Would you pay any price for liberty?

"Robert Cialdini has had a greater impact on my thinking on [psychology] than any other scientist" - Charles T. Munger

One of the books that tops Munger's recommended reading list is Influence: The Psychology of Persuasion by Robert Cialdini, which outlines 6 weapons of influence: reciprocation, commitment and consistency, social proof, liking, authority, and scarcity. I highly recommend the book. It is interesting to see companies exploiting many of these weapons of influence although frustration to find oneself a victim to them. Understanding these weapons though can help one to have an even deeper understanding of things like network effects and how powerful such a business model can be.

The story of QVC (the main operating asset of Liberty Media Interactive) reminds me of many of these psychological biases. This article is a few months old, but it keeps coming to the forefront of my memory as I look at Liberty Media Interactive under the ticker LINTA:
The Genius of QVC

The article covers the qualitative aspects of the company very well. In summary, the business has a devoted customer base and their effectively recurring revenue, a wide moat, huge scalability, and a low cost mentality.

The company trades at for $9.5B. It has full ownership of QVC as well as a couple web properties/retailers (QVC is main driver of revenue and profits), as well as stakes in Expedia (24%), IAC (11%), Interval Leisure Group (30%) and HSN (33%). Those stakes are valued at $2.9B. That puts the value of QVC at about $6.6B. There's also $4.7B of net debt attributed to the LINTA tracking group. Since QVC is the core, and practically sole, cash generator for LINTA, I'm going to attribute the debt to QVC for this back of the envelope valuation and ignore the other niche web properties they own. This gives QVC an enterprise value of $11.3B.

The company should bring in around $1.1B in operating earnings (EBIT) - do note that this number is a very rough guestimate. They did $1B, $.95B, and $1.1B in 2009, 2008, and 2007 respectively. Depreciation should come in around $550m, while capex should be about $300m ($176m already plus about $100m more expected). John Malone is known for leveraging his companies, but I would prefer to see cash return to shareholders instead of constantly being eaten up by lenders. The company does do buybacks, but there would be a lot more without all the debt. Interest payments eat up all of that arbitrage between D&A and capex and then some. That puts QVC at a multiple of 10x EBIT/EV, not exactly cheap even though it is a great business.

Wally Weitz gives the stock a positive pitch in this article:
"Liberty has split itself into six or eight different pieces, one of which is Liberty Media Interactive (LINTA), which is basically QVC. It's going to become an independent company, getting out from under the tracker-stock confusion. QVC grew right through the recession. It's doing beautifully. It doesn't have to worry about bricks and mortar. It can change its product mix on the fly, as the presenters are showing their cookware or whatever. We think the QVC business itself, which also does business in Germany, Japan, England, and Italy now, is worth $16 or $18 a share, and it's got another $5 or $6 a share of marketable securities. That adds up to $21 to $24 a share, and the stock's currently at about $15.50. Not only do you have good assets, you have liquid assets that [founder and CEO] John Malone can do something else with."

While the spinoff of LINTA into an asset-backed company as opposed to a tracking stock will eliminate the tracking stock discount, I'm not sure there is much more value on the upside. I do not know what assumptions Weitz was using in his valuation, but my guess is that he would like to accord a very premium valuation to QVC. I would not disagree with according QVC a premium valuation. Home Shopping Network (HSNI), which is 33% owned by LINTA trades at 18x earnings and is in the same business. QVC due to its size and dominant position might receive a 20x earnings valuation. QVC has recorded about $80m in net income excluding a $394m gain on a disposition in the past 9 months which I don’t believe is indicative of the health of the business. In the last 3 months it earned $100m. I'll annualized the last quarter's earnings since it probably represents a more normalized operating environment, and venture they do about twice as much business in the 4th quarter (this is not out of the blue, they do state they do a lot more business in the 4th quarter for holidays) as any quarter for annualized earnings of $500m. Adding in the $200m different between D&A and capex puts FCF at $700m. At an implied stock market value of $6.6B, that values QVC at just under 10x FCF. This is a little cheaper but that stock trades closer to 16x FCF/EV. At the 20x earnings that Weitz might be forecasting, QVC is worth $10B.

Considering QVC worth $10B, with an additional $2.9B of equity investments gives a total value of $12.9B less net debt of $4.7B for an equity value of $8.2B or $13.6/share. This is an extremely rough estimate of value as a reminder.

I'm prone to discount stocks with debt. QVC does have robust cash flow to service the debt and it fared quite well during the depths of the recession. While I would not refute that downside appears limited, I question where the upside lies. There is certainly growth in the future, but at this price it seems like a buyer isn't getting that growth for cheap and mostly likely the upper ends of what one might consider a reasonable price.

