Strategies for Silently Scuttlebutting

The internet is one of those tools that should theoretically be a boon for the investment process.  If you consider anyone who buys and sell shares on public markets as an investors, this is very far from the case.  There is an almost infinite supply of crap on the internet.  It's actually mindboggling.  Conversely, Michael Price used to take rolls of dimes to the NYSE to photocopy 10-Qs.  I’ll take the tidal wave of information from the internet over such a monotonous barrier to simple information.  I would get frustrated without ctrl+f even though it would mean avoiding the distraction of reddit.  He didn’t even an iPod to listen to during photocopying.  How ever did the world function?

Most of the stuff you will read on the internet is useless.  It’s not enough to do a simple google search for a business and see what comes up.  There are tons of SEO firms out there trying to keep up with the system and tons of faux content creators.  How could anyone forget the quantum leap in innovative technology achieved by Demand Media?  Oh, wait…

That being said, I like to do some research beyond SEC filings on companies, especially public facing ones.  Conference calls and presentations are alright, but everyone knows that a business will think highly of itself and believe they have so many opportunities.  The internet – or a library, if those still exist – is a great repository of experiences and information.  You don’t need to call up local businesses or visit factory sites to learn a lot about a company or industry if you can find the right information on the internet.

Scuttlebutt is what Phil Fisher called his method for gathering a lot of qualitative information about companies.  How do customers see the business?  How do competitors see the business?  How important is the industry to other businesses?  What type of pricing power do they have as demonstrated by how their products are used?  Is the CEO a hard worker?  All those kinds of things you want to know about a business, but don’t exactly get presented in a perfect package that directly answers the question.  You aren’t going to find reviews by water utility workers letting the world know what they think about a Xylem pump.

Reading periodicals like American Banker or Oil & Gas Journal would be nice if they didn’t cost so much.  For example, I wrote about HomeFed a while back.  They are a land developer in Southern California.  There is a very media savvy realtor in the form of Jim the Realtor who operates specifically in North San Diego County.  He uses his site, bubbleinfo, to discuss a lot of local and national real estate issues.  I know you’re not supposed to ask a barber if you need a haircut, but there would be no other place to go if you wanted some informed conversation on hair dye or other care products.  The same goes with someone looking for a view on the housing market. 

There was a Calculated Risk link to a post where Jim the Realtor claims that the market is really starting to heat up for those with the resources since rates are so low.  Jim posted on his site about the negative reception it received when linked to on Business Insiders (side note: it is beyond my comprehension why commenters on articles on news aggregators with 1000+ comments will somehow reach the penultimate conclusion in a labor vs. capital debate or something of that nature).  I think it's pretty clear he is a realtor and his online presence helps him sell houses, but that doesn't mean his views are automatically void of insight.

Jim’s youtube channel is actually a treasure trove of real estate knowledge.  I am but a pup, but would anyone else show you how shitty the location and construction of house was like he does in this video?  Or this video on red flags of drywall repairs.  My point is that he isn’t just shoveling nonsense on the web to sell homes.  He is a great resource to gain additional perspective from individuals participating in San Diego real estate.  The tips about cracks in the concrete slab or how huge power lines will make noise when its humid are not things I learned in high school.  I think after watching a couple videos, you can get the idea he is competent.  There's insight in the foreclosure, bank owned, new construction, and regular real estate market.  It’s an informed perspective on real estate and as long as you understand who is doing the informing, it isn’t a problem.  I do worry about him driving and videotaping at the same time though.

  

Another bountiful source of business intelligence is The Consumerist.  I can’t speak more highly of Consumer Reports as an institution, so I will refer you to these articles.  Basically, Consumer Reports is a nonprofit organization wholeheartedly dedicated to blunting the greed of corporations for the benefit of consumers.  They praise those that provide quality customer service and heap opprobrium on those that torture their customers.  They have dedicated tons of coverage to the horror behind all those gold4cash commercials on TV.  They’re just legit from a consumer’s perspective.

That they essentially curate the opinions of consumers and post them on their website is very useful for anyone looking to properly deal with cell providers, airlines, or cable companies.  There are posts from the mailbag about very positive or negative customer experiences.  Is there a chance some companies concoct elaborate schemes to covertly praise themselves?  Sure.  But the complaints and praise are fairly well documented.  I'm comfortable taking The Consumerist at close to face value over angry Amazon reviews from even more anonymous parties.  This is a great way to find out how a business treats their customers.

