Friday, June 30, 2006

Freddie Mac- Continuing Progress

Freddie Mac released its annual report a couple of days ago with the title "Continuing Progress."

Though Washington seems to be abuzz with anti-Fannie (FNM) and Freddie rhetoric as Washington prepares for the summer, it occurs to me that these franchises, and especially Freddie's are discounting the worst that regulators can throw at them.

Freddie (FRE) addresses its challenges rather forthrightly in its annual. Remember, the accounting sins of FRE were related to under-reporting of earnings not over-statement of earnings. This was a case of holding reported earnings back for a rainy day rather than trumpeting success that was not there. An accounting sin, but more venial than mortal as accounting misrepresentation goes.

The company continues to address some Sarbanes-Oxley shortcomings....internal controls still need some work in financial reporting. The weaknesses are not credit or derivatives related. The internal controls weaknesses are being addressed.

Portfolio limits which have been imposed and accepted by Fannie have been asked for by OFHEO of Freddie, as the annual puts it, "Limitations on our portfolio activities for some period of time."

Derivatives exposure is down considerably at only $225 million in net exposure versus a gross notional exposure of $683 billion. The market value of derivatives which was $15 billion at the end of 2004 is down to $6.5 billion.

The 30% of capital requirement for surplus is comfortably exceeded. Freddie has core capital of about $36 billion or about $3.5 billion more than the 30% requirement entails.

The credit risk in the mortgage portfolio is low. For 2005, 87% of its business had loan to value ratios below 80% and 21% were below 60%. The credit scores for the borrowers were also more than satisfactory...only 4% had FICO's below 620 and 64% had FICO's over 700.

What happens if Fannie and Freddie are constrained in their portfolio purchases? From an investor viewpoint, at least this one's, I suspect nothing. I believe that the current valuation for FRE already suggests a zero growth assumption for mortgage growth. Even with zero growth, my guess is a valuation of $70-75.

If Congress blesses some growth in the portfolio, this provides upside to my valuation estimate.

A vindictive Congress had better be careful with an unwinding and a downsizing of the two biggest players in this marketplace. Banks are counterparties on many derivative exposures for both FNM and FRE. Significant amounts of the banking system's core capital is exposed to Fannie and Freddie paper. So pulling the plug has adverse consequences for the banking system in total.

Even though the political climate could well become more adverse as November approaches, the low valuation of FRE and its "innocence" at least relative to the mis-deeds of FNM, seems under-appreciated. In the interim, the large banks have been buying mortgages at a much faster pace than the GSE's. The constraints on FNM and FRE have been a benefit to BAC, WB, and WFC.

But in my opinion, the valuation of the portfolio even without growth favors FRE as an investment.

Disclaimer: I, my family, and most clients currently have a position in FRE. Neither I, my family, or clients have a current position in FNM, or WB. Neither I, nor my family have a position in WFC though certain clients do own a current position.

Tuesday, June 27, 2006

Difficult Markets-The Rubble of Neglect

Roy R. Neuberger, the eponym of Neuberger Berman, an investment management firm now owned by Lehman has (he is 102) a great love of painting which he financed through his successful investment career. He was especially adept at short-selling, which brought him great fortune through the Great Crash of 1929 and well into the Depression.

A famous quote about the stock market that comes to mind in difficult markets is attributed to Neuberger," bull markets, who needs bear markets, they'll kill you!"

Hans Deuel of the blog Clearfish Research describes the phenomenon well in "No Matter What You Do, You're Wrong."

  • You buy on the way down, and it keeps going down (should have waited), or
  • You sell on the way up and it keeps going up (should have waited), or
  • You buy on the way up and it keeps going up (you should have bought earlier), or
  • You sell on the way down to stop losses and it turns around, or
  • You don't buy at all (opportunity loss), or
  • You don't sell at all and hold those losses, or...
As he points out, you can't beat yourself up. This is not a game of perfect. You have to quit beating yourself up in these choppy markets, keep the right investment horizon in mind, and don't expect that you will pick bottoms or tops.

I can recall Buffett describing his purchase of a large position in General Dynamics. At the annual meeting, he was asked about how much time he had spent in the analysis of GD's large submarine division . He replied about half an hour.

Sometimes, the obvious should not be an impediment. Mr. Market may agree over the short term or otherwise. Focus on decisions that favor your long term horizon. If Mr. Market continues his despondency, you can buy more of a good thing.

The beauty of markets like we are experiencing, and this is a good thing, is that we get the opportunity to buy businesses at prices much better than we could have expected. The high flying commodities are not a place where you want to be in my view...periods following gold rushes are not a lot of fun.

A friend of mine put it best, "In today's market, people are buying things they should have owned five years ago, but wouldn't touch."

Isn't that almost always true? Twenty years ago, the investment firm DLJ sponsored their last coal conference after only 18 people attended, 16 representatives of presenting companies, a buddy and myself. Coal went nowhere for some years until some shrewd investors discovered the mineral was cheaper on Wall Street than in Appalachia. At energy or mining conferences today, it is SRO...little firms such as mine can't possibly get in.

Not that we'd want to! I think similar thinking should be applied to your investments. Unpopular, boring, seemingly out of step ideas might turn into real jewels with a bit of time. No one cares in the capital markets. But is there still a business underneath the rubble of investor neglect?

On the Road Again....To Zagreb??? Barr Labs

Well, it's a big, wonderful world out there and a xenophobic focus on the domestic opportunity set just does not provide sufficient perspective for successful investors, whether individual or corporate. Ergo, Barr's brave international move.

Barr Labs (BRL) today announced a potentially transformational bid for Pliva d.d.for $2.2 billion.Pliva has over $600 million in sales in Europe. The combined company, according to management's conference call this morning, will have nearly $2.5 billion in sales with EBITDA in excess of $875 million and net income greater than $550 million. Barr, which has been essentially a U.S. company, suddenly will find itself selling in about 30 countries. Germany is the largest base, but there is sales force in Poland, in Russia and across all of Europe...a very diverse group of countries with a very diverse set of regulations that Pliva has experienced and thrived in.

Founded in 1921, Pliva is today the largest pharmaceutical company in Croatia and by sales, the largest in Central and Eastern Europe. Since April 1996, Pliva's shares have been listed on the London Stock Exchange, a first for a Central and Eastern European manufacturing company.Healthcare is central to Pliva and the company produces a wide range of quality pharmaceutical, animal health and agrochemical products. Pliva also produces a range of food and beverage items and a line of cosmetics and personal hygiene products.Pliva's best selling product is its patented oral antibiotic, azithromycin, which Pliva markets in Central and Eastern Europe under the brand name Sumamed. Pliva's azithromycin has also been licensed to Pfizer, marketed as Zithromax in the United States and elsewhere. Pliva also produces and markets drugs under license from a number of multinational pharmaceutical companies.

Barr becomes a leader in bio-generics, a capability that is embryonic because of the lack of regulatory structure in the States, but a capability that can be highly useful in Europe. But with Barr's penchant and skill for the important regulatory side of generic drug development, and this is the primary skill for generics operating in the U.S., the company should develop some valuable legal and regulatory expertise in crossing the pond with this skillset. The company gains some valuable sterile injectable drug manufacturing facilities in Brno, Czechoslovakia and in Krakow, Poland. In India, there is a bioequivalence laboratory, another significant capability for the future. In addition, transfer of some manufacturing to other countries should result in a lower tax burden for Barr.

The significant manufacturing and research capabilities should greatly increase the amount of research and cthe number of submissions that the company will be able to make for approval. These are very low cost facilities relative to the U.S. based facilities that the company operates. The company currently offers about 150 different dosage forms of some 75 different generic pharmaceuticals. As well, Barr has had a proprietary pharma strategy largely concentrated in women's healthcare with SEASONALE extended cycle oral comprehensives, Plan B emergency contraceptive, and ParaGuard Intrauterine contraceptive device, A total of 19 proprietary products are manufactured and distributed.

The combined company will have over 150 projects under development and will be marketing a current portfolio of about 120 products.The combined company has 65 ANDA's (Abbreviated New Drug Applications...used for generic approval) in front of the FDA.

Some of the Pliva products seem quite plain vanilla relative to other generics, but given their low cost structure, have significant margins.

The financials are not very clear. Pliva is being acquired for twice sales, which seems remarkably low relative to other generic deals in the States. The company claims that the deal is neutral to slightly accretive to its internal (not Street estimates) for 2007. Additive for 2008. The company expects some $50 million in cost savings in 2008 followed by $100 million in 2009.

Though the actual acquisition will follow a timeline requiring several approvals, Hart Scott Rodino approvals July/August, August/Sept Croation Agency Supervision approval, then the tender offer. The transaction will not be complete prior to October.

