Gee golly, G. Willi and my thoughts on hummus

G. Willi-Food International (WILC) is a company that is cheap by just about all metrics, easy to understand, obscure, sits on a huge net cash position, and does most of its business in a foreign country.  All of these factors combined tend to create investment opportunities.  Not here.  This optimistic scenario is incredibly deceptive and ignores a poor track record and the huge benefit from exchange rates which is not exactly sustainable.

The company has growing revenue and profits.  The company has introduced new products that will grow revenue and profits even more.  They are a kosher food distributor mainly in Israel with a minor presence in the US and Europe that they are looking to expand.  With a market cap of $101m, the company trades at 12x earnings, but has $50m in net cash, of which I'll venture $40m is excess, although that might be an understatement since a company with $100m in sales and $10m in inventory might not even need $5m in cash hanging around.  Anyways, netting out the cash leaves the company trading at 7.5x earnings(6.25x if you net out all the cash), which is very low for a company that is growing and earns an 18% ROE adjusted for excess cash.    Additionally, since it is 53% own by insiders, there is likely not enough liquidity to attract any large investors.

The dangle is the purported growth opportunities the company has, and the top line growth has certainly been strong over the years.  Operating profit has been a lot more volatile though due to currency fluctuations since most of the products they distribute have to be imported, and Israel has had some wild currency fluctuations in the past 5 years.  Net income and the cash balance have also received a huge boost from the strength of the New Israeli Shekel (NIS) as well.  Bottom line growth from 2005-2010 has been helped by a 25-30% increase in the value of the shekel.  While Allied Healthcare's growth was being masked by a weak GBP to the USD, G Willi's growth is partially being driven by currency fluctuations. Some might claim they like that exposure to foreign currency and diversification from the USD, but the benefit here is overstating some of the growth, which is a factor that should take precedence over currency diversification.

The cash/securities balance has definitely been helped by the exchange rate of the USD:NIS, but something else has helped the company grow its cash balance to 50% of the market cap.  The ever pernicious practice of pointless share issuance.  While one can quibble over the issuance of JNJ shares for Synthes or Kraft for Cadbury, there is an easy to understand explanation for it even if you disagree with the economics.  In 2010, G. Willi issued 3.3m shares, increasing the share count by 32%.  At $6/share, despite the stock previously trading for ~$7 prior to the announcement, it was done at a pretty steep discount to an already undervalued stock.  The stated purpose was to fund working capital and general corporate expenses, but the company had no debt and $30m in cash and securities.  Their reason doesn't hold up water when you compare the $30m in cash to $6m in net receivables (accounts receivable minus accounts payable) and $12m in inventory.  They could have already doubled the amount of capital tied up in the business and had tons of cash left over.  They didn't need an extra $19m (proceeds from 2010 issuance).  They also issued shares in the 2 years from 2005-2007, raising share count from 8.6m to 10.2m through a private placement and warrants involved with that placement.  Again, they had tons of excess liquidity then as well.  These historical actions speak poorly of management and inspire no confidence.  Additionally, WILC shares a bullish analyst research report on its website.  It's by the people who underwrote the 2010 share offering and who also underwrote offerings for Universal Travel Group  and China Agritech among many other dubious Chinese companies.  Fool me once, shame on you.  Fool me twice, shame on me.

One of the other reasons I've seen brought up for the share issuance was to acquire a US based distributor to leverage their hummus/Mediterranean food expertise.  This is bunk.  I'm a huge hummus fan.  It's a pain in the ass to prepare on your own (you have to boil chickpeas for a while and don't even get me started on cleaning up the food processor afterwards), but tastes great with pita or crackers.  I'm also a fan of using red pepper or onions, both of which have exceptional naturally occurring scoopable functionality and provide a nice flavor to contrast the hummus.  I'm not sure G Willi's desire to expand into this area, my enjoyment of hummus, and the potential growth in this area can be reconciled as a reason to purchase the stock.  And I think due to currency fluctuations and the fact that the company didn't earn its cash pile, one can't justify this as a "call option" for free with the stock.

Kraft owns the Athenos brand and Pepsi has a JV for its Sabra brand.  They've put a lot of marketing muscle behind it.  Athenos has arguably not done a good job flexing that muscle.  This is more anecdotal, but Sabra has been giving out free samples + coupons at Penn Station in NYC, and doing similar promotional activity around the country.  This will make the overall market bigger, but that doesn't mean WILC is going to capture any of it.  I get Abraham's hummus, which doesn't have preservatives and cheaper than Sabra's ($3.99 vs. $4.49 if I recall correctly.  I do know that I first tried it because it was cheaper).  It's also markedly better.  Hummus tastes best when it is fresh, so anything with preservatives, which I usually have nothing against, tends to be less tasty.  I think that Abraham's is fairly local contributes.  I wonder where WILC would fit in.

My point though is that there is plenty of competition (that link just names a few) out there in the hummus field already.  Certainly WILC could get involved, but this isn't anything novel or exciting.  That they would have to acquire a distributor in the US to do so already puts them at a disadvantage since I would say the field is already crowded.  I'd also question the volume that could be achieved with generic brand hummus that WILC would supposedly supply.  Additionally, a recent article in the WSJ will tangentially give you some additional flavor on the kosher food industry.  The marketing appeal of kosher food is not something only WILC is aware of and will attempt to exploit.  I'm unconvinced that kosher food is an investment angle to play, or that WILC would be a vehicle through which to do it.  It's not such a tiny niche that food distributors in the US wouldn't waste their time on it.  There are plenty of major brands that only produce kosher versions such as Coke.  Even ignoring the fishy share issuance, I find the US/European growth potential unconvincing, although they have and will find growth from introducing new products in Israel.