Another source of scuttlebutt are the Sequoia Fund annual meeting transcripts (05, 06, 07, 08, 09, 10, 11).  These guys are savvy investors who dig really deep into companies.  Knowing this, their opinions are worth something.  Most websites of asset management companies talk about how they speak with management and all that jazz, but it is just a sales pitch to make people feel comfortable about parting with their savings.  These guys really do speak with management, competition, customers, suppliers, employees, and everyone in between.  All of the transcripts contain distilled wisdom about various businesses and industries.  Is it a reusable tool?  No.  But the transcripts contain nuggets of insight on plenty of businesses that might interest a value investor.

And for better or worse, consulting businesses capture the zeitgeist of the corporate world.  Consulting is paying somebody else to abscond responsibility for your own incompetence.  Business is and always will be brisk to say the least for such a service.  If you want to know what schemes will be foisted on businesses you might own, look no further than the McKinsey Quarterly or Strategy + Business, a Booz & Co production.  The people behind these are smart people, but they clearly have an interest in pitching their product.  You can still gain insight into bank IT systems or web based mobile strategies, which will probably have a broad impact in the future.  These are ideas and strategies that get sold to corporate America.  Through self-fulfilling prophecies or their own innate wisdom, these guys have an impact and it is worth seeing what they have to say about certain industries. 

So there’s plenty of well-articulated expertise on various subjects out there on the web.  You will never find an unbiased opinion out there.  I suppose the trick is to just read a lot, and you will have your bases covered when the need arises for insight on a specific industry or business.  Above are just a few sources that I’ve found useful from time to time.  

What other resources have you found useful for scuttlebutt on various industries or businesses?

Uncertainty, Technology, Content, and Tangible Examples

I'm easily contented in certain scenarios with uncertainty.  DreamWorks Animation, which I recently wrote up, faces an uncertain future in regards to DVDs.  While they have historically been a major contributor to profits, there is a clear change as the digital era gains traction.  I recommend The Black Swan and I consider it a key intellectual text for investors - you can find the same intellectual strains in texts from Ben Graham to Stephen Jay Gould, but Taleb's writing is particularly approachable.  

One of the key points is not to focus on details you can't control, but instead on creating robust systems.  Just-in-time lean inventory is fragile, where as having 2 eyes, kidneys, and lungs is robust.  Most debt free companies are robust.  They can lose a customer or lose production in a natural catastrophe, but bounce back. 

Taleb doesn't like stock pickers, having famously (among the value investing circus) declared that he is much more certain Soros is a better investor than Buffett.  I think a person that genuinely adheres to an empirically rigorous margin of safety approach with investing is implicitly recognizing black swan risk and the limits of their intelligence.

Am I a good example?  No.  I try but I know there are blind spots in my approach.  I write this blog in part to help myself recognize blind spots either in hindsight or with the help of kind readers.  Many people - including prominent "value investors" - do not adhere to this.  I'm sure this is where psychological biases and individual human inclinations play a role, but I have read plenty of stock commentary that is sloppy, self-serving, and nearsighted.  There's no exam to pass to in order to call oneself a value investor or a practitioner of Buffett style investing. 

But an intellectually honest approach to valuing a company, then halving it, discounting it, or handicapping it in someway will make money over time distributed over enough opportunities.  The problem is less the approach and literal activities involved than the person tasked with actually executing them.  The way I read The Black Swan was that there is nothing wrong with the world itself, it's how humans overlay a shoddy and disingenuous perspective on everything.  And alas, investing properly is not about figuring out what a company might be worth tomorrow if they do XYZ successfully, it is about figuring out what it is worth today and paying a lot less.

One aspect of uncertainty is technology.  Technology risk is increasingly pervasive in investing.  The rate of change is increasing across industries.  What effect will 3D printers have on UPS and Fedex in 10 years?  Does Comcast have a viable future physically piping information around the country?  Will tobacco leaf merchants get cut out of the supply chain?  Taleb addresses technology and innovation as evidence for how flawed our thinking can be on occasion.  If we actually knew what technology would exist 10-20 years from now, we would already have it.  Look around today and simply observe all the technology exists today.  Nobody knew the world would exist as it does today 50 years ago. 

So I recently wrote about DreamWorks Animation and have gotten some criticism from readers over casually brushing aside the fact that DVDs are in a terminal decline due to increasingly common digital distribution mediums.  I don't know how you figure out the effect.  I could take a static view, which is that studios have no way to replace the profits from DVDs.  There was once a time when Amazon made a lot of money from selling physical books.  There was once a time when Netflix actually sent movies to people through the US Postal Service.  There was once a time when America used to make things! 

