Friday, March 31, 2006

CBRL Group-The Dutch Auction Tender

CBRL Group (CBRL) better known as Cracker Barrel announced back on St. Patrick's Day its restructuring plan which consists of a large repurchase of stock, funded by large borrowings of $800 million and finally the divestiture of Logan's restaurants, perhaps by spin-off.

The company announced this morning
that it will be buying back up to 35% of the outstanding stock of the company in a modified Dutch tender auction at a price range of $42-$46.

Some time ago, I had discussed the merits of CBRL and my general lack of enthusiasm for restaurant stocks at current levels. No question, this is an easy entry business.

Value Discipline Restaurant link

CBRL has cleverly chosen to retain its real estate which is a very significant asset. Yet, given the inherent cyclicality in the industry, and the commodity price pressures and wage pressures that seem to be building, the leveraging of this business into a 90% debt to capital ratio seems very brave.

The move will be accretive to earnings, but the risks have expanded dramatically, in my opinion.

Perhaps the ultimate divestiture of Logan's sometime in the fiscal fourth quarter of 2006 (July 06) or fiscal first quarter of 2007 (October 06) will replenish the coffers and pay down some of the debt. But in the interim, shareholders have a far better price than they had prior to Mr. Peltz's "interest" in the stock at its current $42 versus less than $30 prior.

Shareholders do have the opportunity to sell up to 35% of their holdings (assuming everyone tenders) at up to $46. But what's left on the other side of this transaction?

A very highly leveraged, riskier security that in my opinion, is likely to trade for less than the price being paid in the tender.

Logan's is performing well onthe sales front, but CBRL does not break down its profitability separately. Street estimates for the value of Logan's seem to hover between about $7.50 to $9.00 per share.

The use of the Logan's proceeds is also somewhat up in the air-will they be used to buy back additional stock or to pay down the debt.

The downside in the CBRL "residue" stock post tender will be moderated by the perceived real estate value, but the upside will be truncated by the weakened balance sheet. The history of highly leveraged restaurant chains (I think of Shoneys) is pretty scary

Too much uncertainty for me to call...I think I'd rather be on the sidelines than in the midst of this battle.

Who says greenmail is dead???

Disclaimer: I, my family, and clients do not currently have a position in CBRL.

Thursday, March 30, 2006

Columbia Biz School visits Buffett

Please take a moment to read these wonderful notes from Investoblog, a visit to the most famous alumnus, Warren Buffett.

Some really terrific insight here.


Bank of New York - Is IT finally happening?

Bank of New York (BK) may have finally done some restructuring. I eagerly await.

Rumors have been swirling that BK has sold its retail branches to JPMorgan-Chase (JPM.) The valuation that Capital One found appropriate in North Fork Bank just a few weeks ago, may have stirred BK into action.

If BK gets a NFB kind of a valuation on a premium paid for deposits, this would represent about $15 billion. This is a highly optimistic valuation but that was the going price for what I believe to be a less attractive, less established franchise.

There appears to be some discussion that certain branches, probably within Manhattan itself, would be excluded from the deal.

I believe that BK could engage in a fairly significant share buyback with the proceeds of such a sale. BK to date has done a relatively modest effort in share buybacks. In the last five years, only in 2005 was there a buyback of stock in excess of issuance. This amounted to a net buyback of merely $174 million, which compared to a market cap of $28 billion seems like a modest effort.

What will remain? Hopefully, this becomes a much more focused bank involved in security services and global processing. Perhaps, some multiple expansion will ensue as this becomes a wholly fee driven bank resembling Northern Trust (NTRS) or State Street Bank (STT) much higher return and higher multiple stocks.

With the almost 5% rise in the stock, is there much left on the table? In my view, if BK pulls off a NFB kind of a deal, the stock should see $40...combine that with a decent buyback of at least 10% of the stock and I think we could see mid $40's valuations.

I, my family, and my clients have a position in BK and do not currently own a position in COF, NFB, NTRS, or STT.

Tuesday, March 28, 2006

Being an Average Joe, Learning Investing, and a few Maxims

Occasionally, it is useful to sit back and read some of the prior posts that one has published. I can be rightfully accused of using a lot of buzzwords and financial lingo that may not be broadly understood.

My goal is to create a blog that is useful and relevant to a broad spectrum of people, not just the value geeks or those who are financially adept. Sometimes, I throw out terms like operating margin, free cash flow, return on invested capital, etc without providing any support for those unfamiliar with these words.

There are a number of places for you to clarify these terms.

I found a new blog, "The Average Joe Investor" that is providing a basic run through understanding financial statements. "Joe" does a great job in easing investors who want to gain greater understanding of financial statements through this kind of information. So far, he has reviewed both the income statement and the balance sheet in his back to the basics approach.

I would be remiss not to mention my friend Geoff Gannon who continues to have one of the best organized financial blogs out there, Gannon on Investing. Using everything from regular postings to podcasts to surveys to newsletters, Geoff goes out of his way to make investing better understood by investors. He has also provided a very useful glossary, the "Value Investing Encyclopedia" to guide you through some of these terms.

My friend Bill at has a wonderful post this morning about the index effect with numerous links and references to some great information. Bill, who blends some great contrarianism with his fundamental and technical analysis (and some political economics) is highly readable, entertaining, and provides us all some terrific insight and education. In light of Googles admission to the S&P 500 index, I think you will find his post very useful. For veteran readers of this blog, please note that Bill has moved to the Wall Street 2.0 community and you should update your link.

Finally, "Not a Lemming" at"Mr. Market-Musings of a Value Investor" has published some of Bruce Berkowitz' (of Fairholme Funds fame.) I think you will find these maxims very entertaining and useful. The most important, I believe is the last one:

Zeroes don't grow (don't lose)

Above all else, Benjamin Graham had it right. Minimizing the risk of permanent loss of capital is what all of us mentioned here share.

Monday, March 27, 2006

Asset Manager Stocks

Barron's highlighted the ebullient valuations accorded some asset management stocks in an article this weekend entitled, "Slim Pickings."

For the most part, I do agree with the conclusion that there are few bargains to be had in this sector. The profitability of this industry is truly remarkable, but starting to be reflected in generous multiples.

Two names do stand out in my mind Federated and Nuveen.

Federated Investors (FII) has a return on invested capital of 23.3% as well as a very high operating margin of almost 33% in the 2005 year. The company has bought back over $480 million in stock in the last five years as well as paid out about $140 million in dividends. The share count has been significantly reduced in the last five years from 120 million shares to a current 108 million (fully diluted.) The five year growth rate in the dividend has been 32.9%, well above the industry average. The stock trades at about 14 times EV/EBIT based on today's lift in the stock price.

Contrast this with Waddell & Reed Financial (WDR) with a return on invested capital of 13.5% currently, well below historical averages. The last significant buybacks for WDR occurred in 2001 and 2002, but the five year total did amount to just over $300 million. Consequently, the share count in the last five years has shrunk only slightly from 83.4 million shares to 82 million (fully diluted.) The five year growth rate in the dividend is only about 11.2%. Yet, the stock trades at a higher multiple of EBIT at 18.2 times.