When dealing with stocks that appear so dramatically and obviously undervalued, it becomes even more important to look for a reason why.  I will admit that I was pretty convinced upon reading several bullish articles on the stock, but I took a moment to closely examine the stock and look at more than just the financials from the past 12 months.  The share offering is doubly suspect due to the parties involved.

Previously it was my hope that by not enabling comments I would spur more substantive discussion via email with readers.  It has been mildly successful, but I would prefer to engage in more dialogue with peers.  As such, I've enabled comments.  Keep it classy, and don't worry about offending me if you disagree.  I would much prefer you disagree with me and will forgive ad hominem attacks since this is the internet after all (hopefully none of my articles have driven anyone to feel the need to attack me though).

How to Sell a Stock and Other Food for Thought from Tweedy, Browne

While the question of when to sell a stock is not something I’m particularly knowledgeable enough to answer, I’ve been doing some reading lately and discovered some thoughtful ideas about how to sell.  Tweedy Browne writes a lot of academic/empirical investing research that is very applicable and easy to understand.  Their paper What Has Worked In Investing is a classic in my opinion for corralling a collection of empiricism to the value investing process that is otherwise just intuitive and logical.  I recently read Investing For Higher After Tax Returns (h/t Whopper Investments) and while the main thrust is equally thought provoking and worthwhile, one of the corollaries struck me as having broader implications and as a worth while topic of further discussion.  While the paper focuses on the implication of investing for after-tax returns, one of the underlying themes is that how you sell a stock can have a large effect on your after tax returns and warrants serious consideration.

One reason cited by professional portfolio managers for selling is finding even more undervalued stocks.  An example would be having stocks A and B, which you think are both worth $10 and are for the purposes of this exercise identical businesses (margins, sales, ROE, etc).  You bought stock A for $6 and now it is trading for $8.  You don’t own stock B, but it is trading for $7.  Theoretically you should sell stock A and buy stock B as your potential return is 43% instead of 25%. 

The Tweedy paper would offer conditions to this, and I would agree.  Say stock A and B both earn $1/share and will grow 10% a year in perpetuity.  At their respective prices of $8 and $7 and a common value of $10 might be reason to sell.  If you sell stock A for $8, you receive $6.80 in after tax returns at the long term capital gains rate.  So you are selling a stock for proceeds that are 6.8x earnings, to buy a stock at 7x earnings.  This should remind you of Warren Buffett's criticism of the frozen pizza business sale by Kraft (Geoff's entire article is a great real world example of exactly what Tweedy is empirically pointing out)

You could truthfully say you bought stock A at $6/share and sold it for a $2 gain at $8/share and theoretically buy stock B at $7/share and sell it for a $3 gain if it goes to $10/share.  You could truthfully say you made $5 in gains.  Or could you?  Within the limits of this scenario, with the after tax proceeds you could not have even bought one share of stock B, since you only had $6.80 per in proceeds from stock A.  Clearly the closeness in valuation of stock A and B are a cause for pause and reflection.  In real life, no situation is guaranteed to be remotely close to this simplistic.  It might help to go to page 37-38 of the paper since the numbers are laid out in greater detail if you don’t find the above clear. 

While none of this will tell you exactly how to go about deciding when to sell, Tweedy (probably not me) does provide a cogent explanation that can at least serve as a starting point.  Depending on how you learn and think, their presentation through the use of a numbers in an example might help. 

I find that investors/bloggers/journalists that say one should sell a stock when it reaches one’s target price are not really telling you or I anything that is all that applicable.  Material events can happen that change the value of the stock for better or worse before your target price is ever reached.  What if you reassess the value and its higher, but at the current price you aren’t going to add more.  Blindly selling at an arbitrary price is not very scientific or thoughtful.  Selling when it reaches a price target oversimplifies something a lot more complex.  While Tweedy doesn’t exactly answer the question (they didn’t set out to and their paper is more about finding stocks that you won't be selling any time soon), they do provide a useful starting point to develop an understandable framework for how to sell your stocks, assuming you are going to buy another in its place.  


Some other interesting nuggets in the paper:
- A defense on their diversification, which I find compelling starting on page 43
- Checklist on earnings outlook in Appendix C starting on page 63
- Checklist on assessing growth prospect, competitive position, and economics of a business starting on page 65

Supertex, an interesting semiconductor company

I’ve been lukewarm to the possibility of investing in broadly defined technology companies.  Semiconductors fall into that category.  That doesn’t stop me from finding some interesting names.  The industry is volatile, subject to obsolescence, and competitive.  With those risks, the short term perspective of the market can be to your advantage.  Supertex is a cash rich company with a history of profitability that popped up on the 52 week low list.  There’s a lot to like about this company, but I’m not sure those factors can make up for not fully understanding the business.

Supertex was founded in 1976 by the Pao family, who still play a role in the firm.  Supertex makes chips for medical, imaging, LED, industrial, and telecom equipment.  For example, they have focused on niche markets such as medical ultrasound imaging and backlighting for LCD displays.  The company has been profitable for the past 10 years, although sales have range bound for the same period.   Supertex has continually invested in R&D, spending 10-23% of their revenue annually over the past 10 years and has come out with ~20 new products annually in the past few years.

The stock popped up on the 52 week low list earlier this week and when I took a brief look at the financials, I noticed it had a huge cash/investment pile of just under $170m and no debt compared to a market capitalization of $270m.  While further digging and the nature of the business reveal that it wouldn’t be prudent to just net out the cash balance, cash has just been building up on the balance sheet for the past 10 years.  The company announced a $60m buyback, which seems to be the proper use of cash as the stock price is languishing.  The most recent 10-Q reveals that they already $2 million worth of shares in the short time between the filing and the announcement, so it looks likely that it isn’t empty rhetoric.

