Why I don't like speciality clothing retailers

When I first started investing, it was all about low PE stocks. Earnings are a real important part of the formula for making money, but it is future earnings and not trailing earnings. A low PE on a retailer can be misleading though. It is a cutthroat business with no barriers to entry tasked with selling perpetually changing products. Oscar Wilde sums up the problem that clothing retailers face - "Fashion is a form of ugliness so intolerable that we have to alter it every six months." A clothing retailer reverting to the mean is incredibly difficult because of the constant change.

Too many value investors comfort themselves with past consistency. Selling clothing to people is not a steady business with the exception of men's dress clothing. Tastes can change rapidly - look at Crox. The clothing industry is not part of some broader cycle that allows any individual company to piggy back on the broader upswings like housing or steel. Marginal capacity remains just that even when clothing demand is strong. My scientific method for establishing that is looking at the stocks of steel and housing companies from 2000-2008 and 2000-2005 respectively compared to clothing retailers over the same periods. The former was correlated, the latter not at all.

To understand the differing economics a clothing retailer faces, it helps to put them against the backdrop of retailers in general, where there are many dominant players. Target is not likely to start carrying a small selection of lumber and Home Depot is not going to start offering fresh produce or 10 pairs of socks for $5. This allows for some modicum of a competitive advantage among certain retailers. The same competitive advantage is not available to clothing retailers. When skinny pencil jeans are all the rage, anyone that sells pants - i.e. any clothing retailer - is more or less free to jump on that band wagon regardless of what is perceived as their core focus. Even though this implies that a "brand" plays a key role, there are very few enduring clothing brands based on specialty retailers.  Brooks Brothers is the only one I can think of off the top of my head, but men's dress clothing is the exception to the rule.

The LBO of J. Crew centered less on the stores, logistics, etc than the presence of CEO Mickey Drexler, who is credited with J. Crew's success in recent years and Gap's success in the 1990s. Gap suffered in the year or two leading up to his departure though, so even the most skilled merchandisers run out of steam every so often.

The limited focus of some clothing retailers - Aeropostale, American Eagle, Gap, etc - makes it hard to rapidly adjust to changing preferences. The existence of retailers built on a model of rapid turnover and super short lead times makes the job of some of the more traditional retailers mentioned above a lot harder. H&M and Inditex don't "miss" a fashion cycle because they focus on rapidly duplicating current fashion and putting it on their shelves. This model rests less on a maestro merchandiser and more on a system focused towards a specific end. H&M and Zara don't stand for anything, they simply mirror whatever is fashionable at the moment.

Aeropostale is a name that keeps popping up in portfolios of many value investors, but I find that it has more traits that don't make it a value investment. The company caters to the 14-17 crowd and is suffering right now. People seem to be focusing on the broader economy leading to more intense discounting and higher cotton prices squeezing the company. While these seem transient at first blush, I don't know how accurately this portrays what is really hurting the company.

There is nothing fundamentally dishonest about such an interpretation, but it is narrow in focus. More broadly speaking, it is that their key demographic is suffering disproportionately to the rest of the economy. Cotton is a marginal issue in comparison to this. Every clothing company has to deal with cotton costs and a weak economy. Why have Aeropostale's recent results been so relatively weak?

I'd like to think that Aeropostale's weak results in recent quarters stem from the fact that teenagers by and large are a mindless and fickle group. When I think back to myself at this age, once some brand or style became uncool in my opinion, it was done. I never gave something a second chance. I moved on. There is such a variety when it comes to arraying oneself in fabric.

Maybe Aeropostale is just in a fashion funk and their clothes are no longer selling well. That seems hard to judge in the near term. I view fashion as practically random, in that in practice it is difficult to really know what items will be a hit. The issue of fashion applies to more than just the special focus retailers, except that they have their own distribution which leverages the business model. I have a hard time figuring out how one could have knocked one out of the park with Uggz or "luxury denim", survived the rollercoaster of Crox or recognize that Heely's now trades for below cash. The monstrous successes and failure would not have been apparent in SEC filings - perhaps incremental successes of sales growth outpacing inventory - and personally I would have scoffed at the idea of anyone buying any of these products before the fact.