John Nuveen or what is now known as Nuveen Investments(JNC) is also favorably mentioned in the article. JNC has bought back some $312 million in stock in the last five years. It share count over the applicable time frame has been significantly shrunk to 86 million shares from 101.6 million in 2001. Its five year growth rate in dividends is about 14%. On an EV/EBIT multiple the company trades at 14.7 times.

The mix of assets under management varies considerably among these companies with FII managing primarily money market (about 75%) and WDR primarily (over 80%) equity oriented. JNC, known historically for its muni bond expertise is now much more balanced between fixed income and equity management.

Bear Stearns upgraded FII earlier today noting its valuation as well as its potential to merge with another money manager.

It should be noted that Federated has resolved with the SEC and the NY Attorney General its mutual fund trading issues regarding market timing, late trading and foreign security valuation.

I and my family do not currently have a position in FII, WDR, or JNC. I do have clients with a position in FII.

Friday, March 24, 2006

Unloved if not hated-H&R Block

Unloved if not hated, disparaged if not ridiculed. Large earnings misses, legal difficulties, getting its own taxes wrong. H&R Block (HRB) has been beset by everything but locusts in the last year.

Is there any value here?

Well let’s go through the litany of issues:

1) Eliot Spitzer- On March 15th, the NY AG sued HRB for alleged fraudulent marketing of a money-market linked account called the Express IRA. The suit claims that HRB clients were guided into an account which was fee heavy and generated little interest, consequently customers were almost certain to lose money. An interesting editorial in today’s WSJ defends and supports the H&R Block position on this disputed product:

Here is the op-ed piece of Mark Ernst, the CEO of H&R Block to which the above post refers:

2) Disappointing Volume of Returns-Interim tax season return volumes (to Feb 28th) are down about 4% at owned and franchised offices. However, digital solutions volume (H&R Block’s own Do It Yourself tax software) is up about 14%

3) Mortgage Volume Down- Mortgage Operations revenues represented about 25% of total revenues in the most recent quarter. This is down from peak levels of just over 30% a year ago. Pre-tax margins on mortgage services had run at 57% two years ago…currently, would you believe 16%!!!

4) Investment Services Still Running Losses- Olde, which is the core around which this business was built, was purchased in 2000 (timing??) The business saw a profit of $9 million on $366 million in revenues back in Fiscal 2001. Pretty much red ink since then and last year down to $240 million in revenues.

5) Business Services- This is payroll services to small businesses. Starting to grow nicely but margins are in the 5% area.

6) Managed to mess up its own taxes on matters relating to the Olde acquisition.

What has gone right?

1) Pricing on tax returns has been up about 6% YOY. This could actually expand as tax season draws to a close since more complex, and consequently more lucrative returns tend to be done later in the tax season.

2) TaxCut software receives very favorable reviews compared to other tax software.

3) Tax simplification ain’t happening, not now, not soon.

4) Dominant position in tax services in the U.S. The company processes about 16% of all personal tax returns filed representing about 19 million clients.

4) H&R Block has received approval for a bank charter. HRB has 12,000 potential locations for full service financial services. This provides HRB another opportunity to offer early refund loans at favorable spreads.

5) The company enjoys incredible profitability based largely on its dominant position in tax services. Every diversification in which it has engaged brings lower returns on capital if not losses. But despite this “de-worsification” the aggregate company continues to have tremendous profitability:

Year.....ROIC.....FCF ($ millions)......Fully Diluted Shares Outstanding(millions)

EV/EBIT is currently 10 times. The company is trading on a forward P/E of only 12.5 times trailing EBIT. Contrast this with Jackson Hewitt(JTX) with an EV/EBIT of 13.3 times trailing EBIT and a forward P/E of 19.3 times. For JTX, its ROIC is also considerably lower at only 10.2% for the TTM.

Though I am not quite ready to step up to the plate on HRB, given today's strength, I do find it quite intriguing. Despite the litany of problems, the company continues to enjoy a dominant position in its primary business. The potential for a national bank charter serving the "under-banked" has been ignored by the market in my opinion. Hopefully, lower prices will present an opportunity.

Disclaimer, I, my family, and clients do not currently maintain a position in either HRB, or JTX.

Have a great weekend!

Hedge Funds and Stock Market Manipulation

I suspect that many of our readers will be interested in viewing a Sixty Minutes segment this Sunday on CBS.

There will be a segment investigating stock market manipulation and hedge funds, in particular, SAC Capital, a highly successful hedge fund run by Steven A Cohen. Accusations of market manipulation have been flying around hedge funds for years and such allegations have been thrown at financial journalists like Herb Greenberg and of course Jim Cramer.

Company bashing per se, so long as it is backed up with bona fide research and facts, can result in very positive changes in corporate governance, corporate behavior and occasionally management changes. However, when it is done to benefit a few, without disclosing one's self-interest, other motivations occur, and such actions reek of manipulation and fraud. Above all, any commentator must disclose his self-interest and conflicts and should be able to differentiate facts from opinion.

Bob O'Brien's Sanity Check Blog has brought this to my attention. I think you will find his post and some of the related comments quite interesting. Should be interesting viewing on Sunday.

Link Bob O'Brien's Sanity Check

Thursday, March 23, 2006

Private Equity Buyouts cont'd

There is an interesting article in addressing the growing phenomenon of private equity buyouts.


In particular, the article discusses the growing number of deals where private equity firms are combining their resources in an effort to share the risks and to increase the size of the game hunted.

The growth in buyouts is quantified:

“The rise of club deals comes at a time when business at private-equity firms has never been better. Last year, buyout shops broke all previous records, spending about $200 billion in 845 deals. The amount spent was nearly 50 percent more than 2004's total, more than twice the amount in 2003, and upwards of eight times the amount spent by buyout shops in 2001, the industry's most recent low point.”

As we posted recently, this is a trend that investors should heed. Buyouts of franchise companies throwing off free cash and having decent balance sheets will be recognized by both activists and the private equity buyers.

Wednesday, March 22, 2006

Ford Recovery?-Not According to Insider Sales

Confidence in Ford’s (F) recovery is greatly undermined by looking at the insider sales at the company. At least that's my view. Though the auto stocks may well be buoyed today and near term by the news of the GM, Delphi, UAW agreement, follow the capital of the insiders.

Though lots of people wish to speculate in the North American automakers, turnaround prospects seem to be too distant to commit any capital at present. Healthy businesses with fairly steady high returns are being sacrificed to maintain highly cyclical, low return, capital intensive businesses.

Lots of decent value buyers have stepped up to the plate. I hope for their sake, and for the sake of my many friends from my hometown of Windsor, Ontario directly South of Detroit, that they are right. I recognize that if I wait for complete clarity and assuredness, I will miss the bottom in these stocks. Yet, given the deteriorating profitability, and the weak financial standing, I just can’t do that to myself, let alone my clients.

Here is the record of insider sales at Ford.

