the "too far, too fast" thinking (?) that keeps you out of decent businesses. Throw out the macro thinking...there probably are decent housing, mortgage and title insurance businesses that I should be thinking about even though my gut tells me that the macro "housing" sucks. I may be exhibiting this sort of contrary thinking as I approach radio stocks...hopefully, the valuations reflect what most of us "think" is a no-growth area.

Bottom line...focus on the business itself, not the top-down picture.

Thursday, February 09, 2006

Terrestrial Radio-Down to Earth Valuations

Even someone my age can understand that regular terrestrial radio is losing share to satellite radio, iRadio, MP3, Ipods, Internet radio, etc. etc. etc.

Radio advertising has foundered in the new millennium. For the third consecutive year, radio lost share of the advertising pie as dollars went to Internet and cable. Prior to 2000, for decades, radio advertising grew at a fairly steady 6-7% pace with economic cyclical fluctuations and occasional banner years reflecting political election years. A great industry for years with franchise value defined by the possession of a broadcasting license, an F.C.C. sanctioned permit to steal.

Today’s Oprah announcement for XM only increases the XM, Sirius rivalry and of course the heated and generally misguided speculation about these two names. Is terrestrial radio completely irrelevant?

Radio listenership has declined in the last 5 years, but, AHEM, at about 1% a year. That’s slight erosion, not exactly dropping off a cliff.

Though clearly, advertising dollars are shifting to other media, I believe that some “smart” money is still backing terrestrial radio.

For example, the Disney sale of the ABC Radio network and stations to Citadel (CDL) was done at 16.5 times 2005 EBITDA. Citadel is not some bunch of crazies in my opinion, being 67% owned by Forstmann Leff, some of the brightest private equity people around.

Cumulus Media (CMLS) last fall acquired a substantial interest in a partnership that acquired Susquehanna Media, a privately held collection of radio stations at 15 times EBITDA. Cumulus’s partners in this enterprise include Bain Capital, Blackstone, and Thomas H. Lee (well until Refco, they were considered to be smart guys!)

Terrestrial radio will likely remain a no-growth industry forever until it suffers its final technological obsolescence and ultimate disappearance. However, in the interim, it does generate a tremendous amount of free cash flow. Capital expenditures will be minor, maintenance in their orientation, and perhaps some upgrades to High Definition radio to help maintain audiences. As well, radio networks will continue to provide content both to other stations as well as to new services like Motorola’s iRadio.

Stable free cash flows, relatively low capital requirements, and owners’ frustration with the public equity market’s low valuation for these assets, should lead to more and more acquisition activity, most likely through leveraged buyouts. When public equity markets ignore an industry that has terrific cash flow, LBO and private equity managers will step in as they already have.

Considering that recent deals have been done at 15-16.5 times EBITDA, let’s look at current public valuations of some of these companies:

Clear Channel (CCU) 10.6 times

Entercom (ETM) 10.6 times

Radio One (ROIAK) 12.1 times

Belo (BLC) 8.6 times

Westwood One (WON) 9.1 times

As well, it is interesting to note that the entire satellite radio business is trading at about $14 billion in enterprise value, compared to the entire terrestrial radio station business (top 7 companies) is trading at about $10 billion. The EBITDA of the entire satellite radio business (TTM) is negative $1 billion compared to the EBITDA of the terrestrial radio business of $800 million.

By way of disclosure, I, family members, and clients have a position in Westwood One.

Wednesday, February 08, 2006

This link and its associated link to Bill Miller's letter capture the essence of value investing.

A disdain for conventional wisdom, and a pursuit of understanding the drivers of intrinsic value are the factors in stock selection. Having the capability to sit alone in an empty room, having the ability to allow benign neglect to allow ideas to develop and mature, having the ability to discern signal from noise are all attributes that contribute to the low turnover and the consequent success of Miller and many others.

The investment philosophy is one that many of us share; the deductive ability to discern intrinsic value in such unusual, controversial, and seemingly unlikely sectors and securities define his unique genius.

The honest humility and gratitude for his following also showcase a decent human being.

Fisher Scientific - Great Biz...WHAT ABOUT THE SHAREHOLDERS?

Fisher Scientific (FSH) has been a model of a well-run business. Its free cash flow has equaled or exceeded net income for the last five years.

The just announced quarter exceeded Street expectations on the basis of slight improvement in gross margins to 34.7% , up about 50 basis points, and lower S,G,&A, which improved by over 1%.