You can't tell me that you would believe that these fabulous moon boots get sold in stores, except that they do:

Back to Aeropostale. It's the end of summer right now, when most 14-17 year olds should have gotten summer jobs that allow them to support their spending habits in lieu of the parental payroll. Except that according to the July BLS data on youth employment, 16-24 year olds, the labor force participation rate for all youth in July was the lowest on record. So when your store is targeting that specific demographic, it should come as no shock that same store sales are down and merchandise needs to be heavily discounted to sell it. My inclination is to believe that this is the major factor driving Aeropostale's results and that this is going to obscure whether or not Aeropostale is remaining relevant, since other teen retailers are not seeing as much gross margin or sales pressure.

Sentiment is clearly at an all time low with Aeropostale, but that is not a reason to buy a stock. How can you extricate the effect of cotton, youth unemployment, and a weak economy from a retailer losing its merchandising touch or its appeal to teenagers? That is, how can you establish the difference between a permanent impairment in the business and a temporary blip?  At 2.4x book value, there is no downside protection in the form of hard assets backing the valuation and I am skeptical of trying to peg their earnings power going forward with the potential for a fundamental change in Aeropostale's prospects.

I chose Aeropostale because it seems to be the most extreme of the bunch right now in terms of share price. Plenty of people have opinions about the company and its prospects. It just demonstrates why I don't like clothing retailers. It's a hard business with prospects that are difficult to evaluate. Talbot's, bebe, Wet Seal, or Cache are some other examples one might look to for evidence that reversion to the mean is a hard thesis to put forth for a retailer.

K Swiss: Funny for everyone but investors?

This K Swiss/Kenny Powers video is nothing short of hilarious:

The comments section are filled with "K Swiss is awesome!  I'm buying a pair of these shoes."  Is this bankable scuttlebutt?  No.  Eastbound and Down, the HBO comedy series that created the Kenny Powers persona is going to be a cult classic for years to come.  K Swiss is a different story.  While I don't think there is much value in the stock, there is value in looking back at what was once a turnaround situation with what I might have thought was once a margin of safety.

In late 2008, when the shares were around the same price, the company had 75% of it market cap in net cash, $327m in sales, and $24m in profits for Fiscal 2008.  In 2010, the company did $217m in sales and lost $68m and currently 25% of its market cap in net cash.  The CEO owns a big slug of stock and has grown the company over the past few decades, so by that traditional indicator of aligned interest, shareholders are in decent hands.  The situation has changed, but the stock price is about the same (using year end 2008 prices).  The company has tripled sales of its Palladium brand in the past 3 years from $11m to $31m, but the K Swiss brand has seen a 40% contraction in sales despite the release of new products and the Kenny Powers centric ad campaign from $315m to $185m.  The recent video might be the funniest of them all, but it is not a brand new branding approach - Kenny Powers K Swiss commercials are about a year old).

One reason for the losses is that the company hasn't righted the ship in terms of expenses.  Instead of bringing its costs in line with revenue, it has continually sought to find ways to force its revenue to justify its costs.  In 2006 with $489m in revenue, the company had $130m in selling, general and administrative costs, but fast forward to 2010 and the company had $217m in revenue and $142m in SG&A.    The lowest SG&A has been in the past 5 years was $118m in 2009, before the company started pumping money into an aggressive ad campaign.  Even if the company wants to hide behind a long-term view approach to their SG&A, the past 5 years of >50% sales decline has not seen the cost structure budge to be remotely in line with sales.  At the same time, it is hard to envision reviving a consumer brand without an aggressive advertising campaign.  

