Spinoffs are something of the corporate transaction du jour. Conglomerates are being broken up (Fortune, ITT), oil majors switching up their business models (Marathon, Conoco Phillips), companies just shaking things up (Mittal, ThyssenKrupp, Cablevision). Some are forced, some are out of the blue, some a long time coming. Greenblatt rightfully points to spinoffs are a fertile hunting ground for undervalued companies in You Can Be A Stockmarket Genius. It's worth reviewing why spinoffs are worth keeping an eye on and a pitfall I've encountered in the past with spinoffs.
Spinoffs allow a larger company to jettison a smaller subsidiary for any number of reasons - underperforming, focus on core competencies, activist rumblings. One less advertised benefit is a tax efficient way to return money to shareholders. Spinoffs are usually tax free for the corporation and shareholders. Since the spinoff is usually a relatively small company it is more likely to be acquired in a broad statistical sense.
There are several aspects of spinoffs that increase the likelihood of it being acquired. As I've said, it's smaller. While not universal, spun off divisions tend to be underperformers. This is probably more attractive to acquirers because they can a) strip out costs and b) an underperforming company will not be as highly valued by the market so the potential returns will be greater. Conversely, there's a decent chance that nobody wants it.
Why is this tax efficient for generating shareholder returns? Well, if the parent company sold X division for $1bn and wanted to return all the proceeds to shareholders, there would be a huge gain on the sale if the division grew organically over the years, say $500m. This would get taxed at 35%. Corporate proceeds would only be $825m. Then when the company returns this as a special dividend, shareholders get $700m.
But if instead the subsidiary is spun off and sold as a separate entity for $1bn and shareholders pay a 15% long term capital gain on it, shareholders get $850m, or a 21% boost for what is fundamentally the same. As we saw with Buffett's criticism of Kraft during the Cadbury deal, the disposal of the pizza business was a point of contention. It largely rested on the fact that it was a highly tax inefficient way of creating shareholder value.
The above is something of a stretch. It's certainly not a reason to buy a spinoff. It's one of those hidden, intangible benefits that you can't bet on, but shouldn't be surprised by. It is very rare that someone gives away something that they actually want. It is even more rare to be given something that will potentially benefit the receiver in the future with no benefit to the giver. I need to be more aware of that, because I'm often drawn to things that nobody else wants.
While I rarely attribute malice where stupidity will suffice, managers are very rarely concerned with such a benefit for anonymous individuals. Seeing as the future is notoriously difficult to predict, I can't claim that Pride International was being malicious in spinning off Seahawk Drilling. It was I who was stupid. In fact, I indeed thought it was quite hard to kill and would be fine - I was wrong. It started life with tons of cash, a huge discount to book value, and was in a super distressed segment of an industry. Why wouldn't I be convinced it was a great buy?
There were plenty of elements I should have identified - rapid cash burn, lack of interested buyers in old dry stacked rigs, difficulty in predicting a turn in demand for shallow water natural gas drilling - but one thing that made my simple mind have a click, whirr moment (Cialdini reference, read his book if you don't get it) that made me comfortable buying the stock was that it was a spinoff. This is the absolute dumbest reason to buy a spinoff. I simply extrapolated occasional past successes in spinoffs with the idea that by virtue of the transaction it would work out fine - similar to a mutual thrift conversion where there really are mechanisms that can minimize downside risk and offer nice upside by virtue of the transaction.
Another spinoff that caused me to have a click, whirr moment was Artio Global, which has been as much of a dog as Seahawk. I wrote them up a few months back. They were spun out of Julian Baer, a Swiss bank. It was cheap on a PE basis and management owned a good chunk of the company and I was hot on the idea that asset managers were cheap/good businesses. There are broader mistakes I made than just assuming that since it was a spinoff and had an odd share structure it was misunderstood by the market. I was the one with the misunderstanding since it was facing headwinds with the 2 flagship funds that made up essentially all of its assets underperforming and bleeding assets. Still, not all spinoffs are worthwhile investments - most in fact aren't, although you probably realized this already.
I recently wrote about Treasury Wine Estates, a spinoff from Fosters. It was underperforming and causing tons of goodwill write downs at the parent company. Combined with a strong AUD and glut in Australian wine, the business is suffering. It has very little debt, similar to Seawhawk, but it is currently profitable and not in financial danger despite a weak market for its goods. It was a division not wanted by the parent company, like Artio, but the tangible assets on the balance sheet makes it hard for it to wither away like Artio's intangible business managing money. Even on an intangible basis, Artio doesn't have a brand like Beringers, Penfolds, etc like TWE that gives it an edge over other competing products.
This brings me to a group of spinoffs that have caught my eye. The break up of the ITT conglomerate looks to be in shareholder's interests. ITT has long been a well run company focused on various industrial businesses. The conglomerate has 3 divisions: water, defense, and industrial products. These are all fundamentally well managed businesses each with their own attractions - long growth runway, defense, and high barriers to entry. Michael Price pitches ITT in an issue of Graham and Doddsville, although it is a few months old and the price is now 20% lower. I will delve into more details in the coming days.
What I find intriguing about the spinoff is it's cheap after the recent sell off and all the businesses are fundamentally strong even with recessionary headwinds. Without the $150m in transformation costs so far this year, ITT has earned $400m in the first 6 months of the year, $681m in the TTM net income, and a $340m pretax charge for asbestos liabilities in the 3rd quarter of 2010 is depressing that figure. Depending on how generous with excusing these 1 time charges, the stock trades at 10-15x earnings. All of the businesses are going to be distinct and cater to specific investors, potential acquirers, and analyst coverage. Most importantly, all the businesses look like they are worth owning with lots of free cash flow, conservative balance sheets, and ability to grow organically and with bolt on acquisitions with which they have a good track record. The division of liabilities and debt is being done in an equitable way that doesn't seem to favor any business. It will be interesting to see what the market does after the split up in terms of which division(s) get dumped by current shareholders and which division(s) draw the most attention. There's a benefit of it being bundled together right now though, because there is no market price to distract you from valuing the business.
Anyone have an opinion on whether it is "spinoff" or "spin off"? Spinoff seems more noun-ish. Any linguists out there?
Long ITT
Wednesday, August 31, 2011
Tuesday, August 30, 2011
A low point in Xenith Bankshares' valuation
Xenith Bankshares is an interesting bank that trades at a pretty steep discount to TBV despite a bright future that is getting brighter. I put my analysis on scribd because I'm not tech savvy enough to format tables in blogger. You can read it via this link or embedded below:
XBKS Write Up
Monday, August 22, 2011
Peapack-Gladstone Financial
Peapack-Gladstone Financial Corporation (NASDAQ: PGC)
Current Price: $11.00
Shares Outstanding: 8,825,882
Market Capitalization: $97,084,702
TTM Common Net Income: $6,651,000
Tangible Common Book Value: $101,311,000
Overview
Peapack-Gladstone Financial Corporation is the parent company of Peapack-Gladstone Bank, a community bank in New Jersey with $1.5bn in assets. The bank has 23 branches, all from organic growth with the exception of 2 branches acquired in 2000 and 4 Trust & Estate offices. The bank sits atop the three pillars of a strong community banking franchise: growth, profitability, and quality. With the exception of trust-preferred securities held for investment, which blew up in 2008, the bank has performed well and is close to repaying TARP funds. The bank has a demonstrated long term ability to prudently grow in a profitable manner without diluting the quality of its loans or deposits. The current bear market in banks has created an opportunity to acquire this fundamentally strong banking franchise at a cheap price.
There is downside protection due to the low valuation (1x book, 4.5x PPPT income) relative to the normalized earnings power of the business (>1% ROA, historically 1.3%). As the bank finishes repaying TARP funds in the next 18 months, market interest should renew as the bank has less negative overhang. The bank has continued to prudently grow its business through the recession, which includes a trust division that generates fee income that will remain unaffected by increasing regulation. Even with a continued weak economy, the stock price doesn’t reflect the value of the business.
Valuation
There are two approaches to value PGC. The first is to look at the returns of the business and attach a multiple to its normalized earnings power. The second is a sum of the parts analysis that treats the earnings streams of the core banking business and trust division as two distinct businesses.
#1 The bank historically earned a 1.3% ROA over 1997-2007. As loan loss provisions decrease and increased regulation takes hold, the bank can earn a 1% ROA as a base case. With assets of $1.5bn, the normalized earnings power of the bank is $15m or $1.69/share. Currently at 6.8x normalized base earnings, an average market multiple of 14x earnings would present a double.
Once the bank pays off its remaining TARP preferred stock, it can begin to build up its capital to continue growing its loan book and increasing earnings. An improvement in the economy to where the bank can earn a 1.3% ROA with its current balance sheet would imply normalized earnings of $19.5m or $2.21/share. At 5.2x normalized bull earnings, an average market multiple of 14x earnings would present a triple.
The bank is earning a run rate $21m in pre-provision pre-tax income annually against run rate provisions of $8m annually. If charge offs were to remain about 1% of loans, provisions would have to remain at $9.3m, which still leaves the bank in a position to continue rebuilding capital and repaying TARP funds. Looking at the business on a normalized earnings basis is an appropriate approach to valuing the business because its current earnings power remains ample to get it through a soft economy.
The other side of the earnings valuation would be a multiple of book value, which would reflect the earnings power of the franchise the bank has in excess of tangible assets. As will be discussed in the following section, the bank has a high quality deposit base that is growing. It has been able to profitably exploit it in the past, and should it continue to do so in the future, above average returns on assets should be attainable and an above average multiple of book value would be assigned. The bank currently trades at just under 1x tangible common book value, so no premium on the deposit franchise exists. This implies a low valuation for an investor as well as an acquisitive bank.
#2 The bank has a traditional bank business as well as a trust division that generates fee income in addition to the more traditional fee income generated by loan origination or overdraft fees. The trust division has a symbiotic relation with the core bank by making deposits at the bank stickier while driving customers to the trust division and helping that business generate earnings. The businesses could not exist separately, but they do possess distinct earnings streams. The trust division is more predictable than the core banking business. A sum of the parts valuation can show the market disconnect about the true value of the bank.
Core Division: Currently the bank is doing poorly with the economy and only started provisioning heavily in late 2009 as they were well provisioned going into the downturn. The company’s assets and equity are all in the bank, which is currently earning subpar returns. If these subpar returns of 0.5% return on assets continue, a discount to the book value is necessary. If the bank trades at .75x book, it is worth $76m. If the bank can return to earning 0.75-1% ROA, it would deserve a valuation of at least 1x common book value or $101m. This will receive a boost from repayment of TARP funds as well.
Trust Division: The trust division fluctuates in terms of market value of assets, but the fee income has been fairly consistent. Earnings fall in the $3-4m range. The company opened up an additional trust office in Bethlehem, PA to expand into the Lehigh Valley region in 2009. This division should continue to grow and requires only $1.5m in assets to run overall. This earnings stream is very valuable as a result and is worth around 15x earnings or $45m.
Even if the core division continues to underperform, the business is worth $121m, although the underperformance is clearly transient and tied to higher loan loss provisions. The bank is adequately reserved for loan losses, which should allow them to report higher returns in the core business. The most recent quarter indicated a subsiding in credit issues and a partial repayment of TARP. If the core division continues its improvement, the entire bank’s common equity is worth $146m on a sum of the parts basis. This does not include potential growth in the trust business.