As mentioned before, the stat that really impresses me has been the FCF generation of this business.

Here is the net income, free cash flow generation, and FCF margin for the last five years:

2005 $455.7 $484.2 8.7%

2004 $166.4 $299.4 6.4%

2003 $78.4 $137.8 3.9%

2002 $50.6 $115.4 3.6%

2001 $16.4 $118.5 4.1%

No evidence of share buybacks at all, but what a gorilla at income and free cash flow growth. No dividend either!

The fully diluted share base has grown from 53 million shares outstanding at the end of 2001 to a current 128.5 million shares.

Returns on capital have been unimpressive at 5-6% for the last few quarters, representing some improvement versus the 3-4% we experienced in 2004 and 2003, but well below the 8- 9% that we saw in 2001 and 2002.

Huge free cash flow generation, returns on capital which seem well below optimum, and NO return of capital to shareholders. Debt to assets , which in 2001 represented almost 100% has been paid down to only about 25% of total assets.

The company completed 4 acquisitions in 2005, 3 in 2004, one in 2003, two in 2002, and 4 in 2001.

In the company’s conference call, management continues to talk of organic growth of 6-8% and ongoing price improvement. As well, the company considers internal and external opportunities for growth investment, but less chance of a major stock repurchase.

Given the less than stellar returns on capital, the huge free cash flow generation, the resultant improved balance sheet, isn’t it time for the board to consider returning capital to the shareholders?

Capital has been allocated to the benefit of the bondholder, to the seller of the businesses acquired, and to some fairly hefty options compensation.
What about us, the owners of the business???

Tuesday, February 07, 2006

A few thoughts on Adobe

Adobe (ADBE) is clearly a magnificent franchise by almost any definition. Adobe Acrobat certainly plays an important role in office productivity. Creative professionals use Illustrator, Photoshop, InDesign and Dreamweaver. The product cycle seems to demonstrate that the integration of Macromedia with parent Adobe is well underway. Pretty impressive, given the fact that the deal only closed at the beginning of December.

PDF and Flash are ubiquitous platforms on which customers can build very feature rich Internet applications that drive even better customer interaction against a backdrop where broadband also is becoming more ubiquitous.

But a few things bother me:
  • How much of a cross-selling opportunity is there really?

  • Will the growth rates of Illustrator and Photoshop not slow dramatically, below a consensus 15% top-line growth rate?

  • Will the push into “intelligent documents” not require more S,G&A costs than the current business?

Finally, a few thoughts on current valuation: Enterprise Value/EBIT is currently at over 30 times. Operating margins at 37% are near peak levels. Free cash flow yield is only at 2.9% versus FCF margins that run at an amazing 33%.CFFO, always exceeds net income showing high quality earnings and has totaled about $2.3 billion over the last five years. In contrast, capex over that period has been merely $200 million.

How much free cash flow found its way back to shareholders? Only about $270 million in share buybacks net of stock issuance over the last five years and roughly another $60 million or so in dividends. The company has been very wise to continue to reinvest in itself at these fabulous ROIC, running at almost 35% last year, and still above 30% despite the Macromedia integration.

There is some economic sensitivity…revenue growth in the last five years was about 9.2% but clearly below the 15% estimates that I see.

Overall, there seems to be a rather cheery consensus for what I agree has been a real gorilla of a business.

Insiders too seem to be decided sellers in the last six months.

One final note, a tongue in cheek but I think a relevant comment. There were more than twice as many attendees at the recent analyst meeting versus the last similar meeting, at least according to one of my analyst friends/ observers.

This is a great company, but it seems well exploited and fully valued, at least in my view.

Sunday, February 05, 2006

Have commodities become the new tech stocks?

There is a fascinating article in today's NY Times on this topic

Commodities...the new tech stocks?-NY Times subscription required

This article echoes my views that commodities prices were separating from reality and that expectations were getting well ahead of themselves.

Jan 8th Link

What the NY Times article fails to mention is the fact that insider sales have been rampant in the basemetals in particular. Who can blame them...returns on capital have reached levels that seem once in lifetime!

As the interview with Grantham points out, analysts may be viewing stocks as being quite reasonably valued, with seemingly modest P/E's, however, levels of profitability as measured by net profit margins are well above norms.

Ergo, multiples may be conveying the wrong message...consider the sustainability of the competitive long can these levels of profitability reasonably last in this commodity run?

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