Experiences are quite nice for finding things out, but some things you don't want to experience whatever it is to find out. For instance, do you want to know what its like to be tortured first hand? For me, I'd rather just read an account. Look, reading is essentially how you are going to get most of your information on investments. You can do some gritty scuttlebutting, but you likely have a day job. I've touched on how reading non-investing articles can yield plenty of stock picks before.
A lollapalooza of events occurred today. First, I read most of the articles posted on The Browser. It's just a very well curated daily linkfest essentially. In running the gamut of gamuts of topics, The Browser inadvertently widens the scope of my reading. I get warm and fuzzy when I see an article posted that I've already read. I recommend it to everyone.
The second thing that happened was that I read this article about a nuclear waste facility being proposed in Texas. It was purely out of curiosity. This applies tangentially to my post on Energy Solutions which esssentially has a monopoly on everything but the most dangerous nuclear waste in the US. In the aforementioned article, I found an even longer article about the man behind the proposed waste facility in Texas. It's quite a damning article that offers an interesting look at whats behind a potential threat to Energy Solutions. It's also interesting because it discusses the man behind Valhi, Kronos, and NL Industries, mid cap companies that are fairly dull and easy to understand (ie. more companies that you can further research, but now have a better depth and understanding of the management). I really don't know in this case, but such negative perceptions can often represent noise that offers a rational and patient investor an entry point to profits. Judging from the PEs though, the market doesn't seem too concerned.
No lollapalooza can occur without at least three factors. The third thing that happened today was Energy Solutions closed down 13%. That constitutes a material change in the company's valuation. They guided a lower level of EBITDA than expected, which is especially worrisome considering the debt load which I addressed in my previous write up. I shouldn't moan about such things, but I do wish I had the capacity to transact in debt instruments. I don't even know how to get a real time quotes on a bond price, truth be told. I imagine that the high yield debt ES issued recently is looking pretty interesting.
I don't want to sound like a some kind of capitalist zen guru, but investing is a way of life that requires your awareness of all that's around you to maximize your gain. To invest, is not to invest, but to live an aware life and know what to ignore. I wish I was kidding, but I think it definitely helps to a) read everything and b) have a subconscious mentality that some type of investment angle or edge can be gleaned from reading everything. I'd point out that Li Lui essentially disproved the conventional wisdom about Timberland's management and made a bundle in the process.
Talk to Andrew about reading
Thursday, March 31, 2011
Friday, March 25, 2011
Immucor - Strong Razor and Blades Franchise looks cheap
Immucor (BLUD) is high quality stock that was formerly an expensive growth stock that the market deemed worth >30 times earnings for the better part of the past decade. The company manufactures machines that perform various blood tests and sell the reagents that are required for each test. There are only 2 other companies – a subsidiary of Johnson & Johnson and Bio-Rad – that offer a full line of reagents and testing machines. The stock is not exactly trading for a distressed price, but the current price might allow a patient investor to cheaply purchase shares in a strong franchise with strong long term growth potential.
The company currently trades at 16x TTM earnings and 13x TTM earnings if you net out the cash ($84m in TTM net income, $1.35 mkt cap, $.25bn cash). On the face, this is not the kind of multiple that attracts a value investor, but investing is not done solely based on one statistic. The company has a cash adjusted TTM ROE of 33% and a ROIC of 30% achieved with no leverage and minimal cap ex requirements. The company achieves these great returns through its business model and competitive advantage.
The company sells its machines in order to get long-term contracts guaranteeing the purchase of reagents by customers at a fixed price. These contracts usually secure annual price increases as well. This is a genuine razors and blades business model. The reagents (blades) garner 80% gross margins. Once the company sells or rents a machine to a customer, they are guaranteed a steady stream of high margin revenue. Recently, the company began disclosing how many machines it has placed that are generating revenue. Just between August 2010 and November 2010, the companies placed machines grew from 1392 to 1,478. While I wouldn’t extrapolate this growth, the company is still placing new machines which will drive the top and bottom line.
The growth in the business was phenomenal from 2005-2010, with earnings and revenue doubling and powering right through the recession. Growth has slowed down in the recent year, despite more machines being placed with customers and a healthy backlog. The company states that many of the blood tests its products perform have a discretionary component. According to the CEO, 51% of transfusions are for cardiovascular disease and skeletal diseases (joint and hip replacements). These are generally procedures that are associated with the elderly. While people have been putting off what procedures they can, the sheer volume of baby boomers will begin to move the needle along with the increased machine placement.
There are several risks thought with this company. The Department of Justice recently dropped an investigation in price fixing and monopolistic behavior on behalf of the company and Johnson & Johnson. While this investigation was dropped, it spawned a class action lawsuit on behalf of several customers. The company’s products are a small part of the overall cost structure of their operations, but the company and its competitors are well aware that they serve a crucial and essential function. While one takeaway would be that the company has a very strong moat, there are some signs that it could as a result of illegal practices. I’m not a legal expert. These cases can go either way, although its no surprise to see customers annoyed by the high prices they pay and the lack of alternatives.
Another risk is a not yet resolved issue with the company’s manufacturing facilities. The FDA has inspected the facility and not been entirely satisfied. While the company has taken measures to fix the problems brought up by the FDA, issues still remain. It would be very difficult to shut down the company though because it does not carry a lot of excess inventory and its products play a crucial role in the day-to-day operations of hospitals. The details of the issues are not disclosed, but the company has been improving its facilities and there would be a large disruption in many hospitals if the company was forced to cease production at its facilities.
For a patient investor willing to tolerate the downturn in the cycle, the combination of increasing machine placement and increasing long term demand could potentially prove profitable. An additional long-term driver of growth is the company’s somewhat unique automation strategy. Their “edge” relative to competitors is that its machines don’t require a full time skilled technician to analyze blood samples and results. This minimizes errors as well as reduces the labor costs of the blood banks, labs, and hospitals that are its main customers. An additional catalyst in the stock could be the involvement of ValueAct, a hedge fund whose involvement in another company I have touched upon before. This collection of attractive long-term characteristics will likely allow the company to overcome the short-term bumps it has encountered in its growth trajectory as well as legal and operational difficulties.
Disclosure: None
Talk to Andrew about Immucor
The company currently trades at 16x TTM earnings and 13x TTM earnings if you net out the cash ($84m in TTM net income, $1.35 mkt cap, $.25bn cash). On the face, this is not the kind of multiple that attracts a value investor, but investing is not done solely based on one statistic. The company has a cash adjusted TTM ROE of 33% and a ROIC of 30% achieved with no leverage and minimal cap ex requirements. The company achieves these great returns through its business model and competitive advantage.
The company sells its machines in order to get long-term contracts guaranteeing the purchase of reagents by customers at a fixed price. These contracts usually secure annual price increases as well. This is a genuine razors and blades business model. The reagents (blades) garner 80% gross margins. Once the company sells or rents a machine to a customer, they are guaranteed a steady stream of high margin revenue. Recently, the company began disclosing how many machines it has placed that are generating revenue. Just between August 2010 and November 2010, the companies placed machines grew from 1392 to 1,478. While I wouldn’t extrapolate this growth, the company is still placing new machines which will drive the top and bottom line.
The growth in the business was phenomenal from 2005-2010, with earnings and revenue doubling and powering right through the recession. Growth has slowed down in the recent year, despite more machines being placed with customers and a healthy backlog. The company states that many of the blood tests its products perform have a discretionary component. According to the CEO, 51% of transfusions are for cardiovascular disease and skeletal diseases (joint and hip replacements). These are generally procedures that are associated with the elderly. While people have been putting off what procedures they can, the sheer volume of baby boomers will begin to move the needle along with the increased machine placement.
There are several risks thought with this company. The Department of Justice recently dropped an investigation in price fixing and monopolistic behavior on behalf of the company and Johnson & Johnson. While this investigation was dropped, it spawned a class action lawsuit on behalf of several customers. The company’s products are a small part of the overall cost structure of their operations, but the company and its competitors are well aware that they serve a crucial and essential function. While one takeaway would be that the company has a very strong moat, there are some signs that it could as a result of illegal practices. I’m not a legal expert. These cases can go either way, although its no surprise to see customers annoyed by the high prices they pay and the lack of alternatives.
Another risk is a not yet resolved issue with the company’s manufacturing facilities. The FDA has inspected the facility and not been entirely satisfied. While the company has taken measures to fix the problems brought up by the FDA, issues still remain. It would be very difficult to shut down the company though because it does not carry a lot of excess inventory and its products play a crucial role in the day-to-day operations of hospitals. The details of the issues are not disclosed, but the company has been improving its facilities and there would be a large disruption in many hospitals if the company was forced to cease production at its facilities.
For a patient investor willing to tolerate the downturn in the cycle, the combination of increasing machine placement and increasing long term demand could potentially prove profitable. An additional long-term driver of growth is the company’s somewhat unique automation strategy. Their “edge” relative to competitors is that its machines don’t require a full time skilled technician to analyze blood samples and results. This minimizes errors as well as reduces the labor costs of the blood banks, labs, and hospitals that are its main customers. An additional catalyst in the stock could be the involvement of ValueAct, a hedge fund whose involvement in another company I have touched upon before. This collection of attractive long-term characteristics will likely allow the company to overcome the short-term bumps it has encountered in its growth trajectory as well as legal and operational difficulties.
Disclosure: None
Talk to Andrew about Immucor
Sunday, March 20, 2011
Sutron - small cap instrument maker trading at discount to peers
Sutron is a company that makes equipment to measure various hydrological and meteorological data such as tsunami warning systems or airport weather monitoring equipment. I had this company in my "to do" pile and saw that it was mentioned in one of those "PROFIT FROM DISASTER: GREAT WAYS TO PLAY THE JAPANESE EARTHQUAKE!" articles that the media loves to crank out. Well quite frankly, I don't think so and the market doesn't seem to think so either. That is not to say that the company does not possess some positives.
The company only has a market cap of $34m and should earn a shade past $2m for fiscal 2010 (only 9 months of 2010 reported so far and $1.7m earned, and the company hasn't lost money in any quarter for at least 5 years). There's about $10m in cash on the balance sheet, of which at least $5m seems excess, but the cash balance seems inflated due to fluctuations in working capital. At ~15x earnings net of cash the company is not cheap. The company requires very little capex, has achieved a cash adjusted ROE north of 20% for the past several years excluding the hiccup in 2008.
I don't think that the barriers to entry into the scientific instruments business is difficult on the face of it. From the sole perspective of product offering, how hard can it be to make a comparable measuring device? Despite this, a lot of companies that make scientific instruments and measuring devices trade at high teens or low 20s multiples and at a level that ignores hard assets. The reason for this is that people become accustomed to using certain tools and it just makes sense not to change because of relearning a new system as well as hoping that a product with a shorter track record works as well as the old one. The entire scientific instrument sector has come back very strong in 2009-2010 from 2008 lows. While they serve different end markets, a brief glance at OSI Systems, Measurement Specialties, and OYO Geospace should give you an idea of the valuations of a lot of these companies.
Why might the market not be willing to pay up for Sutron's earnings to the same degree they do for the 3 aforementioned companies? Sutron seems to largely earn its bread from government projects. Even the international projects, such as those in Iraq and Afghanistan have the whiff of US involvement due to the political situation. There are other projects they have worked on and provided equipment for, such as one for the Three Gorges Dam in China. The company is headquartered in a suburb of Washington, DC. While I might be full of shit, many companies located in such close proximity to government and the largess it entails tend to depend on the government for their survival. Northtrop Grumman is moving its headquarters to the Washington DC area from LA for this very reason. I don't know if this is really that great of a risk.
I'm not sure I exactly buy the above reasoning that it is the heavy concentration of government revenues. Certainly it could play a role. Most of the customers for Sutron's products are going to logically be governments. They play a key role in monitoring weather, tsunamis/water based weather events, and data on river flows. There's definitely pressure on government budgets around the world, but Sutron's products seem to be part of the guts of the "system" and necessary for any long-term project involving water flows.