Quality
The balance sheet is clean since the bank took a huge write down on its trust preferred security portfolio of $56m in 2008. The bank took $28m in TARP funds as the loss was $36m after tax and the bank earned $11m that year helping to cushion the blow. The bank’s earnings have declined in recent years as the loan book has shrunk and provisioning for non-performing loans has increased.
While the bank’s common equity ratio is 6.7%, the equity ratio is 7.6% due to the preferred stock. The bank has been repaying TARP funds with earnings. It is on track to finish repaying TARP in 18 months if provisions remain at this level, although lower provisioning in recent quarters opens up the possibility that TARP is repaid before then, as does additional income from loan growth.
The loan book is primarily composed of residential (45%) and commercial (32%) mortgages and commercial loans (13%). The bank is focused on its local geography and there is a senior officer at every branch. This has appeared to lead to solid and conservative underwriting. The bank’s commercial relationships are with small businesses and professionals so no single loan dominates the portfolio. Over the past 4 years, nonperforming loans and REO peaked at 2.22% of assets in June 2010. The bank’s current nonperforming loans, OREO, and troubled debt restructurings total 1.85% of assets as of June 30, 2011. The ratio of allowances to nonperforming loans is at 91.54%, so the bank is more or less caught up with provisioning and has the pre provision earnings to continue adding.
The loan book has shrunk from a peak of $1.05bn in 2008 to $965m as of June 30, 2011. The loan book has become more conservative than just a $100m decrease suggests. Construction loans have decreased from $66m as of December 31, 2008 to $15m as of June 30, 2011 with $8m getting charged off along the way. The bank has let their residential mortgage loans get paid off instead of refinancing or seeking new borrowers in order to reduce interest rate risk. The bank has historically sold 30-year mortgages to minimize risk, but keeps shorter duration mortgages on its balance sheet.
The loan book shrinking is appropriate since the leverage ratio also won’t support a large expansion in the loan book at this time. The bank has been able to accomplish this while maintaining its earnings power by letting time deposits roll off and be replaced with stickier and lower cost deposits. Time deposits are only 15% of deposits and the bank only makes minimal use of FHLB advances for funding, which are under 2% of funding. The ratio of loans to deposits excluding time deposits is 84%, so the bank has ample access to funding once the capital position improves. The bank has continued year over year increases in deposits going back over 15 years. The bank has a very attractive deposit franchise, with 17% and 22% being non-interest bearing and checking respectively, with both seeing consistent growth over the past decade.
The combination of the quality of the deposit franchise and the success of the trust division are solid indicators that the bank actual achieves that mythical quality customer service that many banks try to ascribe to themselves. The management letter included in the 10-K does mention that quality customer service is an aim of theirs, but more importantly the financials back up the assertion. Additionally, in their 10-K is a list of officers at every bank branch, indicating that an empowered individual is present at all bank locations to be responsive and nimble to customer needs.
To look at credit quality indicators, the bank breaks down its loans into pass, special mention, substandard, and doubtful. The bank doesn’t disclose underwriting criteria, but the resilience of the loan book over the past years indicates that they don’t just talk the talk about conservative underwriting. Out of a $965m loan book, $883m pass, $30m special mention, and $51m substandard. If the economy worsens and all the special mention and substandard loans default with 85% recoveries, the bank would lose $12.1m, which is fully covered by pre-provision pretax earnings in conjunction with the current run rate of provisioning. The leverage ratio would drop to 6.7% and common equity leverage would be 5.8%, but the bank would still be standing and a share offering would be dilutive but not wipe out current equity holders. This doesn’t acknowledge the dynamic nature of banking which gives the bank the ability to earn back its capital. The historical results don’t indicate poor underwriting that would result in such extreme losses, but it is worth examining the potential losses in such a scenario.
Profitability
The bank has remained profitable throughout the recession with the exception of the loss on the trust-preferred securities. From 2005 to 2007 as the yield curve flattened and inverted, the bank’s profits decreased. In this period the ROA dropped from 1.30% in 2004 to 0.90% in 2007, with a low of 0.79% in 2006. In the years prior to 1997, the ROA never dropped below 1.30%, and averaged 1.30% over the next decade (1997-2007). While normalized earnings might be closer to 1.30%, the uncertainty of the interest rate and regulatory environment make 1.00% appear a more conservative case to base earnings on. Even in a poor economy with credit losses, the bank has earned a 0.50% ROA, which allows it to repay TARP funds
The efficiency ratio currently stands at 66.8%, although was in the 55% range for many years +/- 200 basis points prior to 2005. The same management has been in charge since 1997 with little drift from a disciplined approach. The “decrease” in efficiency is coming from lower revenues rather than expenses getting out of control.
The bank has opened 4 branches since 2007 when noninterest expenses started to creep up as measured by a percentage of assets. The bank had consistently expanded over the past decade, but banking was a much easier business prior to 2007. The bank moved headquarters and upgraded the system used in the trust division during 2010. The bank expanded its trust division, which has 4 total offices, into Bethlehem, Pennsylvania in 2009.
All of these expenses have yet to produce the necessary revenue and asset growth to bring the efficiency ratio in line. The bank has closed branches it has opened in its expansion plans in the past, consolidating them into a close branch or turning two into one. If newer expansion initiatives don’t generate enough earnings, the bank’s past actions indicate they know when to stop wasting money.
Growth
The company has been a steady grower. The bank started 2000 with 13 branches, $423m in assets, $380m in deposits and the value of assets under administration in the trust division was $651m. As of June 30, 2011, the bank has 23 branches, $1,510m in assets, $1,361 in deposits, and the value of assets under administration in the trust division is $2,010m. There is operating leveraging in the branch network as the bank has expanded into commercial lending over the past 7 years with its larger balance sheet. The bank’s more recent branch openings in Morristown and Summit give the bank access to broader commercial lending opportunities. Assets and deposits grew at a rate of 12% annualized from December, 31, 1999 through June 30, 2011. The value of assets under administration in the trust division grew at a rate of 11% annually. Even without continued long-term growth, the bank is undervalued. If the bank can continue this growth rate, there is additional upside.
Management
The role of management at a bank is crucial because there is a lot of leeway that can lead to impropriety. In the early 90s, management decided to start prudently expanding the business while still offering quality customer service. The CEO until 1997, Leonard Hill, was a commendable steward of the bank who grew it from a much smaller footprint starting in the late 1980’s. The bank has a deep management team that Hill consciously cultivated.. There has never been high turnover in the senior management. Compensation is fair and there is a meaningful level of inside ownership relative to compensation.
When Hill retired, he had three senior officers ready to take on varying roles. Frank Kissel, now 60, became CEO and chairman. He owns 82,568 shares outright, worth just under $1m compared to a salary $687,000 in 2010. His financial stake is higher when including shares in the profit sharing plan and restricted stock.
Robert Rogers, now 52, became President and COO. Craig Spengeman, now 55, became President and CIO. They were appointed to these positions when Kissel became CEO. Their ownership stakes are not as large relative to annual compensation as Kissel, but they do own shares valued around one times their annual salary in addition to options. Senior management was granted a new slug of options in 2010 after their 2007 option plan. Their older options have strike prices at pre-TARP prices of $28/share or higher. The scale is not egregious and bank executives should not have incentives for them attempting to double the share price on a short timeline.
The Chief Loan Officer, Vincent Spero, joined in 2009 from Lakeland Bank, a well performing New Jersey community bank. He was the leader of the commercial loan team, an area that PGC has been slowly expanding into over the past decade. He owns shares, including restricted stock, about equal to his compensation excluding the 2010 options issuance. Even though he has only been there for 2 years, he already owns at least $100,000 worth of stock outright.
Frank Kissel became CEO in 1997, but had been a director since 1989. A brother of his, John Kissel, is on the board. He has been on the board since 1987 though, so there is little indication that there is any form of mutual corruption. The last time a new member joined the board was when the CIO and COO joined in 2002. This isn’t as much of a concern as it would be at other companies because board members do own shares in the company and the company has remained prudently run.
Anthony Consi, a board member since 2000, represents James Weichert. Weichert owns a 9.54% stake in the company due to its acquisition of Chatham Savings Bank in 2000. In 2007, Weichert filed a 13-D stating he had sent a letter to management demanding they seek an appropriate buyer and that he would take it upon himself to find a suitable buyer if the company failed to do so. The bank discloses as well that Weichert owns a mortgage originator from who the bank might purchases mortgages. It has not done so since 2005, when they purchased $191.8m in mortgage loans. There has been no indication that those mortgages have been of lower quality than the rest of the loan portfolio. The residential mortgage portfolio has performed well and was never polluted with alt-A or subprime loans.
Consi and Weichert provide some upside optionality if they decide to push for a sale again, as well as downside protection in a watchful, incentivized eye on management. Consi sits on the compensation committee, although there are no hard facts to support that management would go crazy if not for his presence.
Geography
The bank is in an affluent and economically resilient geography. The bank is located in New Jersey in towns that mostly fall between Route 78 and Route 80. Hunterdon, Morris, and Somerset counties where the bank has 4, 6, and 10 branches (out of 23 total), are the 4th, 8th, and 9th richest counties in the US based on median household income.
There are numerous corporate campuses and headquarters in this area. The bank does not serve these large corporations, but the small businesses and residents that in one way or another benefit from their presence. In this specific region include Bell Labs (Alcatel-Lucent), Chubb, Merck, Honeywell, and Quest Diagnostics. Some companies that are headquartered right outside the immediate geography, but with employees that live near bank branches include Johnson & Johnson, ADP, Bed Bath & Beyond, Prudential, and Avis. AT&T, Pfizer, Exxon, Novartis, and BASF have major offices in the area as well. The area is also a convenient commute for people working in New York City. The area is economically diverse, robust, and services oriented in defensive industries.
Conclusion
Peapack-Gladstone Bank has been a consistently well-run community bank in New Jersey that was not flawless over the past few years. The core value of the business remains and the bank has steadily worked its way through rebuilding its capital and managing its loans. As the bank finishes repaying TARP funds, the market should recognize the underlying strength. The business is undervalued even if the economy continues to muddle along, while it has the earnings power to absorb further loan losses.
Long PGC
Current Price: $11.00
Shares Outstanding: 8,825,882
Market Capitalization: $97,084,702
TTM Common Net Income: $6,651,000
Tangible Common Book Value: $101,311,000
Overview
Peapack-Gladstone Financial Corporation is the parent company of Peapack-Gladstone Bank, a community bank in New Jersey with $1.5bn in assets. The bank has 23 branches, all from organic growth with the exception of 2 branches acquired in 2000 and 4 Trust & Estate offices. The bank sits atop the three pillars of a strong community banking franchise: growth, profitability, and quality. With the exception of trust-preferred securities held for investment, which blew up in 2008, the bank has performed well and is close to repaying TARP funds. The bank has a demonstrated long term ability to prudently grow in a profitable manner without diluting the quality of its loans or deposits. The current bear market in banks has created an opportunity to acquire this fundamentally strong banking franchise at a cheap price.
There is downside protection due to the low valuation (1x book, 4.5x PPPT income) relative to the normalized earnings power of the business (>1% ROA, historically 1.3%). As the bank finishes repaying TARP funds in the next 18 months, market interest should renew as the bank has less negative overhang. The bank has continued to prudently grow its business through the recession, which includes a trust division that generates fee income that will remain unaffected by increasing regulation. Even with a continued weak economy, the stock price doesn’t reflect the value of the business.
Valuation
There are two approaches to value PGC. The first is to look at the returns of the business and attach a multiple to its normalized earnings power. The second is a sum of the parts analysis that treats the earnings streams of the core banking business and trust division as two distinct businesses.
