I enjoy reading The Official Activist Investing Blog for ideas and keeping up with corporate governance stuff floating around. There was a recent post that was showcasing a couple of activist investments pushing for changes in corporate governance. While the content is interesting, I thought I would mention this as another way to generate investment ideas.
If you read through the article you will see links to the SEC proxy filings that the activist investors file. The activists tend to file presentations on the company and what they think needs to change. They are usually quite thorough and can be treasure troves of data. Sometimes the way they slice and dice the financial statements and show comparable companies can reveal useful things.
I don't think that a small guy like me could make investments that require an activist investor as a huge part of the thesis. In certain instances it is nice to invest alongside guys pressing for change, although it depends on their approach. Psychology speaking, people tend to become further convinced of their own ideas when others try to convince them of the opposite. I briefly touched up ValueAct Capital in my post on Energy Solutions and mention an interview with a partner at the firm. Based on the interview, I think incorporating their activist presence into a thesis would be more credible than a more combative activist.
A point I'd like to rehash as much for myself as anyone else is that investing comes down to price. If the price of an investment is a lot lower than the value of a company, an activist investor can only be a positive force. If it seems like the price and value are pretty comparable, an activist investor will be acting a way that only they know.
On the aforementioned blog, there is a link to a presentation by Barington Capital about Ameron International. Reading through the presentation, you get the idea that management is pretty greedy and has no stake in the company. While at a certain price this might be acceptable (I still haven't taken a stance whether or not this is a proper stance), the company doesn't seem that cheap to make it worth owning if there wasn't an activist involved. As a point of interest, Barington highlights 10 past successful activist investments they were involved with. This could be a starting point for researching companies because they have already responded to the agitation for change and you don't have to worry about any uncertainty of the activist initiatives.
Talk to Andrew about activist investors and their ideas
Thursday, March 10, 2011
Wednesday, March 9, 2011
Tobacco Leaf Merchants - A publicly traded duopoly
I was reading Khrom Capital's Q4 investor letter over at My Investing Notebook and was quite impressed with the stock ideas discussed in detail. The author discusses Universal Corporation (UVV), a stock I've looked into before as well as its main competitor, Alliance One. Outside of the in house operations of major cigarette companies, Universal and Alliance One control most of the market for tobacco leaf purchasing and processing. The major cigarette companies buy from them as well. It's a pretty much no-growth business, but its fairly consistent, generally profitable, and extremely hard to imagine any new competitors. The recent headline scare (1-2 years) discussing how cigarette companies are bringing in more leaf procurement in-house has worried investors and the stocks don't really have high valuations.
Khrom presents a contrarian view in that the leaf merchants play too integral of a part to ever be cut from the supply chain of cigarette manufacturers. I agree. The business has been around for at least 100 years. A couple points not touched on in the letter are that the company has increased its dividend every year since 1988 - an indication of a shareholder friendly management and an implicit recognition of the minimal reinvestment needs of the business. I'm also of the opinion that it helps free up working capital on the cigarette manufacturers balance sheets to optimize them for repurchases and share buybacks. It might not be a huge amount, but just from looking at their balance sheets they are well run operations. While they don't sell an admirable product, they are for the most part well run and shareholder oriented.
The author casually mentions Alliance One (AOI), Universal's main competitor. A while back I looked into the stock because I saw that Seth Klarman's Baupost Group had a stake in it. The author notes that the new CEO at Alliance One specializes in turnarounds and restructurings and that the stock is at an attractive level. I agree that the stock is beaten down a lot. The company has been restructuring for years since a merger in 2005 of the 2nd and 3rd largest tobacco leaf merchants that created Alliance One. While this is going to result in a lot of frustrated sellers and create an opportunistic buying environment, it is important to make sure there is something worth buying.
I wouldn't chalk up Alliance One's problems completely to its $760m in debt - not included $240m in notes payable to banks. Debt is part of the operating model because the company needs funds to finance its acquisition of tobacco. The alternative to long term debt would be a revolver with a floating rate. As if just under 2x LT debt to equity were not a prudent capital structure, exposing oneself to the uncertainty of fluctuating interest payments would probably be too much to bear. By comparison, Universal's LT debt:equity ratio is 1:4, which is why it is consistently profitable and is able to raise its dividend and buyback stock (they bought back $100m in stock back in 08-09 when the price was lower). Universal's success shows that the business itself is fundamentally sound, but must be conducted with prudent leverage (I apologize if you find the term 'prudent leverage' to be offensive).