I don't know if there is specific historical insight to be gained from looking at the CD industry's decline, but it's an example of destruction wrought by technology.  The decline of the DVD won't mirror it exactly.  Both reflect the underlying change that occurs when disruptive technology interferes with a good thing.  The decline of the CD means one thing.  When consumers get ripped off for countless years buying 2 songs with 10 other audio clips of half-baked garbage, they will jump at the opportunity to pay nothing.  Were CDs wonderfully profitable?  Yes.  The distributors made off like bandits.

Is music dead?  No.  Revenue for artists has shifted to concerts, the number of middlemen is reduced, and quality content still realizes its ultimate value.  Rappers have not gone from Maybach driving drug dealers to rollerskating crack whores.  Even mediocre bands like OK GO have used technology to their advantage.  Think of their epic single shot Rube Goldberg contraption in sync with music.  One of their band members even outlined what the hell is going in the Wall Street Journal.  They sell albums as a result of this – as in people BUY their music, go to their concerts, and splurge on band shirts.  That Rube Goldberg music video was paid for by State Farm.  YouTube splits ad revenue with the band.  One estimate is at least $2 per thousand views once a video goes viral.  They have a good amount of creative low budget music videos with millions of views.

Just another example of content getting monetized.  Epic Meal Time.  These folks just make gluttonous food while cursing, drinking, and joking around.  They sell shirts, pitch Netflix accounts, and probably have other sponsors (they were in Gymkhana 4, a video sponsored by DC Shoes which is just some dude driving around and doing cool stuff with a car).   

Howard Stern is still making hundreds of millions off of a radio program.  Radio is so long gone from being the dominant content distributor it once was.  Yet here is an example of someone who is able to engage an audience skillfully who is finding a way to be compensated for it.

And one more because I have seen every video on YouTube and ponder the business side – this guy has a sponsor that splits revenue with him to make videos of shooting guns and speaking in a fake Russian accent (he has a shade under 300 million views on his uploads, even if he makes $1/thousand views…).  I've read some stuff that he is sponsored, but this is clearly some type of business venture.

Now maybe you want to debate whether or not YouTube content will erode the value of television and movies.  If the costs are lowered, the benefits rise, and technological barriers removed, movies and television must be dead if cheap competitors enter the fray.  I don’t view any of these as mutually exclusive.  People still listen to radios despite the medium being old and usurped by technological advances in the minds of some.  As Stephen Jay Gould would say, you are focusing on one outcome that exists in a system of variation.  There is plenty of room in the content ecosystem for different value propositions and mediums – the point is for the content to be sought after.

The issue is that it is impossible for one to prove or disprove the idea that DreamWorks will find a suitably profitably alternative to DVDs.  It isn’t just the content producers that profit immensely form them.  Walmart, Best Buy, and Target love selling these things.  In 2 square feet, you could stack up 4 across, 5 deep, on 10 tiered levels for $10/each (think of it as part of a shelf or a rotating tower).  That’s $2000 or $1000/square foot.  On average Walmart does ~$450-500.  I don’t know exact figures, but I doubt any foodstuff with a similar volume or display cost generates the same profits.

None of this really supports the idea that DreamWorks will find a substitute for DVDs.  I have no idea what it will be.  I was reading the transcript of a Disney investor conference and there is endless discussion about content.  While DreamWorks Animation is not Disney, they face the same opportunities and uncertainty in the future.  There is no IP behind distribution strategies.  Like with any retail operation, if Disney unlocks the trick to making money, DreamWorks Animation will be able to follow suit.

The introduction of Blu-ray and paid video on demand (VOD) has not replaced the overall decline across the Domestic In-Home Entertainment segment.  VOD is not as profitable and Blu-ray, as far as I’m concerned, is just a more expensive DVD that doesn’t really take anything to the next level.  This presentation highlights a few slides in the opportunities.  Electronic sell through, blu-ray, and superset bundles are actually more profitable per unit than DVD according to the presentation. 

This is important for a few reasons.  First, I think blu-ray is dumb.  It’s just a concocted excuse to get people to restock their home entertainment collections.  The reason it hasn’t taken off is because you look at a blu-ray disc and a DVD and you probably really don’t care about the difference.  People aren’t that stupid.  People already have a data container with a movie on it that doesn't require physical rewinding.

