Engelhard Responds to BASF with Recapitalization

Engelhard (EC) has been a decent specialty chemical business with less volatility than most chemical companies. The company has generated free cash flow since 1997, a fairly remarkable achievement given the vagaries of economic cycles and commodity chemicals pricing.

The company makes value added products based on surface and materials science for a large number of customers. Not unlike BASF's motto, they are in the business of making their customers' products better.

Engelhard shareholders should have a look at the company's response, announced this morning, to the BASF bid.

Engelhard Response

The proposed tender for 20% of EC shares at $45 seems to have evoked little response today in the stock market. At $39, assuming that one could sell at least 20% of your holdings into the $45 tender, this implies that the price on the other side of the bid will be about $37.50, essentially where the stock was trading recently but well above where it had been trading pre-BASF.

Clearly, the tender offer is written as an enticement for BASF to step up and pay up. If EC does go ahead with the tender, the company will have a smaller equity base with 26 million fewer shares, but about $1.2 billion in incremental debt. Based on the company's projections, the incremental interest expense of about 52 cents (for 2007) just about offsets the 49 cent benefit of the reduced share count. Cost savings that the company has proposed would add some 9 cents to earnings.

Other assumptions made by EC management seem aggressive. For example, the company assumes that through 2010, North American vehicle production remains flat. It assumes that European penetration of light diesel engines will grow from 24% to 35%. I do not know how realistic these estimates are but they certainly seem hopeful.

EC management seems to be playing up the fact that the company appears reasonably valued relative to its major competitors Johnson Matthey and Umicore. Well on a P/E basis this may be true, but if we delve deeper into the financials, the price being bid for EC appears quite fair, but certainly not generous.

Umicore earns EBITDA margins of about 28% currently and J&M earns just over 23%. EC earns only about 17% in this comparison. Both Umicore and J&M would have more cyclical businesses than EC, so we may be looking at cyclical peak profitability whereas EC's profitability is somewhat steadier.

However, on an EBITDA multiple basis, Umicore sells at merely 8 times EBITDA on an EV/EBITDA basis. Johnson and Matthey sells at about 12 times. Finally, Engelhard is selling at just over 11 times EBITDA based on this measure. All EBITDA's utilize consensus estimates for 2006 earnings.

Of interest, though, is looking at BASF itself. BASF (BF) sells at merely 4 times EBITDA. Rather than chasing after EC, why not buy back stock itself?

One last observation. EC management looks a little silly if not disingenuous in arguing for the "miserly" price that BASF is willing to bid. Take a glance at the insider trading for EC that has taken place in the last year.

Insider sales at Engelhard

As you can see, insider sales have totalled over $8 million. Why is it okay for management to sell out but minority shareholders can't decide on the best bid? Insider ownership totals 0.7% but with options, represents 3.1%.

Disclaimer: I, my family, and clients do not have a position in Engelhard Corp. Some clients do own a position in BASF.

Inflexible Enterprises versus Management a la Google

I’d like to highlight a couple of recent noteworthy items that I believe all of us should be thinking about as we assess our investments.

So often, as value investors we get caught up in the purely quantitative aspects of our investments. Our focus in finding companies that generate large amounts of free cash flow can draw us into businesses that are not re-investing in themselves.

My own drawn out experience with Reebok years ago is a great example of a business that became heavily driven by the financial engineering aspects of buying back stock but in doing so, completely lost its focus on its operations and its innovation. As the CEO of Adidas observed in his recent New York meeting, Paul Fireman (founder and former CEO of Reebok) had built a great business that had its origin in innovation (women’s aerobic sneakers and the Pump) yet for some years, failed to capitalize on these innovations, or completely dropped them from the product line.

I highly recommend Geoff Gannon’s blog regularly, but in yesterday’s post On Inflexible Enterprises, he has done a particularly outstanding job. He highlights the mistakes that companies make in entangling themselves in the past. As Geoff points out, businesses do put down roots. Xerox clearly did everything it could to be innovative, having developed all kinds of intellectual property. Yet these innovations were relegated to sideshow status, largely because innovation would distract from what management believed to be the core business of photo-copying equipment. Yet, for some years Xerox created the illusion of being a decent business as it had reasonably high free cash flows that it utilized ineffectively to develop these innovations and also had decent returns on invested capital. The gee-whiz moment for me fortunately occurred as I realized that the number of competitors that were piling into office equipment was very high, the cost of entry seemed low, and ultimately the quality of product and service was similar. This was becoming a commodity business, but it was living on the lure of its brand and its past.

A franchise is more than a brand…franchises have the ability to redeploy their capital by investing in the business. That’s where Berkshire Hathaway franchises have generally shown their mettle. When they can no longer find that opportunity within their franchise, management focuses on the generation of cash flow to feed the businesses that can deploy capital effectively.

There is a terrific article in this morning’s WSJ by Gary Hamel of the London Business School, entitled management a la Google:

WSJ-Management a la Google (subscription required)

Don’t misinterpret me…I do not consider Google to be a value stock, but it is a masterful management. As Hamel points out, “While Google’s growth will inevitably slow, there’s a good chance that its revenues will arc upward for years. Why? Because its novel management system seems to have been designed to guard against the risk factors that so often erode an organization’s evolutionary potential.”


He highlights four evolutionary risk factors:

1. A narrow or orthodox business definition that limits the scope of innovation.


2. A hierarchical organization that over weights the views of those who have a stake in perpetuating the status quo.


3. A tendency to over-invest in “What is” at the expense of “what could be.”


4. Creeping mediocrity.

Sleepy, tired traditional businesses have often been the fodder of value investors but unfortunately, may turn into value traps. Look at the innovation of the BBC, which no longer regards itself as primarily a producer of television and radio. Contrast that with some of the media companies that we may own.