Thought exercise - If the Alliance One didn't have to pay $80m in interest and used all cash to finance its working capital, equity would rise from $415m to $1,175m. The company is not really earning much money right now, so I will use Fiscal 2010 and 2009 as an example when the company earned $120m (excluding debt retirement expense) and $130m respectively. If they didn't 80m in interest payments (interest expense was actually higher in these years, but this is just a theoretical exercise), they would have earned $172m and $182m (decrease expenses by $80m, taxed at 35%) on equity of $1,175m. That's a ROE of 15% on the business. That's not bad. Even adjusting for goodwill and restructuring charges, earnings from 2006-2008 were nowhere near that good. The problem is that a business that earns a 15% ROE at its peak is not very attractive, and over the cycle of tobacco leaf prices (whole bunch of other agricultural dynamics that would complicate matters) the company probably isn't doing anything much more exciting than 10 year treasuries. You do have the additional risk of them not being able to move excess inventory or any other numerous operational risks. So clearly a debt free tobacco leaf merchant makes very little economic sense. I apologize if this doesn't make sense, I tried to outline my thoughts step by step. I think the ultimate conclusion is correct. There needs to be some leverage in the capital structure for it to make sense.
Back to reality. As stated in their recent earnings release, Alliance One is seeing downward pressure in tobacco leaf prices which is hurting their profits. Another worrisome point is that their profits so far in fiscal 2011 are mostly from asset sales which are non recurring. Their cash flow otherwise would not be enough to service the debt if my calculations are correct (less $37m in other income, but adding back in D&A, non cash debt amortization, and restructuring charges) has cash from operations at ~$33m compared to interest payments of $79m in the past 9 months. This is a very crude calculation and I might have missed something, but clearly there are some difficulties to overcome. They have been paying down debt as best as they can which is encouraging.
Alliance One is a speculation for the aforementioned reasons, and in my case it falls under the "too hard" category. The business is incredibly lumpy. Tobacco leaf is not purchased on a consistent quarterly basis, so cash flows are always going to be erratic. The harvest periods in different regions Alliance One sources from reach their peaks at different times. For a smart person - i.e. not me - wrapping their head around the cash conversion cycle (the quarterly statements don't really reflect whats going on with the company in a way to calculate the CCC in a way that is truthful or beneficial) of the company might allow them to get comfortable with the risks. The company may very well be currently converting a lot of its tobacco inventory to cash which can be used to service and pay off debt. The situation is definitely worth continuing to pay attention to.
One last note is that a big chunk of the balance sheets of both companies consists of tobacco leaves. On the whole, I think impairment of the stated values are unlikely. This is interesting because the in a runoff situation, it could easily be converted into cash. A good chunk of the leaves are slated for delivery to specific parties, so there wouldn't be a huge flood of inventory onto the market. Tobacco isn't exactly a widely traded commodity though, so I don't know how such a scenario would really play out. It is something to think about though.
Disclosure: None
Talk to Andrew about tobacco leaf merchants
Khrom presents a contrarian view in that the leaf merchants play too integral of a part to ever be cut from the supply chain of cigarette manufacturers. I agree. The business has been around for at least 100 years. A couple points not touched on in the letter are that the company has increased its dividend every year since 1988 - an indication of a shareholder friendly management and an implicit recognition of the minimal reinvestment needs of the business. I'm also of the opinion that it helps free up working capital on the cigarette manufacturers balance sheets to optimize them for repurchases and share buybacks. It might not be a huge amount, but just from looking at their balance sheets they are well run operations. While they don't sell an admirable product, they are for the most part well run and shareholder oriented.
The author casually mentions Alliance One (AOI), Universal's main competitor. A while back I looked into the stock because I saw that Seth Klarman's Baupost Group had a stake in it. The author notes that the new CEO at Alliance One specializes in turnarounds and restructurings and that the stock is at an attractive level. I agree that the stock is beaten down a lot. The company has been restructuring for years since a merger in 2005 of the 2nd and 3rd largest tobacco leaf merchants that created Alliance One. While this is going to result in a lot of frustrated sellers and create an opportunistic buying environment, it is important to make sure there is something worth buying.
I wouldn't chalk up Alliance One's problems completely to its $760m in debt - not included $240m in notes payable to banks. Debt is part of the operating model because the company needs funds to finance its acquisition of tobacco. The alternative to long term debt would be a revolver with a floating rate. As if just under 2x LT debt to equity were not a prudent capital structure, exposing oneself to the uncertainty of fluctuating interest payments would probably be too much to bear. By comparison, Universal's LT debt:equity ratio is 1:4, which is why it is consistently profitable and is able to raise its dividend and buyback stock (they bought back $100m in stock back in 08-09 when the price was lower). Universal's success shows that the business itself is fundamentally sound, but must be conducted with prudent leverage (I apologize if you find the term 'prudent leverage' to be offensive).