Note that GM insiders, in a very modest way, have actually made some purchases of their stock, well at least exercising options and not selling the stock.

James Pradilla, the chief operating officer and president of Ford has reduced his exposure to the company from 500,615 shares as of March 11, 2004 with the exercise of roughly 330,000 stock options to a remaining 152,742 shares. Mr. Padilla has been chief operating officer and Chairman of Automotive operations since April of 2004.

Admittedly, Mr. Pradilla has received a large position in stock options as of March 10th of this year, almost 900,000 options exercisable at $7.83. In addition, he has received a gift of some 230,000 restricted shares. I stress gift…not a commitment of his own capital.

Nevertheless, options in my view represent simply a side bet on the market rather than a commitment to the company and a commitment of capital. Mr. Pradilla, through his option exercises and subsequent sales, ended up with less commitment to the stock than the level with which he had commenced the year.

How can he expect any of us to do anything other than follow his lead?

Disclosure: I, my family, and clients do not have a position in Ford or GM.

Tuesday, March 21, 2006

Don't Forget about Private Equity!

This morning, Jeff Matthews’ blog has an exceptionally interesting post about private equity buyers and their influence on the stock market.

Score—Financial Buyers, Five; Strategic Buyers, Nothing

He discusses a small, unpretentious, unknown company that had put itself up for sale. A total of 105 buyers wanted the “book.” Only 15 of those were strategic buyers or buyers who were from that industry. The remainder were all financial buyers, i.e. generally private equity buyers who analyze cash flow projections, determine ways of improving cash flows and reducing costs, and determine a comfortable price that provides a decent internal rate of return. Ultimately, an exit strategy is also considered, often recycling the business back to the public via initial public offering, or simply selling to another private equity buyer.

The relevance of this to public markets should not be underestimated.

There is, in my view, an interesting confluence of factors in today’s markets that one must recognize:
  1. In recent years the combination of strong earnings and controlled capital spending has left many companies with significant cash surpluses. This leads to sub-optimal capital structures and hence sup-optimal returns on capital.

  2. Private equity capital is readily accessible and available in seemingly unlimited amounts.

  3. There is a rise in corporate activism that has not been seen to this extent since the junk bond days of the Drexel dominated dealing of the mid-80’s.

Though in aggregate, I find the overall market to be quite expensive, there remain “jewels” of value that could easily be prone to a leveraged buyout.

Michael’s Stores (MIK) is a case in point that Jeff Matthews mentions. Return on invested capital of 17.7%, and long term debt of zero. Annual capex of about $100 million with cash flow from operations $364 million for Jan 2006 FY and $428 for FY 05. EV/EBIT even at today’s price is less than 13 times.

It seems easily financeable based on the numbers. What is the competitive landscape for this company? It looks fairly benign in my opinion:

Jo-Ann Stores (JAS) has a ROIC of about 4% and long term debt of $290 million, representing 41% of capital and negative free cash flow. Capex has exceeded CFFO (which YTD have been negative) and capex is up 50% from last year’s levels.

A.C. Moore (ACMR) has a ROIC of 4.5% and almost $3.00 per share in cash with LT debt to capital of only about 11%. EV/EBIT is about 18 times. Capex has significantly exceeded CFFO in the last few years.

Just last night, I saw a tiny company with a flawed expansion model. The company as it was, in my estimation had a value that was some 30% higher than its current market value. Its value-eroding expansion plans were subtracting!

Remain cognizant of these opportunities. Don’t get mesmerized by the aggregate levels of the market. Debt financing is still pretty cheap whether Mr. Bernanke has rates at 5% or 5.25%.

The private equity guys are actively looking for places to put dough! Get there before they do.

Monday, March 20, 2006

AIG Review Continued

AIG reported not once but twice on Thursday with its current 10-K for the 2005 year and its amended 10-K for 2004 which restated results for the last several years. The best news of all is that at least AIG managed to bring its filings up to date and on time for the current year despite a lot of sturm and drang.

There is some sense of relief as I went through these numbers that the good ship is back on course.

The company’s reserve additions should provide some sense of comfort rather than alarm. Bringing in an outside insurance actuarial consulting firm provides additional credibility to a management that has had an exceptionally tough year. Between hurricanes, regulatory issues with Mr. Spitzer and the NY Dept of Insurance, and the ongoing issue of Mr. Greenberg, the company has essentially remained on course.

This is a very diverse business. General insurance represents about one-third of the business of which roughly one-third is foreign general and one-third is domestic brokerage.

The Life Insurance segment is almost half of the total business of which 50% is the rapidly growing foreign life segment that includes “hot” markets of Asia

The remainder of the business includes International Lease Finance (ILFC) the aircraft leasing operation (less than 5% of total) capital markets, asset management, consumer finance, etc.

The $1.64 billion settlement with the Department of Justice, the SEC, the New York Attorney-General, went through the fourth quarter result and is now behind the company. Remember, the company neither admitted nor denied any of the DOJ charges.

Because of the higher growth aspects of its international markets (totaling about 1/3 of the total) AIG should be able to offset the inherent cyclicality of property and casualty business. The reserve strengthening also took place at a time when the operating results contained a lot of noise and consequently, should provide for much cleaner results as time goes on.

What question marks remain? There remain some lawsuits alleging conspiracy between insurance brokerage firms and insurance companies regarding contingent commissions and bidding practices. There remain some lawsuits regarding accounting treatment of non-traditional insurance product. Finally, there is the matter of Starr. Starr International is a private Panamanian firm that holds 12% of AIG's shares and has represented, at least historically, another means of providing compensation to retired AIG executives. There are suits and counter suits between AIG and Starr alleging unjust enrichment as well as breach of contract and breach of fiduciary duty. Still somewhat ugly for me to read, but more importantly, these matters are not materially dire to the company’s long term health, at least in the judgment of management.

C.V. Starr and Company appears to have sold 5 million shares of AIG earlier this month but retains some 23 million shares.

The auditor’s statement references the internal controls that were lacking in the past which allowed the former CEO and CFO to influence certain reconciliations and thereby achieve “desired accounting results.” Most of these issues have been addressed fully, but some issues remain:

“As of December 31, 2005 and as described under Remediation of Material Weaknesses in Internal Control Over Financial Reporting below, the material weaknesses relating to the control environment and controls over the evaluation of risk transfer were remediated, and the material weaknesses relating to controls over certain balance sheet reconciliations, controls over the accounting for certain derivative transactions and controls over income tax accounting remained, as they were not fully remediated.”

Overall, the company appears to be recovering from this “year from hell” and appears to much chastened in its attitude toward disclosure. A few clouds remain, but these should dissipate soon, in my opinion.

Though the valuation is not exactly rock bottom cheap at 260% of tangible book value, for its current 13% ROE, my sense is that the company should return to a more normal 17-18% return on tangible equity within the next year or two.

Buried somewhere in the noise of last year as well is a notion that the company is reviewing its capital allocation methodologies which could well result in some restructuring of the core businesses that may cause us all to re-examine the shareholder value improvement that is feasible here. This review probably awaits further clarification of the remaining legal issues as well as restoration of complete confidence in internal controls.