The content has control over how it gets distributed.  A Superset Bundle can be a blu-ray DVD combo with an option for a digital copy or an older prequel title.  Increasingly as consumer adoption permits, they will be able to cross sell digital right with a bundle and electronic sell through.  Basically, the 12 oz. mustard is now 10 oz. but the same price.  When you produce desirable content and through trial and error find the value proposition for the consumer that still allows attractive return, you don’t need to worry about the medium.  Perhaps blu-ray is a false dawn and people will restock their digital libraries with film rights once cloud services are introduced or the Netflix deal will make up for a chunk of what is currently thought to be lost revenue.

Everyone knows that the DVD is dead.  Long gone.  Does DreamWorks Animation have an alternative revenue source?  Will people still want to watch a movie again after they see it in theaters?  I don’t like saying things are “priced into” a stock, but Mr. Market is definitely indicating that something in DreamWorks Animation’s future isn’t bright. When faced with uncertainty, there are really only two things you can do: focus on downside protection, and make sure there are intelligent people working on solutions. 

Perhaps this is a self-serving justification for my write up.  All the above is simply identifying content and how it gets monetized one way or another regardless of technological medium.  There is such a variety in mediums that it demands an extrapolation of its effects.  There are new mediums emerging and new strategies to deal with them.  While there is uncertainty as to where profits may come from, these things have a way of sorting themselves out.

If you have examples of the contrary, please share.  Perhaps I suffer from the confirmation bias.

Edit - Naturally, I forgot the newspaper industry.  Are newspapers middlemen of news?  No.  Plenty of newspapers, which produce daily content that many people consider a necessity, have suffered over the recent decades.  Readership is dwindling, free alternatives have emerged, and the classifieds advertising section is obsolete.  Alas, I believe that publications like the NY Times and Wall Street Journal will continue existence in some fashion.  The economic situation at the NYT was much more dire 4-5 years ago when they were flat footed in response to the digital era.

Bill Ackman, in that recent Bloomberg interview, mentioned how he thought Murdoch overpaid for Dow Jones/WSJ and there was a vanity aspect or trophy asset mentality to it.  Well he has successfully transitioned subscribers to an online pay wall, increased prices annually for it, and circulation has been increasing.  People will pay for good content.

Can a like for like comparison be drawn between the death of the DVD and the emergence of craigslist and free classifieds?  Possibly.  Piracy is any issue, which equates free after market content consumption.  The above mentioned Disney presentation highlights increasing bandwidth speeds as a potential source of increased piracy in the future.  As some of Disney's initiatives hinted at though, they are still figuring out ways to maximize their profits in the home entertainment segment. 

Housing stock #1: American Woodmark

American Woodmark (AMWD) is one company I’ve looked at as a company whose stock price is among the rubble of the recent selloff and is related to housing.  It’s an understatement to say they have a simple business.  They make cabinets.  I think I can understand this.  There are certain factors that are appealing – capable of 20%+ ROE in good years, chairman owns 24% of the company, and a net cash position.  I didn’t find much of a competitive advantage though as they are heavily reliant on Lowe’s and Home Depot for 70%+ of their sales.  While I don’t think people will find new ways to store their dishes and whatever else people put in cabinets, the heavy concentration on one product line and 2 selling channels makes this a pass.  It’s an interesting example of competitive dynamics and insightful for future analysis.

It does not get more boring than this.  American Woodmark makes cabinets.  That's it.  Just wood, screws, hinges, and a coat of paint/veneer/lacquer.  There's no secret sauce here.  No hidden assets.  Their owned manufacturing plants are in places like Gas City, Indiana or Hardy County, WV (that means the middle of no where, not even an incorporated municipality).  There's really no angle here other than the pessimism surrounding its current industry.  They were originally a division of Boise Cascade in the 1980s until a management LBO.  

The company is sort of cheap.  They actually canceled their dividend at the end of August as well, which practically had no relative effect since it coincide with a broader selloff.  The company has averaged $0.92/share or $15m in net income over the past 10 years.  It’s earned ~$30m in good years and lost ~$20m in bad years.  The 10 year average ROE is 7.82%.  At a current price of $13/share, it definitely will be worth more in a housing recovery since earnings will be above average.  The business has remained cash flow positive due to cutting back discretionary capital expenditures and closing down plants.  Bankruptcy risk is arguably minimal due to a net cash balance of $45m ($70m cash, $14m is restricted contingent on the $25m debt from its revolver).  Their defined pension benefit plan is underfunded by $38m using an 8% return assumption, so while it won’t bankrupt them, the financial condition is not as stellar as a passing glance would lead one to believe.