I could very well be wrong that costs need to come in line with revenue, because the inversion would be that revenue will come in line with costs.  The Kenny Powers-centric ad campaign, as well as several other micro-viral campaigns centered around other personalities, has been around for the past year.  In the 2010 Annual Report, management touted the reception of these investments which are being put through the SG&A line item in the financial statements:

"The first spokesperson was the fictional Kenny Powers from the HBO TV show, “Eastbound & Down,” that featured our Tubes training shoes on Kenny and NFL athletes Jeremy Shockey and Patrick Willis, along with mixed martial arts fighter Urijah Faber. These spots were well received even before their official launch. Online sites, social media, outdoors in New York and Los Angeles and a special Tubes micro site featuring Kenny Powers preceded the official launch. We generated great attention for the brand and strong sales for Tubes at retail and at kswiss.com. By late in the year, Footwear News had ranked us as number one on their list of brands with the biggest jump in buzz while our Facebook fans increased 22-fold and our Twitter followers were up 300%"

These are all nice metrics in that they show some kind of growth.  But how is the business doing?  I'm about to use a limited data set since only one quarters worth of financial statements are available to compare pre and post edgy ad campaign.  Next quarter's earnings have the potential to clear things up, but there are indications that celebration might be premature.  What is the right amount of time to judge traction gained in an ad campaign?  I don't know.  Maybe it is more than 9-10 months, but I'll work with what I have.  The CEO recently said “We are seeing the first fruits of 2010’s investments with sizable year-over-year increases in both our domestic and international futures orders and sequential improvement in revenues."  I think when you peel back the numbers and look at the increase in future orders and revenue improvements in relation to metrics such as gross margins, accounts receivable, and inventory, the growth in terms of quality is overstated.

On one hand, the CEO can claim that the ad campaign has gained traction as there has been a YoY growth in revenue of 10%.  People are buying more of their products.  That is a fact.  How and at what price are they purchasing them though?  While revenue grew 10%, accounts receivable grew 22% indicating that they are offering merchants better payment terms.  The deterioration in gross margin indicates that they are lowering their prices as well.  

From the most recent 10-Q explaining the year over year 420 basis point deterioration in gross margin: "The decrease was the result of an increase in inventory and royalty reserves and greater discounts given to customers due to production delays by our factories for the three months ended March 31, 2011 compared to the three months ended March 31, 2010."  To what extent each individual reason is responsible is hard to tell.  Their guidance for 2011 is that gross margin remains at 39%, so I find it difficult to reconcile their own words with their own words.  I didn't include it in the above chart, but gross margins in later quarters of 2010 had 40%+ gross margins, while the full year margins came in at 39%.  Full year gross margins should iron out any issues in the quarterly numbers, so that things like production delays necessitating greater discounts should not be the sole cause of a huge drop in gross margins.  It could also be that gross margins were abnormally high in the first quarter of 2010.  

The combination of higher growth in inventory and account receivable relative to revenue growth can indicate a lot of things.  The cynic in me wants to say that the Twitter followers and Facebook friends aren't translating into sales.  As a result, management is having to cut prices and give merchants better payment terms in order to drive sales.  At the same time, one could look at the inventory and claim that management is very confident in their ad campaign is beginning to gain traction and wants to be able to respond to the increased sales growth.  Perhaps even a halo effect has emerged and people are beginning to look beyond the growth in K Swiss Tubes sales.  The company's backlog also increased 45% yoy, but this is lower growth than the inventory by a wide margin.  My cynicism and the company's growing backlog can contribute to the higher inventory at the same time though.