I, my family, and clients own a position in this security.

Friday, March 17, 2006

AIG-Some Preliminary Thoughts

American International Group (AIG) has done an outstanding job in improving disclosure, one of very few insurance businesses that permits you to look at their statutory accounting as well as GAAP accounting on their website. A new and refreshing development.

Speaking of development, it appears that one of the reasons that the earnings appeared light relative to expectations was attributable to recommendations of their independent actuary that they recognize some adverse development in the asbestos liabilities.

Overall reserve strengthening for both core and asbestos liabilities amounted to $4 billion for prior period adjustments plus $1.8 billion due to the actuarial study.

I believe this reflects two things...what apparently was a historic liberal attitude to maximizing and smoothing earnings under the previous management leadership and two, a mea culpa, bold strengthening of reserves in what has been a tumultuous year.

To come out after all of that with an ROE of 11% reflects an incredibly strong franchise.

I hope to grow through these numbers this weekend to hopefully have a little more insight. I really appreciate management's efforts in bringing greater clarity and transparency to what historically has been a fairly opaque and minimalist disclosure.

Have a great weekend everyone!

Wednesday, March 15, 2006

Yankee Candle

Yankee Candle (YCC) is a manufacturer, designer, wholesaler, and retailer of premium scented candles with the largest market share (over 40%) in the premium, quality end of the market. The company has also announced plans to enter the “premium mass” market which could add significantly to its wholesale volume.

The company continues to tinker with its retail store initiative, having some 400 stores currently, and has plans to add another 200-300 stores, as it gets its formula right. Retail same store sales have been flat to negative for some time and to some extent has been hurt by the wholesale division’s expansion into supplying stores like Bed Bath and Beyond which has hurt not only YCC retail stores but also small wholesale customers of YCC such as gift shops. The company has recently teamed with Hallmark stores in a line called Celebrate Home.

The premium mass market initiative includes shelf space in Kohl’s, Costco, Target, as well as odor-eliminating candles at PetSmart!

Analysts seem to fret over earnings growth which has slowed down from the heady pace of a few years ago:

Earnings growth
2002 48.1%
2003 19.7%
2004 20.0%
2005 2.9%

The company generates a steady and growing free cash flow stream:

2001 $20.2 million
2002 $60.2 million
2003 $65.9 million
2004 $91.4 million
2005 $92.4 million

Because of the strong free cash flow, the company has returned capital to shareholders with a $100 million share buyback in 2003, followed by two subsequent $100 million annual buybacks. Its fourth buyback program, initiated in 2005 now of $150 million, I understand is more than half completed at this time.

Operating margins are quite impressive at around 22% and return on capital has been very strong at about 27% for last year, though this is down from the last couple of years where ROIC was 32.5% and 39% respectively.

At a current market cap of $1.23 billion, and an enterprise value of $1.4 billion, this business is selling at only 10.3 times EBIT. From a free cash flow standpoint, the business is selling at a FCF yield of 7.5%.

Why is Wall Street waffling here? What’s wrong with the story?

  1. There is some margin pressure because of energy costs and the cost of wax moving higher. The company has addressed this to some degree with a 4% price hike in the fourth quarter.

  2. Insider sales.

  3. Seasonality…this is a company that generates significant sales and earnings in the fourth quarter.

  4. Conflicting distribution channels…can the retail operation be managed to improve same store sales. Can gorwth in new store openings be resumed?
One should be aware that there is a 13D filer in YCC, Blue Harbour Group, of Greenwich, CT with a 5.3% stake. This was filed on January 18th of this year.

The valuation and the free cash flow characteristics are very attractive in my view. Given the share buybacks, the share base has been trimmed from about 54.5 million shares a few years ago to the current fully diluted base of 43 million shares. I view these share buybacks as being very effective.

I find the stock quite interesting and will be buying it after our 24 hour rule. Clients already have a position here.

Tuesday, March 14, 2006

Monetizing Life's Work at North Fork Bank

A few interesting comments on the tough banking environment in today's Wall Street Hournal from John Kanas, the CEO of North Fork Bank.

Link- WSJ Subscription Required

Of even greater interest is a comment by Mr. Kanas on the $185 million payout that he is receiving as a result of the takeover of NFB by Capital One (COF.) In answer to the question of "What's in your wallet?" Mr. Kanas response was," I know how the story looks, and its an egregious amount of money."

However, he went on to defend the payouts, monetizing his life's work at a company. "It's not like I flew in here on a private jet three years ago and prettied up the company and then booted it out of here."

There is very little question that Mr. Kanas has down a superb job of transforming what was a fairly miniscule operation that literally existed only on the North Fork of Long Island into a fairly major regional bank. An operation with clean credit, high operating efficiency and superb profitability.

But Mr. Kanas is getting his entire payout tax-free as well as monetizing $48 million in stock. Looking at last year's proxy, Mr. Kanas has received a total of $30.3 million in salary, bonus, other comp and restricted stock over the last three years.

I applaud Mr. Kanas on his success and the outstanding job he has done in managing and growing this enterprise. But its not exactly like he has monetized "sweat equity." He has been paid handsomely in these last few years in my view.

Shai Dardashti on Grahamian Value- Farewell!

Most value oriented blogs have a link to Shai Dardashti's Grahamian Value blog as it has proven to be a highly useful compendium of value thinking for many of us. Shai, truly a champion of value thinking has decided to shut down his blog and as he says, to go underground. Shai, through his generosity of spirit, has been kind enough to introduce Value Discipline to others through his blog and I will always be grateful for this.

He plans to be dedicating his time to the development of Dardashti Capital, an investment management partnership that he will be operating following his upcoming graduation. Entrepreneurial spirit requires full time diligence and time to succeed and consequently, Shai has decided to focus completely on the building of Dardashti Capital.

Maintaining a blog and providing thoughtful content takes a great deal of time as my partners will attest! Shai has selflessly educated, entertained, and stimulated thinking in many of us with his youthful exuberance and precocious insight.

His blog will be missed but I am sure his vision of an investment partnership will be a successful next step in a long career.

Please take a moment to thank him for his efforts and to wish him luck.


Monday, March 13, 2006

North Fork Bank and Capital One

Why now? I can certainly understand why North Fork Bank (NFB) would want to sell. Financial services companies tend to have a tough time in a rising interest rate environment but banks in particular face a few other challenges.

My sense is that there is ever increasing competition for both loans and deposits. The rising rate environment tends to be associated with higher loan provisioning as banks seek to maintain their credit quality.

Finally, banks seem to be interested in improving their customer relationships by improved servicing and improved convenience.

All of these factors contribute to a less than robust earnings picture.

North Fork Bank is the most important factor in Long Island banking for Suffolk County where it has close to 30% of deposit share and also in Nassau County where it has 15% share. In New York City, NFB has only about a 2% share of deposits.

The NYC metropolitan area is a very attractive area for banking with very high median incomes. NFB has been a terrific operator with superb expense control. Its return on tangible equity was about 31% and return on assets 0f 1.81%.