#1 The bank historically earned a 1.3% ROA over 1997-2007. As loan loss provisions decrease and increased regulation takes hold, the bank can earn a 1% ROA as a base case. With assets of $1.5bn, the normalized earnings power of the bank is $15m or $1.69/share. Currently at 6.8x normalized base earnings, an average market multiple of 14x earnings would present a double.
Once the bank pays off its remaining TARP preferred stock, it can begin to build up its capital to continue growing its loan book and increasing earnings. An improvement in the economy to where the bank can earn a 1.3% ROA with its current balance sheet would imply normalized earnings of $19.5m or $2.21/share. At 5.2x normalized bull earnings, an average market multiple of 14x earnings would present a triple.
The bank is earning a run rate $21m in pre-provision pre-tax income annually against run rate provisions of $8m annually. If charge offs were to remain about 1% of loans, provisions would have to remain at $9.3m, which still leaves the bank in a position to continue rebuilding capital and repaying TARP funds. Looking at the business on a normalized earnings basis is an appropriate approach to valuing the business because its current earnings power remains ample to get it through a soft economy.
The other side of the earnings valuation would be a multiple of book value, which would reflect the earnings power of the franchise the bank has in excess of tangible assets. As will be discussed in the following section, the bank has a high quality deposit base that is growing. It has been able to profitably exploit it in the past, and should it continue to do so in the future, above average returns on assets should be attainable and an above average multiple of book value would be assigned. The bank currently trades at just under 1x tangible common book value, so no premium on the deposit franchise exists. This implies a low valuation for an investor as well as an acquisitive bank.
#2 The bank has a traditional bank business as well as a trust division that generates fee income in addition to the more traditional fee income generated by loan origination or overdraft fees. The trust division has a symbiotic relation with the core bank by making deposits at the bank stickier while driving customers to the trust division and helping that business generate earnings. The businesses could not exist separately, but they do possess distinct earnings streams. The trust division is more predictable than the core banking business. A sum of the parts valuation can show the market disconnect about the true value of the bank.
Core Division: Currently the bank is doing poorly with the economy and only started provisioning heavily in late 2009 as they were well provisioned going into the downturn. The company’s assets and equity are all in the bank, which is currently earning subpar returns. If these subpar returns of 0.5% return on assets continue, a discount to the book value is necessary. If the bank trades at .75x book, it is worth $76m. If the bank can return to earning 0.75-1% ROA, it would deserve a valuation of at least 1x common book value or $101m. This will receive a boost from repayment of TARP funds as well.
Trust Division: The trust division fluctuates in terms of market value of assets, but the fee income has been fairly consistent. Earnings fall in the $3-4m range. The company opened up an additional trust office in Bethlehem, PA to expand into the Lehigh Valley region in 2009. This division should continue to grow and requires only $1.5m in assets to run overall. This earnings stream is very valuable as a result and is worth around 15x earnings or $45m.
Even if the core division continues to underperform, the business is worth $121m, although the underperformance is clearly transient and tied to higher loan loss provisions. The bank is adequately reserved for loan losses, which should allow them to report higher returns in the core business. The most recent quarter indicated a subsiding in credit issues and a partial repayment of TARP. If the core division continues its improvement, the entire bank’s common equity is worth $146m on a sum of the parts basis. This does not include potential growth in the trust business.
Quality
The balance sheet is clean since the bank took a huge write down on its trust preferred security portfolio of $56m in 2008. The bank took $28m in TARP funds as the loss was $36m after tax and the bank earned $11m that year helping to cushion the blow. The bank’s earnings have declined in recent years as the loan book has shrunk and provisioning for non-performing loans has increased.
While the bank’s common equity ratio is 6.7%, the equity ratio is 7.6% due to the preferred stock. The bank has been repaying TARP funds with earnings. It is on track to finish repaying TARP in 18 months if provisions remain at this level, although lower provisioning in recent quarters opens up the possibility that TARP is repaid before then, as does additional income from loan growth.
The loan book is primarily composed of residential (45%) and commercial (32%) mortgages and commercial loans (13%). The bank is focused on its local geography and there is a senior officer at every branch. This has appeared to lead to solid and conservative underwriting. The bank’s commercial relationships are with small businesses and professionals so no single loan dominates the portfolio. Over the past 4 years, nonperforming loans and REO peaked at 2.22% of assets in June 2010. The bank’s current nonperforming loans, OREO, and troubled debt restructurings total 1.85% of assets as of June 30, 2011. The ratio of allowances to nonperforming loans is at 91.54%, so the bank is more or less caught up with provisioning and has the pre provision earnings to continue adding.
The loan book has shrunk from a peak of $1.05bn in 2008 to $965m as of June 30, 2011. The loan book has become more conservative than just a $100m decrease suggests. Construction loans have decreased from $66m as of December 31, 2008 to $15m as of June 30, 2011 with $8m getting charged off along the way. The bank has let their residential mortgage loans get paid off instead of refinancing or seeking new borrowers in order to reduce interest rate risk. The bank has historically sold 30-year mortgages to minimize risk, but keeps shorter duration mortgages on its balance sheet.
The loan book shrinking is appropriate since the leverage ratio also won’t support a large expansion in the loan book at this time. The bank has been able to accomplish this while maintaining its earnings power by letting time deposits roll off and be replaced with stickier and lower cost deposits. Time deposits are only 15% of deposits and the bank only makes minimal use of FHLB advances for funding, which are under 2% of funding. The ratio of loans to deposits excluding time deposits is 84%, so the bank has ample access to funding once the capital position improves. The bank has continued year over year increases in deposits going back over 15 years. The bank has a very attractive deposit franchise, with 17% and 22% being non-interest bearing and checking respectively, with both seeing consistent growth over the past decade.
The combination of the quality of the deposit franchise and the success of the trust division are solid indicators that the bank actual achieves that mythical quality customer service that many banks try to ascribe to themselves. The management letter included in the 10-K does mention that quality customer service is an aim of theirs, but more importantly the financials back up the assertion. Additionally, in their 10-K is a list of officers at every bank branch, indicating that an empowered individual is present at all bank locations to be responsive and nimble to customer needs.
To look at credit quality indicators, the bank breaks down its loans into pass, special mention, substandard, and doubtful. The bank doesn’t disclose underwriting criteria, but the resilience of the loan book over the past years indicates that they don’t just talk the talk about conservative underwriting. Out of a $965m loan book, $883m pass, $30m special mention, and $51m substandard. If the economy worsens and all the special mention and substandard loans default with 85% recoveries, the bank would lose $12.1m, which is fully covered by pre-provision pretax earnings in conjunction with the current run rate of provisioning. The leverage ratio would drop to 6.7% and common equity leverage would be 5.8%, but the bank would still be standing and a share offering would be dilutive but not wipe out current equity holders. This doesn’t acknowledge the dynamic nature of banking which gives the bank the ability to earn back its capital. The historical results don’t indicate poor underwriting that would result in such extreme losses, but it is worth examining the potential losses in such a scenario.
Profitability
The bank has remained profitable throughout the recession with the exception of the loss on the trust-preferred securities. From 2005 to 2007 as the yield curve flattened and inverted, the bank’s profits decreased. In this period the ROA dropped from 1.30% in 2004 to 0.90% in 2007, with a low of 0.79% in 2006. In the years prior to 1997, the ROA never dropped below 1.30%, and averaged 1.30% over the next decade (1997-2007). While normalized earnings might be closer to 1.30%, the uncertainty of the interest rate and regulatory environment make 1.00% appear a more conservative case to base earnings on. Even in a poor economy with credit losses, the bank has earned a 0.50% ROA, which allows it to repay TARP funds
The efficiency ratio currently stands at 66.8%, although was in the 55% range for many years +/- 200 basis points prior to 2005. The same management has been in charge since 1997 with little drift from a disciplined approach. The “decrease” in efficiency is coming from lower revenues rather than expenses getting out of control.
The bank has opened 4 branches since 2007 when noninterest expenses started to creep up as measured by a percentage of assets. The bank had consistently expanded over the past decade, but banking was a much easier business prior to 2007. The bank moved headquarters and upgraded the system used in the trust division during 2010. The bank expanded its trust division, which has 4 total offices, into Bethlehem, Pennsylvania in 2009.
All of these expenses have yet to produce the necessary revenue and asset growth to bring the efficiency ratio in line. The bank has closed branches it has opened in its expansion plans in the past, consolidating them into a close branch or turning two into one. If newer expansion initiatives don’t generate enough earnings, the bank’s past actions indicate they know when to stop wasting money.
Growth
The company has been a steady grower. The bank started 2000 with 13 branches, $423m in assets, $380m in deposits and the value of assets under administration in the trust division was $651m. As of June 30, 2011, the bank has 23 branches, $1,510m in assets, $1,361 in deposits, and the value of assets under administration in the trust division is $2,010m. There is operating leveraging in the branch network as the bank has expanded into commercial lending over the past 7 years with its larger balance sheet. The bank’s more recent branch openings in Morristown and Summit give the bank access to broader commercial lending opportunities. Assets and deposits grew at a rate of 12% annualized from December, 31, 1999 through June 30, 2011. The value of assets under administration in the trust division grew at a rate of 11% annually. Even without continued long-term growth, the bank is undervalued. If the bank can continue this growth rate, there is additional upside.
Management
The role of management at a bank is crucial because there is a lot of leeway that can lead to impropriety. In the early 90s, management decided to start prudently expanding the business while still offering quality customer service. The CEO until 1997, Leonard Hill, was a commendable steward of the bank who grew it from a much smaller footprint starting in the late 1980’s. The bank has a deep management team that Hill consciously cultivated.. There has never been high turnover in the senior management. Compensation is fair and there is a meaningful level of inside ownership relative to compensation.
When Hill retired, he had three senior officers ready to take on varying roles. Frank Kissel, now 60, became CEO and chairman. He owns 82,568 shares outright, worth just under $1m compared to a salary $687,000 in 2010. His financial stake is higher when including shares in the profit sharing plan and restricted stock.
Robert Rogers, now 52, became President and COO. Craig Spengeman, now 55, became President and CIO. They were appointed to these positions when Kissel became CEO. Their ownership stakes are not as large relative to annual compensation as Kissel, but they do own shares valued around one times their annual salary in addition to options. Senior management was granted a new slug of options in 2010 after their 2007 option plan. Their older options have strike prices at pre-TARP prices of $28/share or higher. The scale is not egregious and bank executives should not have incentives for them attempting to double the share price on a short timeline.
The Chief Loan Officer, Vincent Spero, joined in 2009 from Lakeland Bank, a well performing New Jersey community bank. He was the leader of the commercial loan team, an area that PGC has been slowly expanding into over the past decade. He owns shares, including restricted stock, about equal to his compensation excluding the 2010 options issuance. Even though he has only been there for 2 years, he already owns at least $100,000 worth of stock outright.
Frank Kissel became CEO in 1997, but had been a director since 1989. A brother of his, John Kissel, is on the board. He has been on the board since 1987 though, so there is little indication that there is any form of mutual corruption. The last time a new member joined the board was when the CIO and COO joined in 2002. This isn’t as much of a concern as it would be at other companies because board members do own shares in the company and the company has remained prudently run.