While the company is incredibly attractive, the price seems to fall in the realm of fair value. I definitely see this stock as more of a Phil Fisher than Ben Graham style investment, but would like to see it come down more in price to receive a better margin of safety.

I hold no position in stocks mentioned in this article.

Talk to Andrew about LINTA

Global Power Equipment Group - Investment Profile

Global Power (GLPW) is a post reorg equity whose predecessor went into bankruptcy due to accounting irregularities. The structural rather than economic nature of the bankruptcy means that the business is good but the market’s perception of it is bad. As a result, a discrepancy exists between the price and value. GLPW has brought in new management, relisted on the NASDAQ, shed a loss-making unit, and has been growing and profitable. With cash piling up on the balance and attractive growth prospects, investor awareness should increase and the price should catch up to the value.

The company declared bankruptcy way back in 2006 and emerged at the start of 2008 and relisted in 2010. The bankruptcy was a result of a failure in internal accounting controls that resulted from acquiring a Chinese company. The company boasts many of the characteristics that portend the strong performance of companies upon emergence from bankruptcy: a non-economic reason for bankruptcy, a new senior management with an ownership stake in the company, a net cash and almost debt-free balance sheet, and a business revitalized from the waning stigma of its bankruptcy.

The business is divided in two segments: services and products. The services division was acquired in 2005 as a way to offset the cyclicality of the products division. The services division focuses mainly on maintenance and construction services at nuclear power plants within the United States. The business is split between recurring revenue and multiyear projects and requires little capital. The products division focuses mainly on gas turbine parts and heat recover steam generators to a small extent. The company outsources a large part of its manufacturing in order to focus on design, marketing, and relationships. Their products are custom made with past customers including Exxon, GE, Mitsubishi, and Southern Electric. This business line requires little capital as well. Both businesses possess attractive characteristics that make GLPW a desirable investment candidate, assuming the price is right.

Management was replaced during the bankruptcy process with people who have experience in the sector. Management and directors own 670,831 shares at current value of $14.7m or 4% of the company. They are compensated with RSUs and stock options that are well in the money currently. The new CEO was formerly the President and COO of McDermott International.

Services - This segment does maintenance and construction at nuclear plants in the US. They have a presence at 55% of nuclear facilities in the US. The US nuclear fleet is aging and their lives have been extended from 40 to 60 years. Stretching their life is going to require exactly the kind of work that this division provides and they are well positioned to get the contracts. They already have multiyear contracts in place for certain projects and have a growing backlog for their services. Management claims the normalized net margin on this business is around 10%-13%. Margins have been trending up, but 10% seems a little high or still further down the road, unless the full year report records more additional profit than revenue. The first 9 months of 2010 had 7.2% net profit margins, up from 2.7% in 2009 and a modest gain and loss in 2008 and 2007, respectively. The service contracts are structured as cost-plus and GLPW should have additional leverage in discussions as the bankruptcy stigma diminishes.

The services segment will benefit from strong tailwinds in the nuclear industry. The nuclear fleet operating in the US has been in operation for an average of 30 years. The expected life of these plants was 40 years, but the Nuclear Regulatory Commission in the government has extended many of their lives to 60 years. As if they weren’t already old, they will now be allowed to operate further into their operational lifetime. As with any machinery, the older it gets the more maintenance it will require. GLPW has been involved in increasing security features at plants, valve services, insulation, and other forms of maintenance. The industry dynamics present a huge opportunity for Global Power, which has an excellent safety record performing maintenance at nuclear plants around the US. Furthermore the maintenance sector for nuclear plants is fragmented and their net cash position and stated desire to acquire smaller businesses in the sector should boost earnings if done at appropriate valuations.

Management anticipates flat to mid-single digit declines in the service segment due to the completion of a $170m contract. There is about $225m in service contracts in the backlog, but service revenue for the first 9 months so far has been $287m and was $347m in 2009, $245m in 2008, and $195m in 2007. As the large contract about to be completed demonstrates, the business can be lumpy. The overall trend of the past few years has been one of growth, and the aging of nuclear facilities substantiates this. Management has cited the numerous contracts that are coming up for bidding as well as projecting higher normalized margins than are currently being achieved, which bodes well for the business. Management has stated a desire to acquire some engineering capabilities for this segment to broaden the type of work it would be capable of performing and leveraging their current relationships. This is a reasonable development and extension of the company assuming it is done at the right price.