What does any of this have to do with Japan? Well, one thing the company makes it the sensors for tsunami alerts. While Japan had sensors that were aware of the tsunami, there might be the halo effect of other countries looking to bulk up their systems or set one up. If you were to buy stocks based on Japan right now, it should be on price relative to current operations as opposed to price relative to potential future operations. Furthermore, the company hasn't done much business in Japan, where they do have some tsunami early warning systems. It's definitely not a foregone conclusion that Sutron will get any business as a result.
One nice thing about the company is that they have been spending 7-9% of its revenue on R&D for several years, which indicates they are focused on maintaining their position in the industry. While I was peaking at other scientific instrument companies, I was trying to figure out if there were any direct competitors. The risk section of the 10-K alludes to them, but never mentions one by name. I wondered if the company might make a nice tuck in acquisition for a larger instrument manufacturer (not a reason to buy a stock), but the CEO owns 18% of the company and has been involved since just after the company started. I have no insight into his intentions, but I suspect he is more likely to prefer to stay at the helm than cash out. At the same time, he is 71 and he could retire and cash out which would put the company in play. I simply have no idea.
The company does have a subsidiary in India which is interesting. A lot of people focus on China exposure as some kind of gateway to corporate success. Regardless of where a company makes it, money is money, so I'm quite impartial to geographies. That being said, having a footprint in an emerging market that can grow substantially is an attractive characteristic. It's not a reason to buy a company, but it's certainly not a reaosn not to. It isn't difficult to imagine Sutron generating a lot of profits in India, but I have no ability to handicap that possibility and I wouldn't want to pay anything for such an option when I purchase a stock.
While I wouldn't be surprised if someone concluded there was some upside in the stock based on relative valuation, I'd rather not bet solely on someone paying up for the earnings from a 15 to a 20x earnings multiple. It's much safer to play that game with a stock going from 5 to 10x earnings to 10x to 12 or 13x otherwise your margin of safety is eroded. The entire scientific instruments sector is definitely interesting because the companies usually have minimal capex and high margins, but I'd wait until irrational selling or something ugly happens before I would step into this area. There's definitely some interesting small caps in this space though, but more as businesses than stocks at this point.
Disclosure: None
Talk to Andrew about Sutron
The company only has a market cap of $34m and should earn a shade past $2m for fiscal 2010 (only 9 months of 2010 reported so far and $1.7m earned, and the company hasn't lost money in any quarter for at least 5 years). There's about $10m in cash on the balance sheet, of which at least $5m seems excess, but the cash balance seems inflated due to fluctuations in working capital. At ~15x earnings net of cash the company is not cheap. The company requires very little capex, has achieved a cash adjusted ROE north of 20% for the past several years excluding the hiccup in 2008.
I don't think that the barriers to entry into the scientific instruments business is difficult on the face of it. From the sole perspective of product offering, how hard can it be to make a comparable measuring device? Despite this, a lot of companies that make scientific instruments and measuring devices trade at high teens or low 20s multiples and at a level that ignores hard assets. The reason for this is that people become accustomed to using certain tools and it just makes sense not to change because of relearning a new system as well as hoping that a product with a shorter track record works as well as the old one. The entire scientific instrument sector has come back very strong in 2009-2010 from 2008 lows. While they serve different end markets, a brief glance at OSI Systems, Measurement Specialties, and OYO Geospace should give you an idea of the valuations of a lot of these companies.
Why might the market not be willing to pay up for Sutron's earnings to the same degree they do for the 3 aforementioned companies? Sutron seems to largely earn its bread from government projects. Even the international projects, such as those in Iraq and Afghanistan have the whiff of US involvement due to the political situation. There are other projects they have worked on and provided equipment for, such as one for the Three Gorges Dam in China. The company is headquartered in a suburb of Washington, DC. While I might be full of shit, many companies located in such close proximity to government and the largess it entails tend to depend on the government for their survival. Northtrop Grumman is moving its headquarters to the Washington DC area from LA for this very reason. I don't know if this is really that great of a risk.
I'm not sure I exactly buy the above reasoning that it is the heavy concentration of government revenues. Certainly it could play a role. Most of the customers for Sutron's products are going to logically be governments. They play a key role in monitoring weather, tsunamis/water based weather events, and data on river flows. There's definitely pressure on government budgets around the world, but Sutron's products seem to be part of the guts of the "system" and necessary for any long-term project involving water flows.
What does any of this have to do with Japan? Well, one thing the company makes it the sensors for tsunami alerts. While Japan had sensors that were aware of the tsunami, there might be the halo effect of other countries looking to bulk up their systems or set one up. If you were to buy stocks based on Japan right now, it should be on price relative to current operations as opposed to price relative to potential future operations. Furthermore, the company hasn't done much business in Japan, where they do have some tsunami early warning systems. It's definitely not a foregone conclusion that Sutron will get any business as a result.
One nice thing about the company is that they have been spending 7-9% of its revenue on R&D for several years, which indicates they are focused on maintaining their position in the industry. While I was peaking at other scientific instrument companies, I was trying to figure out if there were any direct competitors. The risk section of the 10-K alludes to them, but never mentions one by name. I wondered if the company might make a nice tuck in acquisition for a larger instrument manufacturer (not a reason to buy a stock), but the CEO owns 18% of the company and has been involved since just after the company started. I have no insight into his intentions, but I suspect he is more likely to prefer to stay at the helm than cash out. At the same time, he is 71 and he could retire and cash out which would put the company in play. I simply have no idea.
The company does have a subsidiary in India which is interesting. A lot of people focus on China exposure as some kind of gateway to corporate success. Regardless of where a company makes it, money is money, so I'm quite impartial to geographies. That being said, having a footprint in an emerging market that can grow substantially is an attractive characteristic. It's not a reason to buy a company, but it's certainly not a reaosn not to. It isn't difficult to imagine Sutron generating a lot of profits in India, but I have no ability to handicap that possibility and I wouldn't want to pay anything for such an option when I purchase a stock.
While I wouldn't be surprised if someone concluded there was some upside in the stock based on relative valuation, I'd rather not bet solely on someone paying up for the earnings from a 15 to a 20x earnings multiple. It's much safer to play that game with a stock going from 5 to 10x earnings to 10x to 12 or 13x otherwise your margin of safety is eroded. The entire scientific instruments sector is definitely interesting because the companies usually have minimal capex and high margins, but I'd wait until irrational selling or something ugly happens before I would step into this area. There's definitely some interesting small caps in this space though, but more as businesses than stocks at this point.
Disclosure: None
Talk to Andrew about Sutron
Saturday, March 19, 2011
Just a brief word on the whole Japan situation
I mentioned a talk by Tim McElvaine a few weeks ago, which is even more worth taking a look at now. Of note now though is that he talks about 2 Japanese stocks, Makita (which has an ADR) and Monex. Well, it just so happens that there's lots of uncertainty in the Japanese market now.
Here is a link to the pdf of the presentation he gives, which contains slides on his thesis for both the companies. He provides an ABBA analysis, his approach which I briefly mentioned back in January. The first A stands for "accident" which has certainly happened at a macro level in Japan. His picks are interesting in that they are great or above average companies. I would highlight that because many people talk about how there are tons of net-net and low PE stocks in Japan that have gotten even cheaper in the aftermath of the earthquake. Prior to the earthquake there was the debate if these cheap stocks would ever increase in value. While they've now gotten even cheaper, you don't need to worry about that debate with a company like Makita or Monex. They're simply great franchises trading at modest prices.
One thing that is important to keep in mind with investing is that the cumulative dividends of researching stocks, even when they aren't cheap, can really be reaped in times like these. Looking back at McElvaine's picks, he has already articulated a solid thesis on the stocks. In the aftermath of a "black swan" event, he doesn't need to spend a lot of time researching historical finances or management's background. He just needs to look and see if the long term prospects of the company have been harmed and then buy more. I always try to follow companies after I've done some initial research on them, because you really never know when some unexpected event happens and drives down the price. I'm just using this as an example of a tangible event that supports a more abstract investing principle - an ontological-esque argument about investing. Pascal's wager applied to stocks in a way. You really have nothing to lose by reading that 10-K and while the reward might not be infinite, a low hanging 2 or 3 bagger could await you in the future.
This seems like a level headed perspective on the situation at the reactor:
Here is a link to the pdf of the presentation he gives, which contains slides on his thesis for both the companies. He provides an ABBA analysis, his approach which I briefly mentioned back in January. The first A stands for "accident" which has certainly happened at a macro level in Japan. His picks are interesting in that they are great or above average companies. I would highlight that because many people talk about how there are tons of net-net and low PE stocks in Japan that have gotten even cheaper in the aftermath of the earthquake. Prior to the earthquake there was the debate if these cheap stocks would ever increase in value. While they've now gotten even cheaper, you don't need to worry about that debate with a company like Makita or Monex. They're simply great franchises trading at modest prices.
One thing that is important to keep in mind with investing is that the cumulative dividends of researching stocks, even when they aren't cheap, can really be reaped in times like these. Looking back at McElvaine's picks, he has already articulated a solid thesis on the stocks. In the aftermath of a "black swan" event, he doesn't need to spend a lot of time researching historical finances or management's background. He just needs to look and see if the long term prospects of the company have been harmed and then buy more. I always try to follow companies after I've done some initial research on them, because you really never know when some unexpected event happens and drives down the price. I'm just using this as an example of a tangible event that supports a more abstract investing principle - an ontological-esque argument about investing. Pascal's wager applied to stocks in a way. You really have nothing to lose by reading that 10-K and while the reward might not be infinite, a low hanging 2 or 3 bagger could await you in the future.
This seems like a level headed perspective on the situation at the reactor:
Despite this, the 40-year-old Fukushima Daiichi nuclear power plant, built to withstand a 7.9 magnitude quake, stood up to a seismic event that shook it over 30 times more powerfully than it was designed to survive. It held up to the onslaught, and shut down automatically as the tremors began.The key point you can take away form this article is that once the dust settles and panels and commissions do their thing, it might be reasonable to expect the nuclear industry to mimic Wayne and Garth:
It appears that the 10-metre tsunami that followed is what brought the reactors to the brink of meltdown, as back-up diesel generators for the facility's coolant pumps failed, and the cores began to heat up. Attempts to cool the cores were unsuccessful, and containment buildings blew up as the pressure built.
When a 20 km exclusion zone was declared – a standard emergency protocol – the global news coverage frothed with “NUCLEAR CATASTROPHE”, “ATOMIC CRISIS” and “MELTDOWN ALERT”. And how did they deal with the 9.0 magnitude quake? “TSUNAMI CARNAGE” and “NATURE'S TERROR”.
Sunday, March 13, 2011
BABB, a nanocap cigar butt
This is an interesting stock, because it is very under the radar and possesses many value characteristics. The best days of this company are behind it, but it still possess a strong balance sheet and generates positive earnings. BAB Inc. is a company that franchises bagel stores under the Big Apple Bagels and My Favorite Muffin brands. This is a company in a very similar position to Pizza Inn, recently profiled on Whopper Investments. It faces many of the same challenges and possesses some of the same attractive characteristics.
BAB is small with a market cap of $3,632,00 (7,263,508 shares, $0.50 share price) and 2010 net income of $410,000 for a PE of 9. The valuation becomes more compelling when you net out $1,242,000 in unrestricted cash for a cash adjusted earnings multiple of 6. Due to the franchise model of the company, it requires very little cash, so one could argue the company doesn't really need any of this cash. I'm feeling conservative today, so I will say the company needs $400,000 in cash on the balance sheet, so the excess cash adjusted earnings multiple is 7.
Some additional attractive characteristics:
- Management owns 38.4% of the company, the CEO's compensation is between 3-4 times his annual salary and has been at the company for 18 years
- Company paid out $.06/share in dividends last year, $.04 in regular quarterly dividends and an extra $.02 at the end of the year. That's 12% on the current $.50 price.
- There are $6m in tax loss carry forwards, which means the company won't have to pay taxes for 15 years at the current rate of earnings
- It is very rare for a $3.6m market cap company on the pink sheets to do so, but it is audited and files with the SEC.