Anthony Consi, a board member since 2000, represents James Weichert. Weichert owns a 9.54% stake in the company due to its acquisition of Chatham Savings Bank in 2000. In 2007, Weichert filed a 13-D stating he had sent a letter to management demanding they seek an appropriate buyer and that he would take it upon himself to find a suitable buyer if the company failed to do so. The bank discloses as well that Weichert owns a mortgage originator from who the bank might purchases mortgages. It has not done so since 2005, when they purchased $191.8m in mortgage loans. There has been no indication that those mortgages have been of lower quality than the rest of the loan portfolio. The residential mortgage portfolio has performed well and was never polluted with alt-A or subprime loans.
Consi and Weichert provide some upside optionality if they decide to push for a sale again, as well as downside protection in a watchful, incentivized eye on management. Consi sits on the compensation committee, although there are no hard facts to support that management would go crazy if not for his presence.
Geography
The bank is in an affluent and economically resilient geography. The bank is located in New Jersey in towns that mostly fall between Route 78 and Route 80. Hunterdon, Morris, and Somerset counties where the bank has 4, 6, and 10 branches (out of 23 total), are the 4th, 8th, and 9th richest counties in the US based on median household income.
There are numerous corporate campuses and headquarters in this area. The bank does not serve these large corporations, but the small businesses and residents that in one way or another benefit from their presence. In this specific region include Bell Labs (Alcatel-Lucent), Chubb, Merck, Honeywell, and Quest Diagnostics. Some companies that are headquartered right outside the immediate geography, but with employees that live near bank branches include Johnson & Johnson, ADP, Bed Bath & Beyond, Prudential, and Avis. AT&T, Pfizer, Exxon, Novartis, and BASF have major offices in the area as well. The area is also a convenient commute for people working in New York City. The area is economically diverse, robust, and services oriented in defensive industries.
Conclusion
Peapack-Gladstone Bank has been a consistently well-run community bank in New Jersey that was not flawless over the past few years. The core value of the business remains and the bank has steadily worked its way through rebuilding its capital and managing its loans. As the bank finishes repaying TARP funds, the market should recognize the underlying strength. The business is undervalued even if the economy continues to muddle along, while it has the earnings power to absorb further loan losses.
Long PGC
Thursday, August 18, 2011
HDD manufacturers. Plus ça change or the restoration of the fallen?
I've always toyed with idea of a series of posts under the topic "plus ça change" because saying "the more it changes, the more it is the same thing" is a recurring theme in investing. I originally intended to point out all the nonsense that happens on Wall Street with a current event and compare it to an event of yesteryear. This post points out instances when this time is different, and the more it changes, the more it is not the same thing. It can be different this time. A lot of value investors seem to forget this when they jump head first into a company with the idea that past returns are going to correlate with future returns when a paradigm shift is clearly afoot (photography, video games, books). It's just too convenient to repeat the clichés and seem like a market maven, so it's not true and people should look for disconfirming evidence.
I quoted Seth Klarman in my last post on patents as I've been rereading Margin of Safety since it's the investment book to end all investment books. The other month I posted about the hard disk drive makers and how some investors were seeing value in the newly consolidated commodity product. This isn't a post about the value of the patents laying unexploited on their balance sheets. Klarman points out something that would later inspire NYC gangsta rapper, David Einhorn to proclaim "things done changed."
As I started the post, the plus ça change concept can be pertinent to investors trying to avoid pitfalls. Speculative nonsense hasn't changed much. The more the subject of it changes, the more it is the same thing whether it's internet stocks or hard disk drive manufacturers...in the 1980s! Fancy the HDD manufacturers being the subject of speculative fervor. Klarman uses hard disk drive makers as an example of an irrational market:
When it comes to the HDD industry, it's quite possible that things done changed. The Horace quote that Ben Graham uses at the beginning of Security Analysis is on the money right here, "many shall be restored that now are fallen, and many shall fall that now are in honor." One reason is that when it comes to price, the more it changes, the more it is not the same thing. People probably don't hark back to the 1980's and the HDD industry much, but the historical perspective can show you how things do change, even if it doesn't fit most people's short memory. The French and Horace speak to two sides of the same coin. First, recognize and avoid situations where the more it changes, the more it is the same thing, such as patent fever, social media, and coffee. On the other side, looking at the fallen for what shall be restored can uncover some unloved investment opportunities such as the HDD industry.
I quoted Seth Klarman in my last post on patents as I've been rereading Margin of Safety since it's the investment book to end all investment books. The other month I posted about the hard disk drive makers and how some investors were seeing value in the newly consolidated commodity product. This isn't a post about the value of the patents laying unexploited on their balance sheets. Klarman points out something that would later inspire NYC gangsta rapper, David Einhorn to proclaim "things done changed."
As I started the post, the plus ça change concept can be pertinent to investors trying to avoid pitfalls. Speculative nonsense hasn't changed much. The more the subject of it changes, the more it is the same thing whether it's internet stocks or hard disk drive manufacturers...in the 1980s! Fancy the HDD manufacturers being the subject of speculative fervor. Klarman uses hard disk drive makers as an example of an irrational market:
Speculative activity can erupt on Wall Street at any time and is not usually recognized as such until considerable time has passed and much money has been lost. In the middle of 1983, to cite one example, the capital markets assigned a combined market value of over $5 billion to twelve publicly traded, venture- capital-backed Winchester disk-drive manufacturers. Between 1977 and 1984 forty-three different manufacturers of Winchester disk drives received venture-capital financing. A Harvard Business School study entitled "Capital Market Myopia'? calculated that industry fundamentals (as of mid-1983) could not then nor in the foreseeable future have justified the total market capitalization of these companies. The study determined that a few firms might ultimately succeed and dominate the industry, while many of the others would struggle or fail. The high potential returns from the winners, if any emerged, would not offset the losses from the others. While investors at the time may not have realized it, the shares of these disk-drive companies were essentially "trading sardines." This speculative bubble burst soon thereafter, with the total market capitalization of these companies declining from $5.4 billion in mid-1983 to $1.5 billion at year-end 1984.Certainly the HDD manufacturers are not being touted in a speculative frenzy these days. In fact, quite the opposite. Greenlight Capital's recent shareholder letter not only dabbles in the French language, but discusses their investment in Seagate Technologies (via Marketfolly). Instead of a bright future, the HDD industry faces a lot of headwinds, and Mr. Market is no fan. The thesis goes that there are still tons of cash flows that can be siphoned off from the company for several years that are well in excess of the market capitalization. Also, the market is very consolidated now and nobody is paying attention to sector. Essentially, this time is different. Things done changed. It's 30 years later, but shifts can and do occur in industries. Greenlight estimates Seagate has $3 in earnings power and considered it a bargain at $16/share. It's now at $10. Adib Motiwala does a great job echoing a similar sentiment on Western Digital (via Gurufocus). It's quite hard to figure out what the future looks like for these companies, so I'm staying away, but they certainly would be cheap if things start to shape up with the consolidation.
When it comes to the HDD industry, it's quite possible that things done changed. The Horace quote that Ben Graham uses at the beginning of Security Analysis is on the money right here, "many shall be restored that now are fallen, and many shall fall that now are in honor." One reason is that when it comes to price, the more it changes, the more it is not the same thing. People probably don't hark back to the 1980's and the HDD industry much, but the historical perspective can show you how things do change, even if it doesn't fit most people's short memory. The French and Horace speak to two sides of the same coin. First, recognize and avoid situations where the more it changes, the more it is the same thing, such as patent fever, social media, and coffee. On the other side, looking at the fallen for what shall be restored can uncover some unloved investment opportunities such as the HDD industry.
Wednesday, August 17, 2011
Patently absurd.
Patent fever is becoming patently absurd. Maybe we are about midstage in a scramble to pile up as much money as possible and burn it. I just hope that the burning ink doesn't cause too many harmful emissions. Owning patents for the sake of owning patents is a poor business decision, so it is likely a poor investment decision too.
This is the type of market activity that should cause investors to walk in the other direction, but many people who fancy themselves value investors are probably getting excited about this. Value traps like Eastman Kodak suddenly have value. Now anyone can look at a tech company and be caught by the siren call of patent portfolios. You can't really value a patent unless you see it helping a company extract additional money from its products, but it seems like people are finding ways. Bloomberg has an article about Eastman Kodak being worth oodles of money because of its patents. One guy claimed the patents were worth at least $3 billion. The article also attributes the following quote to him:
The wider this patent nonsense net gets cast, the more likely people will make poor decisions with their money. None of this makes any stock interesting. Mark Cuban was prescient in stating in a WSJ interview last week that, "it’s gotten so bad that big companies are buying patent troves to act as a nuclear deterrent to other big companies with their own patent troves.”
What should be pointed out to people trying to speculate on what company will be bought next as a nuclear deterrent is that each time an "implied value" is able to be calculated as a result of another deal, the actual value of an unacquired patent falls. There are only so many large cap tech companies with excess cash looking to stock up on nuclear armements. When they've had enough, the leftover patents will just be worth what the company earns from producing products protected by that moat.This all reminds me of the story of the sardine speculator that Seth Klarman shares at the beginning of the Bible:
For all this patent speculation, I would venture that RIM has the most actual value because of its security features and messaging system. Those aren't nuclear deterrent patents though. Those have actual value, which is ironic. For better or worse though, management has a large stake in the company so the company is not going to be taking that route any time soon, so extrapolating some value of the patent portfolio out 4-5 years is pointless when the company will either be toast or the toast of the town. Useless patents might not be such hot commodities by then. But who knows, maybe companies will be purchasing useful patents in 4-5 years time, or maybe they won't exist at all.
This is the type of market activity that should cause investors to walk in the other direction, but many people who fancy themselves value investors are probably getting excited about this. Value traps like Eastman Kodak suddenly have value. Now anyone can look at a tech company and be caught by the siren call of patent portfolios. You can't really value a patent unless you see it helping a company extract additional money from its products, but it seems like people are finding ways. Bloomberg has an article about Eastman Kodak being worth oodles of money because of its patents. One guy claimed the patents were worth at least $3 billion. The article also attributes the following quote to him:
“Kodak is the lowest hanging fruit out there,” Chris Marlett, chief executive officer at MDB Capital, a Santa Monica, California-based investment bank specializing in intellectual property, said in a telephone interview. Kodak’s patents “could go for a huge number and nobody’s talking about it,” he said. (link)That's Bloomberg's money quote. That's the quote. The emphasis is about all I saw. This is a transaction driven "bubble" and the attribution of that insightful quote is all you need to see realize that. This is a total fee frenzy that every party with something to gain is going to be talking up to anyone that will listen.
The wider this patent nonsense net gets cast, the more likely people will make poor decisions with their money. None of this makes any stock interesting. Mark Cuban was prescient in stating in a WSJ interview last week that, "it’s gotten so bad that big companies are buying patent troves to act as a nuclear deterrent to other big companies with their own patent troves.”
What should be pointed out to people trying to speculate on what company will be bought next as a nuclear deterrent is that each time an "implied value" is able to be calculated as a result of another deal, the actual value of an unacquired patent falls. There are only so many large cap tech companies with excess cash looking to stock up on nuclear armements. When they've had enough, the leftover patents will just be worth what the company earns from producing products protected by that moat.This all reminds me of the story of the sardine speculator that Seth Klarman shares at the beginning of the Bible:
There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines."While companies like Google and Apple/Microsoft/RIM aren't speculating with their patent purchases, people purchasing shares to profit from this wave can't possibly be investing. All the money chasing this theme is chasing sardines. The acquiring companies aren't incorporating any of this into their products. I'm sure there is a cute anecdote their PR machines will concoct to riposte such an accusation. Now quite frankly, spending billions of dollars on something to not use is foolish. I should point out that use is an anagram for sue. A company does gain something in the sense that they can now deter some of the uncertainty that results from potentially being sued and the potential damages/back royalties/whatever the cost is due to litigation. They'd all gain from not being such punks. I think academics refer to this type of stuff as a Nash Equilibrium. There's no space for an investor to benefit though.