Late 2008 had the benefit of a large net cash position and strong trailing earnings over a multi year period.  At the same time the forward looking environment was not as kind.  Luckily, despite what I would consider a weakening financial profile, the share price hasn't really dropped much.  Is the opposite true now?  Is a smaller cash position and trailing losses obscuring a business in revival?  It's hard to tell, although it seems like management's claims that its ad campaign had traction hasn't played out in the first quarter of 2011.  This will play out in the next few quarters, but the margin of safety isn't there if a negative scenario plays out - and I don't think that the financials indicate this is six sigma probability event.  It's also worth noting that had you invested based on a turnaround in late 2008, you would not have lost money including the $2 special dividend as the price is pretty much unchanged since then.  While vindicating the concept of investing in turnaround with a margin of safety, such a scenario doesn't exist for investors today.

Brand turnaround - Wendy's

Wendy's is an interesting turnaround situation of sorts.  It looks cheap, especially if it can start to resemble McDonald's financials in the next few years.  It isn't as cheap as the narrative would have you think.  Is it overpriced?  Not really.  I think there are some really phenomenal characteristics to the Wendy's brand and management, but I'm stuck on the valuation and the margin of safety.

Turnarounds can be interesting if the price is low enough.  If you can buy a poor business at a discount to the value of a poor business - as a result of extreme pessimism or the like - that is showing tangible signs of becoming a good business, even a mediocre one, then it seems logical that you could make some money.  Seahawk Drilling, one of my least favorite mistakes, qualifies as the wrong type, but a business less bankruptcy risk can be attractive.  Wendy's is potentially such a business.

I hit up Wendy's every now, but when they reintroduced the bacon mushroom melt burger, which I was a fan of when they had it 5 years ago, I looked at the stock.  It seemed like a turnaround that Bill Ackman had touted once upon a time was actually underway.  Not only my specific experience, but Wendy's seemed to be improved the customer experience and trying to create reasons to get people in the store.  The nice thing was that the stock price hasn't really moved since then as the turnaround in product offerings and operations has been dealt the blow of hard economic times and food commodity inflation.

Nelson Peltz and Peter May are the guys behind the turnaround at Wendy's.  This appeals to me because they can be financial engineers if you go back in their history (National Can) but their focus over the past decade has been activist investing in a way that builds real value.  They push for  improvements in leveraging the brand and margins.  They've been successful at Heinz and Tiffany's.  The extent of their recent financial engineering was agitating Cadbury to spinoff DrPepperSnapple.  They aren't activists per se at Wendy's since they basically control the company.  The corporate structure is that of the former Triarc parent because Wendy's was acquired in a reverse merger with the smaller company taking over the bigger one.  Peltz's hedge fund, Trian, has been kind enough to lease the private jet and prior office space from Wendy's.  Wendy's still pays for insurance and calendar maintenance on the jet since they own it.  Trian should have bought this outright.  This ticks me off but it won't make or break an investment.

Wendy's has so far under delivered on expanding the store margins, but this is probably due to a weak economy and commodity prices.  There has been an uptrend since 2008 despite all this, although 2011 has been pretty bad due to commodity costs.  So far, 2011 has been bad for margins.  Prices fluctuate, but it seems like part of the pessimism over the stock lies in continued commodity pressures.  A case for optimism might be made since 40% of the corn crop is used for ethanol and the government may or may not be coming around the insanity of this proposition.  The company has the system in place to get at least a couple points in margin improvement once commodity costs come under control.

The company is also under represented internationally.  They are taking steps to get franchisees abroad and seem to be doing a decent job knocking off country after country with franchising deals.  This will increase the high margin, high return royalty stream.  This is happening as more deal are being signed and the first restaurants in new countries are beginning to open.

The rollout of breakfast is a catalyst for the stock as it would provide a ~10% boost to sales if the $150k+ in additional unit sales projection is to be believed.  That's less than 100 customers buying $5 worth of breakfast stuff daily or 17 customers/hour if breakfast is served 5am-11am (even less on a transaction basis, ex. 2 construction workers on their way to a site).  This is reasonable assuming they do a good job with the rollout.  Management has also claimed people have been ordering burgers in the morning where breakfast hours have been rolled out, so maybe the breakfast products don't have to be all that successful.    