I think this indicative of several things, but importantly it is a reason to be hesitant about the qualitative attractiveness of the business.  Sales growth through the boom came on the back of Home Depot and Lowe’s.  There are instances – power tools, white goods, etc. – where people are going to come in and buy exactly what they want, but Home Depot and Lowe’s both have exclusive brands that American Woodmark produces for them.  They account for 70%+ of sales, so you tell me who has the upper hand in this relationship.

I don’t like to just say something then hope the facts bear this out.  There are certain instances where a concentration of sales isn’t awful.  Defense contractors don’t seem to get the short end of the stick, which is a pity for taxpayers but not shareholders.  Why do I think AMWD doesn’t have this kind of relationship? 

From Fiscal 2002-2006 (April start), revenue went from $499m to $838m, or a 68% increase.  During this same period A/R + Inventory went from $66m to $122m or an 84% increase.  This slight divergence in revenue growth and A/R + inventory isn’t terribly worrisome on its own, but A/P only grew from $23m to $34m, or a 47% increase. 

So working capital didn’t grow in line with revenue, it outpaced it.  If you just use the difference between A/R + Inventory and A/P, it went from $43m to $88m, or a 102% jump.  So the increased volume AMWD was doing with Lowe’s and Home Depot went solely to the benefit of the retailers.  That isn’t it either.  AMWD has to install their own promotional displays at these stores and the cost sits on their balance sheet at $6.6m in the most recent quarter.  That’s just another indicator that they don’t call the shots.

Another way to skin the cat is observe that from 2002-2006, the company’s sales went from $499m to $838m, but net income went from $32m to $35m.  That they couldn’t eke out more than $3m in profit from $339m in revenue from the scale of producing more cabinets indicates zero operating leverage, which is bizarre.  Even when the sky knew no limit, they didn’t go along for the ride – although they are no suffering from it.  The ROE from 2000-2006 actually dropped from 22% to 14% during a housing bubble!  So the business quality actually declined since it took a greater investment on behalf of owners to maintain the same amount of profits. 

In my prior post on housing, I mentioned how it wasn’t intelligent to simply pluck numbers from historical results and assume they will be achievable in the future.  In the past 12 months, AMWD has had $474m in revenue and reported losses of $20m, whereas in 2002, they reported profits of $32m on $499m in revenue.  The difference?  Even though AMWD and plenty of others have closed down plants and cut down on, the market is still weak.  Straight from the 10-Q:  “the Company’s largest remodeling customers have continued to utilize aggressive sales promotions in the Company’s product category to boost sales.  These promotions typically included free products and cash discounts to consumers based upon the amount and/or type of cabinets they purchased.  The Company’s competitors have participated vigorously in these promotional activities and the Company has generally chosen to meet these competitive offerings.”

In both good and bad times, the market is pushing around AMWD with little control over their destiny.  In their defense, management is doing a good job operationally.  They are turning their inventory over 18x annually or every 20 days.  Not that it’s in any way comparable, Owens & Minor, a company I’ve written about, turns their inventory over 10x and they consistently get awards for being a very efficient distributor.  Dealing with a tangible good like cabinets, its impressive that they achieve this.  It is a shame they aren’t achieving attractive returns as a result though.

AMWD never maintained steady margins through the boom (declining in fact) so it is difficult to peg a “normalized” earnings range.  If they managed a 10-12% ROA like they did in 2002-04, earnings could be $26-32m.  Even though 6-7x normalized earnings is a generally attractive proposition, the paucity of returns makes the business unattractive to own and the customer concentration creates risks to achieving normalized earnings.  They do have the financial wherewithal to be around for a housing revival assuming they don't lose their key customers.

Housing stock and housing stocks

If you watch the recent Charlie Rose interview with Warren Buffett, or pretty much any recent interview with friend of the blog Warren, he always chimes in about housing.  Not next quarter on some specific date, but his general sentiment is that housing will recover.  Is this really something worth debating beyond the issue's ability to generate hits, clicks, and magazine sales?  The US is now supplying fewer houses than the long-term demand, and sooner or later this will kick in and new homes are going to necessary (homes, apartments, trailers, etc.).  This seems logical when viewed with a bird’s eye perspective, but it’s clearly no surprise that this does not seem intuitive if one were to extrapolate the current weakness in the US economy.