For all this patent speculation, I would venture that RIM has the most actual value because of its security features and messaging system. Those aren't nuclear deterrent patents though. Those have actual value, which is ironic. For better or worse though, management has a large stake in the company so the company is not going to be taking that route any time soon, so extrapolating some value of the patent portfolio out 4-5 years is pointless when the company will either be toast or the toast of the town. Useless patents might not be such hot commodities by then. But who knows, maybe companies will be purchasing useful patents in 4-5 years time, or maybe they won't exist at all.
Tuesday, August 16, 2011
Treasure at Treasury Wine Estates?
Treasury Wine Estates is an Australian based spinoff of the wine business of Fosters Group. It was spun off for the all the reasons that create interesting spinoff investments. The business is the result of a ~10 year roll up of several Australian and California wine brands sold globally that is facing the headwinds of a strong Australian dollar and a glut of Australian grapes. It cost about $6bn to assemble is now trading for $2bn. The combination of goodwill write downs depressing earnings at Fosters and horrible outlook starting in 2008 are behind the parent’s decision to separate the wine business. All figures are in AUD, although there is a US ADR that trades under TSRYY.
The two economic drags on the stock – strong AUD and wine oversupply – are as transient as the lack of interest due to the recent spinoff. If these factors reverse course or even stabilize, investors are well positioned to profit. The combination of a higher relative interest rate and strong demand for commodities has made the AUD a strong currency, although these things can change. I have a hard time extrapolating the USD weakness and AUD strength into infinity.
Even if the status quo remains as such, the company is conservatively capitalized with a debt/EBIT ratio of 1x and trades at 14x trough fiscal 2010 FCF of $150m using a $3.20/share price and 647m shares outstanding. Trailing 5-year average FCF is $250m. The company trades close to its reported tangible book value of $3.18/share.
The business was spun out with $200m in debt and $60m in cash, so leverage is low, especially for a company that sells alcohol. Debt to tangible equity is 10%. This is appropriate because the wine business can be volatile as the current environment is proving. I would head for the exits if the company levered up even if it was for a buyback or dividends. The company has the cash flow to service the debt as well as pay it off quickly, so bankruptcy risk seems distant.
Five year EBIT, ended June 30th
2010 - $221m
2009- $304m
2008 - $394m
2007 - $431m
2006 - $430m
I use EBIT because that figure is the only one I could pull from past filings with consistency. The 2008-2010 figures include the company’s pro forma projection of what the stand-alone business will generate if they retroactively apply stand-alone costs. If you assume a 10% interest rate on the debt of $200m, pretax income was $200m in 2010 and the business is on track for about $180m pretax in fiscal 2011, which translates into roughly $120 in net income for fiscal 2011.
In the past 3 years depreciation has been $95, $103, and $92 million, while capital expenditures have been $77, $99, and $79 million in 2010, 2009, and 2008 respectively. Disclosure is minimal, but the filings state it was for oak barrels and vineyards, and upgrades to winery and packaging facilities. The fiscal 2011 filing should have more color, but FCF could be a lot higher than net income rather than just a few percent. Maintenance capital expenditures are likely a portion of the whole, which is already less than depreciation.
The company produces wine in Australia (66%), California (32%), and Italy (2%), Where the company produces wine though doesn’t really tell the whole story though, because only 28% of the Australian wine and 10% of the Californian wine is from company owned/leased vineyards. The other portion of grapes that go in their wine is split between third party growers and bulk purchases. While the Australian wine glut has had the effect of lowering prices on wine sales, the company has remained profitable. They don’t have as much capital tied up in land and raw materials as other producers and are able to mitigate the effect of falling grape prices. They did have wider margins prior to the current wine glut, although it is difficult to extricate this factor from the AUD, which is up 30% in the past 5 years. Both clearly play a role, but the company is not on its last legs as a result of the wine glut.
In the demerger documents from Fosters, the company stated it intends to pay out 55-70% of its earnings out in the form of dividends. This should act as a catalyst for the stock when it is announced. This business is not very capital intensive when it comes to growth. It does have half its tangible assets in inventory, but that is a feature of the wine business. A little more than half is classified work in progress, which I interpret as meaning they aren't sitting on a time bomb of unsellable wine - the wine is liquid. Any growth would require additional working capital, but the company will not need additional facilities or farmland. The company should be able to distribute a lot of cash flow.
The long term incentive plan takes into account 2 factors equally – total shareholder return including dividends reinvested over a three year period, and the CAGR in return on capital employed. This bodes well for distributing cash and limiting debt. The company doesn’t indicate if it calculates capital employed with or without goodwill, which may have an effect on management deciding to take a bath on the goodwill. This wouldn’t materially affect the underlying value though. What is interesting to note is that EBITDA or a measure of that sort isn’t included. Maybe they are wise to the fact that this is easily manipulated and a poor incentive, or maybe they realize they will have a hard time manipulating it since it is greatly affected by currency fluctuations.
Fiscal 2011 ended on June 30th, so a filing should be released shortly. There will be continued downward pressure due to the grape glut and strong AUD, but there will likely be additional information for investors to digest. The H1 2011 pro forma EBIT was up 30% YoY excluding the impact of exchange rate movements, which shows how much pressure the AUD is putting on reported results while the actual business remains strong. An investor can't eat - maybe drink in this case - results excluding currency conversions, but it is worth noting.
Looking forward the company is trying to fundamentally improve operations which would further blunt the impact of a strong AUD and/or the supply picture of wine. The company is attempting to move upscale with its brands. I have no particular opinion on how likely this is, but more expensive wine has higher margins and competes for customers that are less affected by a wine glut. They do own the Penfolds brand which sells bottles for several hundred dollars a pop. Operationally, the company built centralized automated bottling plants in 2005 in both Australia and California, which gives them capacity to further expand output. They have opportunities in their distribution in the US that is being revamped. They may also divest lower margin more competitive brands, but that is speculation. They have dropped some lower priced brands into JVs in the past, so it is not wild speculation.
The company appears to be in the fairly valued range based on just using trailing one-year earnings, although on a trailing 5 year basis it is a lot more interesting. A good portion of this is due to currency volatility, Australian wine dynamics, and a weak economy. Using the 5 year average smooths out a lot of this. If the company can benefit from spinoff dynamics such as operational improvements tied to changing incentives and a stronger focus on its core business, the business will increase in value. The business will also strengthen if the AUD and the wine oversupply moderate. A weakening AUD can change the oversupply more quickly as well as boost exports, but a weaker AUD is not necessary for the Australian wine market to return to equilibrium. There have also been rumblings of a buyout, but that would just be a kicker. There are several factors that would cause the market to give TWE a higher valuation, while having downside protection.
(h/t Nate over at Oddball Stocks)
Long TSRYY
The two economic drags on the stock – strong AUD and wine oversupply – are as transient as the lack of interest due to the recent spinoff. If these factors reverse course or even stabilize, investors are well positioned to profit. The combination of a higher relative interest rate and strong demand for commodities has made the AUD a strong currency, although these things can change. I have a hard time extrapolating the USD weakness and AUD strength into infinity.
Even if the status quo remains as such, the company is conservatively capitalized with a debt/EBIT ratio of 1x and trades at 14x trough fiscal 2010 FCF of $150m using a $3.20/share price and 647m shares outstanding. Trailing 5-year average FCF is $250m. The company trades close to its reported tangible book value of $3.18/share.
The business was spun out with $200m in debt and $60m in cash, so leverage is low, especially for a company that sells alcohol. Debt to tangible equity is 10%. This is appropriate because the wine business can be volatile as the current environment is proving. I would head for the exits if the company levered up even if it was for a buyback or dividends. The company has the cash flow to service the debt as well as pay it off quickly, so bankruptcy risk seems distant.
Five year EBIT, ended June 30th
2010 - $221m
2009- $304m
2008 - $394m
2007 - $431m
2006 - $430m
I use EBIT because that figure is the only one I could pull from past filings with consistency. The 2008-2010 figures include the company’s pro forma projection of what the stand-alone business will generate if they retroactively apply stand-alone costs. If you assume a 10% interest rate on the debt of $200m, pretax income was $200m in 2010 and the business is on track for about $180m pretax in fiscal 2011, which translates into roughly $120 in net income for fiscal 2011.
In the past 3 years depreciation has been $95, $103, and $92 million, while capital expenditures have been $77, $99, and $79 million in 2010, 2009, and 2008 respectively. Disclosure is minimal, but the filings state it was for oak barrels and vineyards, and upgrades to winery and packaging facilities. The fiscal 2011 filing should have more color, but FCF could be a lot higher than net income rather than just a few percent. Maintenance capital expenditures are likely a portion of the whole, which is already less than depreciation.
The company produces wine in Australia (66%), California (32%), and Italy (2%), Where the company produces wine though doesn’t really tell the whole story though, because only 28% of the Australian wine and 10% of the Californian wine is from company owned/leased vineyards. The other portion of grapes that go in their wine is split between third party growers and bulk purchases. While the Australian wine glut has had the effect of lowering prices on wine sales, the company has remained profitable. They don’t have as much capital tied up in land and raw materials as other producers and are able to mitigate the effect of falling grape prices. They did have wider margins prior to the current wine glut, although it is difficult to extricate this factor from the AUD, which is up 30% in the past 5 years. Both clearly play a role, but the company is not on its last legs as a result of the wine glut.
In the demerger documents from Fosters, the company stated it intends to pay out 55-70% of its earnings out in the form of dividends. This should act as a catalyst for the stock when it is announced. This business is not very capital intensive when it comes to growth. It does have half its tangible assets in inventory, but that is a feature of the wine business. A little more than half is classified work in progress, which I interpret as meaning they aren't sitting on a time bomb of unsellable wine - the wine is liquid. Any growth would require additional working capital, but the company will not need additional facilities or farmland. The company should be able to distribute a lot of cash flow.
The long term incentive plan takes into account 2 factors equally – total shareholder return including dividends reinvested over a three year period, and the CAGR in return on capital employed. This bodes well for distributing cash and limiting debt. The company doesn’t indicate if it calculates capital employed with or without goodwill, which may have an effect on management deciding to take a bath on the goodwill. This wouldn’t materially affect the underlying value though. What is interesting to note is that EBITDA or a measure of that sort isn’t included. Maybe they are wise to the fact that this is easily manipulated and a poor incentive, or maybe they realize they will have a hard time manipulating it since it is greatly affected by currency fluctuations.
Fiscal 2011 ended on June 30th, so a filing should be released shortly. There will be continued downward pressure due to the grape glut and strong AUD, but there will likely be additional information for investors to digest. The H1 2011 pro forma EBIT was up 30% YoY excluding the impact of exchange rate movements, which shows how much pressure the AUD is putting on reported results while the actual business remains strong. An investor can't eat - maybe drink in this case - results excluding currency conversions, but it is worth noting.
Looking forward the company is trying to fundamentally improve operations which would further blunt the impact of a strong AUD and/or the supply picture of wine. The company is attempting to move upscale with its brands. I have no particular opinion on how likely this is, but more expensive wine has higher margins and competes for customers that are less affected by a wine glut. They do own the Penfolds brand which sells bottles for several hundred dollars a pop. Operationally, the company built centralized automated bottling plants in 2005 in both Australia and California, which gives them capacity to further expand output. They have opportunities in their distribution in the US that is being revamped. They may also divest lower margin more competitive brands, but that is speculation. They have dropped some lower priced brands into JVs in the past, so it is not wild speculation.