Despite the uncertainty that surrounds this new twist in Barr's strategy, the valuation for BRL is quite reasonable. EV/EBIT on a TTM basis is about 10.5 times. Return on invested capital for TTM was 18.4%. Long term debt is miniscule at about 1% of capital. However, the acquisition will be financed largely with about $2 billion in incremental debt both short and long term. Management indicated that it is working through those details.

Until I have a chance to work through some financials, I don't have sufficient comfort with the numbers and the assumptions. But strategically, I suspect the deal makes a great deal of sense for Barr. There is a lot of integration risk in deals of this scale. Barr has been a poor performer this year with a YTD decline of about 22%. Returns on capital have been sinusoidal ranging between 11% and 30% in the last five years. Free cash flow generation has been strong, especially in recent years with last year totalling over $300 million. About $80 million in net share buybacks occured last year. There is a $300 million buyback authorized since 2004.

Disclaimer: Neither I, my family, or clients have a current position in Barr Labs or Pliva.

PETsMART versus Petco-The Debate

Pet ownership in America grows at about twice the rate of the human demographic. This basic approximation has driven the growth of pet retailing. This growing marketplace is very compelling because of its growth and its relatively unconsolidated nature. The largest participant in the industry is PETsMART (PETM) holding about 11% market share followed closely by PETCO (PETC) with about 6% market share.

The industry has come under increased scrutiny lately as value pricing on some SKU’s by PETCO resulted in some Wall Street downgrades of PETsMart stock.

A recent Motley Fool post seems to have promulgated further concern.Since year-end, PETM is actually up about 4.3% (total return) versus a decline of about 9.6% for PETC, but the recent downgrades of PETM have diminished PETM’s lead.

In my view, PETM stands out from its superstore competition with the broadest offering of services that is available in the industry. PetsHotels, pet grooming, Doggie Day Care, dog training and access to full veterinary care provides a much broader experience than any other retailer can. Translate broader experience into greater selling opportunities. Its loyalty program, PetsPerks was modelled after the loyalty program of Harrah’s (HET) generally believed to be one of the most successful loyalty programs known in marketing. The program is designed to increase the average spend by each customer without sacrificing gross margins.

PetsMart is in the midst of a remodelling program which should bring greater focus on its service offerings. Remodelled stores have demonstrated much improved same store sales comparisons. The remodelling costs are minor at between $50K and $100K per store. So far, 170 of over 800 stores have been remodelled.

A recent Citigroup report highlights the strong impact that the service side of this business can provide.The service business has grown by over 25% CAGR in the last five years. The services side represents only about 8% of sales at this point but I believe this will grow substantially over the next five years to some 15%. There is a leveraged benefit to these services. According to Citigroup, PetHotels have provided a 25% lift to same store sales at maturity as well as significant improvement in store operating margins of some 430 basis points.

The impact to profitability at the margin can be substantial. Taking your dog in for a grooming, often results in additional sales of grooming accessories, toys, and shampoos. According to the Citigroup report, incremental revenues of 25% arise from a PetHotel, but of greater importance, pre-tax margins lift from 8.1% to 12.4%. Pre-tax income per square foot lifts a very impressive 94%. The rollout of hotels is accelerating. Starting with only 7 stores in 2004, to a year-end 2005 total of 32, PETM should have a count of over 60 hotels by year end 2006.

The economics of PETM don’t really require much improvement. The essential story is one of free cash flow generation, a better model, in my view, than that of PETC.

Pet Superstore Cash Flow Characteristics



The picture that this presents, in my opinion, demonstrates that PETM has superior financial flexibility to effect change. Long term debt to total capital for PETM represents about 27% versus about 44% for PETC. Generally, cash flow from operations is somewhat higher relative to revenues for PETM versus PETC. Finally, PETC appears to be spending a significantly great proportion of cash flow from operations in capex as it endeavours to grow. PETM’s superior free cash flow yield is almost twice that of PETC’s.

PETM has demonstrated improving Return on Invested Capital sequentially over the last five years to a current 14%. The ROIC has shown little variance despite the introduction of the remodelling programs and the step-up in the construction of PetHotels. PETC on the other hand, despite a higher ROIC of 18% in the last quarter, has experienced a steady decline in its ROIC over the last several years when ROIC’s were 24-27%.

PETsMART has utilized its substantial cash flow in value creating ways. In June of 2005, PETM announced a share buyback program of up to $270 million to be completed by the end of 2006. There is about $100 million left in authorization. As well, the company pays a small dividend of 12 cents per share. PETCO has an authorization, which commenced in March of 2006, to buy back up to $100 million in stock and has completed about $19 million in the first quarter.

Working capital management at PETM came under some suspicion in the fourth quarter as inventories were up 18.4% YOY compared to a sales increase of only 13.4%. It appears that most of this was a build up in inventory for a new distribution center it opened in August of 2005, as well as a program to avoid stock-out situations in its stores. There is room for improvement here as PETM’s investment in working capital for each incremental dollar in sales has been about 7.5% compared to PETC’s 5.5%.

On an EV/EBIT basis PETM is trading at 11.4 times TTM EBIT and 7.5 times EBITDA. Given its strong free cash flow characteristics, its improving ROIC, and its innovation in adding margin opportunities through its new services, I find the business very attractive.

The threat of PETCO going into an everyday low pricing strategy to match PETsMART seems to be the great bugaboo over the stock. PETCO sales growth slowed last year and it has cut prices on a few SKU’s. There remains a price differential according to several analyst reports that is now about 10% versus 15% previously...PETM still offers the cheaper price. BUt remember that despite PETCO’s 10% higher prices, this is still 10% below that of the average grocery store. The grocery chain share of the pet food marketplace is 48%...there is plenty of room for both of these companies to gain share rather than butt heads with one another.PETsMART’s loyalty program which is just coming into fruition can continue to build sales and average ticket. A good offset to PETCO’s price cutting.

Other competitors loom...WalMart (WMT) and Target TGT) are both expanding the space dedicated to pet supplies, but mostly at the lower end foods rather than other supplies. The destination store with its massive selection should continue to outperform the general merchandiser with a few hundred square feet of space to dedicate. Again, I believe that the service offerings of PETM should continue to draw customers.

Overall, I like the strategies that are being employed here. Analysts estimate long term growth for Petco between 8 and 20% with a consensus of 15.11%. For PETsMART, the growth estimates are slightly higher at 14-20% with a consensus of 17.78%. At current prices, in my opinion, PETM is discounting less than 10% growth or alternatively a significant and permanent drop in operating margins. I have a difficult time finding much credibility in either scenario.

Disclaimer: I, my family, and some clients have a current position in PETM. Neither I, my family, or clients have a current position in PETC.

Sunday, June 25, 2006

Assessing the Costs and Benefits Of Brokers in the Mutual Fund Industry

There are some brokers who do a truly outstanding job. But according to this study, and my own anecdotal experience, purchasing funds through the broker channel provides little tangilbel benefit.

This study in NBER (National Bureau of Economic Research) focuses on five measurable potential benefits to consumers of brokered fund distribution:

(a) Assistance selecting funds that are harder to find or harder to evaluate;
(b) Access to funds with lower costs excluding distribution costs;
(c) Access to funds with better performance;
(d) Superior asset allocation,
(e) Attenuation of behavioral investor biases.

In short, brokerage customers according to this study, generally pay substantially higher fees, and buy funds that have lower riks-adjusted returns than directly-placed funds.

The study does indicate that any benefits that do exist must be found along less tangible  dimensions. It suggests, that perhaps brokers may help investorssave more, better customize their portfolios to risk tolerances, and/or increase overall investor comfort with their investment decisions.

Seeking a benefit suggested in part (e) would be particularly intriguing and beneficial to clients. If brokers are better able to overcome behavioral biases, client portfolios would benefit. As the paper suggests: "From an academic perspective, the past 10 years have seen an explosion in research focusing on how behavioral biases affect investment behavior. While biases like overconfidence, mental accounting, and loss aversion characterize individuals, little research has focused on whether distribution professionals attenuate—or magnify—these biases. For example, while  investors might have bounded rationality—and be unable to process the mountain of information on the thousands of funds available—paid professional  advisors might be able to help them sift through all of this data and make better investment decisions."

Regrettably, the advisors generally demonstrated all the same biases that the rest of us have. Despite the professional standing, they are after all human.

The paper is quite lengthy at 61 pages and will be of particular interest to those with deeper research needs. Bottom line, even when picking actively managed portfolios rather than index funds, invest directly rather than through most brokers. Exceptions to the rule are always there, but they are truly jewels.