Products – This segment primarily makes products used in gas turbine power plants (>90% of segment revenue) and heat recovery steam generators that are used in a variety of industrial processes such as pulp making and refineries. The HRSG product line is small and so discussion will focus on the natural gas turbine products. Orders are done on a fixed-price basis and so margins fluctuate more. The 10-K hit it on the head citing the benefits the product segments products offer: lower construction costs, shorter construction periods, lower CO2 emissions, rapid start-up and shutdown times. Natural gas is at low prices, even relative to coal currently, and the current supply-demand favors continued low gas prices. All the products are custom-designed and engineered in-house, while most of the manufacturing (70%-75%) is outsources. The segment is asset light and faces little technology risk.

The tailwind in this segment is long term in nature. The Department of Energy Annual Energy Outlook from December 2009 predicts that 46% of capacity additions in the power sector from 2008-2035 will come from natural gas. While predictions are usually not too great, the general idea that gas turbines have a huge tailwind is clear. As highlighted above, there are numerous inherent advantages to natural gas electricity production. At current prices, even without a carbon price, natural gas is even attractive relative to coal in certain areas of the world.

Earnings in this segment are cyclical as the products are part of greater capital spending projects. The largely variable cost business model leverages the company to the upside and protects it on the downside. In the first 9 months of 2010, this segment achieved 9.9% net margins compared to 4.7%, 10.5%, and 6.3% in 2009, 2008, and 2007 respectively. Sales have been lumpy and don’t follow a trend. The first 9 months of 2010 recorded $110m compared to $193m, $311m, and $208m in 2009, 2008, and 2007. Despite lower sales, higher margins were achieved YoY. When asked about this on the most 3Q 2010 conference call, the CEO or CFO attributed this the segment VP doing a better job with procurement and all around operationally. There is a lag between when these projects are planned and when they are built, explaining why 2008 was such a banner year for sales. This division is much closer to the trough than the peak of its earnings power. As financing becomes easier to get and projects are planned, demand for the products should pick up. The company already has $114m in product segment backlog as of Q3 2010, matching the sales of the first 9 months of 2010.

Valuation - The two distinct segments necessitate a sum-of-the-parts valuation. The company just announced that its term loan/revolver has been paid off. That leaves the company with a net cash position of around $60m. On the most recent conference call, the company stated it had about $10m in surety bond and at points over the past year that figure got into the high teens. For simplicity’s sake, excess cash will be considered $40m.

There aren’t many pure play companies in either of the fields these segments operate in. There is some overlap in construction firms out there or power equipment firms, but the product lines and services offered differ. The electrical equipment industry trades at an average of 23.5x earnings (TTM). The construction and engineering industry trades at an average of 26x earnings (TTM). GLPW is classified under the electrical equipment industry, but most of its business and profit is currently coming from the construction and engineering segment (that is how the services segment would be broadly defined).

The company has 16,388,351 fully diluted shares outstanding and currently trades at $22/share for a market capitalization of $360m. Net of excess cash, the enterprise value is $320m. The company has earned $32m ($36m if you include discontinued operations) in the past 9 months from continuing operations giving the company a current PE of 10.

The past 9 months are used for 2 reasons. First, there is no breakout of 2009 quarterly earnings by the company or in an SEC filing. Second a breakout of quarterly earnings in an S&P research report showed a sizeable loss in the 4th quarter of 2009 but profits in the first 3 quarters. The company was profitable on a full-year basis and there is nothing structural about the business that makes for a messy 4th quarter. For the full year of 2009, reorganization expenses declined considerably, interest expense moderately, and SG&A modestly. The company was more profitable in 2008 due to the delivery of products that had been ordered pre-Lehman. This back of the envelope valuation will assume a breakeven for the 4th quarter, but there seems to be enough of a margin of safety in the valuation for a surprise. Furthermore, it would be quite difficult to predict what a loss might look like for the upcoming quarter.

A super optimistic valuation might use the industry averages, but more modest multiples can be assumed for a base scenario. A multiple of 15x earnings for the services division and 10x for the products division values them at $300m and $100m respectively. The excess $40m in cash adds up to a valuation of $440m or $26.60 a share, a 20% gain from current prices. The service division receives a higher multiple because it requires very little investment, receives cost-plus agreements for work, and has a great growth runway in front of it. While the same might be said of the products division, it does face a little more commodity risk since it operates on fixed price contracts and is cyclical. Tinkering with the multiples will lead to a higher upside scenario.