The company has earned $12m in the past 12 months, so it trades for about 23x net income, which is not cheap.  They’ve been able to pay for R&D out of revenue, so most of the cash is not very crucial to the running of the business.  Additionally, capital expenditures are minimal with about $30m over the past 10 years.  The cash/investment balance deserves a close look though because $32m is in frozen auction rate securities (ARS), the result of yield chasing on their cash balance.  At least it wasn’t squandered on a ridiculous acquisition.  That figure was closer to $60m until this year, although the balance of ARS could remain stuck for years.  Luckily they don’t need the liquidity.  The $138m balance of cash/investments is in cash or municipal bonds.  

While one could still entertain the notion of valuing the company by netting out cash, the real problem with doing so is that earnings are not recurring in nature and are based on the success of future products.  Management has expressed optimism in their most recent products, which focus on the LED and ultrasound market.  The sales of LED chips have been growing 100% YoY, albeit from a small base.  The company believes that as its ultrasound chips get designed into equipment, sales will surge.  The company would probably not notice if $100m of that disappeared, so the market is valuing the business at $170m or 14x earnings.  While the company trades at 9x earnings when you net out all of the cash, those earnings are of a more dubious quality than Full House Resorts or Artio Global.  This might represent a good deal if you are comfortable with the future growth prospects.

The company allegedly serves niche markets, so one might conclude that the markets can be profitable due to a lack of competition.  I only say "allegedly" because I don't know enough about the industry to judge the competition.  Intel or Texas Instruments has no interest in a $20m chip market because it wouldn’t move the needle.  Their gross margins and net profit margins are in the 37-60% and 4-22% range over the past 10 years, respectively.  Clearly there is a cyclical component, but one might conclude that this means they’ve never been in hypercompetitive markets.  They also have a portfolio of patents which provide some protection.  The company has been in operation since 1976 as well, so the long record of earnings is comforting, although it is not a long record of consistently strong earnings. 

The problem with this competitive position and strong past earnings is that the market itself is ever changing. Even though the company spends a lot of money on R&D, it is to replace products that are constantly becoming obsolete.  Samsung, GE, and Motorola represent 40% of sales.  This can be sticky if Supertex’s chips get designed into their products, but those 3 consistently release new products.  This dynamic of constantly innovating and updating products could likely be sustained by the company due to its sustained profitability and large cash position, but the need to do so makes the business less attractive as an investment.  The company writes off a few millions worth of inventory each year due to obsolescence, further supporting the case that the business is rapidly changing, although it doesn't restrict profitability too much.  They do possess patents on many of their products though, so it may help ensure that the new products they do design are the only ones incorporating their technology and reducing competition.  

Management and the board are respectful of shareholders, which is a pleasant change from the norm.  The CEO and SVP are the remaining founders still involved at the company.  Pao, is part of the founding Pao family.  The father was the initial CEO, and his estate still holds several million shares.  There was also another relative who used to own a portion of the company that has since moved on.  Henry Pao, the current CEO, owns $20m worth of shares and the SVP owns $4m worth.  The entire management team is very fairly compensated.  Every few years they are granted options, which ups their pay a lot ($800k-900k), but most years pay is in the $300-400k range.  In my unscientific casual observations, that’s rare for most $270m companies or companies that make ~$10m a year.   Board compensation is also fair.

I do think that the combination of a long history of operations, strong cash position, supposed leading position in niche market, aligned management, and recent buyback all bode well for the stock and business.  Try reading this though and tell me you aren’t left completely confused as to what their products do.  It's not like an internal combustion engine, which involves some science/technology but I understand.  I’m comfortable not understanding the science behind semiconductors or drugs or geological formations, but I couldn’t even tell you what these semiconductors do.  Taken from a snapshot perspective of the financial statements, I understand well enough what is going on, but from the perspective of the business as a dynamic entity I am stumped.  As the company is not exactly distressed, an investment in Supertex is contingent on future results which are much more likely to stray from past results due to the nature of the business and semiconductors falling out of my circle of competence.

Declining industries food for thought - USA Mobility (USMO)

My post on hard drive makers wasn't the most novel thing to grace these pages, but I find it interesting to muse over.  A smaller example that I just remembered is a company worth looking at that is several years ahead of hard drive makers in facing its obsolescence with consolidating, cost cutting, and returning money to shareholders.  USA Mobility (USMO), a stock that is a perpetual Magic Formula Stock, is in the declining beeper business.  Yes.  Beepers.  There's still a decent sized market that is profitable for beepers.  It is instructive of the risks as well as the rewards of these situations, as well as the extreme sensitivity to price paid in getting a good return on your investment.  In a declining business, you need to be precise and accurate in determining the value.  USA Mobility is interesting in that it was essentially in long term runoff mode up until about a month ago, when it announced an acquisition.  Looking at the pre-acquisition scenario highlights the rewards of these declining industry cash flow machines, but the post-acquisition reality highlights some of the risks.

USMO is a roll up of beeper companies, many of which had gone bankrupt in the past.  The industry has rationalized and USMO is solidly profitable.  The market for beepers is focused mainly on healthcare and emergency services because the reception is more consistent than other technologies, so the company has had a core of customers that has been slow to change.  Further driving profitability is a huge tax loss carry forward, with $370m unencumbered NOLs still to be realized.  From the period of 2005-2011, the company has gone from $28/share to $6/share and is now at $15/share.  Sometimes Mr. Market has been pleased with the company’s strategy and sometimes he hasn’t. Tilson described his Seagate investment as a tricky one only for nimble investors, and USMO is a pretty good example of how true his words are for a company in this type of situation.