The downside is largely going to play out with the decline of the number of franchised stores that operate under the BAB and MFM brands. In 2004, the company had 184 locations. By 2010, the company only had 106 locations (98 franchises, 7 licensed, 1 company owned). There were 108, 115, 129, and 143 locations in 2009, 2008, 2007, and 2006 respectively. Clearly the company has been shrinking over time.
It is dangerous to look at 2009 and 2010 and decide there has been a stabilization in the store count. The company faces competition from Einstein Bro's bagels and Breuger's Bagels for potential franchises and tons of companies for breakfast meals. Panera, Dunkin Donuts, McDonalds, etc all offer bagel options and wider selections. That the company faces competition from these various sources is evident from the decrease in franchisees. Also, in my neck of the woods none of the bagel stores are franchised and are usually family owned businesses, a few of which might have 4-5 locations.
I'm passing on this, because the future cash flows of the company don't look like they will equate the price of the stock. Faced with the decline in stores, earnings would have to be pretty predictable. Accounting for the cash balance, an investor would have to get comfortable with the idea that the company will generate cash that has a net present value of $2.4m. The company will likely have difficulty producing consistent net income, as it has declined continuously over the years, which makes any time of prediction especially difficult to make with any accuracy.
I can imagine a scenario where the company decides to pay a special dividend of 25% ($800,000 in excess cash), but I can also imagine a scenario where the company decides to buy something to put their tax loss carry forwards to use. While the stock will continue to generate an attractive dividend yield, I would echo Raymond DeVoe who once said, "More money has been lost reaching for yield than at the point of a gun." While in reference to bonds, the same point applies. The company will be able to continue paying the dividend, but you might end up with equity (principal, in the case of debt) that is not worth what you paid for it. This stock has a few puffs left on it, but the price to pick it up doesn't offer a margin of safety.
Talk to Andrew about BABB
BAB is small with a market cap of $3,632,00 (7,263,508 shares, $0.50 share price) and 2010 net income of $410,000 for a PE of 9. The valuation becomes more compelling when you net out $1,242,000 in unrestricted cash for a cash adjusted earnings multiple of 6. Due to the franchise model of the company, it requires very little cash, so one could argue the company doesn't really need any of this cash. I'm feeling conservative today, so I will say the company needs $400,000 in cash on the balance sheet, so the excess cash adjusted earnings multiple is 7.
Some additional attractive characteristics:
- Management owns 38.4% of the company, the CEO's compensation is between 3-4 times his annual salary and has been at the company for 18 years
- Company paid out $.06/share in dividends last year, $.04 in regular quarterly dividends and an extra $.02 at the end of the year. That's 12% on the current $.50 price.
- There are $6m in tax loss carry forwards, which means the company won't have to pay taxes for 15 years at the current rate of earnings
- It is very rare for a $3.6m market cap company on the pink sheets to do so, but it is audited and files with the SEC.
The downside is largely going to play out with the decline of the number of franchised stores that operate under the BAB and MFM brands. In 2004, the company had 184 locations. By 2010, the company only had 106 locations (98 franchises, 7 licensed, 1 company owned). There were 108, 115, 129, and 143 locations in 2009, 2008, 2007, and 2006 respectively. Clearly the company has been shrinking over time.
It is dangerous to look at 2009 and 2010 and decide there has been a stabilization in the store count. The company faces competition from Einstein Bro's bagels and Breuger's Bagels for potential franchises and tons of companies for breakfast meals. Panera, Dunkin Donuts, McDonalds, etc all offer bagel options and wider selections. That the company faces competition from these various sources is evident from the decrease in franchisees. Also, in my neck of the woods none of the bagel stores are franchised and are usually family owned businesses, a few of which might have 4-5 locations.
I'm passing on this, because the future cash flows of the company don't look like they will equate the price of the stock. Faced with the decline in stores, earnings would have to be pretty predictable. Accounting for the cash balance, an investor would have to get comfortable with the idea that the company will generate cash that has a net present value of $2.4m. The company will likely have difficulty producing consistent net income, as it has declined continuously over the years, which makes any time of prediction especially difficult to make with any accuracy.
I can imagine a scenario where the company decides to pay a special dividend of 25% ($800,000 in excess cash), but I can also imagine a scenario where the company decides to buy something to put their tax loss carry forwards to use. While the stock will continue to generate an attractive dividend yield, I would echo Raymond DeVoe who once said, "More money has been lost reaching for yield than at the point of a gun." While in reference to bonds, the same point applies. The company will be able to continue paying the dividend, but you might end up with equity (principal, in the case of debt) that is not worth what you paid for it. This stock has a few puffs left on it, but the price to pick it up doesn't offer a margin of safety.
Talk to Andrew about BABB
Full House Resorts, the reports of its death are exaggerated
I found this stock courtesy of Khrom Capital's Q4 Letter over at My Investing Notebook, which I previously mentioned in this post. While the conclusion and much of the reasoning is ultimately the same, I did my own write up of the stock and elaborated on some other factors. While some might accuse me being redundant and unoriginal, my response is that I won't invest in a stock without articulating a thesis. The stock is pretty compelling, because the market seems to be pricing in the company becoming a lot less profitable than it currently is. While this might generally prove to be correct, the magnitude is over exaggerated and there is a strong margin of safety. I've submitted this idea to the GuruFocus Monthly Value Ideas Contest. The link to the article is here, and I would ask that you direct any questions to the comment section there.
Full House Resorts is an ever-changing company with a small track record. In the resulting confusion, the underlying value of its assets is not being reflected in the stock price. The core of Full House consists of three assets: its Stockman Casino in Nevada, a 50% stake in a casino management contract at FireKeepers Casino in Michigan, and the awaited closing of its acquisition of the Grand Victoria Casino in Indiana. Full House is an attractive collection of assets that are trading at an overly pessimistic price.
A Peak Over the Abyss: A Brief Look at the Downside
While it appears the market is unaware of the upside from the Grand Victoria Casino, let’s briefly assume this acquisition falls through. The company has already deposited $5m in a non-refundable escrow account, which no value will be assigned. Ignoring a few more million dollars that the company earned from a management contract in Delaware that ends in 2011, the company has earned $14.5m in EBITDA and $7.7m of net income in the past year from its Stockman Casino and FireKeepers contract. The company has $13m in net cash, a market cap of $77m, and an enterprise value of $64m. So even ignoring the acquisition of the Grand Victoria, the company trades at a fair price of 4.5x EV/EBITDA and 10x earnings (8x if you net out the cash). Since the investor is well protected on the downside, it is time to see if there is anything on the upside.
Asset and Valuation Summary
Stockman’s $1m net income + GEM’s $10m net income + Grand Victoria’s $3m net income - $3m in corporate costs (net attributable to company) = $11m net income
Stockman’s $2.5m EBITDA + GEM’s $12m EBITDA + Grand Victoria’s $8.6m EBITDA - $3m in corporate costs (net) = $20m EBITDA
The company will also receive approximately $2m in net income for the remainder of a management contract it has at a Delaware casino that expires in August, 2011.
There are 19.3m shares outstanding and a current price of $4, for a market cap of $77m. The company trades at 7x normalized earnings and 5x EV/EBITDA.
This ignores 2010 and 2011 earnings from its contract at a Delaware casino which are ~$3m and ~$2m respectively.
A look at the company’s assets:
Stockman’s Casino
Stockman’s Casino is located in Fallon, Nevada. Fallon has a Naval Air Station. The town and casino are essentially built around its existence and it provides a solid recession resistant economic anchor. It generated $2.5m in EBITDA in 2010. In 2010, its slot machines accounted for 23.5% of the slots in Fallon and their share of slot revenues for 2010 was approximately 31.5%. This shows its relative popularity. There are 9 casinos in the market and the company considers 3 of them to be its main competitors, all of which are smaller. While this is not the Bellagio, the casino is the in the market and is doubly recession resistant as a casino and its location in a military town. The casino did lose some sales in 2009 and 2010, but maintained profitability and seems to be rebounding. In recent months, there have been YoY improvements in revenue, which bodes well for future results, but I won’t make any assumptions on the degree.
Stockman’s Casino also provides evidence for the management style and their execution of acquisitions. It was acquired in February, 2007 for $28m. At first glance, for an asset now generating $2.5m in EBITDA it looks like a failed acquisition. As part of the acquisition, the company also got a hotel that it was able to sell in February, 2008 for $7m, so the net purchase price for the casino is $21m, so the casino itself was bought for around 8.5x 2010 EBITDA. The company didn’t break out the earnings on Stockman, but I calculate EBITDA to have been around $5m in 2008, so the acquisition was done at a valuation of around 5.5x EV/EBITDA. The acquisition was done in February, 2007 – before even the Bear Stearns hedge funds imploded – at a reasonable multiple and even after the world went to hell in a hand basket, the company has done alright with the acquisition. Keep this in mind when examining the Grand Victoria acquisition.
FireKeepers Casino /Gaming Entertainment Michigan (GEM)
GEM is 50% owned by the company and is a JV that developed and now operates the FireKeepers Casino in Battle Creek, Michigan. GEM agreed to help finance the construction and part of the deal was that they would then manage the casino and earn a portion of its revenue. Especially if the casino is a tribe’s attempt to better their lot, they need help with the initial capital and know-how to do so. Laws governing Indian gambling only allow a limit of 7 years on management contracts, but it is the big incentive for companies to come in and stump up capital and expertise to get a casino up and running. The contract to run the casino will expire in 2016 and will very likely not be renewed. The contract is generating about $10m in net income annually.
FireKeepers is much larger than Stockman’s Casino - Stockman’s has 47,000 people aged 25+ in a 50 mile radius – with 1.1m adults within 50 miles. In February 2011, the Gun Lake Tribe opened a casino in Grand Rapids, a little over an hour away from FireKeepers. Economics 101 – supply and demand – means that FireKeepers will see decreased demand. The Gun Lake casino is smaller. For example, it has 1,400 slots compared to FireKeepers 2700. FireKeepers is also in the process of constructing a hotel – to which Full House has no financial obligation – that will be a further draw and also be a perk for the more free spending wealthy types that will cost nothing to add from Full House’s perspective.
There’s also competition further away in Detroit and Toledo will get a casino within several years time. The Detroit casino has existed for a while. FireKeepers still maintains a favorable position in Battle Creek, Kalamazoo, and arguably Lansing (based on distance) even with the new Gun Lake Casino. The uncertainty in outcome is exaggerated because there is not an overall glut of casinos in the area. There is certainly increased competition, but the overall market dynamic is still one of localized monopolies and regional duopolies or oligopolies depending on the direction you drive in. It is still too early to see the effect, but management has a pulse so they are aware of it.
Grand Victoria
Full House has a definitive agreement to acquire the Grand Victoria Casino & Resort, in Rising Sun, Indiana at the intersection of the Kentucky, Indiana, and Ohio borders. The deal is fully financed and should close within 2 months at the latest. They are purchasing the property from Hyatt at what appears to be a very cheap price. The feuding of the Pritzkers, who own Hyatt, might partially behind the price, but there is a whole new slate of casinos set to open up nearby in Ohio, most importantly in Cincinnati.
The Grand Victoria is smaller than FireKeepers, but the company controls the assets 100%. The property was built for $143m and has $57m in capital improvements. In addition to the casino, the property has a 201-room hotel with some meeting space, theatre, and 18-hole golf course. Management has no stated intentions with the non casino aspect – note that while they sold the hotel attached to Stockman’s, that property was in the middle of a city – but they are potentially valuable hard assets the company could sell off to pay down debt quickly.
For all of the above, the company is paying $43m for the property (excluding $8m in cash and net working capital balances) consisting of $19m in cash and is using debt for the remainder. The debt carries an interest rate of LIBOR + 550 bps. They have a term loan of $33m and a revolver of $5m already approved.
Since Hyatt is private, there is little disclosure about the earnings of the company other than “the purchase multiple is expected to be approximately 5x.” It is 5x earnings on the $43m or is it EBITDA or does it include the $8m? I don’t know. For the sake of conservatism, lets assume it is 5x EBITDA on $43m, so the property generates $8.6m in EBITDA. Assuming they use the entire term loan and revolver and end up paying 8% interest, that is $3m (On the most recent conference call, management said they expect interest to fall between $2.3-2.5m). With a 40% tax rate, it generates $3.3m in net income excluding D&A, which is minimal for the continued operation of a casino (my numbers are likely understated because of the exclusion of D&A, which would be included in the pretax number, ultimately lowering the number that taxes are calculated from). There might be some debt taken on with the acquisition, but as the next paragraph will discuss, it will likely not be very large.