Thought exercise - If the Alliance One didn't have to pay $80m in interest and used all cash to finance its working capital, equity would rise from $415m to $1,175m. The company is not really earning much money right now, so I will use Fiscal 2010 and 2009 as an example when the company earned $120m (excluding debt retirement expense) and $130m respectively. If they didn't 80m in interest payments (interest expense was actually higher in these years, but this is just a theoretical exercise), they would have earned $172m and $182m (decrease expenses by $80m, taxed at 35%) on equity of $1,175m. That's a ROE of 15% on the business. That's not bad. Even adjusting for goodwill and restructuring charges, earnings from 2006-2008 were nowhere near that good. The problem is that a business that earns a 15% ROE at its peak is not very attractive, and over the cycle of tobacco leaf prices (whole bunch of other agricultural dynamics that would complicate matters) the company probably isn't doing anything much more exciting than 10 year treasuries. You do have the additional risk of them not being able to move excess inventory or any other numerous operational risks. So clearly a debt free tobacco leaf merchant makes very little economic sense. I apologize if this doesn't make sense, I tried to outline my thoughts step by step. I think the ultimate conclusion is correct. There needs to be some leverage in the capital structure for it to make sense.
Back to reality. As stated in their recent earnings release, Alliance One is seeing downward pressure in tobacco leaf prices which is hurting their profits. Another worrisome point is that their profits so far in fiscal 2011 are mostly from asset sales which are non recurring. Their cash flow otherwise would not be enough to service the debt if my calculations are correct (less $37m in other income, but adding back in D&A, non cash debt amortization, and restructuring charges) has cash from operations at ~$33m compared to interest payments of $79m in the past 9 months. This is a very crude calculation and I might have missed something, but clearly there are some difficulties to overcome. They have been paying down debt as best as they can which is encouraging.
Alliance One is a speculation for the aforementioned reasons, and in my case it falls under the "too hard" category. The business is incredibly lumpy. Tobacco leaf is not purchased on a consistent quarterly basis, so cash flows are always going to be erratic. The harvest periods in different regions Alliance One sources from reach their peaks at different times. For a smart person - i.e. not me - wrapping their head around the cash conversion cycle (the quarterly statements don't really reflect whats going on with the company in a way to calculate the CCC in a way that is truthful or beneficial) of the company might allow them to get comfortable with the risks. The company may very well be currently converting a lot of its tobacco inventory to cash which can be used to service and pay off debt. The situation is definitely worth continuing to pay attention to.
One last note is that a big chunk of the balance sheets of both companies consists of tobacco leaves. On the whole, I think impairment of the stated values are unlikely. This is interesting because the in a runoff situation, it could easily be converted into cash. A good chunk of the leaves are slated for delivery to specific parties, so there wouldn't be a huge flood of inventory onto the market. Tobacco isn't exactly a widely traded commodity though, so I don't know how such a scenario would really play out. It is something to think about though.
Disclosure: None
Talk to Andrew about tobacco leaf merchants
Tuesday, March 8, 2011
A radioactive stock that might be worth touching: Energy Solutions
Energy Solutions (ES) provides services primarily to the nuclear industry in the US and UK. I already own some shares in Global Power, a company that provides services to nuclear facilities in the US that I've previously profiled. It's an interesting sector because of the recurring revenue and strong tailwinds industry wide. ES is pretty special though, because it has what essentially amounts to a monopoly within a portion of the nuclear services space.
It's crown jewel is its Clive, Utah facility for handling low-level radioactive waste (LLRW) and mixed low-level waste (MLLW) which is just about every waste material a nuclear plant produces save the spent fuel. They store 95% of the waste of this type in the entire US. There are only 2 other places in the US capable of handling similar types of waste and they are owned by states. Additionally from the 10-K:
The landfill is carried on the books at $30m. The segment it is in, Logistics Processing & Disposal (LP&D) includes several other links in the chain of LLRW disposal generated $240-260m in revnue between 2007 and 2009 and segment EBITDA of $84-100m (Full year 2010 results haven't been released, but it is on track to do about $80m in run rate EBITDA based on the first 9 months). This is the flexing of pricing power, the hallmark of a business you want to own and verification of the huge moat this facility possesses. While the EBITDA figure doesn't take into account corporate expenses, this does demonstrate the massive earnings power of just this one segment/asset. The entire market cap is ~$600m, so ES is potentially undervalued.
There are several other segments: commercial services, federal services, and international. Commercial services cleans up nuclear sites. Federal services does the same but for the DOE. These businesses are more competitive, but the LP&D segment does give it a unique competitive advantage. International operates and cleans up nuclear reactors in the UK. Its contract for the international business is up for renewal in 2012, which is something to look out for.
There's several blemishes to consider when looking at ES though. First is its debt load of $835m. This is eating significantly into EBITDA. Even excluding a goodwill impairment, the company doesn't have 2x interest coverage. A portion of the debt, $300m, is a credit facility to finance restricted cash for collateral on its jobs cleaning up sites through its commercial and federal services segments. While it does operate on long term contracts and has a lot of "guaranteed" revenue, it really isn't guaranteed and even if it had 2x interest coverage, it would be walking a fine line. What would happen if there was a temporary stoppage in shipments to its landfill? That could happen for numerous reasons, natural or man made. Around 10% of the float is sold short, and the risks definitely give some credibility to a short thesis.