Charlie Munger’s thinking helped Buffett develop Berkshire Hathaway into a developer and owner of fabulous brands and franchises. Businesses that can innovate in order to make their franchise immutable are stronger than businesses that maintain status quo.

Managements that find ways to strengthen their relationships with their customers by using innovation, that avoid what Buffett refers to as the "Institutional Imperative" or maintaining status quo are businesses that intrigue me. Buy them at reasonably attractive prices and let the returns compound. This is the essence of today's value investing in my view.

Disclaimer: I, my family, and clients have a position in Berkshire Hathaway.

Heinz-The Battle Begins

Well, yesterday Trian Fund Management finally filed its 13D announcing that it had assembled a position of 18,425,000 shares of Heinz (HNZ) representing 5.4% of the company.

Trian, controlled by Nelson Peltz in conjunction with Peter May and Edward Garden is operating in conjunction with Sandell Asset Management, and Castlerigg International, funds controlled by Thomas Sandell.As the filing states, the total investment of Peltz' group was $475 million and the Sandell Group was about $200 million.

The Trian filing states that as of March 2nd of this year, a letter was delivered to HNZ informing it of its intention to nominate five candidates to the board. On March 13th, Peltz met with William Johnson, the HNZ CEO to inform Johnson of their "status as significant shareholders" and to "express certain operational improvements and changes in strategy that the Filing Persons would like to see implemented." In a subsequent meeting held March 29th, Peltz, May, and Garden met with members of the HNZ senior management team to "discuss ideas to enhance shareholder value." According to an investment banker advising HNZ, HNZ management was positive about the discussions and the Board representation was being considered.

By April 6th, Trian was informed that the Board's Corporate Governance Committee had rejected the request for Board representation. This morning Heinz denies that it had rejected the Trian Board request.

What is interesting to me is that Peltz et al had not owned a single share of HNZ prior to February 28th when they began to assemble their position via a series of privately negotiated back to back call purchases and put writes. Clearly, by assembling the right to purchase stock rather than the stock itself, Trian avoided the obligation to file earlier. Also of note, the agreement between Trian and Sandell allocates purchases up to $660 million on a 70/30 basis Trian/Sandell. Above $660 up to $860 million is allocated to Sandell. Anything above $860 is allocated to both on a pro-rata basis.

Trian clearly has the upper hand as far as final approval on virtually all matters including proxy voting, director nominations, etc. Strangely, "Sandell shall pay 75% of all expenses incurred by the parties in furtherance of the activities engaged in by the parties..."

Also of interest is the termination of the Trian/Sandell agreement "which will terminate at the conclusion of the next annual meeting of the Company's shareholders (including any adjournments or postponements.)"

In short, at least in my opinion, this bears the marks of an opportunistic raider. Not exactly someone whose interests are aligned with those of the long-suffering shareholder, again in my view. The termination date of the Agreement speaks volumes of long-term interests.

The case against HNZ management is very strong as I outlined in a prior post:

Is It Any Wonder that HNZ Shareholders Seem Discontent?

But until the plans for shareholder value creation are revealed, I see little reason for shareholders to applaud the merits of this vague filing. A short-term investment pass based on an agreement that sunsets with the annual meeting hardly describes someone who is looking for a long term solution.

Disclaimer:Neither I, my family, nor my clients have a position in HNZ.

Keep Swinging that Bat!

In Barron's this weekend, under Market Watch, there was a brief
synopsis of opinion from Ray Devoe, Jr. of Jesup Lamont which I
thought was quite fascinating.


As he outlines..."No warning can save from people determined to grow suddenly rich." ..."As I felt six yearsago, I think that this is a high-risk stock market. There are so many things that not only can go wrong, but go badly wrong. With the Dow approaching a six-year high, other major averages near five-year highs, long bond yields at a four-year peak, an aging economic expansion close to five years old-and several severe major economic and financial
distortions straining the financial system-this is a time to be cautious in stock selections."

Contrast this with :

Andy Kessler link

Andy appears to be much more open minded to some upside in this market. "Perhaps here’s how the world works these days. No need to borrow billions and build big ethylene plants anymore. You invent something here (chip, movie, iPod, medicine, financial instrument), email the design overseas for manufacture in $1-an-hour factories (OK, not financial stuff), and then ship it back for consumption. Sure, this runs up trade deficits, and our precious dollars leave the country, but that’s only half the story. Those dollars come back and invest in the U.S. Most go into long bonds, 10-years and 30-years."..."When bonds are scarce, foreigners are going to have to buy our stocks, or so the stock market might be screaming." ..."But make up your own mind. The time to load up was three years ago. The stock market is notoriously schizophrenic. Remember, it thought you could sell pet food over the Internet. But it’s more often right than wrong, especially when proving pessimists wrong and optimists
delusional."

Where do I come out in all of this? I am finding it increasingly difficult to find offbeat, smaller cap names. In looking at my portfolios, the predominant weighting is definitely larger cap, easily identifiable S 500 kinds of names. One of the worst mistakes that you can make in investing is letting the overall level of the market determine whether you will look at securities. As they say, it is a market of stocks not a stock market. I too find that money is a little rambunctious to find a place in some stocks. The zeal for ethanol is one of those places where money has gotten silly. Similarly, the zeal for gold stocks makes much less sense to me than the appeal of the metal itself.

An environment of despair and confusion is always easier to deal with when one looks for bargains. But in an environment that remains decidedly positive and optimistic for stocks, do your homework and find your places. Buy on down days and bite your tongue on up days! Don;t lament about missing hot stocks or sectors...like the batting coach told me many years ago, you've got to keep swinging the bat, There's plenty of stocks to consider, especially if you are willing to accept what seem to be mundane, boring, low growth names. Especially if we open our eyes globally, there are plenty of reasonably priced stocks to consider. The real key is to do your own work, don't get caught up in the frenzy, and keep swinging that bat!