USMO has been a cash flow machine as it has kept ahead of declining revenue by cutting expenses faster.  From 2006-2010, revenue dropped from $497m to $233m, but EBIT has been pretty steady only dropping from $67m to $57m over the same period.  Net income is not as smooth due to the accounting for the tax treatment of the NOLs, but the company has returned $366m to shareholders over the past 6 years while remaining debt free.  They also executed a well-timed buyback in 2008-2009, purchasing $50m in shares in the $9/share range.  I’d consider this a rare and impressive example of a disciplined management team that is genuinely looking to maximize shareholder returns.  Check out Vaxgen for an example of a really shitty outcome for shareholders when management acts in the exact opposite way (slightly different situation, but I think more indicative of the confidence one should place in management of most companies).

Depending on your purchase price, the outcome of an investment in USMO has ranged from a minor loss to a huge gain.  Even if you purchased the stock in 2005 when they first began declaring large dividends and executing intelligently on their runoff, the stock is down about 50%, but you would be about break even based on dividends.  Not a desirable outcome, but it shows that done properly, a declining business will not guarantee a loss of capital.  If you bought it in 2008-2009 (when the company was  buying back shares as well, so I'm not just cherry picking the stock and overall market lows) you've made out pretty smartly on the share price and dividends.  That doesn’t make it a good investment right now necessarily, but it does demonstrate that a declining business doesn’t necessarily translate into a wipe out of your investment, assuming management focuses on returning remaining cash flow to shareholder’s.

The investment thesis behind USMO grapples with the business being in perpetual decline on one hand, but still generating tons of cash on the other.  The company is increasingly approaching the inflection point where revenue will decrease at a faster pace than expenses.  The company’s guidance for 2011 is a revenue range of $182-192m and expenses (excluding depreciation) of $132-136m.  Even using the most optimistic scenarios given, expenses as a % of revenue are creeping up now.  This doesn’t preclude it from being a good investment though.  There seems to be a floor in the decline, as hospitals/healthcare is a huge and sticky contributor to revenue (~60%) and it has only been declining at a low single digit rate compared to other revenue sources declining at much faster rates.

To shift into a discussion of whether or not USMO makes an interesting investment currently, it has become more complicated.  Whether to take advantage of the tax loss carryforwards or to continue receiving a generous paycheck (management owns practically no shares), the company decided to turn a debt-free, cash rich position of $130m into a net debt of about $30m.  While the debt load will be manageable and get paid off, it significantly raises the hurdle on the investment by removing a cash position that was 30% of the company’s market cap.  The language being used to justify the acquisition is also something that requires close reading.

The company is paying $163m for Amcon Software.  From the conference call discussing the acquisition:

Amcom is a leader in providing comprehensive and creative software and critical communications systems to our target market segments in Healthcare, Government and Large Enterprise. This is a company with over 40% of its revenue in recurring maintenance with a 99% renewal rate. This best in class statistic only serves to underscore the fantastic stickiness of their software solutions. Amcom has been and will continue to be led by an experienced management team.

This may sound like a nice business, but the company only had $51m in sales in 2010 and $12m in EBITDA in 2010, so the price wasn't very nice from USMO's perspective.  It’s a growing company and USMO believe that they can use their existing relationships to cross sell products.  You don’t have to be frugal to acknowledge that this is a pricey acquisition.  The company hosted a conference call to discuss the acquisition and why it is a good fit.  The transparency is commendable, but now investors are forced to understand the future to a greater degree.  Now instead of trying to approximate a figure of future cash flows the beeper business will generate and add that to the previous cash pile to get a value, investors are left trying to figure out the value of the beeper business with no margin of safety and trying to figure out what this software company is really going to contribute over the long term.  Management would argue that this is prolonging the cash flow from beepers as the software will allow them to provide additional value with their current offerings, but this is a much more uncertain outcome than $130m in cash. 

None of this is to say that Western Digital or Seagate’s next few years will follow the same path as USMO.  You shouldn’t let this bias how you view Western Digital or Seagate, because they could pursue wholly different paths in the face of decline.  You should let it inform your view of them in as much as you could trick yourself into giving credence that their recent moves will translate into shareholder value.  They very well may.  With all the benefits of having a strong position in a consolidating but declining industry, it is important not to lose site of the risks that the benefits might not accrue to shareholders.

Hard to pass on the hard drive industry?

Seagate and Western Digital are bigger companies than I like to talk about, but there's just a lot of neat things to think about.  The stocks have been talked about before on other sites and Whitney Tilson recently disclosed a position in Seagate.  Both investors spoke about it before the recently announced acquisition of Samsung's hard drive business, which means the prices have come up a bit.  Assuming the Seagate/Samsung deal and the deal for Western Digital/Hitachi close without problems, the market will become an effective duopoly with 2 players controlling 85%+ of the market for hard drives.  Companies that operate in duopolies or have an effective monopoly on certain products or services always interest me since they tend to have more pricing power than businesses in more competitive environments.

Tilson on Seagate (emphasis mine):

Tilson explains this is a tricky trade and one that requires investors to remain nimble.”It’s a declining business and could turn into a value trap,” he says. “But we think the demise of Seagate is overblown in the market. That’s why we own it.”Tilson explains that in these kinds of circumstance he believes, “If you buy it cheaply enough and there’s enough capital allocation you can make money. Seagate is very cheap, producing a lot of cash, paying north of a 4% dividend and buying back a ton of stock.”However, he reiterates “This is a bet that the business doesn’t decline as quickly as the Street thinks.”