ValueAct Capital has a stake in the company. They are polite activist investors who like to get board representation and hold management's hand to run the business with a long term orientation and maximize shareholder value. Here is an interview with one of the guys who runs ValueAct. He is a competent guy who seems to know what he is doing. One thing they look for are choke points in supply chains where out sized pricing power can be exerted. They only like to focus on 10-15 companies, so they don't take a shotgun approach and make concentrated bets. I presume the nuclear waste landfill plays a large part in their thesis.
I love the assets, but I hate the liabilities. I'm not done poking around, and the company should release its 2010 10-K soon, which will be a welcome update on their situation. It is a little annoying the last released financial data dates back almost 6 months. Judging from the monopolistic nature of the nuclear waste landfill, the replacement value is likely greater than the market cap + debt of the company, but I just got burned on Seahawk Drilling with a similar thesis. While I don't want to act like Mark Twain's cat who jumped on a hot stove, it would be necessary to establish the strength of the cash flow and understand some of the other risks.
Disclosure: none
Talk to Andrew about Energy Solutions
It's crown jewel is its Clive, Utah facility for handling low-level radioactive waste (LLRW) and mixed low-level waste (MLLW) which is just about every waste material a nuclear plant produces save the spent fuel. They store 95% of the waste of this type in the entire US. There are only 2 other places in the US capable of handling similar types of waste and they are owned by states. Additionally from the 10-K:
"We are the only commercial disposal outlet for MLLW and operate two of the three commercial LLRW disposal sites in the United States, through our Clive, Utah and Barnwell, South Carolina disposal facilities. The third facility is a state-owned facility located in Richland, Washington that is relatively small, does not accept radioactive materials from outside the Northwest Interstate Compact on Low-Level Radioactive Waste Management States and may eventually stop receiving materials from outside Washington State itself."The company's position as an effective monopoly in the space might be under pressure from another site. There is one planned in Texas that was approved in 2009. It must still go through many phases of permitting, environmental studies, and NIMBYism. Even by the generally business friendly standards of Texas, storing nuclear waste is not a popular business. From ES's 10-K (which might misrepresent the reality, but it strongly correlates with what one would expect from a nuclear waste disposal site construction process):
"Construction may not begin until several reconstruction license conditions are completed and approved by the executive director of the TECQ. Once approved construction is complete, additional conditions of the license must be met prior to commencement of disposal. These conditions will require WCS to complete several major environmental studies, examples of which include groundwater, air emissions, and seismic stability studies. WCS must also demonstrate that the leachate from the landfill will not reach the Ogallala-Antlers-Gatuna Aquifer. Should the license become active, WCS will be allowed to receive waste from the Texas Compact, which includes the states of Texas and Vermont, and from federal facilities (i.e., DOE). WCS will not be able to receive waste via railcar or receive depleted uranium, and will be required to dispose of commercial waste in specially designed containers in the compact portion of the facility."WCS is the company looking to create another landfill for LLRW. Clearly the additional capacity faces constraints in coming online.
The landfill is carried on the books at $30m. The segment it is in, Logistics Processing & Disposal (LP&D) includes several other links in the chain of LLRW disposal generated $240-260m in revnue between 2007 and 2009 and segment EBITDA of $84-100m (Full year 2010 results haven't been released, but it is on track to do about $80m in run rate EBITDA based on the first 9 months). This is the flexing of pricing power, the hallmark of a business you want to own and verification of the huge moat this facility possesses. While the EBITDA figure doesn't take into account corporate expenses, this does demonstrate the massive earnings power of just this one segment/asset. The entire market cap is ~$600m, so ES is potentially undervalued.
There are several other segments: commercial services, federal services, and international. Commercial services cleans up nuclear sites. Federal services does the same but for the DOE. These businesses are more competitive, but the LP&D segment does give it a unique competitive advantage. International operates and cleans up nuclear reactors in the UK. Its contract for the international business is up for renewal in 2012, which is something to look out for.
There's several blemishes to consider when looking at ES though. First is its debt load of $835m. This is eating significantly into EBITDA. Even excluding a goodwill impairment, the company doesn't have 2x interest coverage. A portion of the debt, $300m, is a credit facility to finance restricted cash for collateral on its jobs cleaning up sites through its commercial and federal services segments. While it does operate on long term contracts and has a lot of "guaranteed" revenue, it really isn't guaranteed and even if it had 2x interest coverage, it would be walking a fine line. What would happen if there was a temporary stoppage in shipments to its landfill? That could happen for numerous reasons, natural or man made. Around 10% of the float is sold short, and the risks definitely give some credibility to a short thesis.