Capital One (COF) obviously wanted this footprint badly. The premium to deposits paid was 34% versus a more “normal” premium of 25-28% for premium MSA’s in New York and Florida, often viewed as the "hot" areas of banking where takeover prices are highest. The price to tangible book value was 4.9 times; again well above a median level of around 2.5 times.

COF transforms its earnings base to being much less credit card and sub-prime lending oriented. NFB has enjoyed strong credit quality over time with loan losses miniscule. The reserving policy to me seems quite liberal based on the good experience of the past with reserves to loans of only 1.28% for commercial loans. Contrast this with a battleship mentality at Wells Fargo where the reserves to loans ratio is 2.28% in the most recent quarter.

Over the long run, the acquisition of NFB and the previous acquisition of Hibernia should prove beneficial to COF. Acquisition of a retail deposit base will lower funding costs and increase liquidity. Access to a broadened customer base will help in generating other high margin fee income.

But, as I said earlier, this is a fairly tough environment for most financials. The group represents 21% of the S&P with almost 60% of it banks, thrifts, mortgage, and consumer finance related. The outlook for these companies is neutral at best. Insurance and asset management is the balance of the financial sector. I believe that the outlook for these companies is much more positive.

What remains in New York that could yet be acquired? In my view, this deal should reflect positively in the valuations of Bank of New York (BK) and Sterling (STL.)

But a rising interest rate environment will not be kind to anything in this sector.

I, my family and clients have a long position in Bank of New York.

Vishay Clarifies its Intent-

Vishay Intertechnology this morning released the following:

Vishay Clarifies

The basic message of their release is that the company is only seeking authorization to create the Class C shares but that it is not their intent at this time (my emphasis) to issue those shares. Furthermore, the company mentions its history of using cash and debt rather than stock for acquisitions when it considered the stock to be undervalued.

My comments:

1) In my view, one of the best signals of undervaluation to minority shareholders is to repurchase stock. This hasn't happened since 2000 when the company bought back merely $5.7 million of the stock. At the end of FY 2000, there were roughly 137 million shares outstanding, revenues were $2.47 billion and EBIT was $715 million. At the end of FY 2006, there are 189 million fully diluted shares outstanding up about 40%. Revenues are essentially flat at $2.3 billion and EBIT is $111 million.

2) Corporate governance is undermined by the mini-vote accorded the new class C stock in my opinion. Whether the new class C stock is issued now or later, management has indicated that it chooses to be entrenched by providing shareholders even less say. Class B shares, controlled by Dr. Zandman have ten times the vote of the common. Class C shares will have one tenth the vote of the Class A and consequently one one-hundredth the vote of a "Zandman" common. In my view, boards of directors are more accountable to shareholders when they have to respond to a meaningful vote of minority shareholders. A broad system of accountability is created by providing meaningful voting rights.

3) Returns on capital remain sub-standard. Returns on capital of 2-3% are well below any reasonable guess at cost of capital. This is true for many of VSH's competitors as well, however, many are earning higher ROIC. For example on a TTM basis, AVX has a 4.1% ROIC, CTS has 4.8%, and International Rectifier 5.4%. AVX and CTS have bought back stock as well as returned capital to shareholders through dividends.In the most recent quarter, the return on capital for AVX is 6.65% and that of CTS is 8.11% whereas VSH's is less than 3%.

Sunday, March 12, 2006

Welcome RealMoney subscribers!

Thanks to all of you and particularly James Altucher for your interest in Value Discipline. James has been kind enough to have referenced my blog on a couple of prior occasions in his Blog Watch column in

As you can hopefully tell, I have a strong interest in shareholder democracy and value creation. I am happy to highlight managements that "get it" as well as those that seem to be plodding along without treating minority shareholders as true partners. I am happy to highlight analysts who in my opinion are providing useful logical advancement to understanding a business. As well, when analysts are merely cheerleaders, I love to highlight that as well. Interesting 13-D filings can be mentioned, ongoing proxy battles can also be highlighted here. The purpose in all of this is to entertain, to provide some education and encourage understanding, and to help us all engage in some collective logical thought. Bottomline, if you find the kernel of an investment idea, do your own thinking and examine your own risk profile. I provide no investment advice through this is impossible to do so because I cannot know an idea's appropriateness for you without knowing you. When the disclaimer says that there is no investment recommendation here, that is what is meant. I provide honest, and hopefully straight-forward opinion, not recommendations or advice. I do appreciate your feedback and commentary as to whether you agree or disagree with what I have published here.

I am not entirely sure that I agree with James' contention that there is not much difference between a corporate raider of the 80's and an activist shareholder, though many current activists certainly do fit this kind of role.

There are certainly some activists who use the force of their name to influence change. Essentially, with a short term hedge fund mentality, they buy a few percent ownership in a company to "pick a fight." Nelson Peltz may well be an example of this kind of activist. Though Peltz may well have been the primary influence in CBRL Group's (CBRL) decision to "review potential capital structure initiatives," there has not been a 13-D or even 13-G filing which indicates his ownership of a stake in the company. Conversely, there was a 13-D filing in the case of Wendy's. As of Friday, no Heinz 13-D or 13-G associated with Peltz has yet appeared, though the intent to file a proxy opposing management has been communicated. It is rumored that Mr. Peltz's position in HNZ is largely stock options that he could (or could not) exercise. In my opinion, it is difficult for one to argue about long term interests of all shareholders when one's interest consists of merely a short-term side bet on the direction of the stock.

I am not a shill for Heinz management either. Please note that I have come down hard on executive compensation, poor returns, and under-management of this company.

On the other hand, there are activists who have an investment horizon that extends beyond settlement date! A great example of this kind of thinking is VA Partners of San Francisco, an affiliate of ValueAct Capital, a firm that has taken meaningful positions in companies over long periods of time and appears to have had profound influence in changing management's capital allocation behavior and free cash flow generation.

In my opinion, corporate activists need not "throw the bums out." Influencing management behavior can come from participation on the board and legal actions. but moral and social suasion can also have an effect. The ability to communicate management capital mis-allocations, or misdeeds to the board and to other minority shareholders is another important attribute of these kinds of activists. The first step is recognizing that a company does have a problem or an unexploited opportunity. Spotlighting it for management and fellow shareholders exposes it to the light of day. Members of the affected management will respect and listen to these kinds of shareholders. Activists who provide this type of guidance are not in for a short term "pop" or "punt." They truly are interested in building long-term value. Clearly, this is not charity on their part. They participate in the long term gains that are achieved through enhanced shareholder value creation.

Best of all, the rest of us can ride the coattails of such long term activists' success. The primary focus of an activist in my opinion tends to focus on return on invested capital and its potential improvement. There are only two avenues to navigate to improve ROIC, (1) to reduce costs and improve the profitability , and (2) to reduce the amount of invested capital employed.

We hope to highlight in the coming weeks a few examples of successful corporate activists, their targets, and the subsequent results. As well, we will look at a few companies that, at least in my view, could use some prodding to improve their ROIC and their shareholder value creation strategies. Ultimately, shareholder value comes from only one place...the ability of a business to generate ROIC in excess of its cost of that capital.