The Grand Victoria has been in longstanding competition with the Hollywood Casino (formerly Argosy) in Lawrenceberg, Indiana and Belterra Casino in Florence, Indiana. Hoollywood is the largest of the three. From a presentation I found on the Indiana Gaming website, Grand Victoria produced $24m in EBITDA and had $6.6m in capex in 2003. Their estimate for 2006 (in 2003) was $34m in EBITDA and $4.5m in capex. Also, judging from the long-term debt repayment at Grand Victoria, I don’t believe that the company is acquiring too much in the way of additional debt with the Grand Victoria, although it hasn’t been disclosed. Their 2006 estimate was to have LT debt paid down to $36m. Between the projected 2006 and 2010, the company likely continued to pay down debt, although the actual number now is unknown.
While I believe my projected EBITDA of $8.6m is low, I don’t think that these historical figures will be attainable as there is increased competition – the actual figures predated the opening of the Belterra Casino. While the casino has not exactly been mismanaged, management at Full House likely believes they can increase EBITDA margins. In 2003, Grand Victoria only contributed 5% of Revenue and EBITDA to Hyatt, so it is possible the more focused attention of Full House will allow the company to increase margins. I don’t incorporate any assumptions of that in my valuation.
Management
Management has been competent with their execution of the management contract at FireKeepers. According to one of their presentations, the marketing fore FireKeepers consisted of a billboard on the freeway and the sending out of 50,000 cards, which has resulted in a customer list of 500,000 people. As previously discussed with Stockman’s and just from the general direction of the balance sheet, they have been aggressive in paying down debt.
One great thing about the company is that Lee Iacocca owns 5% of it and is on the board. The founder of the company Allen Paulson, who recently passed away, was a friend of
Iacocca and he brought Iacocca into the business. Andre Hilliou, the CEO owns a little over $1m worth of shares, which is about 2x his annual compensation. The CEO is 63 and Iacocca is now 86, which might pose a more abstract threat, but the executive suite does have people who have been at the company for several years.
There are only 13 full-time corporate employees, 6 of which are senior management. This is an increase of 30% from the 10 people who worked there in 2007, but the company now has the FireKeepers contract and is acquiring Grand Victoria. This indicates that management runs a pretty tight ship, likely a positive benefit of Iacocca’s presence.
Potential Acquisitions and Lack of Historical Record
Management has indicated that they would take advantage of opportunities to acquire asset or engage in development projects if they were comfortable with the valuation. Normally this would be annoying, but the execution has so far been solid on the casinos and they haven’t overpaid. There are only 2 data points – Stockman’s and Grand Victoria – to go off of, but both fit a margin of safety/value framework.
While the company itself lacks what a value investor would consider a long track record of earnings, they have a record of operating casino operations. Their assets, except the FireKeepers casino, have been around for a while. The Grand Victoria was built in 1996. FireKeepers opened up in 2009 and is now earning $10m for the company. While I don’t think management has done anything to deserve the label of morons, one would be hard-pressed to find a moron incapable of making money operating a business that faces little competition and is psychologically addictive. The economics of the casino business, as well as the presence of Lee Iacocca, should give one confidence that the earnings are not transient. The company has done a great job at incrementally increasing the normalized earnings power over the past several years.
Risk
The one risk with the Grand Victoria is that the agreement states Full House cannot use the Grand Victoria name. They have 6 months to transition to a new name, but have indicated they plan on doing this as soon as they can when the acquisition closes. This might have a short-term effect due to the confusion, but the economics of a casino seem pretty overwhelming and there are few alternatives in the area.
While there already seem to be a few casinos slated to open as government revenue generators and job creators, this does not mean than no more will be planned starting 3-5 years out. This is a risk with most businesses – that new competitors will emerge. Casinos are highly regulated by the government, and many states ex. Nevada view it as a revenue generator. While several casinos might maximize revenue, states also have to contend with negative sentiment towards casinos.
Catalysts
Once the acquisition closes, the earnings from the Grand Victoria should begin to flow through the balance sheet. While this might be met with skepticism as a casino opening in Cincinnati looms, the earnings are real. The threats of the Gun Lake Casino and a casino in Cincinnati are real, but the stock price is already reflecting a very pessimistic view. Full House is not like a local supermarket and these casinos are Walmart moving into town. The company’s casinos will continue to generate earnings and the company will remain solidly profitable. The casino business is pretty resilient and
Conclusion
Full House resorts is a company that possesses excellent economics and strong normalized earnings going forward. Its recent acquisition of Grand Victoria has not been fully recognized by the market and it will greatly increase shareholder value over the ensuing months. At a modest valuation to the earnings power of the current assets and low valuation to the earnings power of its current assets plus the Grand Victoria, the company should receive a more suitable valuation as its earnings become more apparent to the general market. The overly pessimistic view of the market is assuming that casinos don’t possess the strong competitive position that they have and Full House will fail to earn an adequate return on its investment.
Disclosure: Long FLL
Talk to Andrew about Full House Resorts
Full House Resorts is an ever-changing company with a small track record. In the resulting confusion, the underlying value of its assets is not being reflected in the stock price. The core of Full House consists of three assets: its Stockman Casino in Nevada, a 50% stake in a casino management contract at FireKeepers Casino in Michigan, and the awaited closing of its acquisition of the Grand Victoria Casino in Indiana. Full House is an attractive collection of assets that are trading at an overly pessimistic price.
A Peak Over the Abyss: A Brief Look at the Downside
While it appears the market is unaware of the upside from the Grand Victoria Casino, let’s briefly assume this acquisition falls through. The company has already deposited $5m in a non-refundable escrow account, which no value will be assigned. Ignoring a few more million dollars that the company earned from a management contract in Delaware that ends in 2011, the company has earned $14.5m in EBITDA and $7.7m of net income in the past year from its Stockman Casino and FireKeepers contract. The company has $13m in net cash, a market cap of $77m, and an enterprise value of $64m. So even ignoring the acquisition of the Grand Victoria, the company trades at a fair price of 4.5x EV/EBITDA and 10x earnings (8x if you net out the cash). Since the investor is well protected on the downside, it is time to see if there is anything on the upside.
Asset and Valuation Summary
Stockman’s $1m net income + GEM’s $10m net income + Grand Victoria’s $3m net income - $3m in corporate costs (net attributable to company) = $11m net income
Stockman’s $2.5m EBITDA + GEM’s $12m EBITDA + Grand Victoria’s $8.6m EBITDA - $3m in corporate costs (net) = $20m EBITDA
The company will also receive approximately $2m in net income for the remainder of a management contract it has at a Delaware casino that expires in August, 2011.
There are 19.3m shares outstanding and a current price of $4, for a market cap of $77m. The company trades at 7x normalized earnings and 5x EV/EBITDA.
This ignores 2010 and 2011 earnings from its contract at a Delaware casino which are ~$3m and ~$2m respectively.
A look at the company’s assets:
Stockman’s Casino
Stockman’s Casino is located in Fallon, Nevada. Fallon has a Naval Air Station. The town and casino are essentially built around its existence and it provides a solid recession resistant economic anchor. It generated $2.5m in EBITDA in 2010. In 2010, its slot machines accounted for 23.5% of the slots in Fallon and their share of slot revenues for 2010 was approximately 31.5%. This shows its relative popularity. There are 9 casinos in the market and the company considers 3 of them to be its main competitors, all of which are smaller. While this is not the Bellagio, the casino is the in the market and is doubly recession resistant as a casino and its location in a military town. The casino did lose some sales in 2009 and 2010, but maintained profitability and seems to be rebounding. In recent months, there have been YoY improvements in revenue, which bodes well for future results, but I won’t make any assumptions on the degree.
Stockman’s Casino also provides evidence for the management style and their execution of acquisitions. It was acquired in February, 2007 for $28m. At first glance, for an asset now generating $2.5m in EBITDA it looks like a failed acquisition. As part of the acquisition, the company also got a hotel that it was able to sell in February, 2008 for $7m, so the net purchase price for the casino is $21m, so the casino itself was bought for around 8.5x 2010 EBITDA. The company didn’t break out the earnings on Stockman, but I calculate EBITDA to have been around $5m in 2008, so the acquisition was done at a valuation of around 5.5x EV/EBITDA. The acquisition was done in February, 2007 – before even the Bear Stearns hedge funds imploded – at a reasonable multiple and even after the world went to hell in a hand basket, the company has done alright with the acquisition. Keep this in mind when examining the Grand Victoria acquisition.
FireKeepers Casino /Gaming Entertainment Michigan (GEM)
GEM is 50% owned by the company and is a JV that developed and now operates the FireKeepers Casino in Battle Creek, Michigan. GEM agreed to help finance the construction and part of the deal was that they would then manage the casino and earn a portion of its revenue. Especially if the casino is a tribe’s attempt to better their lot, they need help with the initial capital and know-how to do so. Laws governing Indian gambling only allow a limit of 7 years on management contracts, but it is the big incentive for companies to come in and stump up capital and expertise to get a casino up and running. The contract to run the casino will expire in 2016 and will very likely not be renewed. The contract is generating about $10m in net income annually.
FireKeepers is much larger than Stockman’s Casino - Stockman’s has 47,000 people aged 25+ in a 50 mile radius – with 1.1m adults within 50 miles. In February 2011, the Gun Lake Tribe opened a casino in Grand Rapids, a little over an hour away from FireKeepers. Economics 101 – supply and demand – means that FireKeepers will see decreased demand. The Gun Lake casino is smaller. For example, it has 1,400 slots compared to FireKeepers 2700. FireKeepers is also in the process of constructing a hotel – to which Full House has no financial obligation – that will be a further draw and also be a perk for the more free spending wealthy types that will cost nothing to add from Full House’s perspective.
There’s also competition further away in Detroit and Toledo will get a casino within several years time. The Detroit casino has existed for a while. FireKeepers still maintains a favorable position in Battle Creek, Kalamazoo, and arguably Lansing (based on distance) even with the new Gun Lake Casino. The uncertainty in outcome is exaggerated because there is not an overall glut of casinos in the area. There is certainly increased competition, but the overall market dynamic is still one of localized monopolies and regional duopolies or oligopolies depending on the direction you drive in. It is still too early to see the effect, but management has a pulse so they are aware of it.
Grand Victoria
Full House has a definitive agreement to acquire the Grand Victoria Casino & Resort, in Rising Sun, Indiana at the intersection of the Kentucky, Indiana, and Ohio borders. The deal is fully financed and should close within 2 months at the latest. They are purchasing the property from Hyatt at what appears to be a very cheap price. The feuding of the Pritzkers, who own Hyatt, might partially behind the price, but there is a whole new slate of casinos set to open up nearby in Ohio, most importantly in Cincinnati.
The Grand Victoria is smaller than FireKeepers, but the company controls the assets 100%. The property was built for $143m and has $57m in capital improvements. In addition to the casino, the property has a 201-room hotel with some meeting space, theatre, and 18-hole golf course. Management has no stated intentions with the non casino aspect – note that while they sold the hotel attached to Stockman’s, that property was in the middle of a city – but they are potentially valuable hard assets the company could sell off to pay down debt quickly.
For all of the above, the company is paying $43m for the property (excluding $8m in cash and net working capital balances) consisting of $19m in cash and is using debt for the remainder. The debt carries an interest rate of LIBOR + 550 bps. They have a term loan of $33m and a revolver of $5m already approved.
Since Hyatt is private, there is little disclosure about the earnings of the company other than “the purchase multiple is expected to be approximately 5x.” It is 5x earnings on the $43m or is it EBITDA or does it include the $8m? I don’t know. For the sake of conservatism, lets assume it is 5x EBITDA on $43m, so the property generates $8.6m in EBITDA. Assuming they use the entire term loan and revolver and end up paying 8% interest, that is $3m (On the most recent conference call, management said they expect interest to fall between $2.3-2.5m). With a 40% tax rate, it generates $3.3m in net income excluding D&A, which is minimal for the continued operation of a casino (my numbers are likely understated because of the exclusion of D&A, which would be included in the pretax number, ultimately lowering the number that taxes are calculated from). There might be some debt taken on with the acquisition, but as the next paragraph will discuss, it will likely not be very large.