Courier Corporation- Great Biz but Full Price

Courier Corp (CRRC) is a successful book manufacturer and publisher. As a manufacturer, it provides services from pre-press to production to storage and distribution. This represents about 85% of revenues. There are over 400 book publishing customers.

As a publisher, its subsidiary Dover Publications publishes 9000 titles in specialty categories such as poetry, classic literature, and mathematics. Its subsidiary Research Education Association publishes test preparation and study guides.

Gideons International bibles represent about 28% of sales and have been consistently at this level for at least the last three years. Sales to Pearson PLC are also significant at 19%.

Sales growth for the last five years has compounded at merely 3.4% about one third the sales growth rate of the S&P 500 but earnings per share have compounded for this period in line with the S&P at 13.6%.

The balance sheet is debt free with a cash balance of $1.63 per share. CFFO has exceeded net income every year for at least the last five years. In this period, the company generated just over $150 million in cash flow from operations. Capex has totalled about $62 million for this period, so there has been significant free cash flow.

In October, the company purchased Moore Langen , an Indianapolis based printer specializing in book covers and known for innovative production techniques. This printer should expand the educational business of CRRC.

The company has returned capital to shareholders primarily through dividends which have grown at an 18.5% pace and in fact were almost doubled last year. There is still room since the payout ratio was only about 18%. Nothing to speak of in share buybacks in recent history/

This is a business that I would love to own, but its valuation is a little problematic to me. The stock has been a rocket this year, up about 25%. EV/EBIT is about 15 times for a business whose return on invested capital is about 14%. On a P/E basis, the company is near its peak on TTM earnings.

Insiders own some 19% of the business on a fully diluted basis.

The analysts have pegged a growth rate of only 5% for the next five years for CRRC. This seems quite low...if correct, in my opinion, the stock should be selling closer to the low $30's, not $43. If growth is closer to my belief of 8%, the stock becomes much more interesting to me in the mid $30's.

But remember, this company has a lot of freedom to do a lot of interesting capital restructuring if it choses. The balance sheet, being squeaky clean, could use some debt to finance share buybacks or expand the business. The dividend has lots of room to grow. As the company says in its website, "To be able to succeed year after year, across the ups and downs of the economy, is very satisfying."

It seems to me that purchases at today's price might not be quite that satisfying.
Neither I, nor my family or clients have a current position in CRRC.

Thomson SA

In January, I had highlighted Thomson SA (TMS) a company that had been featured in the 2005 Barron's roundtable by Oscar Schafer, had performed rather poorly, but was undergoing a massive re-structuring.

Thomson link

I had highlighted the improving operating margins, and in particular, the improving free cash flow characteristics of the business.

In this morning's WSJ, there is an article which suggests that the company's management is growing frustrated with the market's assessment of its value.

Thomson WSJ link (subscription required)

Whether a management led LBO (with Silver Lake Partners et al) transpires or not, the improving FCF characteristics of this business suggest that the stock remains cheap, in my opinion. There company possesses considerable intellectual property abd as described in the article, is a one-stop shop for media and entertainment companies.

Thomson's set-top box business parallels that of Scientific Atlanta but has been somewhat erratic. It appears that new HD boxes have rolled out in March and are finding acceptance with customers such as DirectTV and Canal Plus. The growth of European HD Pay TV services which is in its early stages will be critical to Thomson's profitability.

The valuation parameters suggested in the WSJ article indicate a value of $23.50-$24.70.

LBO speculation remains rife and the precision of the WSJ article leads me to believe that there may be some validity to the speculation. Who knows? Whether a buyout occurs or not, the fundamentals are improving as the company's focus on cost control and execution intensifies.

I. my family and clients have a position in Thomson.

Motorola-Doing More Biz and Enjoying it Less

Yesterday, Motorola (MOT) announced its first first quarter financial results. Record handset shipments of 46.1 million units brought market share to 21% up a full 4.8 percentage points versus a year ago.

Gross margins for the quarter slipped to 30.1% versus last year's 32.6%. Operating profits were up only 3.4% YOY despite sales growth of 22.7%. Margin erosion was significant on the operating line with op. margin for this quarter at 8.9% versus last year's 10.6%. Gross margins have slipped each and every year since 2002 when they had peaked at 40.7%. On a recent quarterly basis, gross margins peaked in September of last year at 39.2%.

The tremendous growth in handsets and mobile devices is skewing revenues from this segment to 64% of the total versus last year's 54%. At the operating earnings level however, almost 79% of earnings are derived from this area. Operating margin deterioration at MOT is a function of segments other than handsets!

In some ways, the handset industry reminds me of what has occurred in the flat panel display industry, tremendous growth in units, tremendous growth in revenues, intense capital spending, but razor-thin margins. Competition remains intense. But I am very impressed with MOT's ability to gain market share as well as sustain operating margins despite what appears to be tremendous gross margin pressure.

The company bought back 37 million shares of stock for the quarter for about $815 million. Despite this, the diluted share count actually rose to 2.553 billion shares from last year's 2.487 billion, not exactly an effective buyback as I would assess. The company expects to complete the sale of its automotive electronic business to Continental AG for $1 billion in the second quarter.

From a valuation standpoint,it all comes down to one's belief in operating margin sustainability. The bulls seem to ascribe to the belief that 13% operating margins are feasible over the long run. This translates into a $30 target. If one ascribes to my view that Schumpeter's creative destruction economic principles will hold margins to 8%, the stock seems appropriately valued.

On an EV/EBIT basis, the stock seems reasonable at just over 10 times EBIT. Return on invested capital has improved significantly over the last few years with current returns up at 20%. On a FCF yield basis, the stock provides jalmost a 7% FCF yield.

Bottom-line, I think the market over-reacted to the earnings disappointment of yesterday. But the upside in my view is somewhat truncated to $25-$27.