The company appears to be in the fairly valued range based on just using trailing one-year earnings, although on a trailing 5 year basis it is a lot more interesting. A good portion of this is due to currency volatility, Australian wine dynamics, and a weak economy. Using the 5 year average smooths out a lot of this. If the company can benefit from spinoff dynamics such as operational improvements tied to changing incentives and a stronger focus on its core business, the business will increase in value. The business will also strengthen if the AUD and the wine oversupply moderate. A weakening AUD can change the oversupply more quickly as well as boost exports, but a weaker AUD is not necessary for the Australian wine market to return to equilibrium. There have also been rumblings of a buyout, but that would just be a kicker. There are several factors that would cause the market to give TWE a higher valuation, while having downside protection.
(h/t Nate over at Oddball Stocks)
Long TSRYY
Thursday, August 11, 2011
Deliberate Practice & Reading
I'm a big believer in the idea that you could find any answer to life's ills in what has already been written. I couldn't tell you any economic thinker that has done much in the past 50 years. Everyone else is just adding layers of complexity to quasi-defunct ideas to justify their tenure. Does Cialdini's Influence really tell us anything How To Win Friends and Influence People hasn't already explained with common sense and folksy anecdotes. Rereading articles or books can be more useful than finding new material that conveys the same message.
I find the marginal returns from reading an additional biography about an investor or a "how to" investing book to be negative. They dilute the original ideas and just rearrange the ideas a bit. You wouldn't really be selling yourself short if you read Margin of Safety and Stock Market Genius then moved on. Some supplemental accounting books like Quality of Earnings can be nice, but you don't need to read 10 additional, slightly differing rehashings of a sound value investing philosophy.
This article titled Deliberate Practice - How To Become An Expert appeared on gurufocus a few months back, but it's worth revisiting in a similar vein. He doesn't waste time rehashing ideas, he just quotes/summarizes others, but then adds value by tying it together with specifics about how they apply to investing. Similar to Tim McElvaine's brief ABBA analysis process, which I highlighted way back, this table from his article is worth keeping nearby:
You should read and reread his entire article, keep the table nearby, but ideally you should be keenly aware of the fact that just doing that isn't enough. Especially when the markets are going crazy like now, it's all the more important to ground your actions in logical and thoughtful reasons. There's no better way to do that than with deliberate practice and there's no better way to figure out what that entails than by reading Neil's article.
I find the marginal returns from reading an additional biography about an investor or a "how to" investing book to be negative. They dilute the original ideas and just rearrange the ideas a bit. You wouldn't really be selling yourself short if you read Margin of Safety and Stock Market Genius then moved on. Some supplemental accounting books like Quality of Earnings can be nice, but you don't need to read 10 additional, slightly differing rehashings of a sound value investing philosophy.
This article titled Deliberate Practice - How To Become An Expert appeared on gurufocus a few months back, but it's worth revisiting in a similar vein. He doesn't waste time rehashing ideas, he just quotes/summarizes others, but then adds value by tying it together with specifics about how they apply to investing. Similar to Tim McElvaine's brief ABBA analysis process, which I highlighted way back, this table from his article is worth keeping nearby:
| Deliberate Practice | Not Deliberate Practice |
Detailing how specific news items may impact your investments
| Reading the newspaper |
Valuing & evaluating Businesses
| Reading Annual Reports |
Engage the ideas in books
| Reading Investing Books |
Engage the ideas and authors
| Reading Articles |
Manage a portfolio
| Buying and selling shares |
Writing your own research
| Posting on message boards |
Be a contrarian
| Buying when the market is doing well or selling when it's doing poorly |
You should read and reread his entire article, keep the table nearby, but ideally you should be keenly aware of the fact that just doing that isn't enough. Especially when the markets are going crazy like now, it's all the more important to ground your actions in logical and thoughtful reasons. There's no better way to do that than with deliberate practice and there's no better way to figure out what that entails than by reading Neil's article.
Monday, August 8, 2011
Historical rhymes - past stock ideas
Certainly you could look at the 52-week low list, but there is plenty of overwhelming noise there at the moment. Apparently, like 3 weeks ago the stock market was cheap. Stuff like fat corporate margins, large cash balances, and the super alluring low forward earnings ratio. That wasn't the case in hindsight. History doesn't repeat itself, but it rhymes. I think looking at past historical events is just as useful as looking at past stock ideas, and note that both exercises can be healthy for investors. Good stock ideas from 6 months ago are better ideas now for the most part.
A couple names from my archives I've been revisiting:
Owens & Minor which is at a similar price as when I wrote it up, but the company has continued to grow. The company got sold down the other week when guidance was a tad below expectations and now the broader selloff is combining for a 1-2 punch. Such an instance was actually a scenario I mentioned that would get me interested in the stock. With a 3% dividend yield, strong balance sheet, and acyclical products, it's a name that could allow one to sleep well at night but still hold upside.
Helen of Troy, which is again at a similar price as when I wrote it up, but the company has continued to grow and garner a mention in the Barron's Roundtable a few weeks back. There is some debt on the balance sheet, but debt:fcf is about 2.8x and interest coverage about 7x. The company is in a steady business with most of its debt long term and the rest from a revolver.
Full House Resorts (original and update) which has just tanked despite announcing some additional revenue sources that don't require much capital. On the other hand, the Grand Victoria acquisition was done at the valuation of my worst case scenario. They announce results today and the conference should give some additional color on what they see in their casinos. This company has more moving parts in that historical results are of little use in the future so a little more pencil sharpening is necessary than for companies like OMI and HELE.
A couple names from my archives I've been revisiting:
Owens & Minor which is at a similar price as when I wrote it up, but the company has continued to grow. The company got sold down the other week when guidance was a tad below expectations and now the broader selloff is combining for a 1-2 punch. Such an instance was actually a scenario I mentioned that would get me interested in the stock. With a 3% dividend yield, strong balance sheet, and acyclical products, it's a name that could allow one to sleep well at night but still hold upside.
Helen of Troy, which is again at a similar price as when I wrote it up, but the company has continued to grow and garner a mention in the Barron's Roundtable a few weeks back. There is some debt on the balance sheet, but debt:fcf is about 2.8x and interest coverage about 7x. The company is in a steady business with most of its debt long term and the rest from a revolver.
Full House Resorts (original and update) which has just tanked despite announcing some additional revenue sources that don't require much capital. On the other hand, the Grand Victoria acquisition was done at the valuation of my worst case scenario. They announce results today and the conference should give some additional color on what they see in their casinos. This company has more moving parts in that historical results are of little use in the future so a little more pencil sharpening is necessary than for companies like OMI and HELE.
Sunday, August 7, 2011
Why now is the time to invest in California real estate
It's the summer and I'm stocking up on wool hats in the form of HomeFed Corporation (HOFD), an interesting company that owns several properties for development in the evergreen real estate favorite state of California. On one hand, the continued weakness in the housing market bodes poorly for near term property sales. On the other hand, the business is unlevered with tons of excess cash to take its pick of promising development properties that come to market. The best part is that the business can be had for vaguely below its liquidation value in the current environment in addition to one of the best management teams out there.
Overview
HomeFed has 4 key assets in various phases of development all in California: several parcels in the Otay Ranch development, a 68% interest in the San Elijo Hills development, a grape farm, and the Fanita Ranch development. The company processes entitlements for the land and pays for the construction of community infrastructure – sewage, roads, lights, etc. – then sells lots to homebuilders. The business eschews debt, which is the main risk in property development as such an immovable force is not cooperative to the numerous pitfalls and obstacles in the business. This allows the company to be opportunistic as well as conservatively positioned to weather any storm.
Background
HomeFed is a post reorg equity if you go back to 1995. It consisted of several different small parcels of development land in California in addition to a nice slug of tax loss carry forwards. It caught the eye of Leucadia, as they enjoy developing real estate and sheltering profits with tax losses. I'm a big fan of their work. Leucadia contributed some land in California in exchange for an interest. You can find the details in the 10-Ks, but basically over the years some complex ownership interests have shifted around and land has been contributed. The situation is now simple to comprehend.
Leucadia’s original interest in HomeFed was spun out to shareholders in 1998 for $1.80/share, so Ian Cummings and Joe Steinberg own about 18% of the company combined. After the spinoff though, Leucadia got involved again by contributing more land to the company in exchange for a 30% stake. On one hand, this has resulted in stellar management but on the other it makes the stock quite illiquid (Steinberg’s address at the shareholder’s meetings is available on EDGAR and is the pseudo shareholder’s letter of HomeFed). The Leucadia culture trickles down to HomeFed and the idea of an investor relations department or pretty powerpoints about their developments is abhorrent. The entire situation is all the more attractive to individual investors because it is entirely unfeasible for anyone close to a financial professional to touch.
Valuation
The company carries its properties on its balance sheet with development costs capitalized. Since the company is unlevered and raw land isn’t taxed heavily, the land is likely undervalued due to the long holding period and opportunistic purchases. I will go into the specific properties and their valuation ranges below. The nice thing about the company is that they have $56m in cash net of all liabilities, with the potential that $9m of the $13m of liabilities is overstated. There is $82m in real estate net of a minority interest and a $13m deferred tax asset. The combined book value is $151m or $19.35/share. On the low end the real estate is worth ~$107m which can be sold mostly tax-free at such a price.
San Elijo Hills
SEH is a development north of San Diego, just outside of San Marcos. The development costs have already been paid for and the company is just letting the property percolate into cash. The company has a 68% interest in the development. The company just 325 single family home units and 30 multi family home units from an original 2,364 and 1,099 respectively. There is also 51,2000 of commercial space remaining.
The current carrying value of the property is $47.2m or $32m net of minority interest. Just to prove the point that the property is clearly undervalued, assume the remaining MFH units and commercial space is worth nothing, which implies the SFH units are worth $145k/unit gross. In 2010, the company sold 52 SFH units for $261k/unit on average. In January 2011 they sold 32 SFH units for $218k/unit. At the end of July 2011, they entered an agreement to sell 59 SFH units for $300k/unit.
You can extrapolate these prices over the remaining units – if the 59 SFH unit sale goes through, the company has 266 SFH units left – and get a value of $45-63m for the remaining SFH lots and about $12m in additional cash for the 59 SFH units in the process of being sold. If the sale doesn’t go through the company gets a $1.8m deposit and the remaining land is worth $54m-60m using extrapolated values excluding the $300k/unit price. My point is that the land is undervalued to the book carrying value. I’m not including the commercial spaces that got sold for $1.4m or $550k that are booking huge gains and what they mean for the remaining square footage. The company is also renting out some commercial space for $400k/year, which makes it worth something.
Otay Ranch
Otay Ranch is a large development in Chula Vista, a suburb between Mexico and San Diego. The company owns 2,800 acres in total but it is largely undeveloped. The company submitted its application to develop up to 6,050 residential units and 1,800,000 square feet of commercial space in 2008. It contributed some land and money to Chula Vista to build a higher education facility in exchange for the city promising to process the application by August 2011. If the city doesn’t the company gets the land and money back, so the incentive is for an announcement in the next few weeks. The company hopes to be fully done with approvals by early 2012 according to the recent annual meeting. This will allow the company to move forward with the development, although the real estate market in south San Diego is in the dumps. The company will be able to move forward with development though so that land sales can commence in the next 2-3 years.