Prior to the go-go years when people would be flipping Miami condos a dozen a day, the only thing sexy about the housing industry was shag carpeting.  All of the businesses associated with the industry are dull, but I think there is a strong likelihood that there are gems in the rubble.  In the past few months, a basket of stocks I would broadly define as housing related has dropped even more than the market (30-40%), so I’ve begun poking around.  This has much more to do with cheapness relative to some vague conception of normalized earnings power than some macro call.

For those who look beyond Berkshire’s insurance operations, another major contributor to the company is housing related industries: Shaw Industries (carpet), Johns Manville (insulation), Acme Brick, MiTek (connectors), Clayton (trailers), and Benjamin Moore (paints).  If you look at the 2000-2006 letters, the housing related businesses get mentioned as easy to understand businesses that make attractive returns on tangible capital over an economic cycle.  For once, I don’t think he is making it sound a lot easier than it really is.

With the exception of Clayton, all of these businesses contribute a small but important part to the final product.  Instead of paying Michael Porter to reveal a secret of the business world, I’ll just throw it out there for free.  When someone produces a product that is a very small but crucial element to an entire system, it creates a competitive advantage.  Whether or not the competitive advantage is exploited will reveal itself in the financials.  Shaving 30% of your costs off an input that is 1% of your total cost is meaningless to the bottom line if it means your end product is crap.  Such a cost differential becomes increasingly irrelevant as the expected life of the product increases.  This is probably why stuff like backyard furnace steel is usually not a hit.  Nobody wants to drive over a bridge or sleep in a building made with that stuff. 

Cheap imports exist for sure, but there is a degree of brand equity and reputation for certain products.  Never doubt that there are people always looking to cut corners and eke out a couple basis points more of margin.  In at least one instance, the relative cost of a slightly more expensive initial input is vastly overshadowed by the legal costs and damages stemming from issues like Chinese drywall (links, links, links if you don’t remember reading about this).  The concentration of these issues in Florida might suggest purchases of inferior inputs are linked to more speculative builders and the broader industry is reliant on reputable suppliers, although perhaps it is a self-serving interpretation.  One might say that it means domestic producers are facing pressure.  Not every input for a building is supplied by someone with a competitive advantage.  MiTek, which makes truss connectors, has a competitive advantage because people don’t care about relative savings of $200 on a $100,000 building if it means the roof will cave in.

I don’t think the above narrative that every housing related company makes a small part of a larger system is correct, but I think it is the right qualitative aspect to seek in the sector.  All of the write offs and restructurings over the past 5 years should have them on solid footing by now in terms of cost structure.  A house that is worth $100k or $800k still needs sinks, cabinets, doors, etc., so one isn’t betting exclusively on a recovery in home prices, even though that will probably be the evidence that many people point to as housing recovering.  Certain industries such as gypsum or concrete may not have obvious competitive advantages that stem from brands, but they can be low cost producers and be able to survive just a little longer than the other guy.  All of these factors should minimize the need to fret over the macro picture, in addition to buying the companies cheap. 

To bring this back to what Buffett is talking about with housing, nobody really knows exactly when it recovers.  The rocket science is in recognizing people need places to live and there are going to be more people tomorrow than there are today.  The calculus is fudged since household formations are being pushed out by poor economic prospects.  Perhaps I’m being stubborn in assuming people will always want to eventually live without their parents or friends.  The average in annual housing starts from 1959-2010 was ~1.5m and recent years have been well below that – ~.6m in 2010.  Is there a huge risk in betting on a reversion to the mean in the next 5 years with a skewed risk/reward scenario due to the prices of the relevant businesses?

So even though incremental demand exceeds incremental supply in theory, the lack of household formations isn’t tipping the balance.  There’s a chicken and egg problem with people talking about how housing will get the economy going again, when the inverse is equally true that getting the economy going again will boost housing.  As Sam Zell pointed out in a recent interview, there are actually more single family homes rented than apartments in the US.  Home ownership rates and house prices are not the only things that matter, since people need places to live.  There are many dueling data points.  Time is an oft-ignored factor that has an effect on the economy, but nobody talks about it since there is nothing they can do about it - no articles to write when all people should do is wait, no sales commissions to be generated, no political talking points.