Disclaimer: Neither I, my family, or clients have a position in MOT.

The New York Times- Is it Finally Stabilizing?

The New York Times Company (NYT) is starting to feel like it is stabilizing at least. Pessimism has abounded for most of the newspaper stocks, and justifiably so. Circulation trends and revenue trends have been weak for some time. The Knight-Ridder-McClatchy deal did little to excite holders of newspapers and in fact, the increased leverage in McLatchy seems to have incensed some holders.

NYT reported first quarter numbers which were a penny better than consensus, which I regard as just noise.

But looking how they got there I find encouraging. Advertising trends are improving; revenues came in slightly better than most estimates. The flagship New York Times itself should report a slight gain in circulation to the end of March in the ABC numbers. The Boston Globe on the other hand will report a decline. The small regional papers in the portfolio appear to be doing reasonably well.

About.com had been regarded as a too little too late strategy when the acquisition was first announced roughly a year ago. WRONG! Revenue growth is exceeding expectations at 14% sequential quarterly growth. The conference call provided some discussion of taking About.com international as well as developing handheld and video capabilities. Over 7.5% of NYT revenues are derived from its digital properties.

The other positive element is cost control. Ex severance costs and digital products development, costs were up by 3.2% in the quarter, and costs will rise by much less than this for the year.

Today, we see that Morgan Stanley Investment Management is becoming activist in the NYT! Apparently, the firm, with about 5.6% ownership in NYT, is withholding its vote for the board and asking for elimination of the two class voting structure. Non-family shareholders elect only 4 of the 13 seats. Class B “Sulzberger” shares represent 1% ownership but elect the balance and the majority. Way to go MSIM!

Valuation is modest at 10.6 times EBIT on an EV/EBIT basis. ROIC is about 11%.Dow Jones enjoys higher ROIC at about 16% but trades on an EV/EBIT of 29 times.

Disclaimer: I. my family, and clients have a position in NYT. None have a position in DJ, KRI, or

Berkshire buys Russell-The Advantage of Long Term Horizon

Russell Corp (RML) is being purchased by Berkshire Hathaway (BRK.A) for $18 per share. A leading manufacturer of fleecewear and athletic products with brand names such as Russell, Spalding, and Huffy, the business has just come off a rather poor and disappointing 2005.

Return on invested capital was a paltry 3.5%, down from 5.5% to 6% a couple of years ago. CFFO for 2005 was only about $50 million compared to $89 in the previous year. Manufacturing issues in Honduras resulting in problems with quality, a shift to hooded fleece resulting in labor inefficiencies, hurricane related expenses resulting in higher shipping costs…the litany of problems last year along with severance costs for a departing CEO resulted in really poor earnings.

But the company appears to be in the midst of a significant restructuring. Aggressive cost-cutting actions appear to be in place or at least forthcoming. Spalding is a decent $400 million brand that could be much bigger with the right promotion. Ditto for Brooks athletic sneakers. Getting back control of the Spalding license for apparel could improve the visibility of the brand. An ongoing shift to offshore production will be complete by 2007 and costs should drop significantly. Most of the savings are coming for 2007 and will be only partially realized in 2006.

Though Wall Street estimates for earnings growth remained quite high at a median 12%, even with modest improvement in operating margins, and a growth rate of only about 5%, the $18 price should prove to have at least a 30% margin of safety in my estimation. Berkshire, by virtue of its Fruit of the Loom franchise and its newly acquired Russell franchise should have significant bargaining power with its largest buyers of apparel, namely WalMart (WMT) and Target (TGT.)

Buffett’s ability to see through the short term crisis in order to capture the long term value demonstrates the importance of investment horizon. A balance sheet that allows him to roll with the punches obviously is a luxury that provides financial sustainability to live through these crises.

Disclaimer: Neither I, my family, nor clients have a position in Russell Corp or Target. I, my family, and clients have a current position in Berkshire Hathaway.

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BAA plc rejects Goldman Sachs bid

BAA is the largest airport operator in the UK and Europe. In fact, the company has ownership interests in 13 airports outside of the UK including airports in the US, Australia, Italy and Hungary.

BAA controls Gatwick, Heathrow, Stansted, Glasgow, Edinburgh, Prestwick and Aberdeen hence accounting for 70% of UK's passenger traffic and 85% of air cargo. BAA also manages and controls the airport based retailing at these locations and operates a duty free operation.

The company had received back in February a conditional bid from a consortium led by Grupo Ferrovial S.A. which was rejected in March. They had bid 15.3 billion pounds.

Apparently, Goldman Sachs just had its 16.5 billion bid rejected.

Why the attraction? This is a highly profitable business with operating margins in the last twelve months of 34.8% compared to the prior year's 47.4%! Return on capital was fairly modest at around 4.5% last year. Debt to assets modest at 32%. Enterprise value of the business was 12 billion Br. pounds.

CFFO was 680 billion pounds for FY2005 (March) and was at 410 for the first half of 2006. Capital expenditures have been quite heavy in the last several years with capex of 741 for the first half of FY06, and 1.4 billion for 2005 and 1.3 billion for the previous year.

Under the current regulatory framework, allowed returns on capital for BAA are equal to the cost of capital. Consequently, there is ample desire to maintain capital efficiency and return capital to shareholders. Obviously, under a private equity ownership scheme, new owners could address the sale of various parts of the business and perhaps securitize some of the cash flow streams that the company enjoys.

This should help to reinforce the valuation of other airport operators globally. As well, given the US response to the Dubai ports takeover of P&O, this could be interesting to watch from a political standpoint.

Disclaimer: I, my family, and my clients do not have a current position in BAA.

Welcome -The Street.com

Thank you to all the guests who are dropping by from The Street.com.

I thank you for your interest. Please stay awhile!