More optimistic scenarios can be entertained due to the trough in capital spending, and the boost gas turbine construction should see in 2011 and 2012. The service division will naturally have more work to bid on as nuclear plants get older and require more services. Both segments should benefit from strong organic growth over the medium horizon and the stock price will reflect that. Additional earnings growth can be achieved through cash flow and current cash being utilized towards acquisitions.

Catalysts:
1) Additional service contracts
2) Greater analyst coverage
3) Smart acquisition

Risks:
1) A double dip recession/China collapse/Europe collapse could push out product division orders
2) Dumb acquisition (management does own 4% of the company which should prevent that)
3) Rising natural gas prices and/or no climate change initiatives
4) Nuclear plant operators decide to close down plants instead of maintain them for an additional 20 years (See Oytster Creek for a recent example, although it will still be in service for another 9 years).

Conclusion:
GLPW represents an attractive investment at current prices. The company is undervalued as a going concern and based on its future growth opportunities. Comparable companies trade at higher valuations and there is the prospect of substantially higher profits in the future. The company has a variable cost structure and debt free balance sheet that will help it weather whatever the economic future holds. A downside/base scenario values the company at a price 20% higher than current prices, although there is potential for much greater upside in the next 2-3 years.

The author is long GLPW. Do your own research before making investment decisions.

Talk to Andrew about GLPW

Hennessy exceeds expections - for the most part

Hennessy Advisors (HNNA) announced full year earnings of $0.16/share and $913,000 in net income on Friday. Since it trades OTC, there is no SEC filing. The company trades at 10x earnings net of cash, has no balance sheet issues, and requires next to nothing in capital expenditures to maintain their position. As of year end, profit margins expanded from 10% seen in previous quarters to 12%, showing the leverage in the business model to increasing revenue. Earnings are only stated up to September 30th, and the stock market has continued to perform well relative to year-ago comparissons. At this moment, the health of the company and earnings are probably greater than is publicly available.

The one negative is the increase in the share count, albeit by a very modest amount. The stock repurchase announcement was made in August, so I would have expected to see a slight decrease to no change.

All things considered, this validates the basic thesis: improving equity markets are boosting earnings and the company trades at a discount to earnings and AUM/EV of other asset managers.

Here is the press release:
http://www.prnewswire.com/news-releases/hennessy-advisors-inc-announces-annual-earnings-of-016-per-share-111289279.html

Talk to Andrew about HNNA's earnings

Hennessy Advisors (HNNA) Investment Profile

Asset management is a great business. The business model is defined by strong recurring revenue, massive scalability and the resultant high returns on invested capital. Hennessy Advisors (HNNA) is an opportunity to acquire an asset manager at a rock bottom valuation. Their investment track record is average, but they are astute operators who have taken the proper actions to increase value.

Overview – Hennessy is the culmination of a roll up of mutual fund assets over the past 10 years. Most of the fund management is outsourced in one way or another – through formulas, such as the “Dogs of the Dow” theory and various quantitative screens (The basic strategies are outlined on Page 11 of the 10K, they are mostly value oriented although apply a small amount of technical indicators) or through sub-advisor agreements where the funds are actively managed. This is a low cost model within an industry that already requires quite low levels of capital. Most of its funds have expense ratios below 1.00%, but the company still boasts strong margins. With the huge downturn in markets during 2008 and 2009, assets under management (AUM) shrunk and profits plummeted as they are derived primarily from AUM. The stock market has returned to higher levels, but the stock has not. At the corporate level, the balance sheet remains strong and the company is proving opportunistic with a buyback, which should result in surprisingly high EPS and will prove a catalyst in realizing a higher share price.

What can go wrong –
1. Morningstar ratings a major selling point of mutual funds. There is a degree of reflexivity from a business perspective here because as the Morningstar rating goes lower, there can be an outflow of funds and remove the sole driver of profit. The median ranking of their funds is 3 stars. Hennessy has had net outflows over the past few quarters, although they have attracted some new money and the rise of the market has helped them.
2. If the buyback is fully executed, management and board will control greater than 50% of the stock. With an underleveraged balance sheet, they can lever up the company and take it private. They would not be the first C-suite to rip off shareholders in history.

Valuation –
Shares Outstanding: 5,800,000; Current Price: $2.50; Market Cap: $14,500,000;
Net Cash: $5,200,000; EV: $9,300,000; AUM(’10): $900,000,000; EV/AUM: 1%

AUM for 2010 should average $0.9 billion. Hennessy has bought asset managers for between 2-3% EV/AUM, and most asset managers trade around 2% EV/AUM, which overall appears undervalued due to the aversion to equities in the current environment (premium managers trade at higher valuations). Even at this level, trading at 2 or 3% EV/AUM would result in a gain of 100-200%. The use of an illiquidity discount and giving it a valuation of 1.5% EV/AUM would result in a 50% gain.