Please let me know of any opportunities that you see that you think I should examine.

Friday, March 10, 2006

Vishay Intertechnology

“Share and share alike” is NOT the byline of Vishay Intertechnology VSH). Though analysts seem to believe that the macro environment is decent for the business, it is clear to me that management does not want you as their “partner.”

As earnings grow, because of the dilutive effect of two large convertible issues, the dilution of earnings per share grows faster. This is a company that has been a net issuer of stock since 2000, and has yet to pay a dividend. So much for sharing the wealth.

The company has just announced that it is introducing a Class C common, which as the proxy indicates will further entrench voting control in the hands of essentially one man, the co-founder Dr. Felix Zandman.

As the proxy states: “The creation of Class C common stock would permit us to raise additional capital or engage in a range of investment and strategic opportunities without materially diminishing the voting power of our existing stockholders. In particular, the effective voting control of our Class B common stock, substantially all of which is beneficially owned by our co−founder and Chairman Dr. Felix Zandman, would be preserved. Dr. Zandman has voting power over substantially all of the Class B common stock either through direct ownership, through a family trust or through a voting trust agreement.”

As the proxy also clearly indicates, you as a minority shareholder will suffer some disadvantages: “For example, the proposed amendment might make us a less attractive target for a takeover bid than it would otherwise have been, or it might at such time render more difficult or discourage a merger proposal, an unfriendly tender offer, a proxy consent or the removal of incumbent directors or management, even if such actions were favored by our Class A stockholders. The proposal may also deprive our Class A stockholders of an opportunity to sell their shares at a premium over prevailing market prices, since takeover bids frequently involve purchases of stock directly from stockholders at such a premium price. Also, issuance in the future of shares of Class C common stock rather than additional shares of Class A common stock will perpetuate the effective voting control of our Company by the holders of the Class B common stock, making it difficult for our public shareholders to elect directors or take other action that is not supported by Dr. Zandman and other members of management.”

Though this year’s preliminary proxy does not yet indicate executive compensation, I looked back to the year 2000 at prior proxy statements. Dr. Zandman has received salary and bonuses totaling $22,750,000 plus. Shareholders have lost 33.77% on their investment over this period of time. I have not included any stock option or restricted stock awards in totalling compensation.

Judging from management’s actions in insider selling, they do not appear to be terribly interested in holding the stock with total sales of $2.4 million and total purchases of squat.

Returns on invested capital have improved to a resounding 3.10% for 2005, which follows similar lackluster returns of 2.7%, 1.3%. 1.4%, 2.6%, and for the year 2000, 26%.

Though the cyclical environment may look terrific, in my opinion, this company does not appear to want the rest of us as partners. Judging from the returns, I am certainly not in a hurry to be part of this.

I, my family, and clients do not have a position in Vishay Intertechnology.

Thursday, March 09, 2006

Triarc-Physician Heal Thyself

Nelson Peltz is gaining a tremendous reputation for his corporate activism.

There is a very long and very successful history here. Having been part of the financial revolution of the 1980’s, which under Michael Milken’s concepts, allowed financiers to acquire large companies through junk bond financing, Mr. Peltz gained control of Triangle Industries, National Can, and American Can. Within only a few years, Mr. Peltz sold the can manufacturing businesses to Pechiney for an $834 million profit in 1988.

He is known for the purchase of Snapple from Quaker Oats for $300 million, effecting a turnaround in the operations, and selling it three years later for $1.5 billion.

Most recently, he has rattled the management of Wendy’s and gained three seats on the board as well as expedited the restructuring of the business. Similarly at Cracker Barrel, Mr. Peltz has effected a potential restructuring of the business. Clearly, he now has Heinz in his sights.

Peltz has become the poster boy for restructuring, or so it seems.

In my view, the paramount issue that drives corporate activism is return on invested capital. Make no mistake about it…the only way that shareholder value increases in the long run is for the return on capital to exceed the cost of capital.

Let’s turn our attention to Triarc Companies(TRY,) a public holding company controlled by Misters Peltz and May. In an announcement last May, the company indicated that it was contemplating a restructuring. In June, further clarification:
“Triarc said today that it is continuing to explore a corporate restructuring that would separate Triarc's non-restaurant operations (primarily its ownership interest in its alternative asset management business, Deerfield & Company LLC) from Triarc, through a spin-off of such operations to Triarc's shareholders. Options for Triarc's other remaining assets are also under review and could include the allocation of Triarc's cash, cash equivalents, short term and other investments, including funds, between its two operations and/or a special dividend or distribution to shareholders.
If the corporate restructuring is completed through a spin-off of Deerfield, it is expected that Triarc would be renamed Arby's. As a result, Triarc shareholders would then hold shares in two "pure play" public companies: Arby's (formerly known as Triarc) which, after the completion of its previously announced acquisition of RTM Restaurant Group, its largest franchisee, would be a fully integrated stand-alone restaurant company, and Deerfield, an asset management business that has approximately $9.0 billion in assets under management.
In addition, Triarc announced today that its senior officers are continuing to actively explore the creation of one or more equity investment funds, which would be managed and owned by such officers, and which would be separate and distinct from Triarc and the spun-off businesses. A portion of the economics generated by the fund(s) may be paid to Triarc (which would be renamed Arby's) and/or Deerfield.”
Note the language! Note that the equity investment funds which have been used for the recent activism have been “separate and distinct” from Triarc and that a portion of the economics may be paid to Triarc and/or Deerfield.
November 1st marked the release of the 10-Q with the following “subsequent event” noted:
On November 1, 2005, the Executives and the Company's Vice Chairman (collectively, the "Principals") started a series of equity investment funds (the "Funds") that are separate and distinct from the Company and that are being managed by the Principals and other senior officers of the Company (the "Employees") through a management company (the "Management Company") formed by the Principals.
The Company has committed to invest $75,000,000 in an account to be managed by the Management Company that will co−invest in parallel with the Funds. The Principals and certain Employees have invested in the Funds and certain Employees may invest in the Funds or in an account to be managed by the Management Company. The Management Company has agreed not to charge the Company, the Principals or the Employees any management fees with respect to their investments. Further, the Principals and the Employees will not pay any incentive fees while Triarc will pay no incentive fees for the first two years and, thereafter, will pay lower incentive fees than those generally charged to other investors in the Funds.”

The good news is that at least Triarc shareholders can participate to a limited degree in what appears to be the primary interest of management. A $75 million participation out of a cash, cash equivalents, and short term investments total of over $1 billion seems disproportionately small.

We have agonized over the poor trends in return on invested capital that Heinz shareholders have faced. The returns on capital for Triarc, in my opinion, have been pathetic:

2000 2.8%
2001 1.4%
2002 -0.9%
2003 -2.0%
2004 0.2%
TTM -3.3%

Deerfield Capital appears to have grown at a rapid pace since its acquisition. My sense is that Arby’s itself is a well-recognized franchise whose value exceeds that of Triarc.