The goal of Value Discipline is to provide some insight into what Wall Street research may be "thinking" and where values may lie.

Enjoy your stay. Look around. And please come back!

Thank you again for your interest!

Rick

Painless Dentistry-What's Left In Dental Equipment?

Yesterday, Danaher (DHR) announced that it was acquiring Sybron Dental (SYD) for $47 cash.

Danaher truly is a world class enterprise with a brilliant culture and a systematic approach to building value. What had been a bit of a hodgepodge of domestic cyclical businesses has developed into an innovator and a global enterprise. Unfortunately, at current prices (EV/EBIT of 16.5 times) I find DHR somewhat expensive.

What I would like to think about however, is the dental supply industry and what is left of it in public companies.

Danaher has been a very effective consolidator of the dental equipment industry with its subsidiaries of Gendex, which is involved in dental radiography and panoramic X-rays; Pelton and Crane, dental chairs and lighting systems; and KaVo, precision instruments.

Sybron, at its take-out price, is selling at about 16.5 times EV/EBIT and has generated a ROIC of 12.1% on a TTM basis. Earnings growth over the last five years has been about 9%.

The remaining non-bulletin board participants in this industry are:

Biolase Technology (BLTI) which manufactures and markets laser-based products for medicine and dentistry as well as bio-materials. Though possessing interesting technology, the business is currently negative CFFO and negative EBIT.

Dentsply (XRAY) is the largest supplier of dental products with a global reach. About 3 times the size of Sybron, XRAY sells at a whopping 65 times EV/EBIT due to about $233 million in last year’s pre-tax impairment and restructuring charges. Normalized, results look more like 15.7 times EBIT. Normalized ROIC would come in at a 18%.About 80 % of CFFO is free cash flow and FCF margins on a TTM basis are about 11%.

Young Innovations (YDNT) has been named to the Forbes 200 best small companies in America list for the last five years.. The business is focused on preventative dentistry with its specialization in prophy and angle products, the basic tools used in dental cleaning. Sales of disposable prophy angles are the biggest source of revenue to YDNT. International sales are less than 10%. The company also markets panoramic X-ray machines and hand pieces (drills.) The company has shown a ROIC of 14.8% last year. Earnings growth over the last five years has been an impressive 14.5%. The company is selling at 12.5 times EV/EBIT. About 75% of CFFO is free cash flow with FCF margins in the TTM of about 16%.With only about 9 million shares outstanding, and insider ownership that is just over 40%, this is a very thin trading stock.

Patterson Dental (PDCO) and Henry Schein (HSIC) are primarily distribution companies rather than manufacturing businesses with PDCO deriving about 75% of its revenues from the dental segment and HSIC deriving some 40% from this area.
I will be doing some further work in the medical distribution area for a later post, so please stay tuned.

As you can see, the dental equipment industry has a fairly short list of pure players. The economics are quite attractive as these returns on invested capital demonstrate. Smart buyers like Danaher appear to have a growing appetite for this industry.

Disclaimer: Neither I nor my family have a current position in DHR, BLTI, XRAY, YDNT, PDCO, SYD or HSIC. A number of clients do currently have a position in YDNT.

Treehouse Foods -Commodity Businesses at Premium Valuation

Treehouse Foods (THS) is a private-label food manufacturer to retail and food-service channels. It is the largest manufacturer of pickles and non-dairy powdered creamers in the U.S. These are lo-margin commodity businesses. The company has purchased a soup business from Del Monte Foods (DLM) which THS management indicates has gross and EBIT margins below that of THS.

Gross profit margins for THS were 19% for the fourth quarter of 2005 versus about 23% for the full year. EBIT margins were 6.2% for the fourth quarter versus about 4% for the full year.

The profitability of Treehouse should be compared with that of Ralcorp (RAH) another food company with a commodity product roll-up strategy. Gross margins for RAH were 23.1% and EBIT margins were 6.7%. ConAgra (CAG), a company that is slowly (emphasis slow….ly) restructuring itself into more of a branded company has a gross profit margin of 24.7% and EBIT margin of 10.4% for its latest un-restructured year.

The Return on invested capital for THS is merely 2.2% versus RAH’s 6.2%. Reflecting some leverage, the ROE on RAH is about 13.1% versus THS’ 2.3%.ConAgra has an intermediate profitability of 7.1% on capital and 12% on equity.

THS sells on an Enterprise Value to EBIT of 16.2 X versus RAH’s 14.6 X and CAG’s 15 times. On a P/E basis, THS is selling at 28.9 times 2006 consensus earnings whereas RAH sells at 16.6 times. CAG sells at 15.9 times EV/EBIT. The processed food industry is selling at 18 times 2006 earnings.

Why is Treehouse so expensive given its commodity nature and its slow-growth characteristics? Is the market rewarding THS for value added in its soup acquisition when management has already indicated that this has lower margins than its existing business? Given the lacklustre prospects for growth (consensus 5-year growth for THS is 7%) why pay up?

Disclaimer: I, my family, and clients do not have a current position in THS, RAH, or CAG.

IMS Health a Class Act

IMS Health (RX) is a class act, dare I say, best of breed. The company has a 35% share of what is believed to be about a $5 billion market in pharmaceutical prescription data. The company has attempted to upsell what has historically (over 50 years) been a business that aggregated data into more of a consultative business. As the company now proclaims, it is turning information into insights.

Its customers have historically been only the pharmaceutical manufacturers but the developing commercial success of biotech industry as well as the growing information needs of the health insurance and managed care industries have broadened the customer base. The goals of understanding what drugs are being sold, to whom, by whom, and for what purpose are important throughout the value chain.

RX is eight times the size of its closest competitor and operates in a far broader range of geographies with over 100 countries of data covered. It should be noted that its closest competitor NDC Health was acquired last year by Wolters Kluwer of the Netherlands.