I think there is a lot of risk in this business.  While pre-merger there is an effective net-cash position, the existence of debt puts unnecessary fixed costs into the operations, and post merger, Seagate will have a net debt position.  Debt takes away a lot of flexibility in a declining business.  Carlos Slim got a great deal (14%+ interest) tossing a lifeline to the NYT in the depths of the recession when advertising budgets were cut across the board.  Debt can force you to do things that aren't in the interest of shareholders simply because you have no choice.

The real question though, is my cherry picked example indicative of what could happen to Seagate?  Is that the kind of thinking Mr. Market is currently applying to Seagate's stock price?  The market has responded well to the announcement of continued consolidation because they anticipate higher margins due to less competition.  Tilson hints at this when he mentions "capital allocation" which I interpret as not throwing more money into this business and returning it to shareholders.  While the shares are admittedly cheap (both Seagate and Western Digital), I find it difficult to get a handle on what the next few years could look like.  The market seems to have already rewarded the companies with higher valuations from foregone margin improvement, further reducing the margin of safety one can receive.

My gut assumption was the companies like Hewlett Packard and Dell would account for like 20-30% of revenue each, but they are only 10-15% (only?).  As hard drives are a commodity product and Dell and HP aren't exactly morons, they likely sprinkle their business around to several suppliers.  It will be interesting to see who gains the upper hand in pricing power as the hard drive makers will have a higher concentration of customers, but will control most of the supply in the market.  The wildcard in this scenario is that with declining volumes due to technological shifts, the Seagate and Western Digital might chose to forgo margins in exchange for volume.

I think this situation has a lot of similarities to UVV and AOI, which I discussed previously.  They are both in declining commodity businesses, but operate as duopolies (tentatively for the hard drive makers). While I profess no knowledge of the future of digital storage technologies, as a casual observer it appears that hard drives will play a role for at least the next few years.  Tobacco leaf merchants will play a role for a while and face no risk of obsolescence, although the market seems to believe they will become redundant.  I find it curious that people state the proliferation of smart phones and tablets, which don't use hard drives, as a reason to be bearish on the hard drive manufacturers.  While some other form of storage may emerge for PCs, I don't think the majority of people will be forgoing purchasing PCs in exchange for their phones and tablets any time soon.

I think trying to sort the forest from the trees when it comes to a business in a declining industries with debt becomes a task beyond my capacity.  I would be a lot more interested if these businesses had little to no debt, because all the cash they generate would be for shareholders and it would take out a lot of the risk.  I know that the industry isn't going to disappear, there appears to be some likelihood of increased profit margins, and Mr. Market seems to have punished these stocks up until recently.  This will make for an interesting case study, but I would struggle to put an accurate value on the possibilities.

Southwall Technologies only offers reasons for skepticism

Southwall Technologies is a stock that has some positive factors, but is not attractive for several reasons that should give any investor pause before they pull the trigger.  Southwall recently listed on the Nasdaq, which usually increases liquidity and can be a catalyst as it gets more investors to pay attention.  It also trades cheaply based on a trailing twelve-month earnings basis.  As opposed to investing in ugly looking situations that are going to change in due time, Southwall looks pretty but a lot can go wrong.

Southwall makes coatings for automotive and architectural glass.  The coatings do things such as reduce heat form light that makes it way through the glass and other doodads that make it environmentally friendly.  Less heat making its way into the car via sunlight will reduce the need for gas guzzling A/C, and the similar principle applies to homes as well. This is the kind of product, assuming the company is already profitable, that one might be drawn to invest in for the upside potential from any legislation regarding more environmentally stringent building codes or the increasing fuel economy mandated by governments.  The company is profitable, but not nearly to the degree that a quick glance would reveal, making the company's future more of a pleasant narrative than an investment opportunity.

Using fully diluted shares, the company still trades at 9 times TTM earnings, so it would appear that the company is trading at a price that offers some downside protection in relation to its earnings.  This first thing I noticed when I looked at the income statement was that 2010 benefiting from a $3.6m tax benefit, a non-recurring charge.  Even taking away the benefit of a tax benefit, the company earned the most in 2010 going back 10 years.  This is not the earnings profile of a fat pitch investment.

While that alone is a pretty plain vanilla reason one would normally attribute to passing on a stock, I decided to write about Southwall because there are some other reasons I would avoid it even if you believed that its future markets will be booming. 

The company just listed its shares on the Nasdaq, moving from the OTC market.  I think the Nasdaq listing requires a closer look.  It will increase liquidity as a larger pool of capital will be able to buy and sell the stock.  It begs the question why the company now seeks liquidity.  The answer is in the form of a controlling investor through shares and convertible preferred stock that is well in the money hoping to cash out.  This will increase share count by 25% when converted. 

The company has a history of dilution, with fully diluted shares in 2001 at 1.6m all the way up to 7.2m in 2010.  While book value has increased at quite a rapid rate, the book value per share has grown at a much slower pace.  This is a sign to stay away.

Needham & Co. owns 60% of the firm assuming conversion of the convertibles.  I think the Nasdaq listing is going to give them an opportunity to cash out.  While the shares trade for $11.50, their cost is much lower and the conversion price on the converts is $5.  I think the listing is only to give them liquidity to offload their stake. Even if I'm wrong, this dilution and historical dilution don't give me confidence that current shareholder's will get their fair share of future rewards.

Another cause for concern is that since 2004, the company has had an agreement with another company that was responsible for 38% of revenue in 2010.  This agreement ends in 2011.  Additionally, the company’s customers are comprised of mostly larger glass makers that are likely far less dependent on Southwall than Southwall is on them.  Their top 4 customers accounted for 74% of the company’s sales.