Link to document

Hedge Funds and the SEC

In a letter to Chuck Hagel, the Chairman of the Senate Committee on Securities and Investment, the writer, describes what he views as the growing risk to capital markets of lightly or unregulated hedge funds.

He draws comparisons with the unregulated pools of money in the 1920's-then called syndicates, trusts, or pools that were instrumental in the 1929 Great Crash.

A fascinating, if not scary read.


Thursday, June 22, 2006

Concorde Career Colleges-Another One Bites the Dust

As you know, I have been positive about the education stocks despite a litany of problems. In particular, my choice has been Career Education (CECO) which has had a number of significant legal issues clarified in the last few months.

Please check these past posts:

Getting an Education in Education Stocks

CECO Revisited-The Clouds are Parting

CECO- Are the Storm Clouds Back?

Company specific risks have held back the valuation. Yet, the industry has been replete with these issues which have affected some of the currently most admired companies (translate- currently most expensive) in the past.

Yet, given the somewhat predictable nature of the revenue stream, and the relatively low capex to support the business, private equity investors have taken notice. This is a business where you get paid before you provide the service, a darn good business model when you think about it. Sure makes working capital less of a concern. You get Title IV funding as financial aid so companies get 70-80% of their revenues backed by U.S. government funding. Not a bad receivable, in my view. Education Management which operates some 70 schools, was bought out for $3.4 billion by Providence Equity Partners and Goldman Sachs Equity Partners earlier this year.

This morning, Concorde Career Colleges (CCDC) announced that it had entered into a definitive agreement and plan of merger with Liberty Partners at $19.80 per share, a 34% premium to last night's close.

The $19.80 valuation suggests an EV/EBIT of 14.7 times TTM EBIT. On an EBITDA basis, the multiple of TTM EBITDA is 10.7 times. CCDC has returned about 20% on capital for the last twelve months. EBITDA margins in the last twelve months have been about 9% and operating margins have run at about 6.5%.

CECO, in contrast, has EBITDA margins of 21.5% despite its difficulties and diversions, twice the margin of CCDC. On the operating line, CECO operating margins are 17% on a TTM basis, again more than twice those of CCDC.

Investors don't seem to care. CECO closed today unch at $31.15. At this level, it is trading at EV/EBITDA of 5.8 times and EV/EBIT of 7.36 times both on a trailing twelve month basis. Return on invested capital for the last twelve months has been similar to CCDC, at 21.2% versus 20%. Given its higher EBITDA and operating margins, I suspect there may be some excess capital here. Should CECO trade at the valuation accorded CCDC, based on the EBITDA multiple, the value would be $57, and based on EBIT, about $62.

Given the increasing competition, I do not believe that operating margins will be what they were. I believe that growth rates will slow down. My valuation for CECO is consequently much more conservative in the mid to high $40's.

But I also believe that ongoing adult education and upgrading will be part of most people's future. Job hopping and skills building are an expectation for most of us. Even at my advanced age post 50, continuous learning is an expectation if not a requirement, even if self-imposed.

There is a terrific roundtable forum on education in the May 29th Wall Street Transcript. (Subscription required.) In it, you will find that the participants are a little less sanguine about the prospects for this industry versus my own largely on the basis of increasing share for non-profits versus the for-profit segments of the education market. As well, there is some useful insight into the issues of institutional accessability, affordability and accountability.

CECO continues to suffer some enrollment backlash from its regulatory problems both on campus and on-line. They remain constrained by the Department of Education from opening any new campuses or doing any acquisitions. AIU, their largest online platform continues to have issues with the State of California. But, at least in my opinion, most negative regulatory risks and outcomes are baked into the price.

Disclaimer: I, my family, and some clients have a current position in CECO. None of us has a current position in CCDC.

Ken Heebner-Independent Thinking and Going Against the Crowd

There is an interesting article by John Birger of Fortune Magazine discussing Ken Heebner, "The Mad Genius of Mutual Funds." As Morningstar describes his CGM Funds' style as "too gutsy to be practical," I find his love of concentration to be very unique in a very plain vanilla mutual fund world where lemming-like behavior is the norm.

What is particularly impressive to me in his recent history is the ability to let go of his winners. Housing stocks were on fire for most of the last five years and Heebner was along for the ride. But in early 2005, he jettisoned his entire portfolio of housing stocks as a result of his concern for "funny-money mortgages" and moved into energy stocks.

Explaining his strategy:"I've made the most money when my strategy was something few people agreed with. My huge outperformance occurs when I find one of these very contrarian strategies - something supported by a lot of deep analysis - and implement it in a concentrated way in the portfolio. Like investing in oil in 2004, when everyone thought it was going back
to $25 a barrel. Or buying savings-and-loans in 1982, back when interest rates were 15%. I wish I could find one every year, but I can't."

He further adds:"When we discussed copper last fall, you clearly knew a lot more about the supply outlook than most commodity analysts. " Obviously, there is great value in doing very intense research, MPT be damned.

"So if all you do is talk to management, you're going to hear there's no problem. But I talked to a mining engineer from one of the companies [operating in Chile], and he started out saying, "We don't have a water problem, we get 700 liters per second from our mine in the southern part of the country." But then he mentioned how those guys up north, they get only four or five liters per second. I go, Really? He says, "Yeah they have to go 200 kilometers to get water." Was it that way two years ago? "No."

Many analysts pride themselves on their "close" relationships with management. Sometimes, all this means is that management has found a shill who is unwilling to ask the difficult questions. Listening to IR or management babel does little to gain understanding any more than reading most research reports. Speaking to customers, speaking to competitors, speaking to employees can often provide greater insight than just listening to the "company line."

The phrase, "Where seldom is heard a discouraging word" describes the typical investor relations experience.

Looking for the investable advantage is a huge part of being a successful investor. Just doing things unconventionally as we described in yesterday's post will get you out of the typical framework in which many investors confine themselves.

Concentration, intense research, and independent thinking set Heebner apart. These traits will set your portfolio apart as well!

Wednesday, June 21, 2006

IP, Reputation, and Google Trends in Assessing a Business-Just Thank Dan

Dan O'Leary of The Intrinsic Value has done some insightful work using Google Trends. This is a fascinating tool and Dan has recognized its potential while it is still in its early stages.

Google Trends provides a comparative analysis of search queries to examine what specific search terms are being entered into the Google search engine, and their relative frequency. For anyone concerned about PR, about relative sales analysis, etc...essentially how various brands may be perceived versus their competition.

Brand names with sustainability truly provide a competitive advantage to a business. The customer knows the name and the image it represents. Distributors and retailers are almost forced to stock the product. Pricing flexibility is inherent in such a brand.

Dan has done some intriguing work to forecast demand for new Harley Davidson motorcycle demand. He has found that new shipments of Harleys have coincided with periods
of declines in "Used Harley" searches. Innovative and out-of-the-box kind of analysis.

Previously, Dan had done some interesting work in studying high-risk mortgage lending
by searching for interest only, home equity, and credit score trends. One can see how information like this could prove very useful in analysing small community banks.

The ultimate test of a great brand I believe comes from superior returns on capital when compared to an industry or industry in general. But there are other drivers of value that extend beyond brand as well. Intellectual capital is clearly one of the success factors.

Consider a company like Dolby Laboratories (DLB)
a business with some 40 years of brand creation behind it that derives 75% of its revenues from the licensing of its intellectual property. As the company indicates in its 10K:
We have a substantial base of intellectual property assets, including patents, trademarks, copyrights and trade secrets such as know−how. We have 928 individually issued patents and over 1,000 pending patent applications in nearly 35 jurisdictions throughout the world. ... We derive our licensing revenue principally from our Dolby Digital technologies.
We pursue a general practice of filing patent applications for our technology in the United States and various foreign countries where our customers manufacture, distribute, or sell licensed products. We actively pursue new applications to expand our patent portfolio to address new technology innovations. We have multiple patents covering unique aspects and improvements for many of our technologies.
We have over 800 trademark registrations throughout the world for a variety of word marks, logos and slogans. Our marks cover our various products, technologies, improvements and features, as well as the services that we provide. Our trademarks are an integral part of our licensing program and licensees typically elect to place our trademarks on their products to inform consumers that their products incorporate our technology and meet our quality specifications.
There is some value in this IP. Clearly, licensees of the technology find it important to place the trademark on their products. Historically, this has been a cash generative, high ROIC business. Deeper analysis of the specifics of the quality of the IP is needed to understand the business. Harken back to the Research in Motion (RIMM) versus NTP lawsuit and the ultimate settlement.