A proposed merger of RX and VNU N.V. had been announced in July of 2005, but due to intense pressure by activist shareholders who believed the deal to be inadequate compensation for RX, was terminated in October of 2005. Ironically, VNU now faces its own activist tribulations.

In the last five years, the company has generated a total of $1.7 billion in CFFO. Capital expenditures have totaled only $502 million, hence, free cash flow over the last five years of $1.2 billion.

The company has been buying back stock quite aggressively with over $780 million in share purchases in the last five years. Last year’s buybacks were disrupted during the VNU interregnum but the company in January announced a buyback of 30 million shares of which already 25 million shares had been bought back. Given prior authorizations, some 11 million shares remain to be purchased.

The company’s return on invested capital was 30% for 2005 but historically has been mid 30’s to mid 40’s. Long term debt is about 60% of assets but interest coverage is substantial 21 times. Currency translation effects can be significant here too with foreign sales representing 56% of sales in 2005.

The company has settled some legacy tax issues with the IRS in March for $20 million having reserved $121 million for these issues.

The dividend was increased 50% in January to 12 cents quarterly.

I believe that the company should be valued in the low to mid $30’s versus its current $26. Enterprise value to EBIT is currently 13.1 times which seems low given the profitability, cash flow characteristics, and shareholder friendly return of capital.

Disclaimer: Some of my clients own a position in RX however, I and my family do not currently have a position here.

Money "Piling" Into Private Equity Funds

Private equity funds raised $27 billion in the first quarter of the year versus about $14 billion in last year's quarter according to data compiled by "The Private Equity Analyst."The big funds are getting bigger, with TA X LP and Bain Capital IX LP accounting for 43% of capital raised overall.For further details, please check link.

Bank of New York Asset Swap

Though admittedly, I am somewhat disappointed in the valuation accorded the Bank of New York (BK) retail business in the asset swap with JP Morgan (JPM). Let’s look at the valuations of the assets swapped.

BK is selling its retail branches for $3.1 billion, significantly less than the $4-5 billion numbers that had been rumored. JPM will also be making a $150 million payment to BK upon closing.

BK is acquiring JPM’s corporate trust operation for $2.8 billion. This almost triples BK’s corporate trust assets from $3 trillion to $8 trillion, making it a global leader in this business.

The deal makes a great deal of sense strategically. BK becomes much more focused on security servicing and wealth management. This is a very scalable business, and hence cost savings should be forthcoming fairly quickly despite management’s relatively conservative views expressed in today’s conference call.

BK also avoids the danger of being an “also ran” in the highly competitive New York retail banking market. The sale at this point infers that potential credit risk issues in the middle market have been avoided. Growth in retail banking has proven a challenge for BK in recent years and an exit strategy is a sensible decision, especially before problems develop.

Finally, like domestic markets have already experienced, international markets are becoming less reliant on traditional banking and increasingly dependent on capital markets instruments, in particular, structured products. Quoting today’s conference call: “Since 2001, debt issuance outside the U.S. has grown at a rate in excess of 20% and the number of issues has nearly doubled during that period. By way of comparison, 80% of U.S. financings are either debt or equity. Only 20% are bank debt. Internationally, it is the reverse -- 20% debt and equity, 80% bank debt.”

The JPM transaction brings with it 15 additional overseas offices which significantly expands BK’s global presence.

I continue to believe that BK, despite some near term earnings dilution, will find a higher earnings multiple in a more rapidly growing, fee income stream versus its previous blend of businesses.

I, my family, and clients have a current position in BK.

Coke and Corporate Governance Trends

Coca-Cola (KO) recently announced that it would pay its directors a fee only if earnings growth goals were met. If such goals were missed, the directors would receive nada. As well, directors would be subject to risking their stock awards over a three year performance cycle. The initial goal is an 8% compound annual growth rate using 2005 earnings of $2.17 as a base.

This move was broadly applauded by many corporate governance watchers including Warren Buffett himself.

Yet, accounting earnings make a very poor proxy for the profitability of a company. Earnings per share can be rather easily manipulated by the judgments that managements and more importantly, the boards themselves must make. Earnings do reflect estimates and judgments and are subject to considerable manipulation. Imagine an insurance company that has a wide scope to decide on its reserving policy. A conservative policy regarding reserve quality damages near-term earnings and improves long term earnings propsepcts. A liberal policy delays the recognition of the inevitable to later accounting periods. The first choice may ensure receiving a zero directors fee but the second rings up the cash register for potentially $175,000. A tough moral dilemma for a director.

Share buybacks have been used craftily by some companies in the past to hit stock value thresholds. I often drone on about the effectiveness of share buybacks.

Are they being used to simply sop up executive share options or are they being used to reduce the fully diluted shares outstanding? Even more important to me, are these shares being purchased at prices below intrinsic value?

Obviously, massive buys at prices above intrinsic value do nothing but enrich the seller, not the buying corporation and the rest of us remaining shareholders, whose wealth is being handed over!

Though "eating their own cooking" is applaudable in that the reward is purely equity based, does such a policy endorse loose and liberal accounting policy?

The trends toward board and committee independence are becoming well entrenched according to a new ISS study on corporate boards. But concomitant with growing responsibility is growing pay. According to this study, the average pay for a director has increased to $143,807 in 2005, up 14% compared to a 23% increase the year before.

Another positive trend is a move to de-classifying boards. Staggered boards were viewed as a means of takeover avoidance, but corporate activists have been able to penetrate this defence.

Here is a link to this very interesting ISS study.

As an alternative to the earnings growth metric which KO chose, why not a return on invested capital hurdle or some sort of measure of the incremental return on invested capital that has been achieved? The use of economic capital modelling makes it relatively easy to measure the true economic profit of an enterprise over time.