The $9m environmental liability is attached to this property as one of the parcels used to be a shooting range. The company is in litigation to get the former owners to help with the lead clean up costs. This presents an opportunity that the liabilities are overstated.
The property is carried for $32m on the balance sheet. I have no idea how to value this with any type of precision. I could create big numbers, such as assuming the company just develops half the maximum residential units and nothing else and goes on to sell them for $50k/unit, which totals $150m in 5-10 years at a cost of $50m. For starters, I made those numbers up. Second, the discount rate’s effect on the NPV for property sold in 2016 vs. 2021 or any year for that matter is immense. The more precise the value, the more likely it is to be inaccurate.
Any figure I conjure up is guaranteed to be ridiculously wrong. The company has held the parcels since 1998, so it stands to reason the book value is at a minimum a decent approximation of the value. There has also been increased road access to the parcels and the surrounding land has been developed, so this isn’t some random plot in the middle of the Arizona desert or that variety of real estate. I’m just looking for a vague approximation of what the company can get for the property today in liquidation, although it will hopefully be worth a lot more as the company develops it.
Rampage
Rampage is a 1,500 acre grape farm. It was acquired out of bankruptcy in 2003. The company is just farming grapes right now and making about $1m/year doing so. The property is carried at $4.5m and is for sale for $25m. At the low end, this property is worth $10m or 10x earnings. They are just farming commodity wine grapes, which management claims can be found in the fine Charles Shaw vino. I’m already a big fan of the 08 merlot (what a vintage!) so this is welcome information.
The original plan was to develop the property but it is outside of Fresno in the Central Valley of California. It’s interesting to point out that the idea behind the purchase totally failed and HomeFed is still positioned to make a boatload of money compared to the original investment.
Fanita Ranch
Fanita Ranch was purchased in January 2011 for $11m out of bankruptcy. The prior developer had $27m in debt on the property then encountered a beast of a downturn and environmental litigation. The parcel is 2,600 acres of land that was entitled for 1,400 SFH units. The city, local merchants, and residents looking for move up housing are all in favor of development, although there is environmental opposition. HomeFed is uniquely positioned with a long term focus and bulletproof balance sheet to flexibly address the environmental opposition and develop the land. This video gives a good overview of the various constituents in the argument and the problems. I’m biased, but I think the economic benefits of a development (more taxpayers, more customers to local businesses) trump environmental considerations in a poor economy more so than in a booming one. Bureaucrats and businessmen are even hungrier for new sources of revenue. This video is a nice roundtable local PBS program on the issue.
An extension of SR 52, a highway, reached Santee in March, 2011 which makes the area more accessible and attractive to commuters into San Diego as well as locals. For now, the parcel is worth $11m, but there is huge upside if this development goes forward, especially within the next 3-4 years. It also gives the company an alternate project to work on while they wait for the Otay Ranch area to improve and uses the excess managerial capacity that is resulting from SEH being in runoff mode.
Property/valuation wrap up
Just looking at what the reaming SEH lots and Rampage can generate in the near future results in $25m increase in book value or $3.20/share on the low end and $40m or $5.10/share in a rosier scenario. This doesn’t assign any value in excess of the carrying value to Fanita Ranch or Otay Ranch, although there are identifiable factors such as development milestones and increased road access that have increased their values since purchase. If the planned sale of SFH units in SEH go through, the balance sheet will have a further bolstered cash balance that represents ~50% of the business. Even in such a shitty economy, the company is worth a vague amount more than the current market cap in liquidation, although patience will reveal that the company is worth substantially more if Leucadia's historical results in property development are anything to go by. This could very well take 5 years, but the share price may possibly rise sooner in anticipation of this all.
On the note of property sales, the company has $24m in NOLs and $31m in AMT credits that will be used to offset profits from sales. In addition to low to no taxes, the costs have all been paid for, so property sales going forward are more cash generative than just looking at net income would have you believe.
Conclusion
I’m sure this stock will see some bizarre price activity in the coming months as people perceive a worsening housing situation, which the company is clearly tied to. The short-term market fluctuation – both stock and real estate – have very little negative effect. If anything, further real estate doldrums offers the company the opportunity to scoop up some more properties, which is a positive when such competent management and a strong balance sheet are behind the purchases.
Long HOFD
Overview
HomeFed has 4 key assets in various phases of development all in California: several parcels in the Otay Ranch development, a 68% interest in the San Elijo Hills development, a grape farm, and the Fanita Ranch development. The company processes entitlements for the land and pays for the construction of community infrastructure – sewage, roads, lights, etc. – then sells lots to homebuilders. The business eschews debt, which is the main risk in property development as such an immovable force is not cooperative to the numerous pitfalls and obstacles in the business. This allows the company to be opportunistic as well as conservatively positioned to weather any storm.
Background
HomeFed is a post reorg equity if you go back to 1995. It consisted of several different small parcels of development land in California in addition to a nice slug of tax loss carry forwards. It caught the eye of Leucadia, as they enjoy developing real estate and sheltering profits with tax losses. I'm a big fan of their work. Leucadia contributed some land in California in exchange for an interest. You can find the details in the 10-Ks, but basically over the years some complex ownership interests have shifted around and land has been contributed. The situation is now simple to comprehend.
Leucadia’s original interest in HomeFed was spun out to shareholders in 1998 for $1.80/share, so Ian Cummings and Joe Steinberg own about 18% of the company combined. After the spinoff though, Leucadia got involved again by contributing more land to the company in exchange for a 30% stake. On one hand, this has resulted in stellar management but on the other it makes the stock quite illiquid (Steinberg’s address at the shareholder’s meetings is available on EDGAR and is the pseudo shareholder’s letter of HomeFed). The Leucadia culture trickles down to HomeFed and the idea of an investor relations department or pretty powerpoints about their developments is abhorrent. The entire situation is all the more attractive to individual investors because it is entirely unfeasible for anyone close to a financial professional to touch.
Valuation
The company carries its properties on its balance sheet with development costs capitalized. Since the company is unlevered and raw land isn’t taxed heavily, the land is likely undervalued due to the long holding period and opportunistic purchases. I will go into the specific properties and their valuation ranges below. The nice thing about the company is that they have $56m in cash net of all liabilities, with the potential that $9m of the $13m of liabilities is overstated. There is $82m in real estate net of a minority interest and a $13m deferred tax asset. The combined book value is $151m or $19.35/share. On the low end the real estate is worth ~$107m which can be sold mostly tax-free at such a price.
San Elijo Hills
SEH is a development north of San Diego, just outside of San Marcos. The development costs have already been paid for and the company is just letting the property percolate into cash. The company has a 68% interest in the development. The company just 325 single family home units and 30 multi family home units from an original 2,364 and 1,099 respectively. There is also 51,2000 of commercial space remaining.
The current carrying value of the property is $47.2m or $32m net of minority interest. Just to prove the point that the property is clearly undervalued, assume the remaining MFH units and commercial space is worth nothing, which implies the SFH units are worth $145k/unit gross. In 2010, the company sold 52 SFH units for $261k/unit on average. In January 2011 they sold 32 SFH units for $218k/unit. At the end of July 2011, they entered an agreement to sell 59 SFH units for $300k/unit.
You can extrapolate these prices over the remaining units – if the 59 SFH unit sale goes through, the company has 266 SFH units left – and get a value of $45-63m for the remaining SFH lots and about $12m in additional cash for the 59 SFH units in the process of being sold. If the sale doesn’t go through the company gets a $1.8m deposit and the remaining land is worth $54m-60m using extrapolated values excluding the $300k/unit price. My point is that the land is undervalued to the book carrying value. I’m not including the commercial spaces that got sold for $1.4m or $550k that are booking huge gains and what they mean for the remaining square footage. The company is also renting out some commercial space for $400k/year, which makes it worth something.
Otay Ranch
Otay Ranch is a large development in Chula Vista, a suburb between Mexico and San Diego. The company owns 2,800 acres in total but it is largely undeveloped. The company submitted its application to develop up to 6,050 residential units and 1,800,000 square feet of commercial space in 2008. It contributed some land and money to Chula Vista to build a higher education facility in exchange for the city promising to process the application by August 2011. If the city doesn’t the company gets the land and money back, so the incentive is for an announcement in the next few weeks. The company hopes to be fully done with approvals by early 2012 according to the recent annual meeting. This will allow the company to move forward with the development, although the real estate market in south San Diego is in the dumps. The company will be able to move forward with development though so that land sales can commence in the next 2-3 years.
The $9m environmental liability is attached to this property as one of the parcels used to be a shooting range. The company is in litigation to get the former owners to help with the lead clean up costs. This presents an opportunity that the liabilities are overstated.
The property is carried for $32m on the balance sheet. I have no idea how to value this with any type of precision. I could create big numbers, such as assuming the company just develops half the maximum residential units and nothing else and goes on to sell them for $50k/unit, which totals $150m in 5-10 years at a cost of $50m. For starters, I made those numbers up. Second, the discount rate’s effect on the NPV for property sold in 2016 vs. 2021 or any year for that matter is immense. The more precise the value, the more likely it is to be inaccurate.
Any figure I conjure up is guaranteed to be ridiculously wrong. The company has held the parcels since 1998, so it stands to reason the book value is at a minimum a decent approximation of the value. There has also been increased road access to the parcels and the surrounding land has been developed, so this isn’t some random plot in the middle of the Arizona desert or that variety of real estate. I’m just looking for a vague approximation of what the company can get for the property today in liquidation, although it will hopefully be worth a lot more as the company develops it.
Rampage
Rampage is a 1,500 acre grape farm. It was acquired out of bankruptcy in 2003. The company is just farming grapes right now and making about $1m/year doing so. The property is carried at $4.5m and is for sale for $25m. At the low end, this property is worth $10m or 10x earnings. They are just farming commodity wine grapes, which management claims can be found in the fine Charles Shaw vino. I’m already a big fan of the 08 merlot (what a vintage!) so this is welcome information.
The original plan was to develop the property but it is outside of Fresno in the Central Valley of California. It’s interesting to point out that the idea behind the purchase totally failed and HomeFed is still positioned to make a boatload of money compared to the original investment.
Fanita Ranch
Fanita Ranch was purchased in January 2011 for $11m out of bankruptcy. The prior developer had $27m in debt on the property then encountered a beast of a downturn and environmental litigation. The parcel is 2,600 acres of land that was entitled for 1,400 SFH units. The city, local merchants, and residents looking for move up housing are all in favor of development, although there is environmental opposition. HomeFed is uniquely positioned with a long term focus and bulletproof balance sheet to flexibly address the environmental opposition and develop the land. This video gives a good overview of the various constituents in the argument and the problems. I’m biased, but I think the economic benefits of a development (more taxpayers, more customers to local businesses) trump environmental considerations in a poor economy more so than in a booming one. Bureaucrats and businessmen are even hungrier for new sources of revenue. This video is a nice roundtable local PBS program on the issue.
An extension of SR 52, a highway, reached Santee in March, 2011 which makes the area more accessible and attractive to commuters into San Diego as well as locals. For now, the parcel is worth $11m, but there is huge upside if this development goes forward, especially within the next 3-4 years. It also gives the company an alternate project to work on while they wait for the Otay Ranch area to improve and uses the excess managerial capacity that is resulting from SEH being in runoff mode.