At times, many of us as value investors focus strictly on the "numbers." Often waaay too strictly!! Endless recitations of ROIC, and valuation ratios provide some comfort, but little understanding. Other aspects of a business accessible through informal, anecdotal surveys; informal canvassing of customers, suppliers, or competitors; or trend surveys such as Dan has proposed can help us gain insight into the deeper aspects of a business.

The art of investing is evolutionary...the process of constantly evaluating new ideas and approaches is imperative to understanding the sustainable competitive advantage of a business.
Again, such analysis in my opinion is an adjunct to the primary tests of looking at a business. If the business cannot produce a fairly regular stream of operating cash flow and ultimately free cash flow, more exotic metrics will not help you create value. Return on invested capital above the cost of capital will.

But the sustainability of that competitive advantage often is derived from brand, from IP, and from reputation.

Disclaimer: Neither I, my family, nor clients have a current position in Harley -Davidson, Dolby or Research in Motion.

Tuesday, June 20, 2006

Agrium-How Cyclical is this?

Agrium (AGU) is the largest publicly traded agricultural retailer in North America and one of the world's largest producers of agricultural fertilizers, nitrogen, phosphate, and potash. AGU is a unique platform in that it crosses the whole value chain with fertilizers, crop protection products, and seeds. The company, originally part of Cominco, a large Canadian mining company understands cycles, and has clearly sought to minimize them in its strategy.

The company has done that through global diversification.The company markets its products to all reaches of the world, doing retail business in Argentina, Chile, and Brazil as well as China.

In a recent interview with The Wall Street Transcript, the CEO Mike Wilson describes the tightening fundamentals for grain globally. Significant changes in diet are taking place among the Chinese. As Wilson points out, it takes 3.3 pounds of grain to produce a pound of pork and almost 8 pounds to produce a pound of beef. Dietary changes from Chinese staples to a more North American diet (God help them!) maintains the long term demand for grain.Combine this with shrinking supply of arable land, and the dynamics of the fertilizer business grow.

Similarly, the growing demand for bio-fuel and ethanol will result in growing demand for corn, sugar cane, and other crops production. I would far rather use this as a lower risk approach to the ethanol industry.

The valuation of Agrium suggests that the market remains concerned about its cyclicality. EV/EBITDA is about 6.8 times for trailing twelve months EBITDA. On an EV/EBIT basis, AGU trades at 9.8 times. The ROIC is about 13% on a TTM basis, partially reflecting the just completed and yet to be integrated acquisition of Virginia based Royster-Clark which has over 250 farm centers throughout the U.S.

The company reported a disappointing first quarter as a result of losses on natural gas hedges of about $43 million resulting in an operating loss of $48 million. The first quarter for a fertilizer company tends to be weak seasonally.

The company has generated CFFO in excess of its reported net income for at least the last five years and generated FCF every year since 2002.

Year......Net Income.......CFFO.........FCF






At current levels, the company has a market cap of $2.8 billion, a cash position of $300 million and long term debt of $477 million for an enterprise value of $3 billion. Analyst estimates for 2006 range from $1.43 to $1.95, a huge range! Estimates for long term growth are around 6%.

This remains a show me stock, whose strategy to reduce cyclicality is still not believed. In my view, this is still perceived as a pure fertilizer company, rather than having the multiple businesses that it now manages.

Disclaimer: Neither I, nor my family have a current position in Agrium. However, certain clients have a current position in Agrium.

Monday, June 19, 2006

Blog Aggregators

A brief note to highlight a bit of reorganization of the links. I have separated out the investment blog aggregators which are sites that feature the many investment blogs that you may wish to access.

Market blogs is a community of about 75 active members that includes all sorts of blogs, both investment and trading oriented. This is the first aggregator that accepted Value Discipline as a participant back in December of last year. The host has provided many new bloggers the opportunity to present their ideas. Market blogs has many participants that you would recognize as well as many fresh new blogs. It has almost grown over 50% since December.

Phat Investor is another large community with about 50 very active bloggers ( I count myself amongst this group) and another 150 blogs that may be in some state of repose or dormancy. But don't get me wrong, the first two pages of this aggregator will provide you insight into some of the best blogs around, both fundamental and technical.

StockBlogs claims to be the largest stock market blog directory. Certainly, one of the best organized. Dividing the world into General Market, Technical Analysis, Fundamental Analysis, Options, Contrarian Investing, Commodities and Miscellaneous, this directory highlights a blog of the week. Again, I am beholden to this directory as one of the very early adopters of Value Discipline.

24/7 Wall Street incorporates content from a wide variety of blogs dealing with economic, general market, and fundamental views and opinions. This is a fairly new directory authored by Douglas McIntyre and Jon Ogg. Doug is the former Editor-in-Chief of Financial World Magazine and has been on the boards of and Edgar Online.  Financial World was a wonderful business magazine of the 80's and early 90's that was truly stock investing oriented. Ditto for this blog directory.

The Money Blogs is a beta site associated with I have recently been asked to allow Value Discipline content to appear in this directory.  Though heavily trading oriented content seems to prevail as opposed to my staid value oriented banterings, there is some fundamental content that ranges from academe to accounting, from personal financial planning to cocoa and commodities. Very new and growing rapidly.

The Market describes itself as part magazine, part newspaper. It is an easy on the eyes, catalog of today's blog thinking...very readable and highly informative. Rather than scrambling through numerous templates and formats, blogs are presented in a much more presentable format. Value Discipline is a recent participant in this terrific new blog aggregator.

Last , and certainly not least is Seeking Alpha, another easy to read aggregator of today's blog thinking. David Jackson, a former Wall Street analyst and his team have put together a very useful compendium of numerous blogs plus have married that to an ability to create transcripts of various recent conference calls. One of the most professional efforts around in my view. I am proud to be a contributor and have been for some time.

I hope that you will find these blogs helpful in your search for investment thinking. As Buffett said, "There are many ways to get to heaven." Many approaches, many opinions, many stocks...ultimately, depend on your own sense of risk and reward to judge what is appropriate for your circumstances. But do the amount of money is so inconsequential to you to warrant being careless or to merely gamble it. Know yourself first...understand your relationship to money... then know what you're buying. Tips, whether transmitted by a buddy at the bar or legitimized through a blog can never be the basis for your decision-making. Investigate first, then invest.

Vonage Holdings-Unsafe at ANY Price

This is just way toooooo much.

What a waste of time. This truly is the #3 box that Munger describes at Berkshire Hathaway. At Berkie, there are three boxes, the inbox, the outbox, and the too difficult to understand box.

Maybe this is easily understood and should have be queued up immediately for the outbox.

Vonage (VG) as all of us have witnessed, appears to have been one of the more mis-priced IPO's in some time. The swoon from an intial $17 to its current half price special at $8.50 resembles a death spiral more so than a correction.

Today's news that Verizon is suing Vonage over alleged patent infringements just adds to the confusion if not disgust. Vonage and its Vonage America subsidiary were served with the lawsuit which relates to seven patents by Verizon Services and Verizon Laboratories.

One certainly must wonder about the quality of due diligence that the seemingly hapless investment bankers practiced. One would have thought that the intellectual property owned by the business would have been thoroughly assessed. But wait, there it is ...big as day...under risk factors, a completely disclosure of what existed at time of issue.

As the prospectus indicates, "We may be subject to damaging and disruptive intellectual property litigation." As it further adds:
We have been named as a defendant in three suits currently pending that relate to alleged patent infringement. See "Business—Legal Proceedings—Patent Litigation." In addition, we have been subject to other infringement claims in the past and may be subject to infringement claims in the future. We may be unaware of filed patent applications and issued patents that could relate to our products and services. Intellectual property litigation could:
  1. be time−consuming and expensive;
  2. divert attention and resources away from our daily business;
  3. impede or prevent delivery of our products and services; and
  4. require us to pay significant royalties, licensing fees and damages.
Needless to say, for a value investor, in my view, there is no price at which this becomes an attractive Ralph Nader's description of the Corvair, Unsafe at any Speed, this may well be unsafe at any price.

Though it is easy to rail against the ineptness of the investment bankers, the investor has some responsibility to him/her self to check out a few facts.Maybe those risk factors mean something!

Let's think about this. Start off with the first risk cited. "We have incurred losses since our inception and we expect to incur losses in the future." Seems pretty clear to me. You were depending entirely on hope, or some greater fool to take you out of this misery.

The prospectus adds that so far the accumulated deficit was $467 million. Revenues for 2005 were about $270 million compared to marketing expenses of $243 million. Seems excessive somehow to get back essentially only one dollar of revenue for each dollar of marketing that you put up. Perpetual motion of the worst kind. Did trends improve...well, not really much, first quarter revs were $119 million and marketing costs went to $88 million. Still spending roughly 75 cents to get a buck.