Disclaimer: I and my family but no clients have a current position in KO.

CECO Revisited- The Clouds are Parting

Exactly one month ago, I wrote a post on the Education Stocks, "Getting an Education in Education Stocks" where I had highlighted the attractive valuations that existed, as well as the interest of private equity capital in this sector.Career Education (CECO) has provided some good news and decent returns since that time.

Let's review what has gone right and what concerns remain.

Yesterday, CECO announced that the MidWest office of the SEC was no longer seeking enforcement action (for the 10-K's of 2003 and 2004) and that this office was recommending the termination of further investigations. One of the class-action lawsuits was dismissed by a U.S. District Court last week, though it may resurface again.

Other class-action suits remain. Finally, in a California case specific to CECO's Brooks Institute business, a judge ruled that a CA regulatory agency had improperly sanctioned the division with a "Conditional Approval to Operate."What remains on the regulatory front? The most serious problem for CECO appears to be the probationary status of AIU, American Intercontinental University, which is operating on a probationary basis, a situation that threatens its accreditation (by the Southern Association of Colleges and Schools,) and has obviously impacted enrollment negatively. Management appears to be addressing the specific concerns by adding administrative staff, qualified admissions staff as well as full time faculty. The school's accreditation will be reviewed again in December according to an excellent William Blair brokerage report (authored by analysts Litfin, Steinke, and McHugh) dated yesterday where the firm upgraded the stock to a "market perform."

The Department of Education has refused to approve CECO applications for adding new locations or making acquisitions until it completes its review, this remains an overhang on the stock. As well, there remains a Department of Justice investigation as well as an investigation by the Pennsylvania Attorney-General.

Again, it is important to remind ourselves that these sorts of investigations are endemic to this industry. Enrollment and recruitment of students, packaging of financial aid, and procedures to deal with student complaints have previously resulted in examinations of ITT Educational (ESI) as well as Apollo Group (APOL.)

The legal and regulatory clouds seem to be dispersing at least partially and CECO's valuation, in my opinion, still incorporates a great deal of doubt. EV/EBIT remains below 10 times, a significant discount to APOL at 11.8 times, or ESI at 14.2 times.

Disclaimer: Several clients are currently long CECO. Neither I, nor my family, or clients have a position in ESI or APOL.

Core-Mark-Too Early for Prime-Time?

SEC filings can be absolutely fascinating. You don’t see filings like the one I am about to describe very often….and that’s a good thing.

Core-Mark (CORE) is one of the largest wholesale distributors to the convenience retail industry in North America, operating 24 distribution centers and distributing some 38,000 SKU of packaged consumer goods to about 20,000 store locations in the US and Canada.
This is a distribution business with some $4 billion in sales through 2004, and about $3.7 billion in sales for nine months of 2005. But margins are extremely narrow. Sales of cigarettes constitute some 72% of sales and excise taxes are a significant part of cigarette sales. Gross profits for the first nine months of the year were only about $207 million or only 5.6%. Net income for the nine months was $6.7 million. This represents a net profit margin of merely a sliver, 0.18%. All this on a share base of only 10.5 million shares outstanding, so there is plenty of sales leverage.

Distribution companies provide valuable service to their customers in terms of planning and inventory control. The cigarette business represents a much lower gross profit margin than non-cigarette businesses which have only 28% of the revenue mix but 64% of the gross profits (2004 figures.)

Core-Mark has emerged from the bankruptcy of Fleming Companies which filed Chapter 11 in April of 2003. The re-org plan of Fleming became effective in August of 2004, and Core-Mark emerged as a separate entity.

This ought to be a fairly interesting, steady-eddy cash flow generating business. It is second only (in cigarette volumes) to McLane Company, Inc, formerly a WalMart subsidiary and now part of Berkshire Hathaway. Capital expenditure needs are de minimus. Cash flow from operations significantly exceeds net income. This really should be an interesting business. Cash flows should be fairly reliable…but the financial statements need to be reliable.

But somehow, Core-Mark may have emerged before it was ready for primetime. The company has just announced that is unable to file its 10-K on time:
“Core-Mark Holding Company, Inc. (the “Company”) is unable to file its 2005 Annual Report on Form 10−K by March 31, 2006, as a result of the need to restate the Company’s audited consolidated financial statements as of December 31, 2004 and for the period from August 23, 2004 to December 31, 2004 and the Company’s unaudited condensed consolidated financial statements as of and for the six months ended June 30, 2005, each included in the Company’s registration statement on Form 10, and the Company’s unaudited condensed consolidated financial statements as of and for the three and nine months ended September 30, 2005 included in the Company’s Form 10−Q for the third quarter of 2005, because of errors in those financial statements relating to the accounting of foreign currency translation adjustments related to intercompany balances.”

These foreign currency translation adjustments seem to be relatively small and somewhat insignificant in the grand scheme. But far more disturbing was the announcement that its auditor, PWC would no longer stand for re-election as auditor.

Though there were no material disagreements apparently, PWC did cite a large number of deficiencies in internal controls, such as:
1) …Insufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles (“GAAP”) commensurate with its financial reporting requirements and the complexity of the Company’s operations and transactions.
2) The Company did not maintain effective controls to ensure the accuracy of debt discount and debt issuance costs.
3) The Company did not maintain effective controls to ensure the appropriate classification and presentation of accounts and disclosures in the consolidated financial statements. Specifically, the Company did not maintain effective controls to ensure the appropriate balance sheet classification and presentation based upon the nature of the account or balance. This control deficiency resulted in audit adjustments to cash, accounts receivable, other receivables, deposits and prepayments, other non−current assets, accounts payable, book overdrafts, cigarette and tobacco taxes payable, and operating expenses in the Company’s 2005 annual consolidated financial statements.
4) The Company did not maintain effective controls to ensure there is adequate analysis, documentation, reconciliation, and review of accounting records and supporting data. Specifically, the Company did not maintain effective controls over the completeness and accuracy of the payroll expense and payroll accrual, and did not maintain effective controls to ensure the timely reconciliation of the payroll registers to the general ledger.
It is very disturbing to think that a company which is so highly linked to cigarette distribution has failed to properly account for cigarette and tobacco taxes payable. Even accounting for “cash” about as basic as you can get, managed to get fouled up. You name it, accounts receivable, accounts payable, operating expenses, payroll…everything needed to be corrected and adjusted.