ValueAct Capital has a stake in the company. They are polite activist investors who like to get board representation and hold management's hand to run the business with a long term orientation and maximize shareholder value. Here is an interview with one of the guys who runs ValueAct. He is a competent guy who seems to know what he is doing. One thing they look for are choke points in supply chains where out sized pricing power can be exerted. They only like to focus on 10-15 companies, so they don't take a shotgun approach and make concentrated bets. I presume the nuclear waste landfill plays a large part in their thesis.
I love the assets, but I hate the liabilities. I'm not done poking around, and the company should release its 2010 10-K soon, which will be a welcome update on their situation. It is a little annoying the last released financial data dates back almost 6 months. Judging from the monopolistic nature of the nuclear waste landfill, the replacement value is likely greater than the market cap + debt of the company, but I just got burned on Seahawk Drilling with a similar thesis. While I don't want to act like Mark Twain's cat who jumped on a hot stove, it would be necessary to establish the strength of the cash flow and understand some of the other risks.
Disclosure: none
Talk to Andrew about Energy Solutions
Monday, March 7, 2011
A great example of how not to think about investing
The constantly repeating newsflash: most market prognosticators are useless. Roger Lowenstein has this article talking about the latest book by James Glassman, he same author who brought you Dow 36,000. In his defense, Glassman will eventually be right, I guess.
The first rule of investing is not to lose money. The second rule is not to forget rule number one. The best way to begin investing is to learn what to avoid, rather than what to seek out. You'll avoid the confirmation bias this way. It is interesting that this psychology shortfall as well as the recency bias is on show by Glassman when talking about psychology:
The first rule of investing is not to lose money. The second rule is not to forget rule number one. The best way to begin investing is to learn what to avoid, rather than what to seek out. You'll avoid the confirmation bias this way. It is interesting that this psychology shortfall as well as the recency bias is on show by Glassman when talking about psychology:
"Glassman argues for reducing exposure to U.S. stocks, investing in “bear funds,” and hedging through put options. He is full of praise for “value” stocks -- by which he means, stocks that trade at low multiples of assets or earnings.
...
Glassman seems to like value stocks because they have performed in the past. You could have said that about Lucent in 1999
...
Glassman says value stocks benefit from “investor psychology.” He says they offer more reward with lower risk. But he still defines “risk” in terms of volatility. And he doesn’t seem to have learned that psychology can change. His new book, he says, “fits the psychology of investors” -- as if that condition were immutable."Interesting article. Mr. Glassman seems like the real life Mr. Market judging from his massive manic depressive rollercoaster market commentary.
Artio Global Investors - An interesting investment in an investment manager
Have you ever seen a company that actually earns more when you dilute the number of shares outstanding? Artio Global Investors (ART) presents an opportunity for the analytical mind, because it actually earns more when you dilute the number of shares. There are many market dynamics and gross misunderstandings that have caused unwarranted pressure on the stock. The company has a strong business model and trades in an unloved sector of an unloved sector: international asset management. I've discussed why asset managers can be such an attractive investment previously. The company trades at a low multiple of earnings and at a discount to peers.
Background
The company was spun of from Julius Baer in 2009. The company’s cornerstone investment product is an international equity fund started in 1995, with a sister fund started several years after due to the increasing size of the first fund. The company has since expanded its offerings to diversify its product line up and take advantage of their position as a respected international investor. The spinoff did not immediately result in a drop in the share price, although the structure of the spinoff is somewhat confusing. The company has not been helped by the lack of popularity in equity markets and the constantly shifting institutional allocation to various strategies.
Spinoff
The key misunderstanding of the spinoff seems to be the dilution. While typically more shares outstanding means a smaller slice of the pie for shareholders, in this case each diluting share bring with it profits not previously attributed to public shareholders. The company was spun off with 3 classes of shares (A, B, and C), obscuring the earnings power of the entire company and created an overhang of excess liquidity. Class A shares are the basic publicly traded shares with no special features. Class B shares were the holdings of the two principals Mr. Pell and Mr. Younes, who are the CEO/CIO and Head of International Equity respectively, which entitled them to some profits. They have been allowed to sell 20% of their holdings each year of the 5 years after the spinoff, and have sold a portion as they converted to A shares, bringing their combined ownership stake from ~30% to 19%. Class C shares are solely held by GAM Holdings, the Julius Baer parent company, and entitle it to a share of the profits. Within 2 years of the spin, all of these shares will be converted to Class A shares, of which 60 million will then be outstanding. GAM Holdings has stated that the Artio shares are a financial stake as opposed to strategic stake. The shares will convert in Class A shares in October 2011 at the latest, giving the looming threat of additional excess liquidity. The principals own 1% each of the holding company that contains the Artio business. The 60 million shares outstanding represent 98% of the underlying company.