The Grand Victoria has been in longstanding competition with the Hollywood Casino (formerly Argosy) in Lawrenceberg, Indiana and Belterra Casino in Florence, Indiana. Hoollywood is the largest of the three. From a presentation I found on the Indiana Gaming website, Grand Victoria produced $24m in EBITDA and had $6.6m in capex in 2003. Their estimate for 2006 (in 2003) was $34m in EBITDA and $4.5m in capex. Also, judging from the long-term debt repayment at Grand Victoria, I don’t believe that the company is acquiring too much in the way of additional debt with the Grand Victoria, although it hasn’t been disclosed. Their 2006 estimate was to have LT debt paid down to $36m. Between the projected 2006 and 2010, the company likely continued to pay down debt, although the actual number now is unknown.
While I believe my projected EBITDA of $8.6m is low, I don’t think that these historical figures will be attainable as there is increased competition – the actual figures predated the opening of the Belterra Casino. While the casino has not exactly been mismanaged, management at Full House likely believes they can increase EBITDA margins. In 2003, Grand Victoria only contributed 5% of Revenue and EBITDA to Hyatt, so it is possible the more focused attention of Full House will allow the company to increase margins. I don’t incorporate any assumptions of that in my valuation.
Management
Management has been competent with their execution of the management contract at FireKeepers. According to one of their presentations, the marketing fore FireKeepers consisted of a billboard on the freeway and the sending out of 50,000 cards, which has resulted in a customer list of 500,000 people. As previously discussed with Stockman’s and just from the general direction of the balance sheet, they have been aggressive in paying down debt.
One great thing about the company is that Lee Iacocca owns 5% of it and is on the board. The founder of the company Allen Paulson, who recently passed away, was a friend of
Iacocca and he brought Iacocca into the business. Andre Hilliou, the CEO owns a little over $1m worth of shares, which is about 2x his annual compensation. The CEO is 63 and Iacocca is now 86, which might pose a more abstract threat, but the executive suite does have people who have been at the company for several years.
There are only 13 full-time corporate employees, 6 of which are senior management. This is an increase of 30% from the 10 people who worked there in 2007, but the company now has the FireKeepers contract and is acquiring Grand Victoria. This indicates that management runs a pretty tight ship, likely a positive benefit of Iacocca’s presence.
Potential Acquisitions and Lack of Historical Record
Management has indicated that they would take advantage of opportunities to acquire asset or engage in development projects if they were comfortable with the valuation. Normally this would be annoying, but the execution has so far been solid on the casinos and they haven’t overpaid. There are only 2 data points – Stockman’s and Grand Victoria – to go off of, but both fit a margin of safety/value framework.
While the company itself lacks what a value investor would consider a long track record of earnings, they have a record of operating casino operations. Their assets, except the FireKeepers casino, have been around for a while. The Grand Victoria was built in 1996. FireKeepers opened up in 2009 and is now earning $10m for the company. While I don’t think management has done anything to deserve the label of morons, one would be hard-pressed to find a moron incapable of making money operating a business that faces little competition and is psychologically addictive. The economics of the casino business, as well as the presence of Lee Iacocca, should give one confidence that the earnings are not transient. The company has done a great job at incrementally increasing the normalized earnings power over the past several years.
Risk
The one risk with the Grand Victoria is that the agreement states Full House cannot use the Grand Victoria name. They have 6 months to transition to a new name, but have indicated they plan on doing this as soon as they can when the acquisition closes. This might have a short-term effect due to the confusion, but the economics of a casino seem pretty overwhelming and there are few alternatives in the area.
While there already seem to be a few casinos slated to open as government revenue generators and job creators, this does not mean than no more will be planned starting 3-5 years out. This is a risk with most businesses – that new competitors will emerge. Casinos are highly regulated by the government, and many states ex. Nevada view it as a revenue generator. While several casinos might maximize revenue, states also have to contend with negative sentiment towards casinos.
Catalysts
Once the acquisition closes, the earnings from the Grand Victoria should begin to flow through the balance sheet. While this might be met with skepticism as a casino opening in Cincinnati looms, the earnings are real. The threats of the Gun Lake Casino and a casino in Cincinnati are real, but the stock price is already reflecting a very pessimistic view. Full House is not like a local supermarket and these casinos are Walmart moving into town. The company’s casinos will continue to generate earnings and the company will remain solidly profitable. The casino business is pretty resilient and
Conclusion
Full House resorts is a company that possesses excellent economics and strong normalized earnings going forward. Its recent acquisition of Grand Victoria has not been fully recognized by the market and it will greatly increase shareholder value over the ensuing months. At a modest valuation to the earnings power of the current assets and low valuation to the earnings power of its current assets plus the Grand Victoria, the company should receive a more suitable valuation as its earnings become more apparent to the general market. The overly pessimistic view of the market is assuming that casinos don’t possess the strong competitive position that they have and Full House will fail to earn an adequate return on its investment.
Disclosure: Long FLL
Talk to Andrew about Full House Resorts
Thursday, March 10, 2011
Allied Healthcare: Looking at past transactions in the sector
I discussed Allied Healthcare a few weeks ago as an interesting investment opportunity. Other than being cheap on an absolute basis, I mentioned a transaction that took place in January 2011 that gave me confidence that the value was much higher than where the shares are currently trading.
I said:
I did some additional digging, because a recent investor presentation (they don't have it on the website and you have to email investor relations for a copy of the most recent one which is odd and annoying. They also stopped publishing transcripts of conference calls a few quarters back, so I had to listen to several hours of audio for what could have taken 30 minutes of reading during my research) had this chart in it:
Housing 21 (Claimar) is also a roll up of care providers. Claimar was a debt laden roll up that was then bought by Housing 21, a non profit for £19.5m with £21m in net debt. The acquisition was announced mid 2009, and full year 2008 figures are used in the comparison calculation. The company reported £2.4m in operating profit and £.5 in net profit on £52.6m in revenue.
I said:
Acromas, a company looking to consolidate the homecare industry through its Saga subsidiary, recently acquired Nestor Healthcare Group, a competitor of Allied Healthcare, for £124m or £136m including debt. Nestor generates more than two thirds of its revenue from social care of patients in their home and about a third from primary care of patients. Three private equity groups own Acromas: CVC Capital Partners, Charterhouse and Permira. Below is a table comparing the valuation of the buyout based on annualizing the first six months of Nestor’s results in 2010. The initial offer was made in August 2010. The deal closed in January 2011 offering an optimal comparison for Allied.
Nestor Healthcare* AHCI Implied AHCI Share Price Upside
Price/Sales 0.8 0.4 $4.54 89%
EV/EBITDA 11.5 5 $4.32 80%
EBITDA 10.5 8 $3.22 34%
P/E 16 12 $3.20 33%
EV/E 18 8 $4.40 83%
I did some additional digging, because a recent investor presentation (they don't have it on the website and you have to email investor relations for a copy of the most recent one which is odd and annoying. They also stopped publishing transcripts of conference calls a few quarters back, so I had to listen to several hours of audio for what could have taken 30 minutes of reading during my research) had this chart in it:
So I checked out those companies to see what was up with them. This is what I came up with those who have been involved in fairly recent acquisitions:
Mears (Careforce) is a roll up that started with a company called Careforce in 2007 for £23.8m, but went on to acquire 8 more domestic care companies for a total of £10.6m. The Careforce segment of Mears did £54.6m in revenue and £3.1m in operating profits for 2008. The buyout valuation to follow is based on full year 2008 results in order to use a full year of consolidate financial data and uses an implied purchase price of £34.4m. Careforce only makes up 15% of Mears’ operating profit, so the current market valuation doesn’t reflect the value of the division. The earnings calculation is derived from operating profit taxed at 35%.
Housing 21 (Claimar) is also a roll up of care providers. Claimar was a debt laden roll up that was then bought by Housing 21, a non profit for £19.5m with £21m in net debt. The acquisition was announced mid 2009, and full year 2008 figures are used in the comparison calculation. The company reported £2.4m in operating profit and £.5 in net profit on £52.6m in revenue.
As you can see, some personal judgment was involved with the calculations so they aren't perfect. I tried to explain my steps so that you can see I'm not going out of my way to produce overly optimistic takeover valuations. The Housing 21 valuation is really only good for the P/S ratio, as the company was especially debt laden relative to the others. If you were to assume Claimar was debt free and operating profit was taxed at 35%, the company would have earned £1.5. If you still use the same £19.5m purchase price, the company was bought for 13x earnings, which is still higher than where Allied trades without even accounting for the cash on the balance sheet.
Looking at activist investors for ideas
I enjoy reading The Official Activist Investing Blog for ideas and keeping up with corporate governance stuff floating around. There was a recent post that was showcasing a couple of activist investments pushing for changes in corporate governance. While the content is interesting, I thought I would mention this as another way to generate investment ideas.
If you read through the article you will see links to the SEC proxy filings that the activist investors file. The activists tend to file presentations on the company and what they think needs to change. They are usually quite thorough and can be treasure troves of data. Sometimes the way they slice and dice the financial statements and show comparable companies can reveal useful things.
I don't think that a small guy like me could make investments that require an activist investor as a huge part of the thesis. In certain instances it is nice to invest alongside guys pressing for change, although it depends on their approach. Psychology speaking, people tend to become further convinced of their own ideas when others try to convince them of the opposite. I briefly touched up ValueAct Capital in my post on Energy Solutions and mention an interview with a partner at the firm. Based on the interview, I think incorporating their activist presence into a thesis would be more credible than a more combative activist.
A point I'd like to rehash as much for myself as anyone else is that investing comes down to price. If the price of an investment is a lot lower than the value of a company, an activist investor can only be a positive force. If it seems like the price and value are pretty comparable, an activist investor will be acting a way that only they know.
On the aforementioned blog, there is a link to a presentation by Barington Capital about Ameron International. Reading through the presentation, you get the idea that management is pretty greedy and has no stake in the company. While at a certain price this might be acceptable (I still haven't taken a stance whether or not this is a proper stance), the company doesn't seem that cheap to make it worth owning if there wasn't an activist involved. As a point of interest, Barington highlights 10 past successful activist investments they were involved with. This could be a starting point for researching companies because they have already responded to the agitation for change and you don't have to worry about any uncertainty of the activist initiatives.
Talk to Andrew about activist investors and their ideas
If you read through the article you will see links to the SEC proxy filings that the activist investors file. The activists tend to file presentations on the company and what they think needs to change. They are usually quite thorough and can be treasure troves of data. Sometimes the way they slice and dice the financial statements and show comparable companies can reveal useful things.
I don't think that a small guy like me could make investments that require an activist investor as a huge part of the thesis. In certain instances it is nice to invest alongside guys pressing for change, although it depends on their approach. Psychology speaking, people tend to become further convinced of their own ideas when others try to convince them of the opposite. I briefly touched up ValueAct Capital in my post on Energy Solutions and mention an interview with a partner at the firm. Based on the interview, I think incorporating their activist presence into a thesis would be more credible than a more combative activist.
A point I'd like to rehash as much for myself as anyone else is that investing comes down to price. If the price of an investment is a lot lower than the value of a company, an activist investor can only be a positive force. If it seems like the price and value are pretty comparable, an activist investor will be acting a way that only they know.
On the aforementioned blog, there is a link to a presentation by Barington Capital about Ameron International. Reading through the presentation, you get the idea that management is pretty greedy and has no stake in the company. While at a certain price this might be acceptable (I still haven't taken a stance whether or not this is a proper stance), the company doesn't seem that cheap to make it worth owning if there wasn't an activist involved. As a point of interest, Barington highlights 10 past successful activist investments they were involved with. This could be a starting point for researching companies because they have already responded to the agitation for change and you don't have to worry about any uncertainty of the activist initiatives.