In short, buyers beware.  I wouldn’t be surprised to see some speculative activity in the stock as some people might neglect some of the company’s warts in hopes that greater upside lies in the “green” image the company could adopt.  This is where investors differ, as they would look to the downside and find that it exists.  This stock was an easy pass just from seeing that 2010 earnings (from which the PE is calculated) were an outlier, but even absent that I would be skeptical that Southwall  would be a worthwhile investment opportunity.

Posting has been light lately because I've been debating how much effort I should put into talking about stocks I don't buy.  Ultimately, I've decided its worth doing because I think it is a valuable teaching tool, forces me to articulate why I'm not buying a stock, and maybe someone will email me with an opposing view.

The irony of investing like Berkshire Hathaway and Leucadia

It is axiomatic to many people that Berkshire Hathaway/Buffett is the gold standard of investing that should be emulated by anyone who considers themselves an investor.  The Buffett style of investment in its current form is not a strategy I would follow because I don’t think the risk/reward is sufficiently evident due to my limited skill set.  I’ve written articles on companies like Owens & Minor, Walmart, Immucor, and Bank of Internet that I think fall into a vague characterization of the modern Buffett investment style.  Note that I never took a position in any of those stocks due to a mix of price and not being able to use my competitive advantage as a miniscule investor.  

When Buffett talks about hiring successors to manage the investment portfolio, he has repeatedly mentioned that he isn’t interested in teaching a new dog old tricks.  Identifying a company with a sustainable competitive advantage that is obscured by transient negative events is not easy.  There are quantitative ways to measure a competitive advantage such as a high ROIC over a long period of time, but this is backwards looking and only part of the picture.  The key to successfully investing in this modern Buffett style is to master the qualitative aspect that the competitive advantage will still exist going forward.  This requires a mix of industry knowledge, a strong grasp of business history, and being able to conceive of unknown unknowns or lack there of (soda and chewing gum).  This is hard in terms of intellectual capacity, but I think it gives a lot of people the psychological comfort even if they aren’t good at it.  It is much easier to hold onto Coke in a bear market than most stocks, or at least this idea makes intuitive sense to me.  It also gives people comfort to hold a stock with Buffett's seal of approval.  Of course, the easiest thing to do would be to purchase any stock that he discloses a position in, but this is increasingly harder as Buffett shies away from buying parts of public companies and he lowers his desired return on stock market purchases.

To switch gears, Leucadia is a company that occasionally gets touted as a mini-Berkshire, which I think is a shallow comparison, but is worth paying attention to because they are equally skilled investors.  The investment styles both fall under the ambiguous and large umbrella of value investing, but diverge markedly in execution.  Leucadia invests in a lot of private deals that require a lot of patience, which is similar to some of what Berkshire has done.  The difference is that Leucadia very actively manages these investments, going through the various paperwork and processes for things such as mines, gasification projects, real estate developments, and casinos.  While they have had duds, most of their investments end up generating huge returns.  The returns would not have existed if Leucadia didn’t play an active role in generating them. 

When you look at the real estate section of Leucadia's annual letter to get an idea of their style or their investment portfolio, you see that they buy whatever is ugly and cheap at the time, and then wait.  In the case of real estate they are patient and use no debt, which has been a recipe for success.  They have invested in a range of public companies over the years ranging from insurance to semiconductors and software.  They’ve taken a long term view on US energy policy and are investing in gasification plants to turn fossil fuels into cleaner forms of fuel.  They purchased a copper mine in its greenfield stage and brought it all the way into production when its previous owner didn’t want to deal with the hassle of various government approvals and permits.   In the past and in the future, the only way to invest alongside Leucadia in these projects is to invest in Leucadia.  

I think the Lecuadia flavored value investing strategy is a lot more attractive than Berkshire’s current strategy because it can generate greater returns.  The problem is that as a small investor, Lecuadia’s strategy is not entirely possible to replicate due to their application of managerial competence.  The philosophy is worth paying attention to though, even though it is not exactly unique (excluding the fact that it has been successfully adhered to over a long period of time).  They want cheap and beaten down stocks/companies/situations, but safe enough that they can simply wait out the bad times.  I don’t think this is limited to the rare high quality net-net stock, but those do present the most obvious example of this strategy.  I mistakenly thought that Seahawk Drilling was a stock that fell into this category.  Changes in leadership at distressed companies, such as Supervalu, can indicate a turnaround of a distressed asset with better management, although I'd venture Leucadia would take exception to the debt load.  

At the same time, a buy and hold Buffett style of investing can work well for someone who doesn’t have the psychological wherewithal to confront the volatility of the Leucadia approach.  Instead of lacking the psychological mettle to invest in the Coke’s and Walmart’s of the world, most people lack the intellectual capacity to identify and invest in the Coke’s and Walmart’s at a price that will result in strong compounded returns and minimal downside risk.  It's increasingly difficult to invest alongside Buffett at similar prices in public companies because he is investing in fewer of these situations.  

The irony of Berkshire vs. Lecuadia is that the current Berkshire investment strategy is not easy to replicate with certainty.  The belief that one can do so is predicated on the assumption that people attempting to mirror the current Berkshire approach are actually mirroring it.  The reality is that most people are just pretending to do so as a psychological cushion to justify a poor margin of safety from either a lack of meaningful evidence or laziness to identify truly undervalued securities (I always feel like a sucker when I click on links to article with titles that include Berkshire and Buffett in it and they turn out to be about overpriced and shitty companies, but I think this indicative of a lot of people's attempts to mirror Buffett's approach even if it is hyperbolic).  From an intellectual and epistemological standpoint, the Leucadia approach is much easier to replicate, but one must successfully reverse engineer and understand their process.  Their process is easier to replicate than Buffett's with situations in which neither are involved, so it is worth studying for those looking spend a lot of time on their stock selection.  It is not unique, but it is another perspective a deep value margin of safety type of investment framework, which I believe is easy to replicate assuming you have the psychological mettle.  Leucadia's most recent shareholder letter is out and they have letters going back a few years on their website.  The suggestion that they are worth reading is not exactly novel, but it is worth repeating.