What is the competitive position? Where is the competitive advantage? Vonage competes with many companies having far greater financial resources, traditional telephone service providers, cable companies, wireless providers,'s all there in the prospectus. As it states," Most traditional wireline and wireless telephone service providers and cable companies are substantially larger and better capitalized than we are and have the advantage of a large existing customer base." It adds further, "Until recently, our target market has been composed largely of early adopters....Attracting customers away from their existing providers will become more difficult as the early adopter market becomes saturated."

So let's see, in picking off the low hanging fruit, we have lost almost half a billion dollars, it now takes us 75 cents to buy a buck's worth of revs, but the outlook is more difficult???

Thes first two risk factors should have proven sufficiently discouraging. There were only another 25 or so that followed.

Customer service at least according to this one blogger appears to be deteriorating.

"Just sending this out as a warning to anyone who considers signing up for Vonage. I’ve had the service since August and honestly, it was pretty good. Over the last month or so, however, the quality has been degrading considerably and so I attempted on several occasions to contact customer support.That didn’t go well. Hold times are frequently in excess of 45 minutes to an hour, and once connected the support representatives are completely clueless with regard to problems with service. They’ll offer to send you to Tier 2 support, which means another half hour or so of holding. Once there, you’re just as likely as anything to be told that the problem lies with your ISP and to try it again later. On the 24th, I signed up for SoftPhone, Vonage’s PC-based additional line service. The login credentials provided to me were incorrect and as such, I never used the service. I called again and was on hold for 90 minutes before I gave
up. I called back this morning to cancel my account."

Well, post deal, Vonage has a balance sheet with equity of $433 million and debt of $278 million. The financiers' preferred got paid down to zero. Operating loss in the first quarter was $82 million. SG&A to run this empire in the first quarter was merely $53 million. Net cash flow used in operating was about $75 million.

I do have empathy for those who have been sold a bill of goods in committing to this offering. But the warnings were quite straight forward and candid. The company's risk factors are quite explicit. In MD&A, the company is forthcoming in its strategy: "We are pursuing growth rather than profitability." "We have chosen to increase our marketing expenses significantly, rather than seeking to generate net income." "This strategy will result in further losses which generally have increased quarterly since our inception."

My conclusion is hardly earthshaking. Too many risks, better financed competitors, apparent reputation for difficult service, and a profitless strategy. Intellectual property that has already been subject to lawsuits with another just in. The stock is unsafe, in my view, at ANY price.

Disclaimer: Neither I, my family, or clients have a current position in Vonage or Verizon.

Sunday, June 18, 2006

Father's Day

Happy Father's Day to all the Dads and to all the father figures that have found themselves in the very important role of giving out paternal advice.

I am very proud of my two daughters who are now grown. My youngest just graduated from university at the beginning of this month. Neither has pursued investing as a career, though both have an understanding of "the magic of compounding" and the importance of saving. One of the lessons that my Dad (rest his soul) taught me was the avoidance of debt, even to the extent of paying down mortgages ASAP and always saving regularly some part of my earnings. Having a rainy day fund to handle distress needs was always paramount in his mind and something I tried to convey to my own kids.

My father had little interest in stocks. As a young teen who was intrigued by the markets, I was advised that real estate was the preferred long term investment, especially rental housing. Having observed too many instances of rental defaults and trashed apartments, and having repaired too many blocked toilets for Dad's tenants, I rapidly soured on the notion of maintaining that family savings plan and turned to the equity markets.

But for most young people, long term investment is established through various qualified plans: 401K plans, and IRAs in the US, or RRSPs in Canada. But considerable savings are too be had just by simple conservation and expense avoidance. Most people are quite surprised by the impact of compounding over some years of even minor savings.

Let me convey a bit of very basic non stock market oriented paternalistic advice.

Pack your own lunch. Using this calculator, you will see that saving $5 bucks a day for twenty years at a long term rate of 8% will provide you a nest egg of $57,000.

Ignore your raises. Bank them, don't change your lifestyle too materially. This is tough love, but what a savings vehicle! A raise of $2000 a year for twenty years at 8% banks you $91,500.

Pay yourself first. I sound like some kind of old-fashioned insurance salesman but the philosophy is quite valid. Participate in the 401K especially when your employer is match contributing. This is free money! Only 31% of workers ages 18-25 participate in 401K's offered by their employers. Don't wait...set it aside now. Five thousand dollars in savings a year for a 40 year career at 8% provides a nest egg of $1.3 million. Waiting 20 years to "think about retirement" and then saving at twice that rate ($10,000 a year) just trying to catch up will provide a nest egg of only $457,000, a full 800 grand less. Save a little less now, but do it NOW!

Don't let tax deductibility arguments regarding home equity loans influence your consumption. Banks want your money and will lure you into handing it them. Don't use your residence as an ATM. Sure it's better than credit card debt, but still weigh the cost of the interest expense, even after tax with your tax savings. Please check out this calculator.

For additional savings calculations and ideas please see Hugh's Mortgage and Financial Calculators.

For my regular blog readers looking for some stock insight, thank you for indulging me with this post today. Even though my girls have grown, I just can't stop being a Dad!

Congrats and best wishes to all the fathers on this special day!

Friday, June 16, 2006

Sun Hydraulics-Earnings Power in Fluid Power

Sun Hydraulics (SNHY) designs and manufactures screw-in hydraulic cartridge valves, manifolds and packaged systems. The business, formed in 1970, has been profitable every year since 1972, quite an accomplishment for a business in what is perceived to be a cyclical business.

SNHY products go into manufacturing capital equipment (historically about 34% of sales) such as metal cutting, injection molding, and metal forming machinery. Other users of hydraulic equipment include bulldozers and construction equipment and oil drilling and mining equipment.

In a recent Wall Street Transcript interview with the CEO,Allen Carlsen, he described the hydraulics industry as a $20 billion industry of which screw-in hydraulic valves represents about a $1 billion market.

Specifically, screw-in hydraulic cartridge valves is a newer hydraulic technology that is taking market share from conventional hydraulic valves. They can be product specific and help to differentiate and improve the end product and as well, represent a more cost-effective solution as they are faster and more reliable. Another technological trend is the integration of electronics into hydraulic applications and SNHY also has products which allow being driven by electronic controls. Screw-in cartridge valves represent a miniaturization of hydraulic valves.

The company generates about 50% of its net sales outside the US and has design and manufacturing facilities in Florida, Kansas, Coventry, England, Erkelenz, Germany, Seoul, Korea, and Shanghai, China.

The company has a clear product driven as well as customer service strategy. As Carlsen points out, " We really are focused on investors who are going to be with us five or ten years, and spend very little time on investors who are speculating on a very short-term horizon." Music to my ears!

This is a $200 million market cap company with long term debt of just $3.7 million which is offset by cash of $5.4 million giving an enterprise value of $197.

Only about 68% of the shares represent free float. Some 30.5% of the company is held by Robert Koski, the co-founder of the company and its former President and CEO.

From a valuation standpoint, the company trades on an EV/EBIT multiple of only 9.8 times. Return on invested capital on a TTM basis is 21%

The returns on capital have improved over time, and as you can see, were positive, even if only slightly, during recession periods:


Earnings quality has been decent with CFFO cxceeding net income for each of the last seven years.Free cash flow has been generated every year since 2000.The company has treated shareholders well with a dividend growth rate over the last five years of 23%. There have been some share buybacks, In December of 2005, the Board authorized the repurchase of up to $2 million in stock to be completed by Jan 15th 2007. They have worked quickly with $1.8 million of stock already completed and retired.

The company also has an intelligent attitude about equity based compensation. As the proxy indicates, "The Compensation Committee determined that the use of restricted stock under the long-term compensation program implemented in 2003 better satisfied the purposes for which such awards were intended than stock options." In other words, the board is more interested in having management own stock rather than placing a side bet on the market!

The company has a very interesting culture with a flat management structure that "encourages communication, creativity, entrepreneurial spirit, and responsibility among employees." As management describes it, "A workplace without walls: both in its offices and its shop floors provides employees at all levels to interface. Few 10-K's openly discuss an objective to avoid unnecessary bureaucracy!

Overall, I like the candid nature of their disclosures, the team spirit that they endorse, and the corporate governance that demonstrates that these are not empty words. The economics are attractive, though obviously subject to the risks of weakening of the economy. I also like the fact that this relatively small business has such a significant global footprint.

Disclosure: Neither I, my family, nor clients have a current position in Sun Hydraulics.

Tuesday, June 13, 2006

Gaining Credibility at the Fed

Barry Ritholtz at The Big Picture has discussed many aspects of the capital market's continuous hand-wringing over the hawkishness/dovishness of Ben Bernanke and its impact on capital markets.