The complicated structure of Triarc, the deferred compensation and trusts of the principals, create unnecessary confusion for shareholders in my view.

To its credit, the company has started to pay a 15 cent special dividend in addition to its regular 8 cent dividend and contemplates paying another 30 cents in special dividends this year.

But when I look at the rapidity of change demanded of others, when I consider the long-promised restructuring, and when I contemplate the lack of progress in returns on capital, this seems to be a case of physician, heal thyself. What is taking so long?

I, my family and clients do not have a position in Triarc.

Monday, March 06, 2006

Getting an Education in Education Stocks

Education Management (EDMC) announced that it was going private, courtesy of two private equity firms, Providence Equity Partners and Goldman Sachs. The price, of $43 represents a valuation of almost 13 times EBITDA.

There is an excellent discussion of this news item in The Stalwart, which I recommend to you!

The Stalwart

What does this transaction mean for this sector? This sector has been beaten up as a result of ongoing regulatory investigations and what had been unrealistic growth expectations by the street. Various federal regulatory agencies and accrediting bodies have questioned the financing of student loans as well as the academic standards for these programs. Since 2004, there have been investigations by the Department of Education, the SEC, or various attorneys-general of ESI, CECO, COCO, and DV.

The successful closing of this transaction would endorse the viability of the for-profit education model. The valuation is about the same as DeVry (DV) paid for Ross University 12.4 times.

Each of these companies is unique in terms of its quality, its growth, and its management. Short term hiccups in growth seem to divert the attention of some analysts, unknown regulatory outcomes can surprise investors and reactions tend to be fierce and universal across the group.

But I am encouraged by the involvement of private equity firms here. It confirms that there is a place in the future for this sector. It confirms that the business model is reasonably predictable and there is opportunity for growth. Finally, the deal provides a template for other companies to consider as they mull their future strategy.

The risks in this sector cannot be overlooked, but I am encouraged by this development.

Here is a list of a few companies and their current valuation based on trailing twelve months EV/EBITDA as well as their price on a 12.4 multiple of EBITDA (2006 consensus forecast.)

Career Education (CECO) 6.48X $49.00

Corinthian (COCO) 10.51X $16.30

ITT (ESI) 13.1X $65.49

Disclaimer: Several clients are currently long CECO.

Stride Rite

One of my readers suggested that I have a look at Stride Rite Corp. (SRR)

Stride Rite Corporation markets the leading brand of high quality children's shoes in the United States. Other well-known brand names, including Keds, Sperry Top-Sider, Tommy Hilfiger, Saucony, Grasshoppers, Munchkin, Spot-bilt and Hind. Apparel products are marketed by the Company under the Saucony and Hind brand names. Saucony, a leading “technical footwear” brand, was acquired in the fourth quarter of last year.

It appears that the company is still suffering some weakness in a few of its core brands such as Keds, where sales in the fourth quarter were down over 20%. Keds appears to be getting repositioned and transformed as a higher-end brand, but the company is quite early in the process. Similarly, the company’s wholesale “Children’s Group” appears to be in need of turnaround with sales in the fourth quarter down 17%.

The good news: The company is sprucing itself up with acquisitions and with determined cost control. The Saucony acquisition remains fresh, and it appears that much of the inventory build-up (inventories were up 32% with Saucony and up only 3% without)and slowing asset turnover that the company exhibited in the most recent quarter is a function of Saucony inventory, especially more fashion oriented footwear. To be fair, we will not see a fresh Saucony line until later this year.

Sperry Top-Sider is doing well against very tough comparisons and the company appears to be doing very well in its 271 retail stores. In fact, the company anticipates adding some 30 stores this year, an 11% expansion.

Children’s footwear sales at its retail stores appear to be quite strong. Saucony’s running shoes are doing well (and are my personal favorite!) Sperry Top-Sider remains strong.

Financials….most recently, they appear disappointing with losses on the operating line and consequent losses in EBIT. I suspect a function of integration costs and repositioning of Keds. Return on invested capital on a normalized basis is about 7.5% down from a more normal range of 8.40-10.40% of the last five years.

Cash flow from operations has always exceeded net income, so the quality of earnings has been high. Depreciation has generally exceeded capex in the last five years as well. Consequently, lots of free cash flow historically until this year.

The company generated $141 million in free cash flow between 2000 to year end 2004. The company has also bought back stock effectively with fully diluted shares currently at 37.2 million versus a share base of 43 million in 2000.

The company appears to be involved with a large potentially activist shareholder who is getting representation (one seat) on its board.

Using somewhat conservative estimates for operating margins and growth, and reflecting some increased spending for the store expansion, I would value this business near $15, essentially, the company is fairly valued. However, should the company be able to restore its working capital turnover to more normal levels from its current peak, the company could easily be valued in the low $20’s.

Some debt was added to finance the Saucony acquisition, but interest coverage remains comfortable, in my opinion.

In my view, the business has some near-term challenges to overcome: the integration of Saucony, the repositioning of Keds, and the turnaround of kids wholesale. The company does have some wonderful and leading brands. The brands own valuable shelf-space in department stores, specialty stores such as West Marine, and shoe retailers. The company faces the pressure of an influential outside shareholder who has demanded (and gotten) one seat. Returns on capital have been somewhat uninspiring and could use improvement. Fully priced, as is in my opinion, but some relatively easy fixes could enhance shareholder value to the low $20's.

Neither I, my family, nor my clients have a current position in Stride Rite.

Sunday, March 05, 2006

Is It Any Wonder that HNZ Shareholders Seem Discontent?

Recently, I did a brief post on Heinz, mentioning the rumors that were circulating at that time about Nelson Peltz and his potential involvement.

Value Discipline post

Well, the rumors were confirmed on Friday as the CEO of Heinz began a campaign to retain his board and oppose Mr. Peltz’ slate.

Heinz fights back by claiming fundamentals are strong

While Mr. Peltz has enjoyed great success recently with his involvement in Wendys, getting three seats, as well as acceleration of Wendy’s spin-off of Tim Horton’s and the potential spin-off of Baja Fresh. . Apparently, he has also been very influential in the soul-searching and shareholder value investigation that is currently taking place at Cracker Barrel.

As I mentioned in my earlier post, this will not be an easy battle in my opinion. As I had mentioned in my prior post:

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

Bill Johnson, the CEO of Heinz speaks of the return of capital to shareholders that has been achieved. The share buybacks and increased dividends certainly demonstrate improved attention to shareholders. Share buybacks on a TTM basis have been (net of share issuance) $1.4 billion. This compares to the prior corresponding period’s $365 million. Similarly, the dividend has grown to 30 cents per share quarterly from its prior 28.5 cents quarterly.

Shareholders may be more willing to pay attention to Mr. Johnson’s arguments had he retained a significant equity position in his company. It is difficult to listen to someone who tells you how much better it is for you as a shareholder when last month, Mr. Johnson sold 262,488 shares of stock for proceeds of $9.25 million. In fact, in the last twelve months, only one purchase of HNZ stock in the open market by an insider, the CFO, for a grand total of 1,000 shares. If you really think I should be a Heinz shareholder who entrusts this management with shareholder value creation, shouldn’t you believe your own story or as Buffett says, eat your own cooking?