Talk to Andrew about activist investors and their ideas
Wednesday, March 9, 2011
Tobacco Leaf Merchants - A publicly traded duopoly
I was reading Khrom Capital's Q4 investor letter over at My Investing Notebook and was quite impressed with the stock ideas discussed in detail. The author discusses Universal Corporation (UVV), a stock I've looked into before as well as its main competitor, Alliance One. Outside of the in house operations of major cigarette companies, Universal and Alliance One control most of the market for tobacco leaf purchasing and processing. The major cigarette companies buy from them as well. It's a pretty much no-growth business, but its fairly consistent, generally profitable, and extremely hard to imagine any new competitors. The recent headline scare (1-2 years) discussing how cigarette companies are bringing in more leaf procurement in-house has worried investors and the stocks don't really have high valuations.
Khrom presents a contrarian view in that the leaf merchants play too integral of a part to ever be cut from the supply chain of cigarette manufacturers. I agree. The business has been around for at least 100 years. A couple points not touched on in the letter are that the company has increased its dividend every year since 1988 - an indication of a shareholder friendly management and an implicit recognition of the minimal reinvestment needs of the business. I'm also of the opinion that it helps free up working capital on the cigarette manufacturers balance sheets to optimize them for repurchases and share buybacks. It might not be a huge amount, but just from looking at their balance sheets they are well run operations. While they don't sell an admirable product, they are for the most part well run and shareholder oriented.
The author casually mentions Alliance One (AOI), Universal's main competitor. A while back I looked into the stock because I saw that Seth Klarman's Baupost Group had a stake in it. The author notes that the new CEO at Alliance One specializes in turnarounds and restructurings and that the stock is at an attractive level. I agree that the stock is beaten down a lot. The company has been restructuring for years since a merger in 2005 of the 2nd and 3rd largest tobacco leaf merchants that created Alliance One. While this is going to result in a lot of frustrated sellers and create an opportunistic buying environment, it is important to make sure there is something worth buying.
I wouldn't chalk up Alliance One's problems completely to its $760m in debt - not included $240m in notes payable to banks. Debt is part of the operating model because the company needs funds to finance its acquisition of tobacco. The alternative to long term debt would be a revolver with a floating rate. As if just under 2x LT debt to equity were not a prudent capital structure, exposing oneself to the uncertainty of fluctuating interest payments would probably be too much to bear. By comparison, Universal's LT debt:equity ratio is 1:4, which is why it is consistently profitable and is able to raise its dividend and buyback stock (they bought back $100m in stock back in 08-09 when the price was lower). Universal's success shows that the business itself is fundamentally sound, but must be conducted with prudent leverage (I apologize if you find the term 'prudent leverage' to be offensive).
Thought exercise - If the Alliance One didn't have to pay $80m in interest and used all cash to finance its working capital, equity would rise from $415m to $1,175m. The company is not really earning much money right now, so I will use Fiscal 2010 and 2009 as an example when the company earned $120m (excluding debt retirement expense) and $130m respectively. If they didn't 80m in interest payments (interest expense was actually higher in these years, but this is just a theoretical exercise), they would have earned $172m and $182m (decrease expenses by $80m, taxed at 35%) on equity of $1,175m. That's a ROE of 15% on the business. That's not bad. Even adjusting for goodwill and restructuring charges, earnings from 2006-2008 were nowhere near that good. The problem is that a business that earns a 15% ROE at its peak is not very attractive, and over the cycle of tobacco leaf prices (whole bunch of other agricultural dynamics that would complicate matters) the company probably isn't doing anything much more exciting than 10 year treasuries. You do have the additional risk of them not being able to move excess inventory or any other numerous operational risks. So clearly a debt free tobacco leaf merchant makes very little economic sense. I apologize if this doesn't make sense, I tried to outline my thoughts step by step. I think the ultimate conclusion is correct. There needs to be some leverage in the capital structure for it to make sense.
Back to reality. As stated in their recent earnings release, Alliance One is seeing downward pressure in tobacco leaf prices which is hurting their profits. Another worrisome point is that their profits so far in fiscal 2011 are mostly from asset sales which are non recurring. Their cash flow otherwise would not be enough to service the debt if my calculations are correct (less $37m in other income, but adding back in D&A, non cash debt amortization, and restructuring charges) has cash from operations at ~$33m compared to interest payments of $79m in the past 9 months. This is a very crude calculation and I might have missed something, but clearly there are some difficulties to overcome. They have been paying down debt as best as they can which is encouraging.
Alliance One is a speculation for the aforementioned reasons, and in my case it falls under the "too hard" category. The business is incredibly lumpy. Tobacco leaf is not purchased on a consistent quarterly basis, so cash flows are always going to be erratic. The harvest periods in different regions Alliance One sources from reach their peaks at different times. For a smart person - i.e. not me - wrapping their head around the cash conversion cycle (the quarterly statements don't really reflect whats going on with the company in a way to calculate the CCC in a way that is truthful or beneficial) of the company might allow them to get comfortable with the risks. The company may very well be currently converting a lot of its tobacco inventory to cash which can be used to service and pay off debt. The situation is definitely worth continuing to pay attention to.
One last note is that a big chunk of the balance sheets of both companies consists of tobacco leaves. On the whole, I think impairment of the stated values are unlikely. This is interesting because the in a runoff situation, it could easily be converted into cash. A good chunk of the leaves are slated for delivery to specific parties, so there wouldn't be a huge flood of inventory onto the market. Tobacco isn't exactly a widely traded commodity though, so I don't know how such a scenario would really play out. It is something to think about though.
Disclosure: None
Talk to Andrew about tobacco leaf merchants
Khrom presents a contrarian view in that the leaf merchants play too integral of a part to ever be cut from the supply chain of cigarette manufacturers. I agree. The business has been around for at least 100 years. A couple points not touched on in the letter are that the company has increased its dividend every year since 1988 - an indication of a shareholder friendly management and an implicit recognition of the minimal reinvestment needs of the business. I'm also of the opinion that it helps free up working capital on the cigarette manufacturers balance sheets to optimize them for repurchases and share buybacks. It might not be a huge amount, but just from looking at their balance sheets they are well run operations. While they don't sell an admirable product, they are for the most part well run and shareholder oriented.
The author casually mentions Alliance One (AOI), Universal's main competitor. A while back I looked into the stock because I saw that Seth Klarman's Baupost Group had a stake in it. The author notes that the new CEO at Alliance One specializes in turnarounds and restructurings and that the stock is at an attractive level. I agree that the stock is beaten down a lot. The company has been restructuring for years since a merger in 2005 of the 2nd and 3rd largest tobacco leaf merchants that created Alliance One. While this is going to result in a lot of frustrated sellers and create an opportunistic buying environment, it is important to make sure there is something worth buying.
I wouldn't chalk up Alliance One's problems completely to its $760m in debt - not included $240m in notes payable to banks. Debt is part of the operating model because the company needs funds to finance its acquisition of tobacco. The alternative to long term debt would be a revolver with a floating rate. As if just under 2x LT debt to equity were not a prudent capital structure, exposing oneself to the uncertainty of fluctuating interest payments would probably be too much to bear. By comparison, Universal's LT debt:equity ratio is 1:4, which is why it is consistently profitable and is able to raise its dividend and buyback stock (they bought back $100m in stock back in 08-09 when the price was lower). Universal's success shows that the business itself is fundamentally sound, but must be conducted with prudent leverage (I apologize if you find the term 'prudent leverage' to be offensive).
Thought exercise - If the Alliance One didn't have to pay $80m in interest and used all cash to finance its working capital, equity would rise from $415m to $1,175m. The company is not really earning much money right now, so I will use Fiscal 2010 and 2009 as an example when the company earned $120m (excluding debt retirement expense) and $130m respectively. If they didn't 80m in interest payments (interest expense was actually higher in these years, but this is just a theoretical exercise), they would have earned $172m and $182m (decrease expenses by $80m, taxed at 35%) on equity of $1,175m. That's a ROE of 15% on the business. That's not bad. Even adjusting for goodwill and restructuring charges, earnings from 2006-2008 were nowhere near that good. The problem is that a business that earns a 15% ROE at its peak is not very attractive, and over the cycle of tobacco leaf prices (whole bunch of other agricultural dynamics that would complicate matters) the company probably isn't doing anything much more exciting than 10 year treasuries. You do have the additional risk of them not being able to move excess inventory or any other numerous operational risks. So clearly a debt free tobacco leaf merchant makes very little economic sense. I apologize if this doesn't make sense, I tried to outline my thoughts step by step. I think the ultimate conclusion is correct. There needs to be some leverage in the capital structure for it to make sense.
Back to reality. As stated in their recent earnings release, Alliance One is seeing downward pressure in tobacco leaf prices which is hurting their profits. Another worrisome point is that their profits so far in fiscal 2011 are mostly from asset sales which are non recurring. Their cash flow otherwise would not be enough to service the debt if my calculations are correct (less $37m in other income, but adding back in D&A, non cash debt amortization, and restructuring charges) has cash from operations at ~$33m compared to interest payments of $79m in the past 9 months. This is a very crude calculation and I might have missed something, but clearly there are some difficulties to overcome. They have been paying down debt as best as they can which is encouraging.
Alliance One is a speculation for the aforementioned reasons, and in my case it falls under the "too hard" category. The business is incredibly lumpy. Tobacco leaf is not purchased on a consistent quarterly basis, so cash flows are always going to be erratic. The harvest periods in different regions Alliance One sources from reach their peaks at different times. For a smart person - i.e. not me - wrapping their head around the cash conversion cycle (the quarterly statements don't really reflect whats going on with the company in a way to calculate the CCC in a way that is truthful or beneficial) of the company might allow them to get comfortable with the risks. The company may very well be currently converting a lot of its tobacco inventory to cash which can be used to service and pay off debt. The situation is definitely worth continuing to pay attention to.
One last note is that a big chunk of the balance sheets of both companies consists of tobacco leaves. On the whole, I think impairment of the stated values are unlikely. This is interesting because the in a runoff situation, it could easily be converted into cash. A good chunk of the leaves are slated for delivery to specific parties, so there wouldn't be a huge flood of inventory onto the market. Tobacco isn't exactly a widely traded commodity though, so I don't know how such a scenario would really play out. It is something to think about though.
Disclosure: None
Talk to Andrew about tobacco leaf merchants
Tuesday, March 8, 2011
A radioactive stock that might be worth touching: Energy Solutions
Energy Solutions (ES) provides services primarily to the nuclear industry in the US and UK. I already own some shares in Global Power, a company that provides services to nuclear facilities in the US that I've previously profiled. It's an interesting sector because of the recurring revenue and strong tailwinds industry wide. ES is pretty special though, because it has what essentially amounts to a monopoly within a portion of the nuclear services space.
It's crown jewel is its Clive, Utah facility for handling low-level radioactive waste (LLRW) and mixed low-level waste (MLLW) which is just about every waste material a nuclear plant produces save the spent fuel. They store 95% of the waste of this type in the entire US. There are only 2 other places in the US capable of handling similar types of waste and they are owned by states. Additionally from the 10-K:
The landfill is carried on the books at $30m. The segment it is in, Logistics Processing & Disposal (LP&D) includes several other links in the chain of LLRW disposal generated $240-260m in revnue between 2007 and 2009 and segment EBITDA of $84-100m (Full year 2010 results haven't been released, but it is on track to do about $80m in run rate EBITDA based on the first 9 months). This is the flexing of pricing power, the hallmark of a business you want to own and verification of the huge moat this facility possesses. While the EBITDA figure doesn't take into account corporate expenses, this does demonstrate the massive earnings power of just this one segment/asset. The entire market cap is ~$600m, so ES is potentially undervalued.
There are several other segments: commercial services, federal services, and international. Commercial services cleans up nuclear sites. Federal services does the same but for the DOE. These businesses are more competitive, but the LP&D segment does give it a unique competitive advantage. International operates and cleans up nuclear reactors in the UK. Its contract for the international business is up for renewal in 2012, which is something to look out for.