Like I said, there is a lot to like about the company.  It is taking steps in the right direction that I would expect of a fast food restaurant to improve its brand and operations.  This is the problem though.  The business model (franchising) is a great business that generates tons of cash flow.  Naturally it is a fiercely competitive field.  That McDonald's is easily the most swaggering it's ever been in its history creates a very steep obstacle to overcome.  There is plenty of room for McDonald's, Wendy's and plenty others to exist.

The problem is that I think a lot of the bull case for Wendy's is based on them replicating McDonald's.  This may very well be the case.  The problem is that McDonald's is an 800 lb. gorilla because as the largest of the pack, it can stomach the commodity pressures the best, and if Wendy's or BK raises their prices on the menu - especially value menu - then price conscious people will just go to McDonalds, increasing their volume, and reinforcing their advantage.  McDonald's is still increasing sales and has higher margins currently than Wendy's is even targeting.  This is a wide gap to overcome, all Wendy's would be very valuable were it to successfully accomplish this.

Breakfast strikes me as the hardest segment to gain momentum in simply because less people eat out for that meal, let alone eat it in the US.  Wendy's doesn't have breakfast mindshare and isn't in people's routines.  Burger King - maybe for reasons not having to do with mindshare (PE deal maybe) - has not been effective in rolling out breakfast.  Products aren't the only thing that need to be strong, but service as well.  Breakfast isn't a slow, casual time for most people, so one bad experience waiting 15 minutes in a  drive thru line could scuttle a location's hope of gaining traction in breakfast.  McDonalds has a really strong breakfast offering -  their coffee offering is highly regarded by Consumer Reports and has the most loyal coffee consumers.  On the downside, Wendy's franchisees will be annoyed and reluctant for further change if breakfast is a flop after they had to purchase additional equipment. While Peltz's influence would make me lean towards conceding that breakfast has a good chance on succeeding, Wendy's isn't arriving early to an untapped market.

Any company that is in the process of a turnaround, even if its headed by a guy like Peltz,  means an investor needs a margin of safety.  Despite giving the impression that I think McDonald's torpedoes the entire turnaround, I don't think that.  I think the valuation torpedoes the idea of investing in the turnaround with a margin of safety.  Wendy's doesn't even have to be half of as good of a business as McDonald's in order for it to be an attractive business.  It would have to be half of its valuation to be a good investment though.  I would own an underperforming business at a low valuation that has identifiable reasons why the business can perform in the future.  Even a turnaround of a poor company can be a good investment if you buy it at the right price and there are some signs that margins and profits will improve (SVU or WINN come to mind as potential candidates in that category).

Since people seem fond of the WEN/MCD comparison, WEN trades at 9x EV/EBITDA (their proforma TTM EBITDA and EV based on Q1 post Arby's sale) and MCD at 11x.  While that may appear to already be a discount, WEN's Debt/EBITDA is ~4x while MCD's is only ~1x.  Just focusing on capital structure, the large amount of debt on Wendy's balance sheet is deserving of a discount.  This is nothing to say the premium MCD deserves for consistent top and bottom line growth, strong international presence, and higher margins.  They also return almost all their FCF in the form of buybacks and dividends.  Just to throw in one more comparison, YUM has many of the same characteristics of MCD give-or-take - you might say inferior brand, I say the amazing success in China.  YUM also trades for about 11x EV/EBITDA and its debt/EBITDA is less than 1x.

The problem using an EV/EBITDA multiple is that even if the net debt is well below the gross debt, they still have to pay interest on the gross debt.  There is a decent amount of cash flow to cover the interest in addition to cash.  Even if the debt load is entirely serviceable, the cash used to do so does not accrue to shareholders.  If the company fails at turning itself around, the debt load starts to look like more of an issue.  They could halt capital expenditures and pay off the debt in 4-5 years with FCF, but that is assuming the business doesn't deteriorate.  They could pay off some debt for 2-3 years to make it more manageable, but that would still give rivals time to take advantage.  The debt load will be less of a knock if the business improves to consistent growth and more profits.  While not the only sticking point, the debt requires an investor to demand a greater margin of safety and have greater confidence than usual that the company is being turned around.  