Bank of Internet - a moat in not having a moat?

I've been pondering Bank of Internet a lot because it looks like a low cost producer in a commodity field.  I use the term "looks like" because there is nothing stopping other companies from replicating the same model and undercutting them, albeit having to absorb some starting costs as they hit critical mass.  What is interesting about Bank of Internet is that they are quite complex in their simplicity, as they have not followed down the money losing path of other internet banks and heck, its been a better performers than most banks in general.  The funny thing though is that everyone who has operating a similar business model, NetBank and ING Direct, have been real duds as far as business operations and investments go.  While just 3 examples don't make for a ground breaking study, NetBank, ING Direct and BofI, make for an interesting example of the benefits of meaningful inside ownership, the herd mentality, and the idea that mindlessly growing the business with no regard for the return generated for shareholders is a really (x10) dumb idea.

The benefit of high inside ownership with some exceptions is generally just seen as an alignment of incentives between management and shareholders.  It trickles down to the basic psychology of the managers.  If their stake is sizable enough they are going to act in the interest of making that stake worth more.  They're going to focus on shareholder value as opposed to more easily manipulated measures of performance, since they are very well rewarded for this.  Bank of Internet has inside ownership that is about 17% of the shares.  While they are likely competent as well, this is the reason their loans are written at ~55% of the value and they had a limited number of write downs and an unsuccessful foray into RV loans that never crippled the company.  They really powered through the worst of the financial panic and have been growing rapidly.  The bank is run as if management owns the company instead of just collecting a paycheck on easily manipulated metrics.  Oh, wait...they do.

Contrast this to NetBank and ING Direct.  According to the most recent proxy before they stopped filing, insiders at NetBank owned about 4% excluding options.  This might explain why the company dived head first into rolling up various companies that expanded the product offerings such as auto financing, selling insurance, and free standing ATMs.  While these are nice extensions for a brick and mortar bank, these all require addition capital and labor to execute on.  This erodes the key competitive advantage of an internet bank, as their low cost servicing allows them to offer super competitive interest rates.  Worse still, these acquisitions were made using debt, even though the company wasn't exactly a stellar profit maker.  From 1997-2005 its best year resulted in a a 1.85% ROA and a 12.25% ROE, which is mediocre.  Its second best year was very similar, but its third best year produced a 0.28% ROA and 2.45% ROE.  That is not good at all.  It's best year, measured in ROA and ROE, was 1998 when they generated a modest $6.6m in net interest income and $4.4m in net income.   All its expansion did nothing.  This is what I think would be referring to as value destruction.

This poor performance was a result of the herd mentality and a desire to grow the business for the sake of growing it that so often grip managers.  The idea that a bank had to offer all those services was, and still is, prevalent.  Everyone else is doing it.  While I could be confusing causation and correlation between a strategy of diversification and poor management, the two combined resulted in NetBanks deposits being sold to ING Direct in 2007.

ING Direct is a different beast than BofI is or NetBank was due to the sheer size.  BofI's management has remarked in conference calls that they don't consider themselves to be competing with ING Direct.  Their homepage does compare their rates to ING Direct though, but I think management is right to a degree.  BofI's value proposition is that it has super competitive interest rates on its products.  They aren't interested in being you insurance broker, or help you plan for retirement.  Judging from interest rates offered , ING Direct is far from a low cost provider and is run along the same lines as NetBank although since it had the backing of ING, it did not need to acquire a suite of companies to broaden its product offering.

There are is another thing that indicate that ING Direct is poorly run and not a real low cost producer despite lacking a brick and mortar presence.  From 2007-2009, $3 billion worth of Alt-A loans were written down in the ING Direct subsidiary of ING.  ING also had its own problems, but this indicates the a) management was poor and b) the net interest margin is earned was artificially inflated by poor asset quality and excessive risk taking.  Additionally, as part of its Dutch bailout, ING is in the process of divesting ING Direct.  This will likely not have the effect of installing a well aligned management since the companies being discussed as potential acquirers are as large as ING.

Judging from the divergent business models and the mishaps encountered by NetBank and ING Direct, it seems like BofI is cut from a different cloth.  BofI benefits from the culmination of several factors such as high inside ownership, a divergence from the herd mentality, and its simple focus.  It's focus on providing plain vanilla banking products appears to have ensured its survival through the financial crisis unscathed.  If my conclusion is correct that these are the key factors behind the differences, then the self restraint that BofI has exhibited is essentially a competitive advantage.  A disciplined management team is going to guide the company to success and intelligently allocate capital.  If BofI continues to be run in such a manner, it should see continued success.  Essentially, everyone else is not properly executing on the internet only model, which seems to only work when it focuses on being low cost as opposed to full service.  This could change though and I just don't have the skills to get comfortable with a bank.  Of course, there could be something I'm missing.  Food for thought.

Talk to Andrew about Bank of Internet

Affirmative Insurance: Potential Turnaround

Full disclosure - I know nothing about insurance companies.  I'd like to though, so I try to keep an eye on some cheap ones and learn from Berkshire Hathaway's annual letters.  Affirmative Insurance (AFFM) came up in the same screen, if not right next to Allied Healthcare, which I wrote about previously.  While Affirmative Insurance would no longer show up on the screen, I was just looking for companies near 52 week lows with positive earnings that were below book value.  I initially passed on the stock and I'm still passing, but it will be interesting to see what happens.  While the quantitative situation has continued to deteriorate, there are increasing signs that the qualitative situation is turning around as new management is given a chance to turnaround the company.