Earnings power has been low due to the volatility of the stock market. Even in the 08-09 turmoil, HNNA only posted a slight loss and now earnings should rebound. The company did just under $6 million in revenue for 2009 and $9 million in 2008, earning -$195,000 and $1,611,000 respectively. This shows how much revenue can flow from the top to the bottom line. Debt repayment has reduced interest expense, and AUM has come off its lowest levels. There are fixed costs in the business, but they are low and give the business a lot of leverage on the upside. The company should be solidly profitable for 2010 in a variety of scenarios:

Low end - Net profit margins for the first 6 months of 2010 have been 10%, and during the bull market they were closer to 25%. A 0.7% expense ratio of AUM of $900 million would yield revenue of $6.3 million, and a 10% profit margin would result in $630,000 or $0.10 per share. Net cash, this is about 15x earnings. The downside case would be about 10x earnings net of cash, a price of $2.00 per share.

Annualized – On an annualized basis, the company is doing about $7 million in revenue with 10% margins. This would translate into $700,000 net profit or $0.12 per share. At the current rate, a large part of revenue would flow straight to the bottom line.

Upside – If the company has been able to buyback enough stock to move the needle on the share count (low volume definitely slows down the pace), EPS could end up being higher. Lower interest expenses could contribute another cent to earnings. Their Japanese funds have 4 star Morningstar ratings and may be able to attract more assets and they have expense ratios greater than 1.00%. Any combination of the market rising since March, stemming outflows, and increasing AUM in their higher rated funds (they also happen to have higher expense ratios) could boost earnings further.

Buyback and dividend – Somewhat ironic in regards to their mediocre investment returns is how astute management is at increasing shareholder value. They authorized a buyback in August to repurchase 1,000,000 shares. This represents 17% of the company and is covered by cash on the balance sheet. This is encouraging due to the size of the buyback relative to size, and management’s awareness that the shares are cheap. Part of their expansion strategy has been to roll up other funds, but at current valuation their own company is a nice acquisition. And a quick note on the dividend, it has been an annual $0.09 for the past several years. With the upcoming changes in taxation, the company is essentially paying their 2011 dividend in 2010 so that it is taxed at a lower rate. While the record date on receiving the dividend has passed, simple yet very astute acts like this are evidence for confidence in management’s ability.

Management – The reason the buyback and dividend seem to represent the desired scenario of alignment of interests between management and shareholders is because it truly exists. The Hennessey family (one is CEO, another is an exec) own 37.4% ($5.4 million) of the company, and the board of directors own (excluding the Hennessey’s) 7.6% ($1.1 million). The CEO makes $180,000 and 10% of pretax profit. He didn’t receive a bonus in 2008 or 2009, although the 10% deal is essentially a performance-based incentive. Even though he has an incentive to drive profits, it should be done smartly since it is unlikely he will want to dilute his ownership, which vastly outweighs his salary including10% of profits.

Acquisitions – Any acquisition would be instantly accretive to earnings since the cash balance is earning nothing and the company already possesses the infrastructure to manage the funds. Management has not been overly aggressive in the past with acquisitions and they have all contributed to the growing the top and bottom line. They might utilize leverage in a deal, but the balance sheet is debt free and the company would not be putting itself in danger by taking on debt. It would also help the company grow since the market has been neutral and means AUM aren’t going to increase through a rising market.

Opportunistic buyout – Management could theoretically use their huge stake in the company and the debt free balance sheet to buyout the company. Cannell Partners, which as been an activist in small-cap companies (they have filed 13-D’s on many firms, including MEDW, VVTV, SLRY – takeaway: someone will speak up if things get out of hand), has a 7% position, which should act as a spokesperson for the rest of shareholders. This decreases the likelihood of shareholders getting robbed if management gains a controlling stake in the company.

Major Catalyst – Their quarterly results up through the March 31st quarter were released in August. This delay creates a huge knowledge gap between the current state of the company and what is publicly available. The main driver of profits is AUM. The stock market has buoyed around current levels for a while and is higher than they were for most of 2009. Revenue should come somewhere between $7-8 million and EPS could surprise on the upside if the buyback has been executed. HNNA is a small fish in a big pond and could be a takeover target – much as the smaller companies they have gobbled up have been to them – and the private valuation on it is substantially higher than the market price.

Disclaimer - Assume the above is the culmination of a chimpanzee locked in a room with a typewriter. Do your own research. I own shares in the company.

Talk to Andrew about HNNA