I can’t calculate any of this with precision, but feel comfortable stating that the housing industry will revert to the mean sometime over the next 5-10 years.  If there is a business that trades at 5x normalized earnings and will survive, you have a double or triple bagger within the next 5-10 years if it eventually trades at 10-15x normalized earnings, which produces a nothing to scoff at 15-30% annualized return.  A bias to avoid is just picking earnings from 2004-2006 and thinking that’s “normalized” – housing starts were well above the 1.5m average then (easily adjustable graph of all the data).  Can we just pluck earnings from years when housing starts were 1.5m, then?  No.  Plenty of companies have closed down facilities in the past 5 years, so perhaps differing competitive dynamics will emerge with better positioned suppliers. It's not so simple that tossing around multiples and gathering evidence to support self serving normalized earnings will generate investment returns.

I don’t know what will fix housing and I don’t know what will happen.  I do think the current macroeconomic rumblings from everyone are myopic and present an opportunity.  Well capitalized, cash flow positive, housing related stocks with a demonstrated history of attractive returns over a cycle, and then wait sounds like something that might work.  This is an edge for long-term value investors since it requires patience and a temporarily contrarian perspective. 

DreamWorks Animation (DWA) Summary

I'll assume that like me, you don't jump to read 14 pages of potential pablum by some random stranger you happen on through the internet, so I'll distill the key points of my DWA write up.  DreamWorks Animation (DWA) is a well-run company that is trading below what shareholders would receive in an orderly runoff.  The company is focused on the most profitable segment of the movie industry and its content can be further monetized due to the brands created by the movie characters in ways that ordinary films cannot.  They operate in an oligopolistic industry with high barriers to entry and owner-operator management.

Valuation Comparison
	Dec-05	Oct-11
Film Library	10	23
Blockbuster Franchises*	2	4
Borrowings	194	0
TTM Net Income	104	168
FD Shares Outstanding	104,062	84,565
Share Price	$25	$19
Market Cap	$2,601,550	$1,606,735
*Shrek, Madagascar, Kung Fu Panda, How to Train Your Dragon

1. Value – I estimate that in an orderly runoff, the business is worth more than $19/share, or the current market price.  The current book value is $15/share.  Every $100m the 8 films carried as inventory on the balance sheet generates in profits over the next 2-3 years is worth $1.18/share (figure ~$200m or $2.36/share).  Were DreamWorks to sell their library and related intellectual property at the same revenue multiple (2.2x) as the Miramax library sale, it would generate another $321m or $3.75/share fully taxed.  I believe these numbers are conservative based on historical performance of DreamWorks movies and prior content sales.  In a runoff, DreamWorks shareholders would receive at least $5-7/share in excess of $15 of book value for a vague value of $20-22/share, or 10-20% higher than the current price (see full write up for discussion and why the vague value is vaguely more valuable than I posit here).  This implies that future movies released will destroy value, although quite the opposite is much more likely.  As a going concern, it trades at 10x earnings, but figuring out future earnings is impossible.  If it trades below runoff value, you don't really have to take a punt on guessing what earnings will be over the next 5-10 years.  If it resembles the past, shareholders should do fine.

2. Profitable Growth Runway – As the combined tailwinds of a growing global middle class and higher per capita revenue due to 3D take effect, revenue per film will increase, even if reception is average.  Both require very little action on behalf of the company.  The company has increased film output from 4 films every 2 years to 5 films, which should further capitalize on this trend.  The 3D film production process adds $10-15m in costs to each film and a rising global middle class is free.  The animated film industry is oligopolistic, communicating in plain sight release dates to avoid competition over audiences.  A focus on declining DVD sales neglects the increasing mediums for distribution requiring desirable content like that produced by DreamWorks.  So even if the company releases the qualitatively similar movies as it has done in the past, it will actually achieve greater quantitative results.

3. Incremental Reduction in Cost of Failure – The company has never been stronger with a film catalogue that has the depth of 4 franchises – Shrek, Madagascar, Kung Fu Panda, and How To Train Your Dragon – that can be monetized through various licensing agreements from live entertainment to TV shows and toys.  This creates a cash stream that requires little-to-no incremental investment and is independent of the film business.  The business is debt free, which reduces fixed costs and removes any pressure from the company to enter lousy deals to meet payments.  Both of these factors are abstract, but make the company very robust, a necessity in an industry with uncertain film-by-film success.  This strength has allowed the company to increase its rate of film production.  Every successful film released that creates a new franchise lowers the company’s reliance on creating successful films in the future to drive profits.