Inside Ownership
There’s a balance between the stock price and inside ownership situation. A lot of the liquidity in the stock is the result of the principals selling shares in the company. While insider buying is a universally bullish signal on a stock, a more nuanced view is necessary on insider selling. It is simultaneously discomforting and irrelevant. As long as the principals hold a meaningful stake in the company, there is a strong alignment of incentives. Now that the company is public, 2m shares in the form of RSU’s were issued to non-senior employees, which vest over the next 3 years. This further entrenches an alignment of interests in the entire operation and mitigates the potential dilution of aligned interests through the sales of the principals.
Without getting philosophical about what stake for the principals to hold would be considered “meaningful,” I would point out that there is a combined ~$200m of stock held by them still. They have gotten themselves a fair amount of cash out of their holdings, and it remains to be see how they will approach future periods when they can sell. This being the real world and considering that most managers are not Warren Buffett (who still has substantial wealth absent his stake in Berkshire), I’m not exactly shocked that they would look to diversify their wealth. While it is not the ideal situation, you are not paying a price for a stock that people expect to be everything but ideal. The principals also own 2% of the underlying company, which means they get 1% of the company’s profits passed through to them. This could potentially be destructive were they to do dilutive things with the other 98% of the shares to increase overall profits, but this 1% is outweighed by their public shares.
Valuation
This is the downside case based on the derivative earnings and EV/AUM valuations based on drops in AUM. The expenses are overstated by using 2010 expenses. There is greater variability in expenses if AUM/performance declines. Any upside through increases in AUM/positive performance is not accounted for. These various valuation situations reveal a margin of safety in spite of potential volatility in markets.
Downside and Risks
The company’s revenue is completely derivative of its assets under management. The main way to retain and attract more/grow AUM is performance. The long term performance metrics of its core strategies are industry leading, although recent performance has been disappointing. While it is difficult to allocate the blame, the recent outflow of assets is attributable to performance as well as changing institutional portfolio balancing. The International Equity funds (their flagship product) has underperformed the index in the past 1 and 3 year periods, which have slowed down the growth in the company. They haven’t done horrible by mutual fund standards and they’ve outperformed the index since inception. There is a risk the fund has “lost it” but it is the same people who have been running it since inception. If this is more than a temporary dip in performance, more assets could flow out.
Potential Upside
There is some upside potential in new fund launches. Their US equity funds are still small and have had a hard time since they launched in 2006. They have a High Yield Fund as well as a High Grade Fixed income fund with $4bn in AUM each. They’ve just launched a Local Emerging Markets Debt Fund (LEMD) , which is a logical extension of the international bent of the company as well as complimentary to their already established fixed income team. While no additional valued is assumed from the US equity or LEMD funds, the LEMD fund has strong potential to attract several billion more in AUM.
Additional Catalysts
The company has a buyback approved, which should be easy to complete with the low stock price and tons of FCF the company throws off. Increasing the dividend is another possibility. While I realize this does not quite constitute startling insight, the payout ratio is 10% and the buyback is only covering dilution from equity compensation.
As stated, the company throws off tons of cash flow. They have casually acknowledged the possibility of an acquisition. Done at a reasonable multiple – and most of the sector is not expensive – it might have the unexpected effect of boosting the stock price. It would give the company much needed diversity as it is considered mostly a one trick pony at this point with its International Equity fund family.
Comparisons
Disclosure: Long ART
Background
The company was spun of from Julius Baer in 2009. The company’s cornerstone investment product is an international equity fund started in 1995, with a sister fund started several years after due to the increasing size of the first fund. The company has since expanded its offerings to diversify its product line up and take advantage of their position as a respected international investor. The spinoff did not immediately result in a drop in the share price, although the structure of the spinoff is somewhat confusing. The company has not been helped by the lack of popularity in equity markets and the constantly shifting institutional allocation to various strategies.
Spinoff
The key misunderstanding of the spinoff seems to be the dilution. While typically more shares outstanding means a smaller slice of the pie for shareholders, in this case each diluting share bring with it profits not previously attributed to public shareholders. The company was spun off with 3 classes of shares (A, B, and C), obscuring the earnings power of the entire company and created an overhang of excess liquidity. Class A shares are the basic publicly traded shares with no special features. Class B shares were the holdings of the two principals Mr. Pell and Mr. Younes, who are the CEO/CIO and Head of International Equity respectively, which entitled them to some profits. They have been allowed to sell 20% of their holdings each year of the 5 years after the spinoff, and have sold a portion as they converted to A shares, bringing their combined ownership stake from ~30% to 19%. Class C shares are solely held by GAM Holdings, the Julius Baer parent company, and entitle it to a share of the profits. Within 2 years of the spin, all of these shares will be converted to Class A shares, of which 60 million will then be outstanding. GAM Holdings has stated that the Artio shares are a financial stake as opposed to strategic stake. The shares will convert in Class A shares in October 2011 at the latest, giving the looming threat of additional excess liquidity. The principals own 1% each of the holding company that contains the Artio business. The 60 million shares outstanding represent 98% of the underlying company.