Return on invested capital at HNZ has meandered over the last several years. When Bill Johnson took the responsibility for capital allocation as CEO in 1998, the ROIC was 16.1%. By astute management, creation of shareholder value (ahem), and restructuring, the ROIC took the following trajectory:
1998 16.1%

1999 11.1%

2000 7.7%

2001 11.3%

2002 13.1%

2003 9.3%

2004 12.1%

2005 12.0%

Q1 06 11.3%
Q2 10.4%
Q3 8.9%

Is it any wonder that HNZ shareholders seem so discontent?

I have totaled Mr. Johnson’s salary, bonuses, and “other comp” since 1988. This does NOT include restricted stock awards and other stock related compensation. The total of salary plus bonus compensation per my calculation is $19.95 million.

Is it any wonder that HNZ shareholders seem so discontent?

The price of HNZ stock as of Friday’s close was $38.23. The price of HNZ stock (adjusted for dividends reinvested) as of April 30th, 1998 was $38.97.(Calculations per Yahoo Finance) Essentially, no return for eight years!!!

Is it any wonder that HNZ shareholders seem so discontent?

The company, as a result of its recent divestiture program, will have some $2.5 billion in cash to deploy. The current enterprise value for the firm is $17.5 billion.

Who will shareholders want to deploy this capital?

Neither I, nor my family, nor clients have a position in Heinz. This will be an interesting battle to watch!

Saturday, March 04, 2006

The Letter to Berkshire Hathaway Shareholders

All of us who aspire, pretend, claim, or actually are value managers await Warren’s letter to Berkshire Hathaway shareholders every year. This year, in my view, is one of the best.

For the first time, he presents not only the usual table of growth in book value (after-tax) versus the growth in the S&P 500 (pre-tax) where BRK’s results is average 21.5% versus the index of 10.3% since 1965, but also presents the results for the business as separated into the marketable securities (including cash) and the non insurance business’ earnings growth.

The marketable securities business has compounded since inception at a 28% rate, inclusive of the drag of cash! However, for the decade 1995-2005, the results seem more mortal at a compound rate of 13%. This contrasts with an S&P return of 9.46% over the decade. STILL OUTSTANDING despite all the naysayers who have been clearly mistaken in their belief that WEB had lost it.

Better yet, his disclosure clearly demonstrates the decided shift toward acquisition of businesses and the outstanding results that have been achieved.

The non-insurance business earnings stream on a pre-tax basis has compounded by 17.2% since 1965. However, it has grown by a sterling 30.2% in the last decade! Compare that with the S&P 500 operating earnings which have grown by a comparable 8.6% over that period.

As Buffett points out, there are now 68 distinct businesses with widely disparate operating and financial characteristics that are part of the holding company. Yet, the power of these earnings streams has not been realized by many critics, let alone, some of his investors.

“Intrinsic value estimates are by nature imprecise, and often seriously wrong” and “The more uncertain the future of the business, the higher the probability that this calculation will be off base.” These words ring so very true as we who actually attempt to value businesses, so often discover. Yet, there is great predictability and certainty about the future of Berkshire, given the tremendous franchises that this business represents.

I will have comments on the four divisions that WEB views as the logical breakdown of this company a little later.. But first, some general comments.

There is another warning about derivatives and the dangers that lurk there. Gen Re is now down to 741 contracts versus the 23,218 contracts that it had in place since acquisition. So far, the unwinding of these positions has cost BRK a total of $404 million, $104 last year alone. He warns of the maze of liabilities that continues to mushroom for the financial world. Gen Re should have been able to exit this sinkhole rather easily as a relatively small player. What danger exists in what I believe is the completely murky accounting of the large global derivatives players?

A few comments on competitive position and its importance.

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.”

But here comes the admonition: to focus on moat-widening!

“When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.”

He reminds us that this has been the problem in the automotive and airline industries. Short term expedience has taken precedence over long-term needs.

A comment on equity valuation related to the portfolio:

Expect no miracles from our equity portfolio. Though we own major interests in a number of
strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth. (Their managers, of course, think my expectations are too modest – and I hope they’re right.)”

Buffett also describes where the Dow Jones Index would need to be to match the performance of the last century. Too depressing to even think about!

Buffett finds justification in the compensation afforded value-creating CEO’s such as Jim Kilts at Gillette who turned around a capital mis-allocating enterprise smartly. However, too often, compensation committees reward executives ridiculously out of line from performance. He tells the following fable:

“Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period. Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options. A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.”

He also warns of the high frictional cost of equity management and the huge slippage that goes through the hands of hedge fund managers and private equity managers, who he has described in his example as ‘The Helpers.”

“A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the owners lose and pay dearly for the privilege of doing so.”

Finally, as to succession, Buffett again describes that there are three potential candidates who will replace him in death, or in addle or feeble–mindedness:

“Moreover, we have three managers at Berkshire who are reasonably young and fully capable of being CEO. Any of the three would be much better at certain management aspects of my job than I. On the minus side, none has my crossover experience that allows me to be comfortable making decisions in either the business arena or in investments. That problem will be solved by having another person in the organization handle marketable securities.”

“The other question that must be addressed is whether the Board will be prepared to make a change if that need should arise not from my death but rather from my decay, particularly if this decay is accompanied by my delusionally thinking that I am reaching new peaks of managerial brilliance.”

It is up to the Board to replace WEB should this occur;

“If I become a candidate for that message, however, our board will be doing me a favor by delivering it. Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests. It would be a tragedy if the philanthropic potential of my holdings was diminished because my associates shirked their responsibility to (tenderly, I hope) show me the door. But don’t worry about this. We have an outstanding group of directors, and they will always do what’s right for shareholders.”

Once again, an outstanding message from the greatest investor.

Wednesday, March 01, 2006

Foot Locker Update

Recently, I posted a comment on Foot Locker where I had disagreed with an analyst downgrade.

Foot Locker

In yesterday's edition of Whitney Tilson's Value Investor Insight, (which I recommend as a first class thought piece on value investing) there is an interview with Ken Shubin Stein of Spencer Capital Management who also likes the stock.

He points out the potential reduction in operating expense that should occur as operating leases on some expensive, over-sized property wind down. He believes that operating margins could expand to 10% from current levels of 7.5% over the next three years.

He believes that the company could be reporting $2.40 in free cash flow in three years, producing an incremental $900 million in free cash from today. To put it in perspective, FCF per share today is about $1.10.

With his somewhat more optimistic view from mine, he thinks FL will show a FCF yield of over 8% (versus my view of 6.5%) and by doing additional share repurchases above my estimate, could be worth $48 per share as compared to my guess of a high $30's low $40's valuation.

In my view, the stock has little downside from current levels. It seems both Ken and I perceive a decent amount of upside.

Note that I, my family, and clients have positions in Foot Locker.

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