I think this morning's post on "How the Fed Chief Gains Credibility" really captures the discussion best. The post captures CNBC's Steve Liesman's explanation of this transition...there is a willingness to take short term criticism, "sacrificing the economy" to take a short term recession if needed just to gain credibility.

A sad reality of life is that markets adjust with expectations. Though much of CNBC's cast is afflicted with histrionics and a feeling that somehow the world is "entitled" to a bull market daily, Steve Liesman in my view, demonstrates a deep understanding that, "every additional year that he remains in office, the less the cost of that additional tightening."

Despite some oscillation in his verbage as highlighted in this post, Bernanke in my view, is the philosophical twin of Alan Greenspan.

There is no choice, in my view, other than to demonstrate firmly his credibility as an inflation fighter. The catch phrase of "data dependent" seems to be interpreted as faltering or hesitating in his decision-making. When was there a Fed chairman who was not data dependent?

Myopia about Fed transitions also seems to be standard fare for capital markets. Paul Volcker's legacy was a difficult hurdle for Greenspan to overcome. Greenspan was labelled by Barron's as "a relatively unknown quantity" at the 1987 transition. The New York Times expressed it at the time " The markets had incredible confidence in Paul. Investors saw him as the one guy with the knowledge, guts, and skill to stop inflation and hold the sytem together....Indeed, some economists are saying that one reason there is growing fear of an economic catastrophe is that the Reagan administration let Volcker go, replacing him with the less-experienced and less-well-known Alan Greenspan."

Another excellent view of Fed leadership transitions from Morgan Stanley's Steve Roach can be read  here.

The transition "curse" is nothing new. Greenspan's gradualism will likely be emulated by Bernanke. Confidence will be restored after credibility is achieved. Bernanke has not spoiled the party. Conditions of excess, particularly in housing are a corollary of previous policy, not the makings of Bernanke.

This is tough, but necessary medicine. In the interim, find your opportunities in high quality names, avoid the dreck. Continue to look for businesses with a sustainable competitive advantage. Lesser businesses will be sorely tested. Quality earnings, quality balance sheets, stable and growing cash flows will be the characteristics of successful investing.

Monday, June 12, 2006

Tuesday Morning will be Difficult for Tuesday Morning- Are You Activists Out There?

Tuesday Morning (TUES) is a closeout retailer of upscale home furnishings and gifts operating over 700 stores. The stock is down some  45% over the last 52 weeks and 22% YTD. The home furnishings area has been tough (looked at Pier One [PIR] lately?) The May-Federated consolidation has resulted in heavy discounting in home furnishings and the general economic environment have made life difficult in this sector.

The situation continues. Earlier this evening, the company announced that same store sales for the quarter were comping down 8.0-9.5%. The company expects earnings for the second quarter to come in at 7-10 cents per share versus consensus expectations of 21 cents.

Tuesday Morning sells first quality brand name merchandise at closeout prices 50-80% below those charged by department stores, not factory rejects or irregulars. Its merchandise can include Hummel figurines, Royal Doulton and Wedgwood, as well as Martex bath towels, and Kitchenaid or Cuisinart applicances. Great stuff, great deals, but highly discretionary purchases.

The store base has grown by about 10% a year for the last five years. Costs are kept low by renting almost anything that is available cheaply for its space.

The treasure hunt atmosphere that prevails at its sales events attracts predominantly women from middle and upper income households, not the mortgage interest and gasoline marginalized customers of Wal-Mart. Median annual income for TUES' customers is believed to exceed $60,000. The weakness that concerns many WMT bears (and we are not bearish on WMT) seems to be reaching higher economic strata.

Retail stock problems are often evident in the gross margin and the working capital accounts. From this perspective, TUES did provide some clues of its difficulties during the first quarter. The cash conersion cycle had moved out to 143.4 days versus the comparable quarter's 113.3 days. Days of inventory outstanding had moved up to 209.2 days versus last year's 141.6 days. Gross margins did not show, at least during the first quarter, any signs of deterioration hanging in at 41.3% versus the prior period's 41.0%

In June of 2005, the company paid its first ever cash dividend of $0.65 per share. Long term debt as of year end 2005 was zero.

This has been a stellar performer with respect to ROIC:

In mid-May, the CFO resigned unexpectedly to accept a position at a privately held aerospace company. The company's problems do NOT relate to any accounting or financial issues that I can ascertain, it appears to be simply a competitive environment that has proven difficult for TUES' merchandise. There may be issues with sourcing as manufacturers have improved their own inventory management or operate their own closeout stores.

On a valuation basis, this is about as good as it gets...EV/EBIT is 7.2 times. The company delivers ROIC is above what one would expect for this price, but the story should not end there.

Looking at CFFO adds to the mystery and to my reluctance to use this name . Here is CFFO:
2000...$  2.4

Madison Dearborn owns 27.5% of the stock, so the company has strong support. Of interest, in the last quarterly conference call, management was peppered with questions regarding the declining profitability by Robert Chapman, a noted activist at Chap-Cap Activists. I suspect that successful activists of Mr. Chapman's ability could utilize tomorrow's weakness to add to positions.

But, until I have a better handle on what's happening with working capital management and hence, cash flow from operations, I really can't own this one just yet. Restained by my discipline...but I am intrigued by price, by long term value, and by the potential for activist interest.

Disclaimer: Neither I, my family, or clients have a current position in Tuesday Morning.

Still Big on Small Stocks

In Barrons this weekend, there was an interesting feature on small cap stocks featuring an interview with Alexander and Alex Paris of Barrington Research Associates. They have presented a number of very interesting and unique ideas, some of which I would like to highlight.

The prevailing wisdom of the street seems to suggest that investors should be looking to larger cap names at this point in the cycle, whatever that may mean. Clearly, smaller cap companies have higher risks and rewards associated with them largely because of the nature of competition. The dominance of capital can quash the competitive advantage of many small cap names. With scale comes cost efficiency...sometimes. However, as with any conventional rule of thumb, the intelligent investor should be looking for opportunities anywhere they may arise, whatever the market cap. Though I certainly advocate using opportunities such as the current market to upgrade portfolios with predicatable and less risky names, and that generally means larger cap, on the other hand, one should not neglect an opportunity when it comes along.

One of the names mentioned was Gentex (GNTX) an auto parts business. Gentex manufactures and essentially invented the self-dimming electrochromic mirror. This has been a wonderful business that I have followed pretty much from the IPO completed many years ago at Furman Selz. The business has grown revenues by about 17% CAGR over the last ten years and similarly for E.P.S. The company has been conservatively managed from the balance sheet aspect since it carries no debt, and in fact has a cash balance of $3.85 per share. Sort of everything that you want to see in an auto parts business.

The valuation of the business also appears quite attractive at first glimpse. Enterprise Value is only about 13 times EBIT which seems fairly reasonable for a company with this growth record and a return on invested capital of about 13%.

The trend in ROIC has been decidedly downward as follows:

Unfortunately, the trend in gross margins has also headed southward:








These gross margin trends have been sequentially down each and every quarter since June of 2004.

Working capital management as well as slowed with the passage of time. Five year average inventory turnover has been 10.6 times versus a current 7.8 times. Accounts receivable turnover has also slowed slightly to 7.8 times versus a five year average of 9.2 times. Not horrendous but nevertheless noteworthy.

Needless to say, Gentex has shown stellar results in a very difficult environment. Their nemesis, Donnelly is a well-heeled subsidiary of Magna International (MGA) a magnificent company except for its attitude to minority shareholders. Ex- Frank Stronach and his consulting agreement, I could learn to love Magna. Clearly, gross margin pressure must be coming from here. As well, some 24% of Gentex revenue comes from GM. This is similar for Magna.

Magna generates ROIC of about 9%, significantly below that of Gentex but trades at an EV/EBIT of only 7.5 times relative to the aforementioned 13 times. Gentex looks expensive relative to the group, its quality generally justifies the price.

Unfortunately, given the uncertainties that I still hold regarding GM, the cyclicality of the auto business, and the slow erosion of working capital characteristics and gross margins, I have a hard time getting excited about Gentex, despite some real fondness for management and respect for its abilities.

Finally, I would like to remind people of Harman International (HAR) the most un-auto of the auto-parts companies in my view. Less than 10% of revenues tied to the Big 3 (at least the former Big 3) Similar earnings growth to Gentex at 17%+ for EPS with ROIC of 18%. Please check the post at :
Harman International-An Auto Parts Growth Story

Disclosure: Neither I, nor my family nor clients have a current position in Gentex or Magna. Neither I, my family have a current position in Harman International. However, some clients do have a current position in Harman International.