There's several blemishes to consider when looking at ES though. First is its debt load of $835m. This is eating significantly into EBITDA. Even excluding a goodwill impairment, the company doesn't have 2x interest coverage. A portion of the debt, $300m, is a credit facility to finance restricted cash for collateral on its jobs cleaning up sites through its commercial and federal services segments. While it does operate on long term contracts and has a lot of "guaranteed" revenue, it really isn't guaranteed and even if it had 2x interest coverage, it would be walking a fine line. What would happen if there was a temporary stoppage in shipments to its landfill? That could happen for numerous reasons, natural or man made. Around 10% of the float is sold short, and the risks definitely give some credibility to a short thesis.
ValueAct Capital has a stake in the company. They are polite activist investors who like to get board representation and hold management's hand to run the business with a long term orientation and maximize shareholder value. Here is an interview with one of the guys who runs ValueAct. He is a competent guy who seems to know what he is doing. One thing they look for are choke points in supply chains where out sized pricing power can be exerted. They only like to focus on 10-15 companies, so they don't take a shotgun approach and make concentrated bets. I presume the nuclear waste landfill plays a large part in their thesis.
I love the assets, but I hate the liabilities. I'm not done poking around, and the company should release its 2010 10-K soon, which will be a welcome update on their situation. It is a little annoying the last released financial data dates back almost 6 months. Judging from the monopolistic nature of the nuclear waste landfill, the replacement value is likely greater than the market cap + debt of the company, but I just got burned on Seahawk Drilling with a similar thesis. While I don't want to act like Mark Twain's cat who jumped on a hot stove, it would be necessary to establish the strength of the cash flow and understand some of the other risks.
Disclosure: none
Talk to Andrew about Energy Solutions
It's crown jewel is its Clive, Utah facility for handling low-level radioactive waste (LLRW) and mixed low-level waste (MLLW) which is just about every waste material a nuclear plant produces save the spent fuel. They store 95% of the waste of this type in the entire US. There are only 2 other places in the US capable of handling similar types of waste and they are owned by states. Additionally from the 10-K:
"We are the only commercial disposal outlet for MLLW and operate two of the three commercial LLRW disposal sites in the United States, through our Clive, Utah and Barnwell, South Carolina disposal facilities. The third facility is a state-owned facility located in Richland, Washington that is relatively small, does not accept radioactive materials from outside the Northwest Interstate Compact on Low-Level Radioactive Waste Management States and may eventually stop receiving materials from outside Washington State itself."The company's position as an effective monopoly in the space might be under pressure from another site. There is one planned in Texas that was approved in 2009. It must still go through many phases of permitting, environmental studies, and NIMBYism. Even by the generally business friendly standards of Texas, storing nuclear waste is not a popular business. From ES's 10-K (which might misrepresent the reality, but it strongly correlates with what one would expect from a nuclear waste disposal site construction process):
"Construction may not begin until several reconstruction license conditions are completed and approved by the executive director of the TECQ. Once approved construction is complete, additional conditions of the license must be met prior to commencement of disposal. These conditions will require WCS to complete several major environmental studies, examples of which include groundwater, air emissions, and seismic stability studies. WCS must also demonstrate that the leachate from the landfill will not reach the Ogallala-Antlers-Gatuna Aquifer. Should the license become active, WCS will be allowed to receive waste from the Texas Compact, which includes the states of Texas and Vermont, and from federal facilities (i.e., DOE). WCS will not be able to receive waste via railcar or receive depleted uranium, and will be required to dispose of commercial waste in specially designed containers in the compact portion of the facility."WCS is the company looking to create another landfill for LLRW. Clearly the additional capacity faces constraints in coming online.
The landfill is carried on the books at $30m. The segment it is in, Logistics Processing & Disposal (LP&D) includes several other links in the chain of LLRW disposal generated $240-260m in revnue between 2007 and 2009 and segment EBITDA of $84-100m (Full year 2010 results haven't been released, but it is on track to do about $80m in run rate EBITDA based on the first 9 months). This is the flexing of pricing power, the hallmark of a business you want to own and verification of the huge moat this facility possesses. While the EBITDA figure doesn't take into account corporate expenses, this does demonstrate the massive earnings power of just this one segment/asset. The entire market cap is ~$600m, so ES is potentially undervalued.
There are several other segments: commercial services, federal services, and international. Commercial services cleans up nuclear sites. Federal services does the same but for the DOE. These businesses are more competitive, but the LP&D segment does give it a unique competitive advantage. International operates and cleans up nuclear reactors in the UK. Its contract for the international business is up for renewal in 2012, which is something to look out for.
There's several blemishes to consider when looking at ES though. First is its debt load of $835m. This is eating significantly into EBITDA. Even excluding a goodwill impairment, the company doesn't have 2x interest coverage. A portion of the debt, $300m, is a credit facility to finance restricted cash for collateral on its jobs cleaning up sites through its commercial and federal services segments. While it does operate on long term contracts and has a lot of "guaranteed" revenue, it really isn't guaranteed and even if it had 2x interest coverage, it would be walking a fine line. What would happen if there was a temporary stoppage in shipments to its landfill? That could happen for numerous reasons, natural or man made. Around 10% of the float is sold short, and the risks definitely give some credibility to a short thesis.
ValueAct Capital has a stake in the company. They are polite activist investors who like to get board representation and hold management's hand to run the business with a long term orientation and maximize shareholder value. Here is an interview with one of the guys who runs ValueAct. He is a competent guy who seems to know what he is doing. One thing they look for are choke points in supply chains where out sized pricing power can be exerted. They only like to focus on 10-15 companies, so they don't take a shotgun approach and make concentrated bets. I presume the nuclear waste landfill plays a large part in their thesis.
I love the assets, but I hate the liabilities. I'm not done poking around, and the company should release its 2010 10-K soon, which will be a welcome update on their situation. It is a little annoying the last released financial data dates back almost 6 months. Judging from the monopolistic nature of the nuclear waste landfill, the replacement value is likely greater than the market cap + debt of the company, but I just got burned on Seahawk Drilling with a similar thesis. While I don't want to act like Mark Twain's cat who jumped on a hot stove, it would be necessary to establish the strength of the cash flow and understand some of the other risks.
Disclosure: none
Talk to Andrew about Energy Solutions
Monday, March 7, 2011
A great example of how not to think about investing
The constantly repeating newsflash: most market prognosticators are useless. Roger Lowenstein has this article talking about the latest book by James Glassman, he same author who brought you Dow 36,000. In his defense, Glassman will eventually be right, I guess.
The first rule of investing is not to lose money. The second rule is not to forget rule number one. The best way to begin investing is to learn what to avoid, rather than what to seek out. You'll avoid the confirmation bias this way. It is interesting that this psychology shortfall as well as the recency bias is on show by Glassman when talking about psychology:
The first rule of investing is not to lose money. The second rule is not to forget rule number one. The best way to begin investing is to learn what to avoid, rather than what to seek out. You'll avoid the confirmation bias this way. It is interesting that this psychology shortfall as well as the recency bias is on show by Glassman when talking about psychology:
"Glassman argues for reducing exposure to U.S. stocks, investing in “bear funds,” and hedging through put options. He is full of praise for “value” stocks -- by which he means, stocks that trade at low multiples of assets or earnings.
...
Glassman seems to like value stocks because they have performed in the past. You could have said that about Lucent in 1999
...
Glassman says value stocks benefit from “investor psychology.” He says they offer more reward with lower risk. But he still defines “risk” in terms of volatility. And he doesn’t seem to have learned that psychology can change. His new book, he says, “fits the psychology of investors” -- as if that condition were immutable."Interesting article. Mr. Glassman seems like the real life Mr. Market judging from his massive manic depressive rollercoaster market commentary.
Artio Global Investors - An interesting investment in an investment manager
Have you ever seen a company that actually earns more when you dilute the number of shares outstanding? Artio Global Investors (ART) presents an opportunity for the analytical mind, because it actually earns more when you dilute the number of shares. There are many market dynamics and gross misunderstandings that have caused unwarranted pressure on the stock. The company has a strong business model and trades in an unloved sector of an unloved sector: international asset management. I've discussed why asset managers can be such an attractive investment previously. The company trades at a low multiple of earnings and at a discount to peers.
Background
The company was spun of from Julius Baer in 2009. The company’s cornerstone investment product is an international equity fund started in 1995, with a sister fund started several years after due to the increasing size of the first fund. The company has since expanded its offerings to diversify its product line up and take advantage of their position as a respected international investor. The spinoff did not immediately result in a drop in the share price, although the structure of the spinoff is somewhat confusing. The company has not been helped by the lack of popularity in equity markets and the constantly shifting institutional allocation to various strategies.
Spinoff
The key misunderstanding of the spinoff seems to be the dilution. While typically more shares outstanding means a smaller slice of the pie for shareholders, in this case each diluting share bring with it profits not previously attributed to public shareholders. The company was spun off with 3 classes of shares (A, B, and C), obscuring the earnings power of the entire company and created an overhang of excess liquidity. Class A shares are the basic publicly traded shares with no special features. Class B shares were the holdings of the two principals Mr. Pell and Mr. Younes, who are the CEO/CIO and Head of International Equity respectively, which entitled them to some profits. They have been allowed to sell 20% of their holdings each year of the 5 years after the spinoff, and have sold a portion as they converted to A shares, bringing their combined ownership stake from ~30% to 19%. Class C shares are solely held by GAM Holdings, the Julius Baer parent company, and entitle it to a share of the profits. Within 2 years of the spin, all of these shares will be converted to Class A shares, of which 60 million will then be outstanding. GAM Holdings has stated that the Artio shares are a financial stake as opposed to strategic stake. The shares will convert in Class A shares in October 2011 at the latest, giving the looming threat of additional excess liquidity. The principals own 1% each of the holding company that contains the Artio business. The 60 million shares outstanding represent 98% of the underlying company.
Inside Ownership
There’s a balance between the stock price and inside ownership situation. A lot of the liquidity in the stock is the result of the principals selling shares in the company. While insider buying is a universally bullish signal on a stock, a more nuanced view is necessary on insider selling. It is simultaneously discomforting and irrelevant. As long as the principals hold a meaningful stake in the company, there is a strong alignment of incentives. Now that the company is public, 2m shares in the form of RSU’s were issued to non-senior employees, which vest over the next 3 years. This further entrenches an alignment of interests in the entire operation and mitigates the potential dilution of aligned interests through the sales of the principals.
Without getting philosophical about what stake for the principals to hold would be considered “meaningful,” I would point out that there is a combined ~$200m of stock held by them still. They have gotten themselves a fair amount of cash out of their holdings, and it remains to be see how they will approach future periods when they can sell. This being the real world and considering that most managers are not Warren Buffett (who still has substantial wealth absent his stake in Berkshire), I’m not exactly shocked that they would look to diversify their wealth. While it is not the ideal situation, you are not paying a price for a stock that people expect to be everything but ideal. The principals also own 2% of the underlying company, which means they get 1% of the company’s profits passed through to them. This could potentially be destructive were they to do dilutive things with the other 98% of the shares to increase overall profits, but this 1% is outweighed by their public shares.
Valuation
This is the downside case based on the derivative earnings and EV/AUM valuations based on drops in AUM. The expenses are overstated by using 2010 expenses. There is greater variability in expenses if AUM/performance declines. Any upside through increases in AUM/positive performance is not accounted for. These various valuation situations reveal a margin of safety in spite of potential volatility in markets.
Downside and Risks
The company’s revenue is completely derivative of its assets under management. The main way to retain and attract more/grow AUM is performance. The long term performance metrics of its core strategies are industry leading, although recent performance has been disappointing. While it is difficult to allocate the blame, the recent outflow of assets is attributable to performance as well as changing institutional portfolio balancing. The International Equity funds (their flagship product) has underperformed the index in the past 1 and 3 year periods, which have slowed down the growth in the company. They haven’t done horrible by mutual fund standards and they’ve outperformed the index since inception. There is a risk the fund has “lost it” but it is the same people who have been running it since inception. If this is more than a temporary dip in performance, more assets could flow out.