This has the makings of being an interesting business, but until I see reliable financials, it can’t be considered as an investment possibility. The valuation (based on what could well be mistaken numbers) looks very reasonable at only 4.9 times EBIT on an EV/EBIT basis. Return on Invested Capital in the last twelve months (again subject to restatement) is also quite attractive at 15.95%.

The company has received a confirmatory waiver on potential defaults regarding its bank borrowings. The company has indicated that it should have its 10-K filed by April 17th. CORE estimates that net income for 2005 was $14.5 million and operating income was $44.3 million. One should also be aware that a potential overhang of 4.4 million shares held by Fleming are subject to distribution by the bankruptcy court and the Post Confirmation Trust which could be distributed to Fleming creditors.

Disclosure: Neither I, my family, or clients have a position in CORE, however, all do have a position in WalMart (WMT.)

NFB Comment-Remember the Employee Impact

A rather poignant comment from a potentially affected North Fork employee reminds us of the human toll of restructuring and takeovers. The search for "redundancies" and cost savings has a real human impact as companies merge.

The question of "Why Now?" is exactly the feeling of thousands of employees of the North Fork Bank who are looking at a pink slip in 6 to 12 months. While they had heard the rumors in the past of Fleet, BOA, or Barclays making a play for NFB, most of the employees thought they had until John Kanas retired, and that seemed unlikely.

It is hard for me to make excuses as both an employee and shareholder of NFB for the tough times of rising interest rates after 20 years in banking in NY.

The successful banks have always weathered storms and cycles. Rising interest rates hardly merit a second glance.

Maybe the question should be "Why Capital One?",the infamous sub-prime lender with the funny ads with marauding invaders of interest.

Right now, NFB VP's are gathering their numbers and stats for COF's review with the hopes that their areas can be saved with the least amount of casualties. No one expects the bank to survive as it is today.

While my bias is obvious as I stand to possibly loose more than a few dollars on my stock value, this deal doesn't make sense for NFB. It does look like somebody went down to the crossroads and made a Robert Johnson type of pact with the devil for wealth and fame.

Long Term, Short Term and Contrarianism

Most "value" investors tend to view their perspective as being long-term. Long term perspectives on stocks differ starkly from short-term, allowing long-term investors to buy into weakness, and to permit short term players to succumb to fears, uncertainty and doubt.

Yet, many short-term players can enjoy spectacular success by repeating their near-term successes in a series of good decisions. "Don't fight the tape," if your perspective is sufficiently short, is a useful mantra that can allow the trader to punt out some decent near-term returns. Perhaps, going with the flow is just not part of my contrarian and skeptical nature.

Understanding your timeline helps to define the kinds of investment that you want to embrace. Independent thinkers, agnostics, doubters, loners and isolates generally make great value investors with long term perspectives. As Keynes described it in "The General Theory:"

"It is the long term investor...who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

It does take a lot of bravado to be a decent long term investor. In fact, almost every really good decision that I have made working as a money manager, has resulted in my almost getting fired because it failed the conventionality test. One head of an investment committee was unmercifully critical described me as reckless as I was buying stocks through the first half of 1982 and suggested that I was too young to be managing anyone's money. As the August 1982 rally marked the bottom of the market, I was skated onside. He was enough of a gentleman to acknowledge some six months later that he had been wrong in his assessment and that perhaps it was he, who was being rash.

The challenge is very clear when you manage someone else's money. Our role is to move our clients in directions that are likely to be profitable and successful but to do so without exceeding the client's risk tolerance. Exceeding risk tolerances is tantamount to not fulfilling the fiduciary responsibilities that we bear. How far can we stray from convention?

As individual investors, we answer only to ourselves, or at least ourselves and our often chagrined spouses! Unconventional decisions can be much easier when we face only ourselves and not a committee.

In a market that most experts viewed as difficult, the S&P total return for the first quarter of 4.21% almost equalled the return for the entire year 2005. Healthcare and consumer staples were barely positive, in fact utilities were negative for the quarter. As Leuthold points out in this week's Barrons, the market is decisively indecisive...stuck in neutral. The world (myself included) thought the small-cap rally ended last year, guess what market cap group led this quarter?

Where are the contrarian ideas? I think some of the best are in communications and media, especially radio, but also cable. I find it hard to believe that terrestrial radio is completely dead, particularly, when some of the smart private equity players are buying stations. Companies like Westwood One (WON,) Emmis (EMMS,) Clear Channel (CCU) and Lin TV (TVL) have histories of free cash flow generation for many years and have performed terribly. Comcast (CMCSK) seems undervalued as well. The traders may see falling knives, but with the flexibility of decent free cash flow, these businesses seem attractive to me.

Other businesses, broadly believed to be in decline, also look fairly attractive to me. Readers Digest (RDA) and Deluxe Corp (DLX) are also bottom feeders in the performance race but seem to generate significant free cash flow and are buying back stock.

The greatest amount of money is made from having the greatest confidence in contrarian positions. Going against the grain makes for boring cocktail chatter...not like debates about Sirius or Lucent, at least the LU debates are over with.

Buying what nobody wants and being sure about the longevity and the balance sheet is what makes money.

Disclaimer: I, my family, and clients have positions in WON, CCU, and CMCSK. My family has a position in RDA.