Friday, June 09, 2006

Shareholder Activism Postscript

Tom Brown of has an outstanding post on Home Depot's Bob Nardelli's behavior and corporate governance which makes for great reading. Tom's simple message should be read by managements and boards of public companies everywhere. Perhaps even their investment bankers could ponder on these suggestions!

1. Shareholders come first, not last.

2. If you're going to take a big comp package, take responsibility for it by being prepared to defend it in public.

3. Courtesy counts.

4. Courage counts too.

As Tom summarizes at the end: " The numbers a business produces counts for a lot. Often, character of the people who run the business counts for more."

Shareholder Activism

There is a tremendous article in the Investment Dealer Digest entitled "Retaking the High Ground" which gives an excellent backdrop on the rise in corporate activism that we witness today. Access to this article is for Fierce Finance subscribers, another great service that highlights current thinking in finance.

Discussions about the benefits or drawbacks of activist investors makes the moniker "Fierce Finance" quite appropriate.

Few managements appreciate the highlighting of their shortcomings, their failures, their misappropriation of funds, or their misallocation of capital. For most individual investors, the proxy statement gets tossed into the trash, the proxy vote itself is rarely cast, and managements press on, relatively secure that their position if not sinecure remains largely beyond reproach.

Today's Wall Street Journal (subscription required) highlights the plight of Friendly Ice Cream (FRN) shareholders and what appears to be an eyeless or at least heedless board if these allegations are true.

To quote the article: "Two weeks ago, a judge dealt Friendly a harsh rebuke. Rejecting its
motion to dismiss the suit, Massachusetts Superior Court Judge John
Agostini said Friendly hadn't investigated Mr. Blake's claims in good
faith. He lambasted directors for 'lockstep loyalty' to management and
for being 'largely oblivious' to their obligation to police dealings
between Friendly and the chairman's other company."

Many managements prefer that shareholders do the "Wall Street Walk" in other words, simply sell the security and move on. Managements and Directors may respond to your letters, may listen politely, or impolitely in the case of of the Home Depot board which decided to sit out the most recent annual meeting.

As the IDD article highlights, the playing field is changing. The framework of corporate governance is the new field of battle...lobbying of management and other large shareholders, inciting public opinion, and utilizing the court system is all fair game. As the article states, these weapons, are all in the cause of effecting change that benefits the company and certainly benefits the investor.

According to the article, the percentage of dissident victories has ratcheted up 59% so far in 2006 up from 58% last year and only 40% in 2001.

The article highlights the fact that the playing field has changed with Sarbanes-Oxley, which despite the rigor and expense that it brings to companies, has "injected a dose of caution, conservatism, and downright nervousness into boards."

Some of the hedge funds that have engaged in this type of activity are clearly in it for short-term victories and have little regard for the long term propects of the company. Companies that rely too heavily on the financial engineering aspects of large Dutch tenders and resultant weakening of balance sheets have done little to create long term value. A prime example of this was Reebok where Paul Fireman's Dutch tender for 25% of the company (instituted the day after showering management with stock options) showed high regard for financial engineering but little understanding of dealing with the operational and marketing difficulties of the business. I have expressed concern about Cracker Barrel's response and significant re-leveraging to the desires of Nelson Peltz' hedge fund.

Investment bankers, always eager to earn a fee, for the most part remain true to the managements that have greased their palms in the past. Loyalty to clients is admirable, but robbing shareholders of their rights is despicable. The poison pill and the staggered board defense are obvious methods of entrenching management but other procedural defenses are beoming prevalent such as limiting a shareholder's ability to call a special meeting or act by written consent.

Not all hedge funds are the dirt bags or short term interlopers that some investment bankers fear. Not all activist shareholders are hedge funds either.

In my own experience as an institutional investor, I have had to confront several managements and boards whose bankers have taken an adamant adverse position from the get go. Some board members were willing to listen. Most investment bankers provided little more than blather and sought ways to undermine the rights of the minority shareholders.

Fortunately, as a long term investor who was joined by fellow long term investors, we were able to militate other shareholders and the school of public opinion.

Managements that attempt to entrench themselves such as Vishay and numerous others are telling shareholders that they do not want us to be their partner. In cases of such disenfranchisement, there is little that one can do except put your capital elsewhere. Why belong to a club that has nothing but disdain for you and your rights?

However, in cases where you do have a vote that means something, VOTE. Let managements know where you stand. If returns on assets and capital are below that of the industry, express your views to management and the board. Let large shareholders know of your views. In short, get involved.

Change can be glacial and patience can be needed. Influence takes time. But if the business has a reputation, has a core competency, and can be improved, the battle is worth it.

I was, with the support of many other shareholders, able to effect significant change in a number of my portfolio holdings. This occurred at a time when such activism was viewed as radicalism. Under the umbrella of Sarbanes-Oxley, such change has actually become easier.

Disclaimer: Neither I, my family, nor clients have a current position in Friendly, CBRL, Home Depot or Vishay Intertechnology.

Thursday, June 08, 2006

Revisiting Masco

Back on January 11th, I drew attention to Masco (MAS) which is truly a jewel of a business and has been a well known quality company for years:

In Masco...The Obvious Should not be an Impediment, I described at that time the quest that most of us undertake to find a cheaper analog of the company that we really wanted to own but always seemed out of reach. The quality, dependable, high return company always seemed to be too expensive. The lesser quality, less reliable second banana was generally cheaper but unfortunately, tended to be a performance laggard. If bought at the appropriate price, the second choice sometimes worked well, but in your heart of hearts, the better company was what you really wanted to own.

This is one of the great aspects of Mr. Market turning they say, in the raid of the house of ill-repute, they even arrest the piano player. Fear and phobia dominate the "thinking" of the herd and great companies are cast off as willingly as the truly poor companies.

Horizons shrink. In bull markets, the investment horizon extends forever. Investors willingly talk about companies that have terrific products, competitive advantages, and strategies that extend for years and years. Competitive advantage periods seemingly are extended into the hereafter when the tape is rising. But bear markets shutter vision. The future becomes murky if not opaque. The investment horizon becomes truncated into "looking for a bounce."

Good news is ignored. The elimination of a terrorist such as al Zarqawi elicits new worries about who will rise to power. Had this occurred in a bull market environment, we would see a tape up 200 points today. Ben Bernanke has been transformed from "Helicopter" Ben to Ironman Ben. The attention to inflationary pressures is perceived as almost iron-fisted and maniacal. Either extreme posture is unlikely to oocur. Remember the jawboning role of the Chairman of the Fed...moral suasion is different than enactment.

Back to Masco. On May 10th the company announced a new buyback authorization of up to 50 million shares of its common stock replacing its existing program under which it had 34 million shares of the 50 million completed. The company expects to return a minimum of $1 billion to shareholders on average annually over the next several years.This is no idle commitment. In the last three years (prior to 2006) the company returned $3.6 billion to shareholders. In the first quarter, $408 million was returned.

On January 11th, I had suggested that I felt it was wise to wait for a better entry point. The stock at that point was $30.85.The stock has dropped below $29 today. At this price, the company offers a free cash flow yield of 5.2%. EV/EBIT dropped below 9 times.

For some additional details about the company please refer to my January 11th post. Admittedly, the housing/ building materials markets offer few catalysts for the near term.

Please check this forum in the Wall Street Transcript.

However, it's exactly at times like this that one can build long term positions for a portfolio. Housing starts will be weaker than what we have gotten used to. I do not recall a year that they dropped to zero. Ditto for home sales in general. Renovations will also be part of the overall building materials demand picture too.

When markets are weak, they provide a great opportunity to buy quality when it is actually there, not when it might have a chance of developing. Ignore the story stocks and buy what actually has fundamentals.

Bear markets or corrections, whatever this may be are great opportunities to improve the average quality in your portfolio. Clean out the dreck, cast out the tip stocks that never quite worked out. Build your wealth. We do not currently have a position in Masco.

At these levels, I am thinking that's a mistake.

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

Tuesday, June 06, 2006

Turbochef Technologies- What's Cooking?

Turbochef Technologies (OVEN) seems to be the king of high speed-cooking. The company's ovens significantly reduce cooking times by combining microwave, convection, and air impingement technologies at the food preparation process but, unlike pure microwave, maintain the product quality. The company has focused primarily on the commercial customer but has just introduced its first residential oven.

Tasting "experts" who have extensive restaurant experience tell me the results are terrific. Wall Street analysts, and there appear to be 8 of them following this $300 million company, tell me that the company is being tested by more restaurant chains (at least 30 of them) than ever in its history. But I'd sure like to see evidence of this in the numbers.