4. Management – The full name of the company is DreamWorks Animation SKG.  The SKG stands for Spielberg, Katzenberg, and Geffen.  All have a meaningful stake in the company.  Katzenberg takes all his compensation in stock options.  Katzenberg has a long-term track record of success in the animated film industry reaching back over 20 years.  He has made mistakes like anyone else, but has been able to create numerous profitable films over his career and at DreamWorks that outweigh the failures.  Most of the uncertainty surrounding the company - success of films, distribution agreements, future of DVD - should be tempered by the presence of a qualified management team and incentivized owners among other factors.  The SKG trio could have retired long ago if they were just in it for the money.

DreamWorks Animation write up

I uploaded my write up of DreamWorks Animation (DWA) to scribd which is embedded below.  If you are just a casual reader who would prefer to avoid my excessive ruminations, the following post will be the elevator pitch version.  If you want to follow my thinking, read the whole thing.  The reason for the length is that I pixelated my exact thought process and basically had a discussion with myself over various aspects of the business, rather than producing a dozen pages of solid gold.  We can look at it in 6-12 months or quarter by quarter and see how things are coming along.

I think the premise is clear - long term value creating company trading below what I approximate is a runoff liquidation value of the company.  DreamWorks has excellent prospects in a -flation and economy neutral industry, owner-operator management, clean balance sheet, and a good dose of growth from higher rate of film production and growing global middle class.  I'm not paying for this expectation.  I just decided to go on about all of this ad nauseum since that's how I enjoy spending my time.

If you hadn't heard, I'm looking for a job, which is one reason I try to be thorough with what I'm thinking (more about me here or just email me).  I also got accepted to the Value Investor's Club the other day, which I guess isn't that hard if I got in, but I guess it's worth mentioning as a seal of approval from a reputable source.

Dwa Write Up

Mutual thrift misdirection

I have some other ideas for specific applications of SJG’sideas to analyzing stocks, which may or may not just boil down to common sense.  Mutual thrift conversions are a category of stocks I can look back on in a different light after some reflection.  The quality of the bank is a distraction from capacity to return excess capital.  The quality of the bank is relevant in as much as it gives one confidence to purchase the shares and wait for the excess capital to be returned.  These aren’t growth stories, these aren’t quaint narratives of local firms doing “better banking”, and most of the qualitative appeal simply isn’t there with the crop from the past 2 years. 

The first thing I would look at is the quality of the bank.  It would be difficult to buy a bank on the thesis of excess capital being returned to shareholders without establishing that excess capital will exist in coming quarters.  If it doesn’t exist due to growth, I wouldn’t jump to a negative conclusion, but the growth would have to be qualified on the historical record.  But none of this is where you make money.  This is where you avoid losing money.

I just uploaded this write up of SPBC to scribd, which is more in depth than my post on it several months ago.  As is my hope with every stock I buy, it’s cheap at 65% TBV and slightly underleveraged for a bank at 11% tangible equity/assets.  They’re located in Plano, a solid economy for a bank to be exposed.  Now that the stock is publicly traded, the thinking is there should be incentives to properly manage the company to peer profitability. 

I don’t think this is how you make money though.  It should be returning what is excess capital and post conversion that can almost be the entire market cap.  So say a bank should ideally have a 9% leverage ratio, SPBC has 2% of its assets that can be returned to shareholders and the bank will still operate fine.  That’s about $6m in this case against a market cap of $20m, so a cool 30% gain and the bank still trades at 77% TBV.  If SPBC had a leverage ratio of 16%+ and traded at 65% of TBV, it would be a lot more interesting from this perspective.

The problem is that the world is not perfect.  I shouldn’t expect a $6m check in the mail any time soon.  This is a slim amount of excess capital.  This isn’t a very sound thesis.  SPBC may initiate a dividend and distribute some of the excess capital as they are allowed, but not to the degree that really provides a nice return in a short time frame. 

Abstractly, there are certain thrifts I stayed away from that never met the qualitative requirements, like Naugatuck Valley Financial, which I spoke about a while back.  In hindsight, they also stated a desire to expand, a de facto statement that I wasn't going to see any of that excess capital.  It’s only been several months, so it’s not like I can this based on an outcome, but the ones I bought were bought cheap and of decent quality.  It’s pretty hard to lose money with balance sheet by and large clean at a large discount to TBV.  They've held up well against the recent market swoons.

So like the dome and the spandrel, a quality bank is what holds up the possibility of gobs of excess capital being returned.  Will this always be the case?  No, but it’s more likely than not the proper aspect to be focusing on if you want to make money.  There’s nothing wrong with owning a quality bank at a cheap price, but there is no excess capital being returned which really creates the reward in the aftermath of thrift conversions.