Property/valuation wrap up
Just looking at what the reaming SEH lots and Rampage can generate in the near future results in $25m increase in book value or $3.20/share on the low end and $40m or $5.10/share in a rosier scenario. This doesn’t assign any value in excess of the carrying value to Fanita Ranch or Otay Ranch, although there are identifiable factors such as development milestones and increased road access that have increased their values since purchase. If the planned sale of SFH units in SEH go through, the balance sheet will have a further bolstered cash balance that represents ~50% of the business. Even in such a shitty economy, the company is worth a vague amount more than the current market cap in liquidation, although patience will reveal that the company is worth substantially more if Leucadia's historical results in property development are anything to go by. This could very well take 5 years, but the share price may possibly rise sooner in anticipation of this all.
On the note of property sales, the company has $24m in NOLs and $31m in AMT credits that will be used to offset profits from sales. In addition to low to no taxes, the costs have all been paid for, so property sales going forward are more cash generative than just looking at net income would have you believe.
Conclusion
I’m sure this stock will see some bizarre price activity in the coming months as people perceive a worsening housing situation, which the company is clearly tied to. The short-term market fluctuation – both stock and real estate – have very little negative effect. If anything, further real estate doldrums offers the company the opportunity to scoop up some more properties, which is a positive when such competent management and a strong balance sheet are behind the purchases.
Long HOFD
Monday, August 1, 2011
The investment process, Fairholme, and Bank of America
One story that has been interesting to follow over the past year is that of Fairholme Fund's underperformance relative to peers and the market. Bank of America has become the talking point for his underperformance, although there are plenty others. It seems to bear a strong resemblance to the typical narrative trajectory of a successful mutual fund sowing the seeds of its own destruction. It has been relatively obscure for many years, only to really burst through to the limelight in 2010 when he was named one of the top mutual fund managers for the decade. The crowd in its infinite wisdom, naturally, decided that Fairholme was the fund to invest in in the aftermath of its out performance. Lo and behold, under performance followed. Is it the inflows? Is it his activist chairman role at St. Joe's? Has he lost his touch?
I find all these arguments unconvincing because his fund has shifted into financials since Morningstar cast the curse of the commentator. The sector has underperformed the market in addition to funds avoiding exposure to the sector, creating the double whammy of underperfoming the market and peers. I think this argument/perspective trumps the other arguments. All the hot money that flowed in in the aftermath of his successful long term record is probably the exact same money that is flowing out afterwards.
1) inflows - I understand the premise from which this explanation flows, but if you look at Fairholme's historical record, the fund has never really generated alpha by investing in tiny obscure companies, so inflows haven't been a drag on actionable ideas. In this case, I'm suspicious of the "size matters" argument, because it's really what you do with the size of your funds. I went through some older 13-F filings to verify this (I use the total value of securities in the filing in the following calculations as a proxy for the portfolio, which ignores what is usually a big cash position and more recently foreign listed stocks - I'm just looking to be vaguely correct and my argument is basically that Fairholme is not wont of investment opportunities as a result of inflows).
In May 2002 (13F), the fund had $550m in stocks - this figure precluded Fairholme from investing with a concentrated value strategy in small companies since mutual funds offer daily liquidity. His largest positions were Berkshire, Household Financial (since bought by HSBC), Leucadia, Markel, Mercury General, and White Mountains, which comprised 91% of the stock portfolio and all had a large finance bent - Berkshire alone was 40%. These weren't tiny names. Six positions were 91% of the stocks the fund owned.
By March 2007 (13F), the US stock portfolio was at $4.9bn, or 9x the size in a matter of 5 years due to inflows. His top 6 holdings - Berkshire, Canadian Natural Resources, Leucadia, Penn West, Mohawk Industries, and Echostar - accounted for 74% of his portfolio. I don't want to obsess over the data point of a decline from 91% in 6 names to 74% as a sign that he had a hard time coping with the inflows, because it really just results of arbitrarily using the top 6 stocks when one would traditionally use the top 10 stocks as that is the point from which diversification doesn't reduce portfolio risk. This is still a heavily concentrated portfolio by any standards.
Jumping to March 2011 (13F), the fund held $14.4bn in US listed securities, with the top 6 positions - AIG, Sears, Bank of America, Citigroup, Berkshire, Morgan Stanley - accounting for 53% of the portfolio, and the top 10 names accounting for 76% - Goldman, Regions, CIT, and Leucadia additionally. I've only been using the top 6, because in 2002, Fairholme really only had 6 significant US listed stocks in the portfolio. A highly concentrated portfolio has been consistent trait over the years, now as much as ever. If anything, the flows are hurting (future) results because the threat is forcing a traditionally high cash position to be used on redemptions rather than opportunism.
2) St. Joe - I'm not sure I understand the argument that this is a distraction, which is based more on the outcome than the process. Fairholme has had hands on roles before in companies. Fairholme was involved in the GGP bankruptcy and some private placement of AmeriCredit financing in what I would call an activist manner. Maybe not in the traditional sense, but Berkowitz couldn't just be chilling in Miami to do all this. From what I've read, Berkowitz's partner, Charlie Fernandez, is an investor with an operational background. In the most 3/31/11 conference call, Berkowitz mentions how Fernandez has been instrumental in many of these activist aspects - financing, lawyers, regulators, and corporate execs. Fairholme never adopted the stance that they wanted to run the company, but stock selection is a similar skill to picking managers to run a business in which you own a stake. While poor performance has correlated with the St. Joe's activist position, it falls well short of causation. One thing that critics haven't mentioned is Fairholme's purchase of AIA and China Pacific Insurance, but Berkowitz mentions in the linked conference call as a potential criticism of style drift and spreading themselves thin.
3) process and outcome - Along the lines of what I mentioned in 1) the fund hasn't really changed its approach. I think it is interesting to compare the Berkowitz thesis on WFC in 1992 to his thesis on BAC in 2011 which is not word for word, but the same process. I think an interesting corollary is the case of Bill Miller, who instead of a long term record of outperformance, had beaten the S&P 500 for 15 years in a row (his Legg Mason coworker, Michael Mauboussin published an interesting paper on untangling luck and skill a while back that I think is more flatteringly applicable in Fairholme's situation). I tried to do some research into what exactly his process was, but it is not nearly as hard and fast as Berkowitz's 2 criteria of tons of cash flow and hard to kill. The top 10 holdings of Legg Mason's Value Equity fund are less than 30% of the portfolio in names that are large and liquid enough to take up 70% of the portfolio if they had the conviction.
My take on the entire situation is that it's probably a mistake to consider Fairholme just another mutual fund. It's like calling GE an industrial firm. It's worth examining because Fairholme has a good long term track record because its managed by people with their money in the funds and a clearly articulated approach by a genetic contrarian. I agree with him along the same lines as to why its a good time to invest in financials right now, banks specifically. On a related note, a newer blog Valuable Behavior, has a series on how to analyze bank stocks that is topical and better written than any type of informative missives I've attempted.
I find all these arguments unconvincing because his fund has shifted into financials since Morningstar cast the curse of the commentator. The sector has underperformed the market in addition to funds avoiding exposure to the sector, creating the double whammy of underperfoming the market and peers. I think this argument/perspective trumps the other arguments. All the hot money that flowed in in the aftermath of his successful long term record is probably the exact same money that is flowing out afterwards.
1) inflows - I understand the premise from which this explanation flows, but if you look at Fairholme's historical record, the fund has never really generated alpha by investing in tiny obscure companies, so inflows haven't been a drag on actionable ideas. In this case, I'm suspicious of the "size matters" argument, because it's really what you do with the size of your funds. I went through some older 13-F filings to verify this (I use the total value of securities in the filing in the following calculations as a proxy for the portfolio, which ignores what is usually a big cash position and more recently foreign listed stocks - I'm just looking to be vaguely correct and my argument is basically that Fairholme is not wont of investment opportunities as a result of inflows).
In May 2002 (13F), the fund had $550m in stocks - this figure precluded Fairholme from investing with a concentrated value strategy in small companies since mutual funds offer daily liquidity. His largest positions were Berkshire, Household Financial (since bought by HSBC), Leucadia, Markel, Mercury General, and White Mountains, which comprised 91% of the stock portfolio and all had a large finance bent - Berkshire alone was 40%. These weren't tiny names. Six positions were 91% of the stocks the fund owned.
By March 2007 (13F), the US stock portfolio was at $4.9bn, or 9x the size in a matter of 5 years due to inflows. His top 6 holdings - Berkshire, Canadian Natural Resources, Leucadia, Penn West, Mohawk Industries, and Echostar - accounted for 74% of his portfolio. I don't want to obsess over the data point of a decline from 91% in 6 names to 74% as a sign that he had a hard time coping with the inflows, because it really just results of arbitrarily using the top 6 stocks when one would traditionally use the top 10 stocks as that is the point from which diversification doesn't reduce portfolio risk. This is still a heavily concentrated portfolio by any standards.
Jumping to March 2011 (13F), the fund held $14.4bn in US listed securities, with the top 6 positions - AIG, Sears, Bank of America, Citigroup, Berkshire, Morgan Stanley - accounting for 53% of the portfolio, and the top 10 names accounting for 76% - Goldman, Regions, CIT, and Leucadia additionally. I've only been using the top 6, because in 2002, Fairholme really only had 6 significant US listed stocks in the portfolio. A highly concentrated portfolio has been consistent trait over the years, now as much as ever. If anything, the flows are hurting (future) results because the threat is forcing a traditionally high cash position to be used on redemptions rather than opportunism.
2) St. Joe - I'm not sure I understand the argument that this is a distraction, which is based more on the outcome than the process. Fairholme has had hands on roles before in companies. Fairholme was involved in the GGP bankruptcy and some private placement of AmeriCredit financing in what I would call an activist manner. Maybe not in the traditional sense, but Berkowitz couldn't just be chilling in Miami to do all this. From what I've read, Berkowitz's partner, Charlie Fernandez, is an investor with an operational background. In the most 3/31/11 conference call, Berkowitz mentions how Fernandez has been instrumental in many of these activist aspects - financing, lawyers, regulators, and corporate execs. Fairholme never adopted the stance that they wanted to run the company, but stock selection is a similar skill to picking managers to run a business in which you own a stake. While poor performance has correlated with the St. Joe's activist position, it falls well short of causation. One thing that critics haven't mentioned is Fairholme's purchase of AIA and China Pacific Insurance, but Berkowitz mentions in the linked conference call as a potential criticism of style drift and spreading themselves thin.
3) process and outcome - Along the lines of what I mentioned in 1) the fund hasn't really changed its approach. I think it is interesting to compare the Berkowitz thesis on WFC in 1992 to his thesis on BAC in 2011 which is not word for word, but the same process. I think an interesting corollary is the case of Bill Miller, who instead of a long term record of outperformance, had beaten the S&P 500 for 15 years in a row (his Legg Mason coworker, Michael Mauboussin published an interesting paper on untangling luck and skill a while back that I think is more flatteringly applicable in Fairholme's situation). I tried to do some research into what exactly his process was, but it is not nearly as hard and fast as Berkowitz's 2 criteria of tons of cash flow and hard to kill. The top 10 holdings of Legg Mason's Value Equity fund are less than 30% of the portfolio in names that are large and liquid enough to take up 70% of the portfolio if they had the conviction.
My take on the entire situation is that it's probably a mistake to consider Fairholme just another mutual fund. It's like calling GE an industrial firm. It's worth examining because Fairholme has a good long term track record because its managed by people with their money in the funds and a clearly articulated approach by a genetic contrarian. I agree with him along the same lines as to why its a good time to invest in financials right now, banks specifically. On a related note, a newer blog Valuable Behavior, has a series on how to analyze bank stocks that is topical and better written than any type of informative missives I've attempted.
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