Inside Ownership
There’s a balance between the stock price and inside ownership situation. A lot of the liquidity in the stock is the result of the principals selling shares in the company. While insider buying is a universally bullish signal on a stock, a more nuanced view is necessary on insider selling. It is simultaneously discomforting and irrelevant. As long as the principals hold a meaningful stake in the company, there is a strong alignment of incentives. Now that the company is public, 2m shares in the form of RSU’s were issued to non-senior employees, which vest over the next 3 years. This further entrenches an alignment of interests in the entire operation and mitigates the potential dilution of aligned interests through the sales of the principals.
Without getting philosophical about what stake for the principals to hold would be considered “meaningful,” I would point out that there is a combined ~$200m of stock held by them still. They have gotten themselves a fair amount of cash out of their holdings, and it remains to be see how they will approach future periods when they can sell. This being the real world and considering that most managers are not Warren Buffett (who still has substantial wealth absent his stake in Berkshire), I’m not exactly shocked that they would look to diversify their wealth. While it is not the ideal situation, you are not paying a price for a stock that people expect to be everything but ideal. The principals also own 2% of the underlying company, which means they get 1% of the company’s profits passed through to them. This could potentially be destructive were they to do dilutive things with the other 98% of the shares to increase overall profits, but this 1% is outweighed by their public shares.
Valuation
This is the downside case based on the derivative earnings and EV/AUM valuations based on drops in AUM. The expenses are overstated by using 2010 expenses. There is greater variability in expenses if AUM/performance declines. Any upside through increases in AUM/positive performance is not accounted for. These various valuation situations reveal a margin of safety in spite of potential volatility in markets.
Downside and Risks
The company’s revenue is completely derivative of its assets under management. The main way to retain and attract more/grow AUM is performance. The long term performance metrics of its core strategies are industry leading, although recent performance has been disappointing. While it is difficult to allocate the blame, the recent outflow of assets is attributable to performance as well as changing institutional portfolio balancing. The International Equity funds (their flagship product) has underperformed the index in the past 1 and 3 year periods, which have slowed down the growth in the company. They haven’t done horrible by mutual fund standards and they’ve outperformed the index since inception. There is a risk the fund has “lost it” but it is the same people who have been running it since inception. If this is more than a temporary dip in performance, more assets could flow out.
Potential Upside
There is some upside potential in new fund launches. Their US equity funds are still small and have had a hard time since they launched in 2006. They have a High Yield Fund as well as a High Grade Fixed income fund with $4bn in AUM each. They’ve just launched a Local Emerging Markets Debt Fund (LEMD) , which is a logical extension of the international bent of the company as well as complimentary to their already established fixed income team. While no additional valued is assumed from the US equity or LEMD funds, the LEMD fund has strong potential to attract several billion more in AUM.
Additional Catalysts
The company has a buyback approved, which should be easy to complete with the low stock price and tons of FCF the company throws off. Increasing the dividend is another possibility. While I realize this does not quite constitute startling insight, the payout ratio is 10% and the buyback is only covering dilution from equity compensation.
As stated, the company throws off tons of cash flow. They have casually acknowledged the possibility of an acquisition. Done at a reasonable multiple – and most of the sector is not expensive – it might have the unexpected effect of boosting the stock price. It would give the company much needed diversity as it is considered mostly a one trick pony at this point with its International Equity fund family.
Comparisons
If you can point out errors in the comps, you can win a cookie. I used SEC filings, but I did not make many adjustments. I excluded Calamos Asset Management and AllianceBernstein because there were substantial adjustments to make due to their structure, and I wasn't sure if I was going to do it properly. Legg Mason is working through some of its own problems with the fall of Bill Miller and issues with money markets. Federated Investors core business has a lot less stickiness in it (money markets) and the fees earned are a lot lower. While the P/E multiple can be subject to manipulations, it is worth noting that money managers typically trade at above market valuations. I don't have a favored integer for the PE multiple, but 9 is definitely too low for Artio considering the many advantages of the the asset manager business model. An asset manager that trades OTC and is a real minnow that I wrote up a while ago, Hennessy Advisors, now sports a higher valuation with its recent run up.
Conclusion - The margin of safety on the downside is great enough that I'm not worried too much about where the upside will come from. From a pure valuation standpoint, Artio Global is cheap. There are no blemishes, outside of its concentrated fund offerings, that lead me to believe the company should trade at such a substantial discount to peers.
Disclosure: Long ART
Sunday, March 6, 2011
Open question to readers on China Media Express (CCME)
I realize I'm on an SEO roll talking about GMCR, Walmart, and now CCME - I will resume talking about stocks that nobody else is shortly. I don't have anything to share about CCME, but am curious if any readers have anything to share about the situation in an archetypal sense. I look at the situation and its clear I might have more insight into what its like to have breasts. I wouldn't really know where to start. There's a lot of conjecture in the debate that seems based on assumptions rather than knowledge of the operations of auditors, the industry it operates in, and the incentives of all the agents involved. This applies to both sides of the argument.