This company was valued at $16 million back in 2001 with much of its revolutionary technology. There was a small acquisition of Enersyst in 2004 for $13.6 million in an equity
swap plus assumption of debt that provided brought in some additional innovation in food service in its 150 patents.The company does have a portfolio of over 200 patents.

Back in 2001, the company was held back by poor access to funding, and what seemed to be mediocre management at that time. A one for three reverse stock split was implemented in December of 2004.

In February of 2005, the company completed a 5 million share offering (including 2,075,000 shares sold by selling shareholders) raising about $56 million for the company and about $40 million for themselves. The deal was done at $20.50 per share.

The company does have a strong relationship with Subway and is the exclusive supplier of speed cook ovens to all Subway franchise restaurants, a majority of which, as of last year's prospectus, had already purchased the oven.In the first quarter of 2006, Subway ordered an additional 2,000 ovens in addition to an original 3,000 to place into Subway's expansion into Wal-Mart stores. Other orders have come from small chains in Brazil and an 800 store chain in Spain. Starbucks and Dunkin Donuts are testing the ovens as well with trials for Starbucks in locations in Washington, Portland, Chicago, and San Francisco.Dunkin Donuts trial is much smaller by comparison consisting of only two stores.

Despite an initial cost that is about three times that of a conventional oven, lower operating costs and lower installation costs (no vent is required) make the economics of this oven very attractive to the restaurant owner.

Now to the stock owner! In the last 8 years, the company has lost money on the operating line in 7 of them. The year 2005 demonstrated sales of $50 million plus another $2 million in licensing revenue for total revenues of $52 million. But the operating loss was also significant at $29.4 million. Cash flow from operations for the year was also negative at $20 million. The first quarter of 2006 also showed a loss on CFFO of about $6 million, compared to the comparable quarter in 2005 of a loss of $1.5 million.

At the end of the first quarter, the retained earnings, well err..., the accumulated deficit was $85 million. So much for all of the "success" in penetrating these various chains. As the prospectus points out:

" The market for our commercial ovens is a nascent sector of the commercial cooking equipment market. As is typical with new products based on innovative technologies, demand for and market acceptance of our commercial ovens are subject to a high level of uncertainty. Achieving market acceptance for our commercial ovens will require substantial marketing efforts and the expenditure of significant funds to increase public awareness of our brand and our products, and to educate potential customers as to the distinctive characteristics and benefits of our products and our technologies. There can be no assurance that our marketing efforts will result in significant market acceptance of our commercial ovens."

The prospectus also addresses the company's potential entry into the residential consumer market.

" An important part of our growth strategy includes the research, development and introduction of residential speed cook ovens. Historically, our expertise has been in the speed cook sector of the commercial cooking equipment market, and although we have developed technologies that currently are being licensed for use in certain existing residential ovens, we have no prior experience in the production, marketing and sale of products in the residential oven market."

I certainly agree that the company has very unique technology and has made significant inroads into commercial ovens. The cost savings afforded its customers provides a reasonable basis for success. In other words, not a half-baked idea ( I couldn't resist.) The selling cycle for commercial ovens is a long one requiring extensive testing in beta sites. Decisions by customers seemingly take at least two years.

But it comes down to finances. Commercial acceptance has not translated into financial success. The valuation on an EV/EBIT basis is negative 8.5 times. Profitability is non-existent, free cash flow is negative. Cash which post offering was at $65 million a year ago is now $33 million. Gross margins declined in the first quarter to 30.4% versus the comparable quarter's 38.8%.

This is an early stage company that should carry venture capital kinds of risks and rewards. Management continues to hold a significant amount of stock at about 40% and close to 45% with executive stock options considered. After the offering last year, very little follow-up selling has occured, only 29,000 shares sold by the chief operating officer.

Bottom line, too much risk for my blood. Fundamentals have yet to catch up with the valuation.

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

As Hurricane Season Commences, Berkshire is There

In an article in Bloomberg yesterday, Harrahs, the casino company says it is paying 50% more for property insurance because Berkshire Hathaway is "one of its only options."

The article points out that Berkshire became the lead insurer for Harrah's when AIG and Ace, their former insurers. declined to provide sufficient coverage.

Premiums are as much as 20 times higher than the prevalent rates a year ago according to an insurance broker at Aon, the insurance broker.

Most insurers with lesser balance sheets are pulling away from the market. At a time when the market is hardening and rates are compensating for the risks undertaken, Berkshire is showing its muscle and acumen.

Sunday, June 04, 2006

Cascade Corp...Not the Dishwashing Detergent Company

Cascade Corp (CAE) will not get your dishes clean and shiny. But this relatively unknown company may shine in your portfolio.

Cascade, based in Fairview, Oregon, manufactures material handling "load engagement" products that are widely used on lift trucks. As per the 10-K: "Products are designed to handle loads with pallets and for specialized application loads without pallets. Examples of specialized products include devices specifically designed to handle loads such as appliances, carpet and paper rolls, baled materials, textiles, beverage containers, drums, canned goods, bricks, masonry blocks, lumber, plywood, and boxed, packaged and containerized products."

The company markets worldwide both to the end-use customer through the retail lift truck dealerships as well as to lift truck manufacturers. In emerging industrialized economies, lift trucks are repolacing manual labor and are viewed as productivity enhancements, consequently, softening the cyclicality of the business.

The company has leading market share in North America, and Europe, but holds significant share in Asia Pacific countries. It has had a strong presence in China for 20 years. The company has manufacturing facilities in the US and Canada as well as the Netherlands,Germany, England, Italy, France,Australia, Korea, and China.

Foreign sales are significant at Cascade representing $200 of $451 million in sales or 44%.The level of profitability of the European businesses has suffered due to price competition from several privately-owned companies in local and regional markets. The company, as a result of the integration of several acquisitions as well as new management is addressing European issues.

Operating margins vary widely across geographic segments. North America provides operating margins of 21.1% on some $250 million in sales last year. Europe essentially broke even on the operating line following an operating loss for 2005 on $132 million in sales. Gross margins run at half of North American levels. The Asia-Pacific geography provided a 10% operating margin on $45 million in sales last year. Finally China, with $22 million in sales operated at a company high 28% operating margin.

Cash flow from operations has exceeded net income for each of the last five years, totalling $224 million.Capex has totalled $53.5 million over this period. Ordinarily capex is slightly less than depreciation expense. The company has invested about $18 million in acqusitions in Europe in 2003 and 2004 (FY 2004 and 2005.) The company is planning to expand its Chinese expenditures over the next year and a half by $15 million. The company has generated free cash flow in each of the last eight years. Though the company has not engaged in significant share buybacks, the dividend growth rate has been 22% over the last five years. The fully diluted share count is 12.85 million versus 12.27 million five years ago up less than 1% per year. The current payout ratio is about 16% of TTM earnings.

Eight members of the senior management team have been with the firm for over 20 years. The CEO, CFO, and COO have been with the firm for over 33 years.

Despite the cyclicality of the business, net income has remained positive over the eight year period I analysed. Return on invested capital has reached a recent high of 15.5% compared to a median of 8.05% for the trailing eight years. The low for ROIC in the last eight years has been 5.5%. This sure doesn't seem to fit the profile of a cyclical name!

Balance sheet quality has improved markedly through the period. Long term debt to capital was 51% of capital eight years ago but is currently only 5%. Cash and marketable securities represent $58.5 million or 22% of equity compared to $30 million in long term debt.

I find the valuation compelling with EV/EBIT of only 7.1 times trailing twelve months EBIT. The stock is down 18% year to date.

Insiders own some 20.5% of the company (23.8% including stock options)

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

Friday, June 02, 2006

Good Luck CFA Candidates!

Tomorrow morning, some 84,000 people in 145 countries will be writing their CFA exams. Candidates write one of three levels of the exam tomorrow, and must successfully complete all three levels in order to be rewarded their charter. The course of study for the CFA program consists of ten different program areas ranging from corporate finance to equity analysis, fixed income management, as well as ethics and professional standards.

The program is rigorous and comprehensive. Only one in five candidates who begins the program actually completes it. On average, it takes most candidates who do complete the charter, four years to make it through the process.

Candidates must complete at least four years of relevant investment work experience and commit to abide by and affirm annually their commitment to the CFA Code of Ethics and Standards of Professional Conduct.

The CFA is recognized globally as the gold standard of the investment profession. The body of knowledge evolves with each passing year to ensure that the program continues to provide the necessary tools to ensure pertinence and relevance to current investment practice.

To all candidates writing tomorrow, I wish you the best of luck. The program is tough but fair. The breadth of knowledge that you need to know is vast, but that's what your clients will demand of you.

To those who wish to learn more about the program, please check out:

CFA Institute

Candidates, watch your time carefully and hang in there. Good luck!

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