To use a metric that actually looks at what a shareholder gets in terms of cash flow, I prefer owner earnings or FCF.  I'm having a hard time pegging their FCF because of the Arby's numbers, but maintenance capex is probably around the levels it is at now and approximately depreciation - $145m for 2011.  They are going to be revamping stores for the foreseeable future.  Taking their TTM pro forma adjusted EBITDA for Wendy's of $328m and using $110m in adjusted interest and $145 in capex/depreciation results in $73m pretax and $51m in FCF.  This is not a bargain and FCF really needs to boom for the valuation to make sense.  If they get the recipe right - capex trails off, sales grow, margins widen, international gain traction, debt paid down - then the company could easily rack up $200m in FCF in a few years and be worth more than it is today.  It begs the question though, why would you pay 11x 2015 FCF for this business?  Is it that predictable or the downside that limited?

I would look at the FCF the company generates above all else because the company needs to revamp all its older stores if it is going to start to even remotely resemble just the sales growth of McDonalds (to say nothing of margins).  On top of the capex, the interest payments mean that EBITDA is a very separate figure from which equity owners will benefit.  Companies with plenty of debt can still generate tons of FCF.  Maintenance cap ex would imply what the company could spend and still maintain it's position.  Sales are declining or bobbing around the same number right now, so I don't know what the figure for zero change in sales is, but they need to spend money to at least ring up consistent sales even if the capex results in sales growth (implying it wasn't maintenance capex).  If they invest their cash pile in the stores and distribute cash along the lines of EBITDA-tax, the EV/EBITDA calculation gets a huge boost in the wrong part of the equation for shareholders.  It increases the net debt and raises the hurdle to overcome for earnings.

The market is already rewarding Wendy's with a reasonably high multiple since the QSR franchise business is a typically a high ROIC and FCF business.  Wendy's is still a ways off from replicating McDonald's success.  They have to remodel tons of stores, fire up sales growth, keep expanding margins, and solidify a strong international presence.  One could play time arbitrage and just wait, but it looks contingent on Wendy's becoming another McDonald's, which seems hard to do.  At best, a Pepsi to their Coke - although Pepsi is still a valuable business.  Wendy's has a slightly inferior brand in terms of positioning and intangible value than Heinz ketchup (old Malcom Gladwell article on ketchup) or the Tiffany's box.  I would caution people against following the McDonald's narrative or the past Peltz activist narrative when reading the tea leaves about Wendy's.  I don't predict armageddon, but the valuation doesn't offer a margin of safety.

Please share dissenting views.

Did I make a BLUD-dy mistake?

Immucor (BLUD), a company I thought I had a lot of things to like, just announced that it is getting bought out for a cool 30% premium.  Not bad for a ~3 month time frame.  Too bad I never purchased it.  Stocks, and women for that matter, are a lot like buses.  If you miss one, another will be along in 10 minutes.  There were a couple factors that are worth mentioning that maybe indicated this buyout would happen, although it's not something I would actively seek in an investment.  Looking at the role a CEO can play in how an investment plays out is worth digging into.

The CEO until last month was also the founder.  He took this company from nothing to a $1.2bn company.  It is hard to depart and it's hard to maybe affect the kind of change necessary when the company needs to put their shoulder to the wheel during hard times.  This is a qualitative factor I hadn't really taken into account before, which is why I tend to shy away from a company like this.  The Buffett's, Sequoia's, and Simpson's are just so much better at identifying the really good companies with a margin of safety than an amateur.