My question to readers: I can definitely conjure up many examples of successful shorts of touted frauds. Can anyone think of a successful long thesis based on a company not being a fraud? Not in the sense that a long is inherently based on the company existing. Has there ever been a company that people thought was a fraud and someone swooped in and took advantage of the uncertainty?
Talk to Andrew about a successful long thesis on a company not being a fraud
My question to readers: I can definitely conjure up many examples of successful shorts of touted frauds. Can anyone think of a successful long thesis based on a company not being a fraud? Not in the sense that a long is inherently based on the company existing. Has there ever been a company that people thought was a fraud and someone swooped in and took advantage of the uncertainty?
Talk to Andrew about a successful long thesis on a company not being a fraud
Thursday, March 3, 2011
Walmart: Offering bargains at more than its stores
Ever since Walmart has been turning around its imagine with consumers, it has been suffering on Wall Street. I hate to frame commentary on stocks in such a way, but its approaching a territory where it becomes more attractive to Warren Buffett. There's plenty of speculation based on people's own personal predilections about the elephant Buffett is about to take down. I'd like to think that my musings assume more prescient form, because as I always do, I'm going to refer you to the excellent description of exactly how Warren Buffett invests. The key takeaway in this instance is that ~14x earnings is the sweet spot for a lot of big cap value stocks that Buffett invests in. He also mentioned on CNBC that he has been buying more, and as far as valuation goes, Walmart keeps getting cheaper.
Walmart now trades at 12.5x earnings. Buffett has said in the past that his biggest mistakes were ones of omission as opposed to commission. One of the biggest? Not buying more of Walmart in the mid 90s. He has stated he believes it cost $10bn in shareholder value, because the price moved up a little after he started to buy and so he backed off. I don't think it takes any conjuring of Buffett or pondering his rationale to understand what would make Walmart an attractive investment.
A lot of people get bearish on the stock by taking a short term perspective and not looking at the business. The company has some warts with the potential class actions lawsuit from female workers, perpetual demonization by unions, potential increases in prices of Chinese manufactures, and stalling US growth. Even the last point, while potentially a stumbling block, has the miasma of poorly thought out short term market views. None of these really have an effect on the long term prospects of the stock.
Rising prices from its Chinese based manufacturers? Is that really the best you could come up with? Walmart's low cost advantage is not who it gets its products from (Walmart gets its products from Hu. Who? Hu. Walmart gets its products from Hu. No, I asked you Walmart gets its products from Hu....readers, I'm sorry you must tolerate my occasional daliances with unhumor). The advantage is in how. Wherever and from whomever it may import products from doesn't negate the advantages of its world class logistics and economies of scale. Will this maybe cause some short term ripples in the supply chain? Sure, just like its always been a huge issue for the company (sarcasm). Is the long term health of the company at risk? No. Walmart will retain its value proposition whether prices are X, 2X, 3X+5, or ∞+1.
Look at the year-over-year growth of the company. Nothing gets more consistent than that. Every year the company reports higher sales and profits. This isn't the financial manipulation that General Electric used to commit through its GE Finance arm. This isn't some deriviatives induced phantom profit like Enron. It earns great returns on capital. It increases its dividend every year and buys back its stock. This is all in spite of stumbling in Germany, Korea and smaller store footprints in the US, a tough economy, and public image issues. This company is totally shareholder oriented, a low-cost operator, and has plenty of years of profitable and consistent growth ahead of it. When I first began investing, it was always about low PEs, dividend yields, buybacks, and growth when it came to an explanation of what makes a good stock to buy. Walmart is a simple company that checks off on just about every point on a checklist of stocks worth buying.
I look at the price its at right now, and Mr. Market is not in a depressive state, he's in a hallucinogenic state. It doesn't take a genius to understand Walmart (see above for proof). There is upside and a margin of safety, but not as much as one can find in smaller stocks if they put in the effort. For all my lovely readers running billions of dollars (real or otherwise), it's worth pointing out that a company liquid enough to move the dial in a large portfolio is trading at a price as cheap as it has been in the past decade based on earnings. I thought the blogosphere deserved a quasi-factually backed pick of a company that Warren Buffett might buy as opposed to the headline grabbing junk being printed (I feel like if I criticized a specific pick, I would end up eating my words, but many of the companies being touted don't really fit the typical Berkshire bill). It helps that he has already bought shares of the company. Not that I have any specific insight, but it wouldn't shock me to see him buying more at these levels.
Disclosure: None.
Although my writing is somewhat convincing, I'd rather have the capital free to take advantage of opportunities in smaller companies. I thought it was still worth pointing out though because the company issued guidance in line with analyst estimates and has fallen ~10% in the past month or so. Not exactly distressed, but noteworthy nevertheless.
Subscribe to:
Posts (Atom)