Basically Affirmative Insurance sells non standard auto insurance, which is for people with poor driving records or a high performance car, or something that generally insurance companies don't want to insure.  From a general business philosophy standpoint, this sounds like a business that one could earn attractive returns since they can likely charge a premium for the product.  Markel, a company touted as a mini-Berkshire, makes a good chunk of money on non traditional insurance such as malpractice insurance for doctors with drug addiction problems.  Theoretically, this should be a pretty good business.  Affirmative Insurance uses agents and retail locations to distribute its policies, which isn't the most profitable way to write car insurance (i.e. GEICO and Progressive), but it does not mean that the business cannot be profitable.  To be clear though, the business is not profitable right now.

As indicated in the financial results, Affirmative Insurance has not been adequately charging for the risk it has been taking on, which is why the company trades below book value and at a multiyear lows.  Additionally, previous management did a horrible job in just about every aspect from pricing to reserve estimates.  Basically, the company was poorly run.  This is why insurance companies are tricky.  They can post phenomenal or even just decent results for years and then when the truth finally catches up, shareholders are left with a crap business and each person in the senior management has 5 vacation homes each they bought with their bonuses based on past results that were purely fictional.  Insurance companies are very dependent on how they are run, if not entirely.  

Results have been pretty atrocious as the company has really increased reserves in the past years to make up for poor pricing.  The company has $200m in debt compared to a book value of $93m, which includes $163m of goodwill.  The company has $60m in cash, although netting that out would be foolish with the liabilities of the company and the nature of the insurance business.  This is a very messy balance sheet.  The risk is definitely high with investing in this company.  The stock price seems to clearly reflect the risk, although that doesn't make the stock any more attractive due to the additional downside.

The company has entered into reinsurance agreements for 2011, so they should be able to continue to write policies without putting further stress on their decreasing amount of capital.  The interesting thing about this company's business is that car insurance is priced and sold on short term contracts.  If the company is making the right moves to become profitable, it will be able to do so pretty quickly as they can quickly move beyond their poorly written insurance contracts.  Management plays a key role in this, and the recent changes are the reason why I would continue to pay attention to this company.

The company has been on the slide for a while now and appointed a new CEO in Octorber, 2010.  While they should have admitted they had a problem long ago, it is good to see that the company is aggressively moving forward to restore the company.  In regards to the recently released results the new CEO said:

The 2010 results are unacceptable, extremely disappointing and the result of poor execution in key aspects of our business. The majority of the 2010 negative results are related to the performance of our subsidiary insurance companies. Several specific factors contributed to the 2010 losses, including most significantly: reserve estimates that resulted in inadequate pricing of our insurance products; unacceptable loss ratios in our independent agent distribution channel; a lack of strong underwriting controls, particularly with respect to proof of discounts for our insurance products; and weak performance of our claims unit, resulting in part from significant changes to the claims processing procedures and methodology. 

While I pay little to no (a lot closer to no) attention to management's typical mealy mouthed quotes in press releases, clearly this guy is not sugarcoating the situation and is confronting the situation head on.  His bio is:

Mr. Kusumi's background includes his most recent experience as President and CEO of GMAC Insurance's Personal Lines business. In addition, he served as an Executive Vice President in the Great American Insurance organization, as well as spending over ten years of experience at Progressive Corporation in a variety of senior managerial positions.

I will do more digging, but Great American Insurance focused on speciality P&C, and Progressive is a company that is phenomenally managed and is very similar to GEICO.  I do not know anything about GMAC Insurance's Person Lines business.  At the end of March, a new Chief Claims Officer was appointed who was previously a senior claims manager at Progressive.  It will be interesting to see if these moves will right the ship.  Progressive is well run, although two people aren't going to be able to single handily fix up the company.  All companies have ingrained cultures and it will take time and effort to change them, although as I stated above car insurance companies are well situated to turn around their operations quickly.

The board is interesting as well, as several investors have stakes in the company and seats on the board.  There are 3 different firms with 51%, 6%, and 5%.  The most interesting is the firm that owns 51%.  David Schamis and Avshalom Kalichstein, both directors of AFFM, are managing directors at JC Flowers, a PE firm that has dabbled in distressed companies.  JC Flowers through "New Affirmative"owns 51% of the company.  JC Flowers has been involved since 2005 and 2006 though at substantially higher prices in the stock.  Their investment is now worth under $20m, down from what I think is well over $150m when they first started buying.  It's a lot easier to lose 85% of an investment than make back the 650% to get back to break even though.  While I doubt they are going to just forget about it, my guess would be that they don't want to throw good money after bad money or that they would use their high ownership to orchestrate a debt financing or recapitalization that is super advantageous to them.  I wouldn't blame them.  I have no idea what these guys are thinking, although I wouldn't be shocked if they did something now that new management is in place.

I realize that I haven't really discussed the financials much and have really just provided a narrative.  Quite frankly, the financials are a lot uglier than the potential upside from a turn around.  Taking a static view of the 10-K, the company is not one I want to go near.  I'm not a pro at insurance balance sheets, which is one reason I'm staying away, but it doesn't take an expert to see that it needs fixing up.  That all being said though, because of the industry it operates in, the new management that has experience at well run companies, and the financially invested directors, good things might happen.  In order for good things to happen though, bad things can't happen.  At this point in time though, it looks like bad things are happening that might get in the way of good things ever happening.

Disclosure: None