I identified BLUD as a good company, but I couldn't figure out the margin of safety.  I'm not even positive it existed.  A 30% premium is mostly a takeover premium and doesn't exactly reflect the idea that I missed some hidden value (this is just a gut feeling).  I think noting that a founder/CEO with a decent inside ownership is not always a de facto sign that they are running the company really well, something to look out for with large cap tech as well.  Obviously TPG sees room to better the operations and they aren't exactly paying a cheap price at 22x earnings.  A new CEO can be a catalyst for public shareholders, although I'm reluctant to believe it's always a positive one.

The new CEO ran a company that was acquired.  When I saw that Immucor had a new CEO, my interest was rekindled.  A new CEO can mean tons of things.  I saw that the new CEO was the former CEO of Mentor (the breast implant maker) that got acquired by JNJ a few years back.  Could I interpret this as a sign that the CEO didn't have the typical CEO ego of wanting to not be his own boss?  I could, but I don't have industry contacts or the scuttlebutt ability to figure out if that really was true.  He did stay at Mentor for 2 years as a subsidiary company.  I'm reluctant to read into this too much since it just confirms what I want to believe.  It certainly meant that some change would occur at the company, although it's difficult to say it would be an acquisition without hindsight.  Certainly the speed indicates that TPG probably was looking at the company before the CEO change, at least beyond preliminary stages.  The CEO change probably gave them the courage to step forward with a bid.  This is all back room kind of dealing though, which is not the basis of an investment process.  It looks hard to do if you aren't a professional.

I can think of one good example of looking at a CEO change as a positive catalyst, although it clearly is based on a lot of research that is scuttlebutt.  The hedge fund manager who had lunch with Warren Buffett after sending him stock research focused on a management change to make a profitable investment in Fiat (source):

"Sergio Marchionne, the new CEO, was a guy with a track record for creating value in Switzerland. He spent time in GE and made his mark at a Swiss quality control company.  He came into a company [Fiat] whose reputation was tarnished and whose brand equity had been decimated. But philosophically smart people choose smart businesses. Marchionne saw the opportunity, and we saw Marchionne.  We were likely the only investors outside Italy interested in Marchionne at the time. After some begging and pleading, he granted us a meeting.  Marchionne joined Fiat with a mandate to do whatever was necessary to fix the company. We bought some shares. He confirmed what we surmised. He had full support of the board and its new chairman. If auto was worth more dead than alive, he'd kill it.  Fiat was the biggest employer in Italy at the time. He took on the labor unions. He was fearless. He had real skin in the game and his incentives were aligned.  Marchionne saved Fiat. He got $2.25 billion to cancel a legacy agreement that Fiat could "put" itself to GM. No one thought it could happen -- there's no way this debt-laden, cash strapped Italian company will win in an international court of law. But Marchionne walked away with $2.25 billion of cash and Rick Wagoner [then CEO of GM] was fired shortly thereafter. This was half of Fiat's market cap.  We exited the position in the mid-teens and made a lot of money. It was the biggest profit generator in Brahman's history."

I can see how this process can work out well, but as you can see from the manager's explanation, it was based in part on meeting the guy.  I'm unaware how an amateur investor could access the information pipeline to figure out what exactly Marchionne did at GE and the Swiss quality control company.

I'm not a fan of the anecdotal nuggets that get released in journalistic reporting, which is the one way I think an amateur could access this kind of information.  I remember when Ken Lewis was touted as a great integrator who had a successful track record pre-CEO integrating some bank into BofA.  Profiles of CEOs tend to be fairly glowing because no CEO would grant an interview to a journalist looking to expose how poorly they do their job.

Did I miss a quick 30% gain?  Yes.  Did I make a mistake?  Maybe, but I'd lean closer to the no end of the spectrum.  The acquisition angle is speculative, although BLUD had merit as an investment.

Does anyone have any other good or bad examples of a CEO change going unnoticed but being a catalyst to the up or downside?  Ford comes to mind although there were serious survival issues when the company was trading at $2/share.

Affirmative Insurance: Potential Turnaround

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: None