Potential Upside
There is some upside potential in new fund launches. Their US equity funds are still small and have had a hard time since they launched in 2006. They have a High Yield Fund as well as a High Grade Fixed income fund with $4bn in AUM each. They’ve just launched a Local Emerging Markets Debt Fund (LEMD) , which is a logical extension of the international bent of the company as well as complimentary to their already established fixed income team. While no additional valued is assumed from the US equity or LEMD funds, the LEMD fund has strong potential to attract several billion more in AUM.
Additional Catalysts
The company has a buyback approved, which should be easy to complete with the low stock price and tons of FCF the company throws off. Increasing the dividend is another possibility. While I realize this does not quite constitute startling insight, the payout ratio is 10% and the buyback is only covering dilution from equity compensation.
As stated, the company throws off tons of cash flow. They have casually acknowledged the possibility of an acquisition. Done at a reasonable multiple – and most of the sector is not expensive – it might have the unexpected effect of boosting the stock price. It would give the company much needed diversity as it is considered mostly a one trick pony at this point with its International Equity fund family.
Comparisons
Disclosure: Long ART
Background
The company was spun of from Julius Baer in 2009. The company’s cornerstone investment product is an international equity fund started in 1995, with a sister fund started several years after due to the increasing size of the first fund. The company has since expanded its offerings to diversify its product line up and take advantage of their position as a respected international investor. The spinoff did not immediately result in a drop in the share price, although the structure of the spinoff is somewhat confusing. The company has not been helped by the lack of popularity in equity markets and the constantly shifting institutional allocation to various strategies.
Spinoff
The key misunderstanding of the spinoff seems to be the dilution. While typically more shares outstanding means a smaller slice of the pie for shareholders, in this case each diluting share bring with it profits not previously attributed to public shareholders. The company was spun off with 3 classes of shares (A, B, and C), obscuring the earnings power of the entire company and created an overhang of excess liquidity. Class A shares are the basic publicly traded shares with no special features. Class B shares were the holdings of the two principals Mr. Pell and Mr. Younes, who are the CEO/CIO and Head of International Equity respectively, which entitled them to some profits. They have been allowed to sell 20% of their holdings each year of the 5 years after the spinoff, and have sold a portion as they converted to A shares, bringing their combined ownership stake from ~30% to 19%. Class C shares are solely held by GAM Holdings, the Julius Baer parent company, and entitle it to a share of the profits. Within 2 years of the spin, all of these shares will be converted to Class A shares, of which 60 million will then be outstanding. GAM Holdings has stated that the Artio shares are a financial stake as opposed to strategic stake. The shares will convert in Class A shares in October 2011 at the latest, giving the looming threat of additional excess liquidity. The principals own 1% each of the holding company that contains the Artio business. The 60 million shares outstanding represent 98% of the underlying company.
Inside Ownership
There’s a balance between the stock price and inside ownership situation. A lot of the liquidity in the stock is the result of the principals selling shares in the company. While insider buying is a universally bullish signal on a stock, a more nuanced view is necessary on insider selling. It is simultaneously discomforting and irrelevant. As long as the principals hold a meaningful stake in the company, there is a strong alignment of incentives. Now that the company is public, 2m shares in the form of RSU’s were issued to non-senior employees, which vest over the next 3 years. This further entrenches an alignment of interests in the entire operation and mitigates the potential dilution of aligned interests through the sales of the principals.
Without getting philosophical about what stake for the principals to hold would be considered “meaningful,” I would point out that there is a combined ~$200m of stock held by them still. They have gotten themselves a fair amount of cash out of their holdings, and it remains to be see how they will approach future periods when they can sell. This being the real world and considering that most managers are not Warren Buffett (who still has substantial wealth absent his stake in Berkshire), I’m not exactly shocked that they would look to diversify their wealth. While it is not the ideal situation, you are not paying a price for a stock that people expect to be everything but ideal. The principals also own 2% of the underlying company, which means they get 1% of the company’s profits passed through to them. This could potentially be destructive were they to do dilutive things with the other 98% of the shares to increase overall profits, but this 1% is outweighed by their public shares.
Valuation
This is the downside case based on the derivative earnings and EV/AUM valuations based on drops in AUM. The expenses are overstated by using 2010 expenses. There is greater variability in expenses if AUM/performance declines. Any upside through increases in AUM/positive performance is not accounted for. These various valuation situations reveal a margin of safety in spite of potential volatility in markets.
Downside and Risks
The company’s revenue is completely derivative of its assets under management. The main way to retain and attract more/grow AUM is performance. The long term performance metrics of its core strategies are industry leading, although recent performance has been disappointing. While it is difficult to allocate the blame, the recent outflow of assets is attributable to performance as well as changing institutional portfolio balancing. The International Equity funds (their flagship product) has underperformed the index in the past 1 and 3 year periods, which have slowed down the growth in the company. They haven’t done horrible by mutual fund standards and they’ve outperformed the index since inception. There is a risk the fund has “lost it” but it is the same people who have been running it since inception. If this is more than a temporary dip in performance, more assets could flow out.
Potential Upside
There is some upside potential in new fund launches. Their US equity funds are still small and have had a hard time since they launched in 2006. They have a High Yield Fund as well as a High Grade Fixed income fund with $4bn in AUM each. They’ve just launched a Local Emerging Markets Debt Fund (LEMD) , which is a logical extension of the international bent of the company as well as complimentary to their already established fixed income team. While no additional valued is assumed from the US equity or LEMD funds, the LEMD fund has strong potential to attract several billion more in AUM.
Additional Catalysts
The company has a buyback approved, which should be easy to complete with the low stock price and tons of FCF the company throws off. Increasing the dividend is another possibility. While I realize this does not quite constitute startling insight, the payout ratio is 10% and the buyback is only covering dilution from equity compensation.
As stated, the company throws off tons of cash flow. They have casually acknowledged the possibility of an acquisition. Done at a reasonable multiple – and most of the sector is not expensive – it might have the unexpected effect of boosting the stock price. It would give the company much needed diversity as it is considered mostly a one trick pony at this point with its International Equity fund family.
Comparisons
If you can point out errors in the comps, you can win a cookie. I used SEC filings, but I did not make many adjustments. I excluded Calamos Asset Management and AllianceBernstein because there were substantial adjustments to make due to their structure, and I wasn't sure if I was going to do it properly. Legg Mason is working through some of its own problems with the fall of Bill Miller and issues with money markets. Federated Investors core business has a lot less stickiness in it (money markets) and the fees earned are a lot lower. While the P/E multiple can be subject to manipulations, it is worth noting that money managers typically trade at above market valuations. I don't have a favored integer for the PE multiple, but 9 is definitely too low for Artio considering the many advantages of the the asset manager business model. An asset manager that trades OTC and is a real minnow that I wrote up a while ago, Hennessy Advisors, now sports a higher valuation with its recent run up.
Conclusion - The margin of safety on the downside is great enough that I'm not worried too much about where the upside will come from. From a pure valuation standpoint, Artio Global is cheap. There are no blemishes, outside of its concentrated fund offerings, that lead me to believe the company should trade at such a substantial discount to peers.
Disclosure: Long ART
Sunday, March 6, 2011
Open question to readers on China Media Express (CCME)
I realize I'm on an SEO roll talking about GMCR, Walmart, and now CCME - I will resume talking about stocks that nobody else is shortly. I don't have anything to share about CCME, but am curious if any readers have anything to share about the situation in an archetypal sense. I look at the situation and its clear I might have more insight into what its like to have breasts. I wouldn't really know where to start. There's a lot of conjecture in the debate that seems based on assumptions rather than knowledge of the operations of auditors, the industry it operates in, and the incentives of all the agents involved. This applies to both sides of the argument.
My question to readers: I can definitely conjure up many examples of successful shorts of touted frauds. Can anyone think of a successful long thesis based on a company not being a fraud? Not in the sense that a long is inherently based on the company existing. Has there ever been a company that people thought was a fraud and someone swooped in and took advantage of the uncertainty?
Talk to Andrew about a successful long thesis on a company not being a fraud
My question to readers: I can definitely conjure up many examples of successful shorts of touted frauds. Can anyone think of a successful long thesis based on a company not being a fraud? Not in the sense that a long is inherently based on the company existing. Has there ever been a company that people thought was a fraud and someone swooped in and took advantage of the uncertainty?
Talk to Andrew about a successful long thesis on a company not being a fraud
Thursday, March 3, 2011
Walmart: Offering bargains at more than its stores
Ever since Walmart has been turning around its imagine with consumers, it has been suffering on Wall Street. I hate to frame commentary on stocks in such a way, but its approaching a territory where it becomes more attractive to Warren Buffett. There's plenty of speculation based on people's own personal predilections about the elephant Buffett is about to take down. I'd like to think that my musings assume more prescient form, because as I always do, I'm going to refer you to the excellent description of exactly how Warren Buffett invests. The key takeaway in this instance is that ~14x earnings is the sweet spot for a lot of big cap value stocks that Buffett invests in. He also mentioned on CNBC that he has been buying more, and as far as valuation goes, Walmart keeps getting cheaper.
Walmart now trades at 12.5x earnings. Buffett has said in the past that his biggest mistakes were ones of omission as opposed to commission. One of the biggest? Not buying more of Walmart in the mid 90s. He has stated he believes it cost $10bn in shareholder value, because the price moved up a little after he started to buy and so he backed off. I don't think it takes any conjuring of Buffett or pondering his rationale to understand what would make Walmart an attractive investment.
A lot of people get bearish on the stock by taking a short term perspective and not looking at the business. The company has some warts with the potential class actions lawsuit from female workers, perpetual demonization by unions, potential increases in prices of Chinese manufactures, and stalling US growth. Even the last point, while potentially a stumbling block, has the miasma of poorly thought out short term market views. None of these really have an effect on the long term prospects of the stock.
Rising prices from its Chinese based manufacturers? Is that really the best you could come up with? Walmart's low cost advantage is not who it gets its products from (Walmart gets its products from Hu. Who? Hu. Walmart gets its products from Hu. No, I asked you Walmart gets its products from Hu....readers, I'm sorry you must tolerate my occasional daliances with unhumor). The advantage is in how. Wherever and from whomever it may import products from doesn't negate the advantages of its world class logistics and economies of scale. Will this maybe cause some short term ripples in the supply chain? Sure, just like its always been a huge issue for the company (sarcasm). Is the long term health of the company at risk? No. Walmart will retain its value proposition whether prices are X, 2X, 3X+5, or ∞+1.
Look at the year-over-year growth of the company. Nothing gets more consistent than that. Every year the company reports higher sales and profits. This isn't the financial manipulation that General Electric used to commit through its GE Finance arm. This isn't some deriviatives induced phantom profit like Enron. It earns great returns on capital. It increases its dividend every year and buys back its stock. This is all in spite of stumbling in Germany, Korea and smaller store footprints in the US, a tough economy, and public image issues. This company is totally shareholder oriented, a low-cost operator, and has plenty of years of profitable and consistent growth ahead of it. When I first began investing, it was always about low PEs, dividend yields, buybacks, and growth when it came to an explanation of what makes a good stock to buy. Walmart is a simple company that checks off on just about every point on a checklist of stocks worth buying.
I look at the price its at right now, and Mr. Market is not in a depressive state, he's in a hallucinogenic state. It doesn't take a genius to understand Walmart (see above for proof). There is upside and a margin of safety, but not as much as one can find in smaller stocks if they put in the effort. For all my lovely readers running billions of dollars (real or otherwise), it's worth pointing out that a company liquid enough to move the dial in a large portfolio is trading at a price as cheap as it has been in the past decade based on earnings. I thought the blogosphere deserved a quasi-factually backed pick of a company that Warren Buffett might buy as opposed to the headline grabbing junk being printed (I feel like if I criticized a specific pick, I would end up eating my words, but many of the companies being touted don't really fit the typical Berkshire bill). It helps that he has already bought shares of the company. Not that I have any specific insight, but it wouldn't shock me to see him buying more at these levels.
Disclosure: None.
Although my writing is somewhat convincing, I'd rather have the capital free to take advantage of opportunities in smaller companies. I thought it was still worth pointing out though because the company issued guidance in line with analyst estimates and has fallen ~10% in the past month or so. Not exactly distressed, but noteworthy nevertheless.
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